This document provides an introduction to derivative securities. It defines derivatives as financial instruments whose value is derived from an underlying asset. The main types of derivatives discussed are options, futures contracts, and swaps. Futures and options markets originated to help farmers and commodity producers manage price risk and have since expanded to other assets. Swaps emerged in response to increased foreign exchange and interest rate volatility in the 1970s. Derivatives are useful for hedging risk but also enable speculation and can be misused, as shown by some major financial losses. The course aims to illustrate how derivatives are used for both risk management and investment.

1. © 2002 South-Western Publishing1
Chapter 1
Introduction

2. 2
Outline
 Intro – what are derivative securities?
 Overview and different perspectives
 Course Objectives
 Types of derivatives
 Participants in the derivatives world
 Uses of derivatives

3. 3
Introduction
 There is no universally satisfactory answer
to the question of what a derivative is,
however one explanation ......
– A financial derivative is a ‘financial instrument
or security whose payoff depends on another
financial instrument or security’ ......the payoff
or the value is derived from that underlying
security
– derivatives are agreements or contracts
between two parties

4. 4
Introduction (cont’d)
 Futures, options and swap markets are very
useful, perhaps even essential, parts of the
financial system
– hedging or risk management
– speculate or strive for enhanced returns
– price discovery - insight into future prices of
commodities
 Futures and options markets, and more
recently swap markets have a long history
of being misunderstood -

5. 5
Introduction (cont’d)
How many have heard of the following:
 Nick Leeson and Barings Bank $1.3B (1995)
 Orange County – California - $1.7B (1994)
 Sumitomo Copper $2.6 B (1996)
 Proctor & Gamble – $102 M (1994)
 Govt. of Belgium - $1.2B (1997)
....market type losses have often been attributed to the use of
‘derivatives’ - in many of these situations this has been the
case i.e a speculative application of derivatives that has gone
against the user

6. 6
Introduction (cont’d)
“What many critics of equity derivatives fail to realize is that the
markets for these instruments have become so large not because of
slick sales campaigns, but because they are providing economic
value to their users”
– Alan Greenspan, 1988
‘In our view, however, derivatives are financial weapons of mass
destruction, carrying dangers that, while latent now, are potentially
lethal’
– Warren Buffett 2002 Berkshire Hathaway annual report
’derivatives are something like electricity: dangerous if mishandled, but
bearing the potential to do good’
– Arthur Leavitt- Chairman SEC 1995

7. 7
Objectives of the Course
 To illustrate the economic function/ application of derivatives
 To understand their application in both risk management and
speculative situations
 To provide sufficient understanding such that the user can
make an informed and intelligent decision regarding the role
of derivatives in a particular situation and to identify the need
for better understanding before proceeding
…working introductory level knowledge of derivative securities

8. 8
Derivatives & Risk
 Derivative markets neither create nor destroy
wealth - they provide a means to transfer risk
– zero sum game in that one party’s gains are equal to
another party’s losses
– participants can choose the level of risk they wish to take
on using derivatives
– with this efficient allocation of risk, investors are willing to
supply more funds to the financial markets, enables firms
to raise capital at reasonable costs

9. 9
Derivatives & Risk
 Derivatives are powerful instruments - they
typically contain a high degree of leverage,
meaning that small price changes can lead
to large gains and losses
 this high degree of leverage makes them
effective but also ‘dangerous’ when
misused.

10. 10
Types of Derivatives
 Options
 Futures contracts
 Swaps
 Hybrids

11. 11
Options
 An option is the right to either buy or sell
something at a set price, within a set period
of time
– The right to buy is a call option
– The right to sell is a put option
 You can exercise an option if you wish, but
you do not have to do so

12. 12
Futures Contracts
 Futures contracts involve a promise to
exchange a product for cash by a set
delivery date - and are traded on a futures
exchange
 Futures contracts deal with transactions
that will be made in the future
 contracts traded on a wide range of
financial instruments and commodities

13. 13
Futures Contracts
 Are different from options in that:
– The buyer of an option can abandon the option if
he or she wishes - option premium is the
maximum $$ exposure
– The buyer of a futures contract cannot abandon
the contract - theoretically unlimited exposure

14. 14
Futures Contracts (cont’d)
Futures Contracts Example
The futures market deals with transactions that will
be made in the future. A person who buys a
December U.S. Treasury bond futures contract
promises to pay a certain price for treasury bonds
in December. If you buy the T-bonds today, you
purchase them in the cash, or spot market.

15. 15
Futures Contracts (cont’d)
 A futures contract involves a process
known as marking to market
– Money actually moves between accounts each
day as prices move up and down
 A forward contract is functionally similar to
a futures contract, however:
– it is an arrangement between two parties as
opposed to an exchange traded contract
– There is no marking to market
– Forward contracts are not marketable

16. 16
Futures/Forward Contracts -
History
 Forward contracts on agricultural products
began in the 1840’s
– producer made agreements to sell a commodity to a
buyer at a price set today for delivery on a date
following the harvest
– arrangements between individual producers and
buyers - contracts not traded
– by 1870’s these forward contracts had become
standardized (grade, quantity and time of delivery)
and began to be traded according to the rules
established by the Chicago Board of Trade (CBT)

17. 17
Futures/Forward Contracts -
History Cont’d
 1891 the Minneapolis Grain Exchange
organized the first complete clearinghouse
system
– the clearinghouse acts as the third party to all
transactions on the exchange
– designed to ensure contract integrity
 buyers/sellers required to post margins with the
clearinghouse
 daily settlement of open positions - became known as the
mark-market system

18. 18
Futures/Forward Contracts -
History Cont’d
 Key point is that commodity futures (evolving from
forward contracts) developed in response to an
economic need by suppliers and users of various
agricultural goods initially and later other
goods/commodities - e.g metals and energy
contracts
 Financial futures - fixed income, stock index and
currency futures markets were established in the
70’s and 80’s - facilitated the sale of financial
instruments and risk (of price uncertainty) in
financial markets

19. 19
Option Contracts - History
 Chicago Board Options Exchange (CBOE)
opened in April of 1973
– call options on 16 common stocks
 The widespread acceptance of exchange
traded options is commonly regarded as one of
the more significant and successful investment
innovations of the 1970’s
 Today we have option exchanges around the
world trading contracts on various financial
instruments and commodities

20. 20
Options Contracts
 Chicago Board of Trade
 Chicago Mercantile Exchange
 New York Mercantile Exchange
 Montreal Exchange
 Philadelphia exchange - currency options
 London International Financial Futures
Exchange (LIFFE)
 London Traded Options Market (LTOM)
 Others- Australia, Switzerland, etc.

21. 21
Swaps
 Introduction
 Interest rate swap
 Foreign currency swap

22. 22
Introduction
 Swaps are arrangements in which one party
trades something with another party
 The swap market is very large, with trillions
of dollars outstanding in swap agreements
 Currency swaps
 Interest rate swaps
 Commodity & other swaps - e.g. Natural gas
pricing

23. 23
Swap Market - History
 Similar theme to the evolution of the other
derivative products - swaps evolved in
response to an economic/financial requirement
 Two major events in the 1970’s created this
financial need....
– Transition of the principal world currencies from
fixed to floating exchange rates - began with the
initial devaluation of the U.S. Dollar in 1971
 Exchange rate volatility and associated risk has been with
us since

24. 24
Swap Market - History
– The second major event was the change in policy of
the U.S. Federal Reserve Board to target its money
management operations based on money supply vs
the actual level of rates
 U.S interest rates became much more volatile hence
created interest rate risk
 With the prominence of U.S dollar fixed income instruments
and dollar denominated trade, this created interest rate or
coupon risk for financial managers around the world .
– The swap agreement is a ‘creature’ of the 80’s and emerged
via the banking community - again in response to the above
noted need

25. 25
Interest Rate Swap
 In an interest rate swap, one firm pays a
fixed interest rate on a sum of money and
receives from some other firm a floating
interest rate on the same sum

26. 26
Foreign Currency Swap
 In a foreign currency swap, two firms
initially trade one currency for another
 Subsequently, the two firms exchange
interest payments, one based on a foreign
interest rate and the other based on a U.S.
interest rate
 Finally, the two firms re-exchange the two
currencies

27. 27
Commodity Swap
 Similar to an interest rate swap in that one
party agrees to pay a fixed price for a notional
quantity of the commodity while the other party
agrees to pay a floating price or market price
on the payment date(s)

28. 28
Product Characteristics
 Both options and futures contracts exist on a wide
variety of assets
– Options trade on individual stocks, on market indexes, on
metals, interest rates, or on futures contracts
– Futures contracts trade on agricultural commodities such
as wheat, live cattle, precious metals such as gold and
silver and energy such as crude oil, gas and heating oil,
foreign currencies, U.S. Treasury bonds, and stock market
indexes

29. 29
Product Characteristics (cont’d)
 The underlying asset is that which you have
the right to buy or sell (with options) or to
buy or deliver (with futures)

30. 30
Product Characteristics (cont’d)
 Listed derivatives trade on an organized
exchange such as the Chicago Board
Options Exchange or the Chicago Board of
Trade, the NYMEX or the Montreal
Exchange
 OTC derivatives are customized products
that trade off the exchange and are
individually negotiated between two parties

31. 31
Product Characteristics (cont’d)
 Options are securities and are regulated by
the Securities and Exchange Commission
(SEC) in the U.S and by the ‘Commission
des Valeurs Mobilieres du Quebec’ or the
Commission Responsible for Regulating
Financial Markets in Quebec for the
Montreal Options Exchange
 Futures contracts are regulated by the
Commodity Futures Trading Commission
(CFTC) in the U.S.

32. 32
Participants in the Derivatives
World
 Include those who use derivatives for:
– Hedging
– Speculation/investment
– Arbitrage

33. 33
Hedging
 If someone bears an economic risk and
uses the futures market or other derivatives
to reduce that risk, the person is a hedger
 Hedging is a prudent business practice;
today a prudent manager has an obligation
to understand and apply risk management
techniques including the use of derivatives

34. 34
Speculation
 A person or firm who accepts the risk the
hedger does not want to take is a
speculator
 Speculators believe the potential return
outweighs the risk
 The primary purpose of derivatives markets
is not speculation. Rather, they permit or
enable the transfer of risk between market
participants as they desire

35. 35
Arbitrage
 Arbitrage is the existence of a riskless
profit
 Arbitrage opportunities are quickly
exploited and eliminated in efficient
markets
– Arbitrage then contributes to the efficiency of
markets

36. 36
Arbitrage (cont’d)
 Persons actively engaged in seeking out
minor pricing discrepancies are called
arbitrageurs
 Arbitrageurs keep prices in the marketplace
efficient
– An efficient market is one in which securities are
priced in accordance with their perceived level
of risk and their potential return
 The pricing of options incorporates this
concept of arbitrage

37. 37
Uses of Derivatives
 Risk management
 Income generation
 Financial engineering

38. 38
Risk Management
 The hedger’s primary motivation is risk
management
 Someone who is bullish believes prices are
going to rise
 Someone who is bearish believes prices are
going to fall
 We can tailor our risk exposure to any points
we wish along a bullish/bearish continuum

39. 39

40. 40
Strategic
-technology & information/knowledge
- business model
-industry value chain transformation
Regulatory Risk
-environmental
-competition
Operating Risks
-distribution networks
-manufacturing
Commercial Risks
- new competitor (s)
- customer service expectations
- new pricing models
- supply chain management
Market & Credit Risk
-price - interest & fx. rate
-commodity price
Organization wide
Risk
Identification Impact Response
A Framework for Integrated Risk Management

41. 41
Risk Management (cont’d)
FALLING PRICES FLAT MARKET RISING PRICES
EXPECTED EXPECTED EXPECTED
BEARISH NEUTRAL BULLISH
Increasing bearishness Increasing bullishness
….for a producer
…the consumer has the opposite view

42. 42
Income Generation
 Writing a covered call is a way to generate
income
– Involves giving someone the right to purchase
your stock at a set price in exchange for an up-
front fee (the option premium) that is yours to
keep no matter what happens
 Writing calls is especially popular during a
flat period in the market or when prices are
trending downward

43. 43
Financial Engineering
 Financial engineering refers to the practice
of using derivatives as building blocks in
the creation of some specialized product
– e.g linking the interest due on a bond issue to
the price of oil (for an oil producer)

44. 44
Financial Engineering (cont’d)
 ‘Financial Engineers’:
– Select from a wide array of puts, calls futures,
and other derivatives
– Know that derivatives are neutral products
(neither inherently risky nor safe)
.....’derivatives are something like electricity:
dangerous if mishandled, but bearing the
potential to do good’
Arthur Leavitt
Chairman, SEC - 1995

45. 45
Effective Study of Derivatives
 The study of derivatives involves a
vocabulary that essentially becomes a new
language
– Implied volatility
– Delta hedging
– Short straddle
– Near-the-money
– Gamma neutrality
– Etc.

46. 46
Effective Study of Derivatives
(cont’d)
A broad range of institutions can make
productive use of derivative assets:
 Financial institutions
– Investment houses
– Asset-liability managers at banks
– Bank trust officers
– Mortgage officers
– Pension fund managers
 Corporations - oil & gas, metals, forestry
etc.
 Individual investors/speculators