Chapter 1 An Overview of Derivative Securities

A derivative is an instrument whose value depends on the value of an underlying variable.

Interest rate or foreign exchange rate Index value such as a stock index value Commodity price Common stock (NEW! Single Stock Futures) Other

Thus, the value of a derivative is derived from another variable.

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The Four Basic Derivatives

Forward Contracts Futures Contracts Swaps Options

However, many say there are only TWO basic derivatives: forwards and options.

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Derivative Markets
Exchange-traded futures and options
standardized products trading floor or computerized trading virtually no credit risk

Over-the-Counter forwards, options, & swaps

often non-standard (customized) products telephone (dealer) market some credit risk

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Uses of Derivatives

To hedge or insure risks; i.e., shift risk. To reflect a view on the future direction of the market, i.e., to speculate. To lock in an arbitrage profit To change the nature of an asset or liability. To change the nature of an investment without incurring the costs of selling one portfolio and buying another.

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The Importance of this Subject - I

The sheer magnitude of size of this market, in itself, makes this an interesting topic. Firms and individuals face financial risks that are greater than ever.

Derivative markets allow participants to shed, or hedge, risk.

Derivative markets allow participants to take risk, i.e., speculate. Using derivatives allows individuals and firms to create payoff patterns that are compatible with their beliefs and degree of risk aversion, at a low cost.

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The Importance of this Subject - II

You will understand the vital linkage between the underlying market (aka the spot market or the cash market) and the derivative market. You will see that the price of the derivative depends on the price of the underlying asset.

You will see what caused many derivative disasters of recent times: i.e., Barings Bank, Sumitomo Bank, Long Term Capital Management.
You will avoid derivative disasters: you will learn to avoid using derivatives when you do not understand their risks you will learn how to use derivatives correctly because you will understand their risks and rewards.
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Just How Big is the Derivatives Market?

The Bank for International Settlements (BIS) estimated the total notional principal of outstanding OTC derivatives to be $111 trillion, as of December 2001! (http://www.bis.org/statistics/index.htm ) However, the figure above overstates the true size of the market. notional principal netting 4.3 billion derivative contracts traded on global organized exchanges in 2001 (in contrast, NYSE volume in 2002 is running at a 322 billion shares per year rate, as of August 1, 2002).

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Forward Contracts - I
A forward contract gives the owner the right and obligation to buy a specified asset on a specified date at a specified price.

The seller of the forward contract has the right and obligation to sell the asset on the date for the price.
At the end of the forward contract, at delivery, ownership of the good is transferred and payment is made from the purchaser to the seller.
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Forward Contracts - II
Generally, no money changes hands on the origination date of the forward contract. However, collateral may be demanded. Delivery options may exist concerning
the quality of the asset the quantity of the asset the delivery date the delivery location.

If your position has value, you face the risk that your counterparty will default.
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Forward Contracts - III

On August 27, 2002, you enter into an agreement to buy 1 million in six months at a forward exchange rate of $1.5028/ . The spot exchange rate is $1.5250/. This obligates the trader to pay $1,502,800 for 1 million on February 27, 2003. What happens if the spot exchange rate on February 27, 2003 is $1.60/? $1.40/?

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Forward Contracts - IV
Profit Profit
change in forward price change in forward price

Profit Diagram for a long forward position

Profit Diagram for a short forward position

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Futures vs. Forwards - I

Futures are similar to forwards, except:
Futures trade on futures exchanges (CME, CBOT, LIFFE, etc.). Futures are standardized contracts
this increases their liquidity but sometimes firms prefer precise, custom made (OTC) forward contracts

More =>
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Futures vs. Forwards - II

Default risk for futures is lower because:

The clearinghouse of the exchange guarantees payments. An initial margin is required. Futures contracts are marked to market daily (daily resettlement)

A consequence of daily resettlement is that futures contract are like a portfolio of forward contracts, each with a delivery day one day later.

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2001 Trading Volume: Top 10 Global Futures Exchanges

Exchange
Eurex (Germany & Switzerland) Chicago Mercantile Exchange (U.S.) Chicago Board of Trade (U.S.) LIFFE (UK) BM&F (Brazil) NY Mercantile Exchange (U.S.) Tokyo Commodity Exchange (Japan) London Metal Exchange (UK)

Number of Contracts
435,141,707

315,971,885
209,988,002 161,522,775 94,174,452 85,039,984 56,538,245 56,224,495 42,042,673 34,075,508
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Paris Bourse SA (France)

Sydney Futures Exchange (Australia)

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Swaps
A swap contract obligates two parties to exchange, or swap, cash flows at specified future dates.
A swap is like a portfolio of forwards. Each forward in a swap has a different delivery date, and the same forward price. Its a $60+ trillion market, as of Dec., 2001 (in terms of notional principal)

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An Example of a Plain Vanilla Interest Rate Swap

I agree to pay you 8% of $40 million each year for the next five years. You agree to pay me whatever 1-year LIBOR is (times $40 million) for each of the next five years. $40 million is the notional principal. If LIBOR > 8%, you pay me: (LIBOR - 8%) * $40 million If LIBOR < 8%, I pay you: (8% - LIBOR) * $40 million I am long five Forward Rate Agreements (FRAs), with delivery dates at the end of each of the next five years. You are short five Forward Rate Agreements (FRAs), with delivery dates at the end of each of the next five years.
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Swaps
Credit risk only involves the Present Value of the remaining expected cash flows from the swap (~3.5% of notional principal). Credit risk does NOT involve the notional principal. Only the party that expects to be paid the remaining net cash flows faces current default risk.

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Call Options
A call option is a contract that gives the owner of the call option the right, but not the obligation, to buy an underlying asset, at a fixed price ($K), on (or sometimes before) a pre-specified day, which is known as the expiration day. The seller of a call option, the call writer, is obligated to deliver, or sell, the underlying asset at a fixed price, on (or sometimes before) expiration day (T). The fixed price, K, is called the strike price, or the exercise price.

Because they separate rights from obligations, call options have value.

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Payoff Diagram for a Long Call Position, at Expiration

Expiration Day Value, CT

0
K

45o

ST

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Profit Diagram for a Long Call Position, at Expiration

We lower the payoff diagram by the call price (or premium), to get the profit diagram

Profit

0
call premium

ST

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Profit Diagram for a Short Call Position, at Expiration

Profit

Call premium K

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Put Option Contracts

A put option is a contract that gives the owner of the put option the right, but not the obligation, to sell an underlying asset, at a fixed price, on (or sometimes before) a pre-specified day, which is known as the expiration day (T). The seller of a put option, the put writer, is obligated to take delivery, or buy, the underlying asset at a fixed price ($K), on (or sometimes before) expiration day. The fixed price, K, is called the strike price, or the exercise price. Because they separate rights from obligations, put options have value.

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Payoff diagram for a long put position, at expiration

K
Value on Expiration Day, PT

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Profit Diagram for a Long Put Position, at Expiration

Profit

Lower the payoff diagram by the put price, or put premium, to get the profit diagram

0
K

put premium

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Profit Diagram for a Short Put Position, at Expiration

Profit

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Option Exchanges
U.S. Option Exchange
Chicago Board Options Exchange American Stock Exchange Pacific Stock Exchange Philadelphia Stock Exchange

Options Traded in 2001

306,667,851 205,103,884 102,701,752 101,278,870

1.4 billion options traded, globally, on exchanges in 2001. Trading on the International Securities Exchange commenced in
2000. It was the first new US securities exchange in 27 years. All trading is electronic. 77.5 million contracts traded on the ISE in the six months ending Aug. 15, 2002. Other leading international option exchanges include OM Stockholm (Sweden), Euronext Amsterdam (Netherlands), etc.
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Types of Derivative Traders

Hedgers (Risk Shifters) Speculators (Risk Takers) Arbitraguers (Alchemists)

Note Bene: Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

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Some Extra Slides on this Material

Note: In some chapters, we try to include some extra slides in an effort to allow for a deeper treatment of the material in the chapter.

If you have created some slides that you would like to share with the community of educators that use our book, please send them to us!

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Using Options in Risk Management, I: Options Provide Insurance

Suppose a firms value is exposed to the risk that some price will decrease

DV

DP
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Suppose the Firm Buys An at-the-money Put Option

DV

Underlying Exposure

DP
Long Put

Recall: The firm is exposed to the risk that a price will decline
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This is the Resulting Net Exposure

DV
Underlying Exposure

DP
Net Exposure Long Put

Buying the put = buying insurance

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Using Options in Risk Management, II: Options Provide Insurance

Suppose a firms value is exposed to the risk that some price will increase

DV

DP

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Buying a call option provides insurance against an increase in the price of an underlying security, an increase that would hurt the firm.

DV
Long Call

Underlying Risk Exposure

DP

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The resulting Net Payoff Profile of Adding a Long Call Option to a Short Underlying Risk Position
Note that the firm is hedged if prices rise, but participates in the benefits should prices decline Underlying Risk Exposure

DV
Long Call

DP
Resulting Net Exposure

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Forwards and Futures and Financial Engineering

You will see that all derivatives can be replicated by a combination of the underlying asset and borrowing/lending. For example: Long Forward = Borrow and Buy the Underlying Asset. Because Futures and Swaps are portfolios of Forwards, they also can be replicated using the underlying asset and borrowing/lending.

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Options and Financial Engineering

Options can be replicated by dynamically trading the underlying asset and borrowing/lending. Note that a position in a futures contract or a forward contract can be substituted for the position in the underlying asset.
Example I: Buy a Call and Write a Put = Long Underlying (or forward/futures). Example II: Write a Call and Buy a Put = Short Underlying (or forward/futures).

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Buy a Call and Write a Put = Long Underlying

profit Buy Call

profit

ST

K ST Underlying price

Write Put

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Showing that Buying a Call and Writing a Put Equals Long Underlying, Tabulated
Let: K=40; S=40; C=4; P=3; Then, at expiration (time T): CF0 = -1

ST 38 39 40 41 42

CT 0 0 0 1 2

PT -2 -1 0 0 0

CFT -2 -1 0 1 2

CF0 + CFT -3 -2 -1 0 1

Profit

ST

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