Derivatives Types of Derivatives Derivatives Markets Valuation Principles of Derivatives

Master of Finance: Derivatives

Lecture 2: Introduction to Derivatives

Prof. Dr. Florian Weigert

University of Neuchâtel
Institute of Financial Analysis

February 24th, 2020

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Table of Contents

1 Derivatives

2 Types of Derivatives

3 Derivatives Markets

4 Valuation Principles of Derivatives

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Derivatives Types of Derivatives Derivatives Markets Valuation Principles of Derivatives

What is a Derivative?
Definition:
A derivative is a financial instrument that has a value determined by a price of an
underlying asset.

Types of Derivatives:
Typical types of derivatives include forwards, futures, swaps, and options
Stocks, interest rates, and commodities are not derivatives, but frequently act
as underlyings
Example:
Agreement on January 1st 2020: derivative is like an agreement

If the stock price of Tesla exceeds 1000 USD during the year 2020, you will pay
your friend 1 CHF
If the the stock price does not exceed 1000 USD during the year 2020, your
friend will pay you 1 CHF
The payment will occur on January 1st, 2021.

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Historical Background (I)

The Babylonian Empire (around 1750 BC):

Derivatives were first instruments developed to secure the supply of
commodities, facilitate trading and insure farmers against crop failures
Code of Hammurabi: If any one owe a dept for a loan, and a storm prostrates
the grain,...; in that year he need not give his creditor any grain, ... and pays no
rent for the year.

The Greek Empire (around 600 BC):

The philosopher and mathematician Thales of Miletus predicted an unusually
large olive harvest for the next autumn
He negotiated with the olive press owners the right, but not the obligation, to
hire all the olive presses in the region
The harvest was as predicted and the demand for the olive presses soared:
Thales was able to lease the presses at a substantual premium

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Historical Background (II)

Figure: Tulip Mania in 1937

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Historical Background (III)

The Tulip Mania (1637 AD):
In the Dutch Golden Age, the prices of tulips were very highly volatile (with
some single tulip bulbs selling for more than 10 times the annual income of a
skilled craftsworker)
The tulip mania is frequently be described as the first major financial bubble;
during that time an active derivatives market for tulip bulbs has been observed
The Dojima Rice Exchange (1697 AD):
The first organized market for futures derivatives trading for rice was established
in Osaka, Japan
The First US Derivatives Exchange (1848 AD):
The first derivatives exchange in the USA was the Chicago Board of Trade
(CBOT)
The CBOT is the oldest organized futures market still operating and specialized
on agricultural futures; it was merged with the Chicago Mercantile Exchange in
2007 to become the CME group
the largest derivatives organization in the world

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Derivatives: Trading Examples

Trading Examples:
A large international corporation uses Foreign Exchange (FX) futures to hedge
their currency exposure
A US airline buys forwards on crude oil to be less vulnerable to oil price increases
A Swiss asset manager buys put options on the Swiss Market Index to be not
affected of a future market crash
you make money if the market don’t move a lot
Trading Example Gone Wrong:
Barings Bank (1995): Nick Leeson engages in speculative derivatives trading.
To recover early losses, he places a short straddle (see Lecture 3) on the
Japanese market index before the Kobe earthquake hit and sent the Asian
markets into a tailspin. Barings Banks was declared insolvent.
LTCM (1998): The hedge fund engages in fixed income arbitrage trades. During
the time of the Russian Financial Crisis, LTCM cannot settle its positions
approriately due to market illiquidity. The fund is bailed-out by the FED.
Société Générale (2008): Jérôme Kerviel nearly brings down the bank by
massive fraudulent speculation in equity index futures.

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Top Ten Largest Trading Losses

Rank USD Lost Country Company Source of Loss Year Person Responsible
1 USD 9.0 bn USA Morgan Credit Default 2008 Howie Hubler
Stanley Swaps
2 USD 9.0 bn UK JP Morgan Credit Default 2012 Bruno Iksil
Swaps
3 USD 7.2 bn France Societe Equity index 2008 Jerome Kerviel
Generale Futures
4 USD 6.5 bn USA Amaranth Gas Futures 2006 Brian Hunter
Advisors
5 USD 4.6 bn USA LTCM Interest Rate 1998 John Meriwether
Derivatives
6 USD 4.1 bn USA Pershing Stocks 2017 Bill Ackman
Square
7 USD 2.0 bn UK UBS Equity ETFs 2011 Kweku Adoboli

8 USD 1.8 bn Austria BAWAG FX Trading 2000 Wolfgang Flöttl

9 USD 1.8 bn USA Deutsche Derivatives 2008 Boaz Weinstein

Bank
10 USD 1.7 bn USA Orange Leveraged Bond 1994 Robert Citron
County Investments

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Two Important Concepts When Studying Derivatives

Leverage:
The term leverage summarizes all activities / investments which result in a
higher amount of money invested (or a higher economic exposure) than the
available equity capital (i.e., the assets under management) of the investor
A main way to invest with leverage is to use derivatives (i.e., buying a future on
a stock reduces the initial amount of capital outlay considerably instead of
buying the stock itself)
Note: Leverage is risky, i.e., while increasing the upside potential, you also
increase downside potential of an investment
Short-selling:
An investor sells a financial instrument on the market without owning the
financial instrument
When short-selling a stock, the investor borrows a security from a broker and
sells it on the market in the expectation of a decreasing stock price
Derivatives can also be sold short; this is usually done when the investor expects
that the price of the derivative will decrease

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Use of Derivatives

Speculation:
Derivatives can be used to make investment bets that are highly leveraged
They can be tailored to retrieve a payoff for a specific investment view (e.g., if
the S&P 500 lies between 3000 and 4000 points at the end of 2020)
Derivatives can be applied to profit from falling underlying prices
Hedging:
Derivatives are a tool to reduce market risk (e.g., a combination of buying a
stock and a put option can reduce the risk of a negative payoff)
Other Purposes:
Derivatives can be used to exploit an arbitrage opportunity on financial markets
Derivatives sometimes provide a lower cost to undertake a particular financial
transaction than trading the actual underlying

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Table of Contents

1 Derivatives

2 Types of Derivatives

3 Derivatives Markets

4 Valuation Principles of Derivatives

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Derivatives Types of Derivatives Derivatives Markets Valuation Principles of Derivatives

Forwards

Definition:
A forward contract is an unconditional agreement to buy or sell a specified quantity of
the underlying at a specified price, with delivery at a specified time and place.

Remarks:
The specified price is called forward price or delivery price
The time at which the contract settles is called the expiration or maturity date
The party that agress to buy the underyling asset has the long position.
The party that agress to sell the underyling asset has the short position
The forward price is set in a way that it has an initial value of zero

Question: What is the fair forward price? To be determined in Lecture 4!

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Forwards: Working Principle

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Futures

Definition:
A future contract is an unconditional agreement to buy or sell a specified quantity of
the underlying at a specified price, with delivery at a specified time and place. It is a
standardized and exchange-traded contract, which is settled through a clearinghouse.

Remarks:
The difference between a forward and a future is that a future is standardized
and exchange-traded, whereas a forward agreement is specified between two
counterparties and traded over-the-counter (OTC)
The specified price is called futures price or delivery price
The time at which the contract settles is called the expiration or maturity date
The party that agress to buy the underyling asset has the long position.
The party that agress to sell the underyling asset has the short position
The futures price is set in a way that it has an initial value of zero

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Futures: Working Principle

it’s more safety to trade

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Swaps
Definition:
A swap is an unconditional agreement between two parties to exchange specified cash-
flows or assets at several specified dates in the future at a specified ratio.

here we have more one payment, many periods

Remark:
Typically, this ratio (swap rate) is set in a way that the swap has an initial value
of zero

Types of Swaps:
Commodity swap: Fixed payment vs. variable commodity price
stock
Equity swap: Fixed payment vs. variable commodity price
Interest rate swap: Fixed interest rate vs. variable interest rate
more traded swaps more than 60% of derivatives
Currency swap: Fixed payment in USD vs. fixed payment in EUR (or CHF)
Credit default swap: Fixed payment vs. specified payment in case of default

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Swaps: Working Principle

Main objective to enter a swap contract: Reduce risk that arises from a stream of
risky payments

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Swaps: Group Work Exercise

+ : Agreement between two parties to exchange cash-flows at specified date et specified price, long position :
fixed ; short-position : variable appartment value

+ : No Payments at the inception of the contract ( except from deposits )

Discuss the following statement:

”Renting a flat is like entering a swap contract.”

- : Both parties have the right to terminate the contract ( under certain conditions )

- : Rent is possibly increased

- : Agreement is usually not limited

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Options
Definition:
An option is a conditional claim, whose value depends on the value of one (or more)
underlyings.
The buyer of a call option has the right to buy the underlying at a specified exercise
price on (or before) a specified expiration date from the seller of the option.
The buyer of a put option has the right to sell the underlying at a specified exercise
price on (or before) a specified expiration date to the seller of the option.

Remarks:
The exercise price of an option is also called strike price
Options can be both traded on exchanges and OTC
The buyer of the option has the long position. The seller of the option has the
short position
An option typically does not have an initial value of zero, but a positive price
(the option premium)

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Table of Contents

1 Derivatives

2 Types of Derivatives

3 Derivatives Markets

4 Valuation Principles of Derivatives

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Classification of Financial Transactions

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Trading Venues of Derivatives

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OTC vs. Trading Exchanges

OTC:
Bilateral trades between market participants; main participants are banks, asset
managers, and large corporations
Before 2008: Largely unregulated; banks acted as market makers quoting prices
for transactions
After 2008: OTC market has become more regulated to reduce systemic risk
and increase financial transparency
Central counterparties (CCPs) are used for transactions and trades are reported
to a central registry

Trading Exchanges:
Investors trade standardized contracts defined by market authorities on major
trading exchanges
When trading futures, initial margins (i.e., deposits) have to be made with
brokers; marking to market (i.e., daily settlement) is applied to minimize default
risk

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Size of OTC and Exchange-Traded Derivatives Markets

the value of derivatives is more higher in OTC

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Contract Volume By Type of Derivative

(OTC and Exchange-Traded)

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OTC Contract Volume By Type of Underlying

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Exchange-Traded Contract Volume By Type of Underlying

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Largest Derivatives Exchanges

Figure: Ranking of 2018, by numbers of contracts traded (in millions)

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Selected Derivatives Exchanges

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Table of Contents

1 Derivatives

2 Types of Derivatives

3 Derivatives Markets

4 Valuation Principles of Derivatives

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Valuation Methods on Financial Markets

Valuation Based on Economic and/or Equilibrium Considerations:

Valuation of stocks: According to the consumption-based CAPM, the expected
return of a stock is a linear function of aggregate consumption growth
Similar approaches are applied to price commodities

No-Arbitrage Valuation:
Assumption: There is no possibility to make a riskless profit by trading financial
markets (without frictions)
Valuation of bonds: The price of a default-free bond is determined by the spot
rate of interest
⇒ The price of a derivative relative to the price of its underlying cannot give
rise to the possibility of a riskless profit (i.e., an arbitrage opportunity)
⇒ We will use no-arbitrage valuation to determine the fair prices of derivatives

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Arbitrage Opportunities: Examples

Vintage Clothing:
A given set of old clothes costs USD 50 at a thrift store
You sell the same set at a vintage boutique to consciuos fashion customers for
USD 100 and realize a profit for USD 50

Exploiting Different Quotes in Sports Betting:

Bookmaker A offers odds of 3 to 1 that Xamax Neuchâtel wins the next football
game; bookmaker B offers odds of 30 to 1 that they will lose
Betting CHF 10 with bookmaker A and CHF 1 with bookmaker B will yield a
guaranteed profit

”Merger Arbitrage”:
When an acquisition is announced, buy the target firm and sell the acquiror
Question: Is this really an arbitrage strategy?

Normally when a company want to buy other company the initial price for example 100 will increase to 108 , because the
company want to buy it for 110 , hedge fund try to have the differecnce between 110 and 108

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Classification of Arbitrage Opportunities

Free Lunch: An investment strategy that delivers a riskless profit with certainty
Free Lottery: An investment strategy that delivers a risk-less profit with a
positive probability
LOOP: If the law of one price holds, than assets with identical payments in the
future must have identical prices today

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Types of Arbitrage Opportunities: Group Work Exercise

1). Violation of Loop => Buy cheap asset , Sell expensive => Free lunch , Free Lotery

Answer the following statements:

Does a violation of LOOP imply the existence of a free lottery
ticket (free lunch)?
Does the existence of a free lottery ticket (free lunch)
necessarily lead to a violation of LOOP?

2) Free Lottery => No necessery violation of LOOP Relative Mispricing may also create a free lottery ( see problem set 1 , exercice 3)

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No-Arbitrage Valuation: Duplication Portfolios

Valuation By Duplication:
Construct a duplication portfolio consisting of a position in the underlying and
the risk-free asset that delivers future payments that are identical to those of
the derivative
No-arbitrage requires that the derivative and the duplication portfolio have the
same price today

Valuation By Hedging Portfolios:

Construct a hedge portfolio consisting of a position in the underlying and in the
derivative that is riskfree. No-arbitrage requires that this portfolio delivers the
same return as the riskfree asset
Construct a hedge portfolio consisting of a position in the underlying, in the
derivative, and in the riskfree asset that does never deliver any payments in the
future. No-arbitrage requires that this portfolio has a price of zero today

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References

Main Textbooks:
Hull (2014): Options, Futures, and Other Derivatives, Chapter 1
McDonald (2013): Derivatives Markets, Chapters 1+2

Additional Reading:
Kummer and Pauletto (2012): The History of Derivatives: A Few Milestones, EFTA
Seminar on Regulation of Derivatives Markets

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