Lecture 1

Introduction to Derivatives

Reading: Chapter 1
Hull J. 2013, Fundamentals of futures and options markets, 8th edn., Pearson
Education

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Lecture Outline
• What are derivatives?
• Background to derivatives markets
• The dangers of derivatives
• The size of the derivatives market
• Exchange Trading & OTC trading
• Introduction to
• Futures / Forwards / Options
• Hedging / Speculation / Arbitrage

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What are derivatives?
• A derivative instrument is a contract between two counterparties,
whose value derives from the price of something else, referred to as
the underlying.
• The underlying can be, for example, a physical asset such as a
specified quantity of a certain kind of wheat or a specified number of
bonds or bank bills, or, a financial index or reference rate (such as
LIBOR).

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• Commodity derivatives are available on various kinds of tradable
commodities such as wheat or gold.
• Financial derivatives are contracts based upon the prices of various
kinds of financial instruments, or financial indexes such as stock
market indexes.

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Background to the Derivatives market
• Derivatives have been around for a long time and became
increasingly important in the nineteenth century in agricultural
markets. But it is from the 1970s that their significance and incidence
grew into what it is today.
• The massive growth of the derivatives market since the 1970s has to
an extent been driven by a need to manage risk in a more systematic
way. However, it is also the case that derivatives can magnify the
exposure of companies using them for speculation, especially where
open positions are heavily leveraged.
• Several key historical events help to explain the growth of the
derivatives market.

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Criticisms of Derivatives
• A common argument about derivatives is that they somehow leech
money away from the productive sectors of economies and waste
economic resources.
• The counter argument is that derivatives allow productive activity to
occur, which would otherwise be unviable if derivative products were
not available to hedge risk.
• For example, companies can engage in international investment
projects and use derivative products to hedge their foreign exchange
risks. Commodity producers can hedge against price volatility by using
commodity derivatives.

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Derivatives market size
• By June 2006 the OTC derivatives market had grown to a market size
of USD 370 trillion. The exchange-traded market value was USD 84
trillion (Graph, slide16). But these figures massively exaggerate the
real size of the market because they tally notional principals, not
contract values.
• The equivalent gross market value of the contracts was actually USD
9,936 billion (rounded by Hull to USD 10 trillion).

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Size of OTC and Exchange Markets
(Figure 1.2, Page 4)

Source: Bank for International Settlements. Chart shows total principal amounts
for OTC market and value of underlying assets for exchange market

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Futures Contracts
• What is a futures contract?
• A futures contract is an agreement to buy or sell an asset at a certain
time in the future for a certain price
• By contrast in a spot contract there is an agreement to buy or sell the
asset immediately (or within a very short period of time)

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Terminology
• The party that has agreed to buy has a long position
• The party that has agreed to sell has a short position

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Futures Price
• The futures prices for a particular contract is the price at which you
agree to buy or sell.
• It is determined by supply and demand in the same way as a spot
price.
• Supply and demand is itself determined by such factors as the
possibility of arbitrage and expectations about the future spot price
of the underlying.

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Exchanges Trading Futures
• CBOT and CME (now CME Group)
• Intercontinental Exchange
• NYSE Euronext
• Eurex
• BM&FBovespa (Sao Paulo, Brazil)
• and many more (see list at end of book)

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Forward Contracts
• Forward contracts are similar to futures except that they trade in the
over-the-counter market
• Forward contracts are popular on currencies and interest rates

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Foreign Exchange Quotes for USD/GBP
exchange rate on July 17, 2009 (See page 5)

Bid Offer
Spot 1.6382 1.6386

1-month forward 1.6380 1.6385

3-month forward 1.6378 1.6384

6-month forward 1.6376 1.6383

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Options
• There are two basic types
• A call option is an option to buy a certain asset by a
certain date for a certain price (the strike price)
• A put option is an option to sell a certain asset by a
certain date for a certain price (the strike price)
• American v. European Options
• An American option can be exercised at any time during
its life
• A European option can be exercised only at maturity

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Call option trade example
• An investor instructs a broker to buy one December Call option on Google shares
with a strike price of $580. The offer price is $35.30. This is the price for an option
to buy one share. Each option contract is for 100 shares.
=> The investor has a right to buy 100 Google shares at $580 each at a cost of
$3,530.
• At the maturity date (Dec. 22, 2012):
• If the share price in the spot market stays (St) below $580 (St < $580) => The option is not
exercised => The investor loses the cost of the option position: $3,530 (excluding commission
costs).
• If the share price rises above $580 (e.g. St = $650) => The investor makes a profit per share of
$650 - $580 = $70 minus the premium cost per share of $35.30 for a total profit of ($70 -
$35.30)*100 = $3,470.
Call option trade example

30 Profit ($ 000)

20 ?

10 Stock price ($)

200 400 600
0
800 1000 1200
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Put option trade example
• An investor instructs a broker to sell one September Put option on Google shares
with a strike price of $540. The bid price is $19.80. This is the price for an option
to sell one share. Each option contract is for 100 shares.
=> This would lead to an immediate cash inflow of $100 *19.80 = $1,980.
• At the maturity date:
• If the share price remains above $540 (St > $540) , the option will not be exercised => The
investor gains all of the premium cash flow
• If the price falls below $540 (St < $540), the long exercises the option to sell above the market
price and the short (the investor in this case) loses potentially all of the premium or more.
Put option trade example

30 Profit ($ 000)

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?
10 Stock price
($)
0
200 400 600 800 1000
-10
Exchanges Trading Options
• Chicago Board Options Exchange
• International Securities Exchange
• NYSE Euronext
• Eurex (Europe)
• and many more (see list at end of book)

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Options vs Futures/Forwards
• A futures/forward contract gives the holder the obligation to buy or
sell at a certain price
• An option gives the holder the right to buy or sell at a certain price

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Ways Derivatives are Used
• To hedge risks
• To speculate (take a view on the future direction of the market)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment without incurring the costs of
selling one portfolio and buying another

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Types of Traders
• Hedgers
• Speculators
• Arbitrageurs
Some of the largest trading losses in derivatives have occurred because
individuals who had a mandate to be hedgers or arbitrageurs switched
to being speculators

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