Melbourne Campus

Australia

FIN3001-DRM
DERIVATIVES AND RISK MANAGEMENT

Subject Coordinator and Lecturer: Dr. Doureige Jurdi

Lecture 1
Lecture 1 – Learning objectives

This lecture will provide you with a general introduction to financial derivatives. The
topics covered today will be expanded on in the coming lectures.

• Subject overview (LMS, SLG, Required readings and other information)

• Derivatives – Definition
• Trading platforms
• Contract settlement and market clearing
• Derivatives types
• Types of traders in derivative markets
• Purposes and criticisms of derivative markets
• Examples and market cases.
Derivatives - Definition

A derivative is a financial asset that derives its value from the value of an
underlying asset or variable.

• Equity indexes, shares, commodities, interest rates, exchange rates

• Rainfall, carbon emissions, …

Derivative securities include forwards, futures, options and swaps.

Trading Derivatives
• A derivative can be created and traded in two types of markets: Exchange-Traded
markets and Over the Counter Markets (OTC).

• Exchange traded products:

o traded on organized markets such as the Chicago Board Options Exchange,
Sydney Futures Market.
o have standard terms and conditions set by the exchange.
o What about default risk (credit risk) ?

• Over-the-counter (OTC) products:

o any transactions created by two parties, based normally on telephone/internet
o have non-standard terms and conditions and is tailored to the needs of
counterparties
o What about default risk ?
Contract Settlement and Market Clearing

• Exchange-traded markets: The clearing house takes care of credit risk by requiring
each of the two traders to deposit funds (also known as margins) with the clearing
house to ensure that they will live up to their obligations.

• OTC markets: Banks, other large financial institutions, fund managers, and
corporations are the main participants in OTC derivatives markets.
Requires bilateral clearing.
❖ See Business Snapshot 2.2 on Long Term Capital Management

• A CCP is like an exchange clearing house. It stands between the two parties to the
derivatives transaction so that one party does not have to bear the risk that the
other party will default.
Bilateral Clearing vs CCP

CC
CCP
CC
CP
Bilateral Clearing

• Usually governed by an ISDA Master agreement with a credit support annex (CSA)
• The agreement explains the rights of one party if the other party defaults
• The CSA defines the collateral which must be posted
• If one party defaults, the other party is entitled to keep any collateral that has
been posted up to what is necessary to settle its claims.
Contract Settlement and Market Clearing – Recent
developments I

• Significant changes in the regulation occurred post the GFC

• OTC market has become regulated. Objectives:
• Reduce systemic risk
• Increase transparency
• In the U.S and some other countries, standardized OTC products must be traded on
swap execution facilities (SEFs) which are electronic platforms similar to exchanges
• CCPs must be used to clear standardized transactions between financial institutions in
most countries
• All trades must be reported to a central repository
Contract Settlement and Market Clearing – Recent
developments II

• Non-standard transactions can be cleared bilaterally

• A transaction with a non-financial corporation can be cleared bilaterally
• New regulations for non-standard trades between financial institutions that are
not cleared centrally require the financial institutions to have CSAs where both
initial margin and variation margin are posted
• The initial margin is posted with a third party
Size of OTC and Exchange-Traded Markets

800
Size of Market
($ trillion) 700

600

500

400

OTC
300

Exchange
200

100

Source: Bank for International Settlements.

Types of Derivative Securities

Forwards

Futures

Options

Swaps
Types of Derivatives - Forwards
A forward contract is an agreement between two parties, a buyer and a seller, to buy or
sell an underlying asset at a certain time in the future for a certain price.

• A certain time in the future: the contract maturity date, delivery date, settlement
date, expiration date.
• Certain price: forward price – a fixed price, the price of the underlying asset under
the forward contract at the maturity date but agreed at the start of the contract
(today). Spot price – the current market price of the underlying asset.
• An over-the-counter (OTC) product usually between two financial institutions or
between a financial institution and one of its clients.
• Down payment not required when entering the contract.
Forwards – Examples of underlying assets

• Forward contracts on equities: the underlying assets can be individual stocks,

stock portfolios, stock indices
• Forward contracts on bonds: the underlying assets can be individual bonds, bond
portfolios
• Forward contracts on interest rates: interest rates e.g. LIBOR; SOFR (Forward Rate
Agreement, FRA)
• Forward contracts on currencies
Forward contract - Positions

Positions associated with a forward contract

• A long position in a forward contract: A commitment to buy an underlying asset at a
fixed price at a future date.
• What does the buyer expect about the price of the underlying asset in the future
in order to take a long position in a forward contract?

• A short position in a forward contract: A commitment to sell an underlying asset at a

fixed price at a future date.
• What does the seller expect about the price of the underlying asset in the future
in order to take a short position in a forward contract?
Payoffs

If the spot price is S0 and the forward price for a contract deliverable in T
years is F, then
𝐹 = 𝑆0 (1 + 𝑟 ) 𝑇
where r is the risk-free rate of interest.
Example: Forward Payoffs and Hedging Currency Risk

Bid Offer
Spot 1.4407 1.4411

1-month forward 1.4408 1.4413

3-month forward 1.4410 1.4415

6-month forward 1.4416 1.4422

• Example: An investor goes long position a 6-month forward contract to buy 1 million GBP in
exchange for US dollars at an exchange rate of 1.4422 $/£
• How much does the investor gain/lose if the exchange rate after 6 months is 1.2 and 1.5?
• Example: A long position can be used to hedge currency risk if a company knows that it will
settle a payment in foreign currency (A US company settling in British pounds) at a future data
and enters the forward to lock in a price.
Types of Derivatives - Futures Contracts

A futures contract is an agreement between two parties, a buyer and a seller, to buy/sell an
underlying asset at a certain time in the future for a certain price. For example:

• Buy 100 oz. of gold @ US$1400/oz. in December

• Sell £62,500 @ 1.4500 $/£ in March

• An exchange-traded contract:
Futures contracts are standardized.
Who specifies certain terms and conditions of the contract such as quantity, quality, delivery
months, delivery dates …?

• Future contracts are settled (or marked to market) daily .

• Do you need to make a payment when you initiate a futures contract?

Differences between forwards and futures Q and A.

• Which contract is traded on organized exchanges?

• Which contract requires a payment on its initiation?

• Which contract is impacted by default risk?

Types of Derivatives - Swaps

A swap is an agreement between two parties to exchange a series of cash

flows in the future.

• Similar to a forward contract, a swap is an over-the-counter (OTC)

contract.
• A swap is equivalent to a series of forward contracts.
• Used to alter the nature of a liability or investment.
Types of Derivatives - Options
An option is a financial instrument that gives the holder the right (not the
obligation) to buy or sell an underlying asset by a certain date for a certain
price.

• Exercise price, or strike price: the fixed price at which the underlying asset
can be bought or sold.
• Buyer (holder, the long), seller (writer, the short)
• The buyer pays the premium (price of the option) to the seller (writer) of the
option.
• If the buyer chooses to exercise his right to buy or sell the asset, the writer of
the option has an obligation to deliver or take delivery of the underlying
asset.
Type of Options

• A call option gives the holder the right to buy an underlying asset by a certain
date for a certain price.

• A put option gives the holder the right to sell an underlying asset by a certain
date for a certain price.

• European vs American options.

Differences between futures contracts and options

• Which security gives the owner the right to buy or sell an underlying asset, a
future or an option?

• Which security requires paying a premium if acquired, a future contract or an

option?

• Which security is traded on organized exchanges?

Option Payoffs -Moneyness
Payoff Payoff
K = Strike price, ST = Price of the asset at
maturity date T (European options)
K
• Call option Payoffs
Long position: Max (0, ST-K)
K ST ST
Short position: - Max (0, ST-K) Payoff
Payoff
• Put option payoffs K
Long position: Max (0, K- ST)
Short position: - Max (0, K -ST) K ST ST

(Options will be covered in detail in the

second half of the semester).
Types of Traders in Derivative Markets
• Hedgers: hold positions in an underlying asset and attempt to protect themselves
against price changes.
• Hedging?
• Speculators: attempt to make profits by predicting the market movements and taking
some risks.
• Speculating?
• Arbitrageurs: attempt to make riskless profits
• Arbitrage?
• Market makers (dealers, the clearing house): They provide quotes at which they are
willing to buy or sell.
Why trade derivatives and are they risky instruments?
• Risk management:
o Hedging: reducing or eliminating risks
• Speculation
o Seeking profits by predicting the market movements and taking some risks.
• Improving market efficiency: low transaction costs, provide liquidity, and enhance price
discovery for underlying assets.
• Possibility of making arbitrage profits: making riskless profits without using your own
funds.
• Derivative markets may be “too risky”, especially to investors with limited knowledge of
complex instruments.
• Known cases where derivatives were linked to major corporate loses: the Lehman
bankruptcy case & Société General
Example: Arbitrage

• A stock that is traded on both NYSE in the US and LSE in the UK for $120 and
£100, respectively. Assume that the exchange rate is $1.23 per pound.

• An arbitrageur could simultaneously buy shares of the stock in New York and sell
them in London. In the absence of transactions costs, the risk-free profit
(1.23$/ £ x £ 100) – $120 = $3 per share.

• The arbitrager should consider transaction costs.

• You will see more examples involving derivatives in the coming lectures.
Example: Speculation

• Assume that an investor has $2000 and is speculating on the

December price movement of a stock given some
information she has in November. The stock is currently
selling for $20, and the next month’s call option with a strike
of $22.5 is trading for $1.
• Alternative strategy outcome for 2 December price scenarios

• See section 1.9 in Ch. 1.

The Lehman Bankruptcy Case

• Lehman’s filed for bankruptcy on September 15, 2008. This was the biggest
bankruptcy in US history
• Lehman was an active participant in the OTC derivatives markets and got into
financial difficulties because it took high risks and found it was unable to roll over
its short term funding
• It had hundreds of thousands of transactions outstanding with about 8,000
counterparties
• Unwinding these transactions has been challenging for both the Lehman
liquidators and their counterparties
• See business snapshots 1.1 and 1.2
Société General Case

• Traders can switch from being hedgers to speculators or from being arbitrageurs
to speculators
• It is important to set up controls to ensure that trades are using derivatives in for
their intended purpose
• Soc Gen is an example of what can go wrong (see business snapshot 1.4).
Required Readings

• Hull: Chapter 1 and 2 (Selected sections on market clearing)

• This is an introductory session. It may include concepts you have covered earlier
in your studies. Details about derivative products will unfold in coming sessions.
• Selected tutorial questions are provided on LMS on lecture day. You must read
the covered materials in the chapters and solve the tutorials.