CHAPTER SIX

INTRODUCTION TO DERIVATIVE
MARKET
 Chapter Outline
• Futures and Forwards
• Options
• Swaps
• Floors and Caps
 DERIVATIVE MARKET
 A derivative is an instrument whose value depends
on, or is derived from, the value of another asset.
 Examples:
 Futures
 Forwards
 Swaps
 Options
 Exotics
 …
 DERIVATIVE MARKET
 Why Derivatives Are Important
 Key role in transferring risks in the economy
 Underlying assets include stocks, currencies, interest
rates, commodities, debt instruments, electricity,
insurance payouts, weather, etc.
 Many financial transactions have embedded
derivatives
 The real options approach to assessing capital
investment decisions has become widely accepted
 DERIVATIVE MARKET
 How Derivatives Are Traded
 How Derivatives Are Traded
 On exchanges such as the Chicago Board
Options Exchange
 In the over-the-counter (OTC) market where
traders working for banks, fund managers and
corporate treasurers contact each other directly
 DERIVATIVE MARKET
 How Derivatives Are Used
 To hedge risks
 e.g. you are a producer of oil or a consumer of soy beans, or
are paid in a different currency
 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
 Forwards
 Forward Price
 DEFINITION: the delivery price that would be
applicable to the contract if negotiated today
(i.e. the delivery price that would make the
contract worth exactly zero today)
 The forward price may (and will likely) be
different for contracts of different maturities
 Forwards
 Some Terminology
 The party that has agreed to buy has a long
position
 The party that has agreed to sell has a short
position
 Selling a derivative is sometimes referred to
writing a derivative (forwards, options, etc.)
 The contract delivery date is sometimes referred
to expiration date, or maturity date
 Forwards
 Forward Example
 On Jan 10, 2013 the treasurer of a corporation enters
into a long forward contract to buy £1 million in six
months at an exchange rate of 1.6115
 This contract obligates the corporation to pay
$1,611,500 for £1 million on the maturity date (July 10,
2013)
 What are the possible outcomes?
 Forwards
 Profit from a Long Forward
 K = delivery price = forward price at time contract is
entered into
 Forwards
 Profit from a Short Forward
 K = delivery price = forward price at time contract is
entered into
 Futures Contracts
 Agreement to buy or sell an asset for a certain
price at a certain time
 Similar to forward contract, but there are
 Differences:
 A forward contract is traded OTC, a futures
contract is traded on an exchange
 A futures contract requires daily settlement of the value
of the contract, a forward contract has a
cash flow only a maturity
 Futures Contracts
 Exchanges Trading Futures
 CME Group (formerly Chicago Mercantile Exchange
and Chicago Board of Trade)
 NYSE Euronext
 BM&F (Sao Paulo, Brazil)
 TIFFE (Tokyo)
 and many more
 Futures Contracts
 Examples of Futures Contracts
 You think gold will appreciate during the year:
Buy 100 oz. of gold @ 1662 $/oz in Dec.
 You will receive GBP in March but want USD:
Sell £62,500 @ 1.661 US$/£ in March
 You are an oil producer and want to hedge:
Sell 1,000 bbl. of oil @ 92 $/bbl in April
 You are a soybean buyer looking to lock your input
costs:
Buy 1mm bushels of soybean in 6m
 Futures vs Forwards
Forward Contract Future Contract

 Private contract between two  Traded on an exchange

parties
 Not standardized  Standardized contract

 Usually one specific delivery date  Ranges of delivery date

 Settled at the end of contract  Settled daily

 Some credit risk  No credit risk

 Who Trades Derivatives?
 Hedgers use derivatives to mitigate the risk they
are already exposed to, coming from their business
or assets/liabilities
 Speculators use derivatives to express a view
 often with leverage
 on a financial sector/asset
 Arbitrageurs use derivatives to lock in a specific
payout for a risk-free profit
 Swaps
 Nature of Swaps
 A swap is an agreement to exchange cash flows
at specified future times according to certain
specified rules
 Typically swaps have two legs as there are two
parties…swapping cash flows
 Swaps
 Vanilla Interest Rate Swap
 An agreement to swap fixed rate cash flows for floating cash flows
over a specified period of time
 Tenor
 determines how often payments are made
 In the US
 floating payments are generally every 3 months
 Fixed payments are made every 6 months
 Floating cash flows reference a “trusted” benchmark rate – e.g.
LIBOR
 Generally the reference rate is fixed at the beginning of
a period and paid at the end
 Swaps
 E.g. “Plain Vanilla” Int. Rate Swap
 An agreement by Microsoft to
 receive 6-month LIBOR
 pay a fixed rate of 5% per annum every 6 months
 Start date: 5 March 2012,
 Maturity: 5 March 2015
 Notional: $100m
 Next slide illustrates* cash flows that could occur

* illustrative trade, day count conventions are not considered, payment

frequency not typical
 Swaps
 A Possible Outcome for Cash Flows
 Swaps
 Typical Uses of an Int. Rate Swap
 Converting a liability from
 fixed rate to floating rate
 floating rate to fixed rate
 Converting an investment from
 fixed rate to floating rate
 floating rate to fixed rate
 Swaps
 Swap Fixed for Floating
 You enter an interest rate swap
 Notional: 100m
 Maturity: 5 March 2015
 Semi-annual payments
 Pay Fixed: 5%
 Receive Floating: 6 Month USD LIBOR
 Swaps
 Other types of swaps
• Credit Default Swaps (CDS)
• Currency Swaps
• Commodity Swaps
• Mortgage Swaps
• Equity Swaps (on price or dividends)
• Variance Swaps
• etc.
 Options
 An option gives the holder the right but not the
obligation to buy(sell) the underlying asset at some time
or times in the future.
 Underlying Assets
• Stocks
• Currencies
• Stock Indices (not indexes)
• Futures
• Commodities (individual and index)
• Interest Rates (swaptions)
• Credit products (credit default swaptions)
• etc
 Swaps
 Option Types
 A Call option is an  A Put option is an
option to buy a option to sell a
certain asset by a certain asset by a
certain date for a certain date for a
certain price (the strike certain price (the strike
price) price)
 Swaps
 Options Style
 An American option  A European option
can be exercised at any can be exercised only
time during its life at maturity

 A Bermudan option can be

exercised only at fixed times
before maturity (e.g. monthly)
 Options
 Option Contracts Specs
• Expiration date
• Strike price (or Exercise price)
• European or American (option style)
• Call or Put (option class or type)
• Delivery details
– Cash or Physical delivery
 Options
 Payoff Diagram
 Options
 Payoff Diagram
 Floors and Caps??

• A rate cap is an agreement between two parties

providing the purchaser an interest rate ceiling or
‘cap’.
• This financial instrument is primarily used by
borrowers of floating rate debt in situations where
short term interest rates are expected to increase.
• Rate caps can thus be viewed as insurance (for the
borrower), ensuring that the maximum borrowing
rate never exceeds the specified cap level.
 Cont’d
• An interest rate floor on the other hand,
guarantees a lower bound for the rate of
interest received on an investment.
• This may be used in conjunction with a
floating rate note (FRN) to ensure a minimum
return on investment.
• Floors are used in times of decreasing short
term interest rates by money managers trying
to obtain higher cash returns on floating rate
investments.
End of Chapter Six