Introduction

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Learning Outcome
Upon successful completion, students will be able
to
Understand the concept and features of
derivatives.
Understand and explain different type of
derivative instruments.
Understand the use and application of
derivatives.
Understand the basic terminology of Derivatives.

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History of Derivatives
Ancient Market

Middle East Market

Amsterdam, Bruges, London Tokyo in

17th and 18th Century

American, European, Asian Market in 19th

Century and beyond

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What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options,
exotics…

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Why Derivatives Are Important
Derivatives play a key role in transferring risks in the
economy
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc
Many financial transactions have embedded
derivatives
The real options approach to assessing capital
investment decisions has become widely accepted

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How Derivatives Are Traded
On exchanges such as the Chicago Board
Options Exchange (CBOE)
In the over-the-counter (OTC) market where
traders working for banks, fund managers
and corporate treasurers contact each other
directly

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The OTC Market Prior to 2008
Largely unregulated
Banks acted as market makers quoting bids and
offers
Master agreements usually defined how transactions
between two parties would be handled
But some transactions were handled by central
counterparties (CCPs). A CCP stands between the
two sides to a transaction in the same way that an
exchange does

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Since 2008…
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 similar to exchanges
CCPs (Central Counter Party Clearing) must be used
for standardized transactions between dealers in
most countries
All trades must be reported to a central registry

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How 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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Forward Price
The forward price for a
contract is the delivery
price that would be
applicable to the contract if
were negotiated today
The forward price may be
different for contracts of
different maturities

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Terminology
The party that has agreed to buy has what is
termed a long position
The party that has agreed to sell has what is
termed a short position

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Example
On May 6, 2013, the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months at an
exchange rate of $1.5532/ £
This obligates the corporation to pay
$1,553,200 for £1 million on November 6,
2013
What are the possible outcomes?

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Profit from a Long Forward
Position (K= delivery price=forward price at
time contract is entered into)

Profit

Price of Underlying at
K Maturity, ST

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Profit from a Short Forward
Position (K= delivery price=forward price at time
contract is entered into)

Profit

Price of Underlying
K at Maturity, ST

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Futures Contracts
Agreement to buy or sell an asset for a
certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC, a
futures contract is traded on an exchange

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Exchanges Trading Futures
CME Group (formed when Chicago
Mercantile Exchange and Chicago Board of
Trade merged)
NYSE Euronext (being acquired by bteh
InterContinental Exchange)
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more

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Examples of Futures Contracts
Agreement to:
Buy 100 oz. of gold @ US$1400/oz. in December
Sell £62,500 @ 1.5500 US$/£ in March
Sell 1,000 bbl. of oil @ US$90/bbl. in April

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1. Gold: An Arbitrage Opportunity?

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The Forward Price of Gold (ignores
the gold lease rate)

If the spot price of gold is S and the forward

price for a contract deliverable in T years is
F, then
F = S (1+r )T
where r is the 1-year (domestic currency)
risk-free rate of interest.
In our examples, S = 1400, T = 1, and r =0.05
so that
F = 1400(1+0.05) = 1470 (mispricing)

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Options
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)

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American vs 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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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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Types of Traders
Hedgers-hedgers want to avoid exposure to adverse movements in the price
of an asset(farmer)
Speculators-wish to take a position in the market. Either they are betting that
the price of the asset will go up or they are betting that it will go down(
Arbitrageurs:Arbitrageurs seek to profit from price discrepancies in different
markets or forms of an asset. They simultaneously buy and sell an asset in
different markets to take advantage of price differences, thus earning a risk-
free profit. Arbitrage opportunities typically arise due to market inefficiencies
and are usually short-lived as they are quickly corrected by the actions of
arbitrageurs.
Example: An arbitrageur notices that a stock is priced at $100 on the New
York Stock Exchange (NYSE) and $102 on the London Stock Exchange
(LSE). The arbitrageur can buy the stock on the NYSE and simultaneously
sell it on the LSE, capturing a $2 profit per share.

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Dangers
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

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