Introduction to derivatives

What Is a Derivative?
An Overview of Financial Markets
The Role of Financial Markets
Ways to think about derivatives
Buying and short-selling
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What Is a Derivative?
Denition
An agreement between two parties which has a value
determined by the price of something else
Types
Options
Futures
Swaps
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An Overview of Financial Markets
Trading of Financial Assets
Stock exchanges, derivatives exchanges, and dealers
facilitate trading
Trading of nancial claims can take place on
organized exchanges or through the over-the-counter
(OTC) market
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Measures of Market Size and Activity
Four ways to measure the size and activity of a market
Open interest: the total number of contracts that are
open(existing obligations)
Trading volume: the number of nancial claims that
change hands
Market value: of the claims that could be traded
Notional value: the scale of a position, referring to
the underlying asset
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The Five Largest Stock Exchanges
The market capitalization of stocks traded on the ve largest
stock exchanges in the world in 2006.
Rank Exchange Market Cap (billions of US$)
1 NYSE Group 15,421.20
2 Tokyo Stock Exchange 4,614.10
3 NASDAQ Stock Market 3,865.00
4 London Stock Exchange 3,794.30
5 Euronext 3,708.20
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Increased Volatility: Oil prices 19472006
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Increased Volatility: DM/$ rate 19472006
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Monthly change in 3-month Treasury bill rate,
19472006.
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Increased volatility Led to New and Big Markets
Exchange-traded derivatives
Over-the-counter traded derivatives: even more!
Millions of futures contracts traded annually at the Chicago
Board of Trade (CBT), Chicago Mercantile Exchange (CME),
and the New York Mercantile Exchange (NYMEX),
19702006. The CME and CBT merged in 2007.
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Exchange Traded Contracts
Contracts proliferated in the last three decades
What were the drivers behind this proliferation?
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Exchange Traded Contracts
Examples of futures contracts traded on the Chicago
Mercantile Exchange (CME)/Chicago Board of Trade (CBT),
Eurex, and the New York Mercantile Exchange (NYMEX).
CME/CBT Eurex NYMEX
S&P 500 index DJ Euro Stoxx 50 index Crude oil
10-year U.S. Euro-bond (10-year German Natural gas
Treasury bonds government bonds)
Eurodollar Euribor Heating oil
Japanese yen DAX stock index Gasoline
Corn DAX index volatility Gold
Soybeans iTraxx 5-year index Copper
Heating and cooling Individual stocks Electricity
degree-days
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Estimated year-end notional value of outstanding
derivatives contracts, by category, in billions of
dollars.
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The Role of Financial Markets
Insurance companies and individual communities/families
have traditionally helped each other to share risks
Markets make risk-sharing more ecient
Diversiable risks vanish
Non-diversiable risks are reallocated
Recent example: earthquake bonds by Walt Disney in
Japan
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Uses of Derivatives
Risk management: hedging use of derivative
instruments to reduce the risks associated with the
everyday management of corporate cash ow
Speculation use of derivative instruments to take a
position in the expectation of a prot
Reduced transaction costs what if you want to sell
stocks and buy bonds?
Regulatory arbitrage circumventing regulatory
restrictions, taxes and accounting rules, like, defering
taxes, or retaining voting rights
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Three Dierent Perspectives
End users
Corporations
Investment managers
Investors
Intermediaries
Market-makers
Traders
Economic Observers
Regulators
Researchers
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Financial Engineering
The construction of a nancial product from other
products
New securities can be designed by using existing securities
Financial engineering principles
Facilitate hedging of existing positions
Enable understanding of complex positions
Allow for creation of customized products
Render regulation less eective
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Short-Selling
When price of an asset is expected to fall
First: borrow and sell an asset (get $$)
Then: buy back and return the asset (pay $)
If price fell in the mean time: Prot $ = $$ $
The lender must be compensated for dividends
received (lease-rate)
Example: short-sell IBM stock for 90 days
Cash ows associated with short-selling a share of IBM for
90 days. S
0
and S
90
are the share prices on days 0 and
90. Note that the short-seller must pay the dividend, D,
to the share lender.
Day 0 Dividend Ex-Day Day 90
Action Borrow Shares Return shares
Security Sell shares Purchase shares
Cash +S
0
D S
90
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Short-Selling (contd)
Why short-sell?
Speculation
Financing
Hedging
Credit risk in short-selling
Collateral and haircut
Interest received from lender on collateral
Scarcity decreases the interest rate
Repo rate in bond markets
Short rebate in the stock market
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Basic Transactions
Buying and selling a nancial asset
Brokers: commissions
Market-makers: bid-ask (oer) spread
Example: Buy and sell 100 shares of XYZ
XYZ: bid = $49.75, oer = $50, commission = $15
Buy: (100 x $50) + $15 = $5,015
Sell: (100 x $49.75) $15 = $4,960
What is your transaction cost?
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