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Assignment 2

Topic : Derivatives

Submitted to
Faculty : M. Ahsanur Rahim (ARm)
Course : Fin444
Section 3

Submitted by
M M Naim
Id : 082011030

Date : 28.6.15

Introduction
Derivatives are financial contracts on a pre-determined payoff structure, whose value
derive from underlying assets, such as securities, commodities, market indices, interest rates, or
foreign exchange rates.

History of derivatives market:


Modern textbooks in financial economics often tend to misrepresent the history of the
derivatives market. For instance, Hull (2006) puts forth that derivatives became significant only
during the past 25years and that it is only now that they are traded on exchanges. Mishkin (2006)
was more specific and he declared that derivatives are new financial instruments that were
invented in the 1970s and that this was a result of an increase in the volatility in financial
markets that created a demand for hedging instruments to be used by financial institutions to deal
with risks (Brown, 2014).
The history of derivatives is in fact traced back to the origins of commerce in
Mesopotamia in the fourth millennium BC. After the collapse of the Roman Empire, contracts
for the future delivery of commodities continued to be used in the Byzantine Empire in the
Eastern Mediterranean and they survived in canon law in Western Europe. During the
Renaissance, financial markets became more sophisticated in Italy and the Low Countries.
Contracts for the future delivery of securities were used on a large scale for the first time in
Antwerp and then Amsterdam in the sixteenth century. Derivative trading on securities spread
from Amsterdam to England and France at the end of the seventeenth century, and from France
to Germany in the early nineteenth century (Brown, 2014).
The first exchange for trading derivatives happened to be the Royal Exchange in London,
which permitted forward contracting. The first "futures" contracts are generally traced to the
Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts,
which made them much like today's futures, although it is not known if the contracts were

marked to market daily and/or had credit guarantees. The next major event, and the most
significant as far as the history of U. S. futures markets, was the creation of the Chicago Board of
Trade in 1848. This came up when farmers faced difficulties to store the enormous increase in
supply that occurred following the Midwestern grain harvest. Chicago spot prices rose and fell
drastically. A group of grain traders then created the "to-arrive" contract, which allowed farmers
to lock in the price and deliver the grain later. The grain was either stored on the farm or at a
storage facility nearby, to be delivered to Chicago months later. These to-arrive contracts proved
useful as a device for hedging and speculating on price changes. The grain could always be sold
and delivered anywhere else at any time. These contracts were eventually standardized around
1865. Profit charts made derivatives accessible to young scientists, including Louis Bachelier
and Vinzenz Bronzin, who had the mathematical knowledge for the rigorous analysis of
derivative pricing. Consequently in 1925, the first futures clearinghouse was formed (Brown,
2014).
The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was
founded in 1848 where forward contracts on various commodities were standardized around
1865. From then on, futures contracts have remained more or less in the same form, as we know
them today. In 1919, the Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to
allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). In April
1973, the Chicago Board of Options Exchange was set up specifically for trading in options. The
markets for options developed so fast that by early 1980s the number of shares underlying the
option contract sold each day exceeded the daily volume of shares traded on the New York Stock
Exchange. There has been no looking back ever since (Brown, 2014).
Thus while a few commodity-based (e.g. agricultural) industries have a long history of
hedging with exchange-traded derivatives, the use of derivatives has indeed grown remarkably
since the introduction of foreign exchange and interest rate products in the 1970s. Derivatives are
not really new products; they were indeed around before the time of Christ however it is as from
the 1970s that they started gaining popularity (Brown, 2014).

Derivative Markets
Exchange Traded market
Where derivatives are traded via an organized financial Markets/ intermediary. This
category includes financial futures and options. These instruments have standard features like
nominal size and maturity date. A derivatives exchange acts as an intermediary to all related
transactions, and takes initial margin from both sides of the trade to act as a guarantee. The
world's largest derivatives exchanges are the Korea Exchange, the Eurex and the CME Group
(Brown, 2014).

Over The Counter


It is a decentralized market of securities not listed on an exchange where market
participants trade over the telephone, facsimile or electronic network instead of a physical
trading floor. Trading occurs through a network of middlemen, called dealers who carry
inventories of securities to facilitate the buy and sell orders of investors. There is no central
exchange or meeting place for this market. Examples of instruments traded in an OTC market
include swaps, forward rate arrangements and options. These contracts are normally 'tailor
made', that is designed to meet the specific requirements of the traders. However their costs are
higher than exchange traded instruments. Also, the absence of a clearing house for OTC contract
means that there is an element of default risk and it is largely unregulated with respect to
disclosure of information between the parties since the OTC market is made up of banks and
other highly sophisticated parties, such as hedge funds. Anyhow the OTC derivative market is
the largest market for derivatives (Brown, 2014).

Types of derivatives
Interest rate derivatives
The most commonly used interest rate derivative contracts by non-financial firms are
swaps, with somewhat limited use of caps, floors, and collars. Interest rate swaps are contracts to
exchange between floating-rate payments and fixed-rate payments. For example, if a firm wanted
to hedge against the risk of an unexpected change in cash flow to be paid, it could enter into a
contract to receive a series of floating-rate payments in return for making a series of fixed-rate
payments, based on some estimated amount of the debt instrument.
Foreign currency derivatives
Foreign currency derivatives commonly involve forwards, futures, options, and swaps.
Currency forwards are contracts that call for future delivery of a foreign currency at some
predetermined exchange rate. Futures are similar to forwards, except for the fact that futures are
traded on organized exchanges. Firms also use foreign currency swaps, which are contracts to
exchange a series of interest payments in one currency for a series of payments in some other
currency. These swap contracts may also involve a swap of interest rates, exchanging between
floating-rate payments and fixed-rate payments. Firms use foreign currency derivatives as
frequently as interest rate derivatives.
Commodity Price Derivatives
These derivatives are mostly futures, forwards, and swaps. Forwards and futures work in the
same way to those involving interest rates or foreign currencies. Commodity swaps involve an
exchange between floating-price and fixed-price payments where the floating price is based on
some price as determined in a futures market and the fixed price is based on the spot price of a
commodity, such as gold. These commodity derivatives, unlike those involving interest rates or
foreign currencies, are limited mostly to firms that produce or use commodities, such as gold or
oil.

Reference

Hull, J. C. (2006) Options, Futures and other Derivatives. New Jersey, NJ: Pearson Prentice Hall.

Frederic S. Mishkin, 2006. "Monetary Policy Strategy: How Did We Get Here?," Panoeconomicus, Savez
ekonomista Vojvodine, Novi Sad, Serbia, vol. 53(4), pages 359-388,

Brown, M. (2014, December 17). A History of Derivatives: Ancient


Mesopotamia to Trading
Places, by Edmund Parker & Geoffrey Parker [Video file]. Retrieved
from
https://www.youtube.com/watch?v=kd2pE5s33Qg