Introduction to derivatives

Susan Thomas Ajay Shah

Sri Lanka, 5 October 2007

 Outline

• What are derivatives

• How trading takes place with futures and options
• Basic relationships between spot and futures
• Hedging, speculation, arbitrage
• Risk management at the clearing corporation
• Assessment
• Fears of derivatives
 Part I

What are derivatives

 The idea of derivatives

The derivatives market is a giant system of side bets on

economic and financial outcomes. Examples:
1. A contract that gives you 1 MT of wheat for $400 on
31-12-2007, regardless of what the spot price then
prevailing is.
2. A contract that gives you 1 MT of wheat at the lower of : (a)
The wheat spot price on 31-12-2007 or (b) $400.
3. A contract that gives you $1 if the price of wheat on
31-12-2007 is above $400/MT.
4. A contract that gives you $1 if the price of wheat on
31-12-2007 is between $400 and $401 per MT.
 But, isn’t this gambling?

Answer 1 Yes.
Answer 2 It can be gambling, but it’s not only gambling.
Answer 3 It performs an economic function.
Answer 4 It performs a critical economic function.
Finance is the brain of the economy.
Derivatives are the brain of finance.
 But, isn’t this gambling?

Answer 1 Yes.
Answer 2 It can be gambling, but it’s not only gambling.
Answer 3 It performs an economic function.
Answer 4 It performs a critical economic function.
Finance is the brain of the economy.
Derivatives are the brain of finance.
 But, isn’t this gambling?

Answer 1 Yes.
Answer 2 It can be gambling, but it’s not only gambling.
Answer 3 It performs an economic function.
Answer 4 It performs a critical economic function.
Finance is the brain of the economy.
Derivatives are the brain of finance.
 But, isn’t this gambling?

Answer 1 Yes.
Answer 2 It can be gambling, but it’s not only gambling.
Answer 3 It performs an economic function.
Answer 4 It performs a critical economic function.
Finance is the brain of the economy.
Derivatives are the brain of finance.
 But, isn’t this gambling?

Answer 1 Yes.
Answer 2 It can be gambling, but it’s not only gambling.
Answer 3 It performs an economic function.
Answer 4 It performs a critical economic function.
Finance is the brain of the economy.
Derivatives are the brain of finance.
 But, isn’t this gambling?

Answer 1 Yes.
Answer 2 It can be gambling, but it’s not only gambling.
Answer 3 It performs an economic function.
Answer 4 It performs a critical economic function.
Finance is the brain of the economy.
Derivatives are the brain of finance.
 But, isn’t this gambling?

Answer 1 Yes.
Answer 2 It can be gambling, but it’s not only gambling.
Answer 3 It performs an economic function.
Answer 4 It performs a critical economic function.
Finance is the brain of the economy.
Derivatives are the brain of finance.
 Vocabulary

• One difficult thing about the derivatives field is an

intimidating vocabulary
• Many ordinary English words are reused, but now they
have technical meanings
• Get a grip of the jargon and you will come a long way.
• “Long” is the buyer of a derivative
• “Short” is the seller of of a derivative.
 Vocabulary

• One difficult thing about the derivatives field is an

intimidating vocabulary
• Many ordinary English words are reused, but now they
have technical meanings
• Get a grip of the jargon and you will come a long way.
• “Long” is the buyer of a derivative
• “Short” is the seller of of a derivative.
 Forwards

• The long and short agree on a transaction on date 0

• They pin down:
1. The identity of the goods (e.g. ‘red winter wheat’)
2. The future date of settlement - always termed T
3. The future price - termed “the forward price”
4. No money changes hands today. This fact constrains the
value of the forward price.
• Once this is agreed upon, both sides are obligated to go
through with the contract.
 Forward positions can be traded

• On date 0, L1 and S enter into a forward contract. (No

money changes hands).
• On date 1, L1 can sell off his position to L2 . (Some money
can change hands). Now the position is between L2 and S;
L1 is out of the picture.
 Extinguishing a position

• Suppose L1 transfers his position to L2

• Suppose S1 transfers his position to S2
• Now L2 is long and S2 is short.
• Now suppose L2 sells his position to S2
• The contract is extinguished.

In a forward market, traders talk to each other on phone, or on

electronic chat systems, and positions are continually
created/transferred/extinguished.
 Open interest

The sum total of all long positions of the market is called open
interest.
 The futures market

Exchange traded forwards are called futures.

Off-exchange trading is termed ‘the OTC market’.
 Options

• A call option is the right, but not the obligation, to buy a

stated product at a stated price at a stated future date.
Jargon: strike price.
• The call-holder wins when the future spot price turns out to
exceed the strike price.
• A put option is the right but not the obligation to sell.
 Part II

How trading takes place with futures and

options
 Let’s focus on exchange traded derivatives

1. The exchange defines a futures contract - pins down the

underlying and the expiration dates.
2. In the case of options, the exchange pins down the
underlying, the strike prices, the expiration dates.
3. Buyers and sellers come to the exchange.
 Contract cycle

Jan Feb Mar Apr

Time
Jan 30 contract
Feb 27 contract
Mar 27 contract

Apr 24 contract
May 29 contract
Jun 26 contract
 Part III

Basic relationships between spot and futures

 Two paths to the same outcome

Path I
1. Borrow money today
2. Buy gold
3. Store the gold till date T
Path II
1. A long position on a gold
forward market
2. Utilise this to get gold on T

Law of one price: Two trading strategies which have the same
risk and return must have the same price.
 Two paths to the same outcome

Path I
1. Borrow money today
2. Buy gold
3. Store the gold till date T
Path II
1. A long position on a gold
forward market
2. Utilise this to get gold on T

Law of one price: Two trading strategies which have the same
risk and return must have the same price.
 Fair price of the forward

• What is the fair price of forward gold?

• The seller of the forward must do this to eliminate his risk:
1. Borrow money
2. Buy spot gold
3. Pay to store it.
• So the forward price on date 0 must be:

F0 = (1 + r )T S0 + δS0
where r is the interest rate for borrowing till T , S0 is the
present spot price and δ is the fraction of S that’s paid for
storage.
• Storage costs can sometimes be negative - e.g. shares
earns dividends while stored.
 “Basis”

Basis = forward price - spot price

Sometimes expressed in percent.
 Part IV

Hedging, speculation, arbitrage

The evil arbitrageur?
 What forces the forward price to the fair value?

We know:

F0 = (1 + r )T S0 + δS0
Suppose this is not satisfied.
Suppose the forward price is higher It is advantageous to buy
gold on the spot, store it, and simultaneously sell
off forward gold.
Suppose the forward price is lower It is advantageous to
borrow gold, sell it on the spot, and simultaneously
buy forward gold.
These are arbitrage: riskless strategies to make money.
 One day in the life of infosys
2090
2080
z.s[, "p"]

2070
2060

11:30 13:30 15:30

 One day in the life of infosys - the basis
0.5
0.4
0.3
basis

0.2
0.1
0.0

10:00 11:00 12:00 13:00 14:00 15:00

 Speculation

• You believe gold prices will go up.

• Buy gold forward today.
• You have to pay nothing today! Unlike speculation by
purchasing on the spot market, which is very capital
intensive.
• This is leverage - it’s akin to speculation based on buying
on the spot market using borrowed money.
• If you are right, spot prices and forward prices will go up.
• Then you’ll close out the forward position and profit
fabulously.
• If you are wrong, you’ll lose fabulously.
 Hedging

• You are a bakery that expects to buy wheat next month.

• You are now exposed to the fluctuations of wheat prices.
• So you get into a forward contract to lock-in a future
purchase.
• This eliminates your risk.
• Forward contracting enables planning.
 Hedging, speculation, arbitrage

Hedging You have a risk, you lay it off onto the derivatives
market. Someone else bears the risk.
Speculation You have a view about future price fluctuations.
You take a position on the derivatives market. This
increases your risk.
Arbitrage You invest capital into the derivatives market to
earn attractive riskless returns.
Any well functioning derivatives market must have all three
kinds of players.
 Part V

Risk management at the clearing corporation

Bilateral credit risk exposures

Long

Funds Goods

Short
 The bane of forward markets

• For centuries, forward markets have collapsed owing to big

defaults.
• It is too tempting for a speculator to build up a large
position.
• Then he gets surprised by the wrong price fluctuations and
goes bankrupt.
• In a large, intricately interlocked market, there can be a
‘domino effect’ where one big failure triggers off a
nationwide payments crisis.
• This kept on regularly happening for centuries.
• The puzzle: How to harness the benefits of derivatives
trading without running afoul of this counterparty credit
risk?
 The bane of forward markets

• For centuries, forward markets have collapsed owing to big

defaults.
• It is too tempting for a speculator to build up a large
position.
• Then he gets surprised by the wrong price fluctuations and
goes bankrupt.
• In a large, intricately interlocked market, there can be a
‘domino effect’ where one big failure triggers off a
nationwide payments crisis.
• This kept on regularly happening for centuries.
• The puzzle: How to harness the benefits of derivatives
trading without running afoul of this counterparty credit
risk?
Interpose a guarantor between the long and the short

Long

Funds Goods

Clearing
Corporation

Funds Goods

Short
 The hot seat: the clearing corporation

• The CC bears the credit risk of every clearing member in

the economy.
• This requires a sophisticated risk management system.
• The CC imposes collateral requirements on market
participants through which it ensures low failure rates and
protects itself when failure happens. It’s requirements are
termed initial margin and mark to market margin.
• 1987 - Hong Kong’s clearing corporation collapsed. Paris
almost had one default.
Barring these, CCs have worked well for over a century!
 Exchange traded vs. OTC derivatives
Exchange traded
Exchange defines product
A centralised place to trade; a
small list of traded products;
high liquidity
Credit risk always eliminated
through CC
User’s exact needs might not
be met owing to a fixed set of
standardised products
Transparency through elec-
tronic trading; low fees to fi-
nancial firms
OTC
Buyer and seller agree on any
spec they like
Fragmented trading; too many
products; inferior liquidity
Credit risk present when
there’s no CC
Limitless customisation
Typically non-transparent;
typically high fees to financial
firms.
 Part VI

Assessment
 The age of vol
2000
1600
KRW per USD

1200
800

1985 1990 1995 2000 2005

How derivatives reshape the market process

Pure Spot Market With Derivatives

News News

Speculators Speculators Cash Market

Cash Market Derivatives Market Arbitrageurs

A flood in Chicago
It’s impact on the spot market in New York
 Part VII

Fears of derivatives
 Derivatives are prominent in every crisis

• Derivatives are now the lifeblood of finance

• So it is inevitable that they are prominent in every crisis.
• Many people blame derivatives for crises.
Derivatives trading - no free lunch
Cause and effect?
 Boeing 747s

• Every now and then a 747 crashes

• These are spectacular events, much reported by the media
• Thousands of mundane flights go unreported
• Trillions of dollars of derivatives activity every day goes
through smoothly.
Go back to the old virtuous days?
 Summary: Jargon

forwards • long • short • forward price • date 0 • date T •

extinguishing a position • open interest • futures • call option •
strike price • put option • exchange-traded derivatives • OTC
derivatives • underlying • contract cycle • law of one price • fair
price • storage costs • basis • arbitrage • arbitrageur • hedging
• speculation • leverage • bilateral credit risk • clearing
corporation • initial margin • mark-to-market margin
Thank you.