Derivatives

What Are Derivatives?

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Types of Derivatives
Types of Derivatives
Advantages
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Disadvantages
● Inherently high risk
● Speculative in nature
● Counterparty default risk
Options in derivatives
● Options are contracts that give the bearer the
right, but not the obligation, to buy or sell an
amount of some underlying asset at a
predetermined price at or before the contract
expires.
● Call option- right to buy
● Put option- right to sell
Call Option example
You, a potential homeowner, see a new development
going up. You may want the right to purchase a home in
the future, but only want to exercise that right once
certain developments around the area are built. You can
buy a call option from the developer to buy the house at
$400,000 at anytime within the next three years. To lock-in
that right, you would have to pay a down-payment, known
as a premium (price of the option contract). Let’s say,
$20,000.
Call Option example (cont.)
Two years have passed, the developments have been built
and zoning has been approved. In that time, the market
price may have doubled to $800,000, but because of the
call option, you may exercise the right to buy the home for
$400,000, as agreed upon. Adversely, if zoning isn’t
approved until the fourth year, the contract has expired,
and you must now pay the market price. In either instance,
the developer keeps the $20,000 premium.
Put Option example
Put options can be seen as insurance. In fear of a bear market
in the near future, you want insurance on your S&P 500 index
portfolio, and aren’t willing to lose more than 10%. If the S&P
500 is currently trading at $2500, you may purchase
(premium) a put option giving the right to sell the index at
$2250 at any point within, let’s say, the next two years. If the
market drops by 20% within the next two years ($2000), you
may exercise your right to sell the index at $2250. If the
market doesn’t drop, the most you lose is your premium.
Evolution of Derivatives
Derivatives Markets have existed since the Middle Ages

- Originally developed to meet the needs of farmers and

merchants.
- Sprouted because of the fact that humans have not
liked the idea of economic and financial uncertainty.
- Seen in the cultures as Mesopotamia, wherein farmers
had the right to walk out of their liabilities, when
uncontrollable factors hinder farming activities.
Evolution Of Derivatives
The Chicago Board of Trade (CBOT)
- First derivatives market established in 1848.
- Purpose: to bring farmers and merchants together.
- Intention was to standardize quantities and qualities of grains
that were traded.
- Eventually of buyers and sellers negotiating ‘customized
contracts’, there were now standard contracts being
exchanged.
- Offers futures contract on corn, oats, soybeans, soybean oil
wheat, silver, treasury bonds, and treasury notes.
Evolution Of Derivatives
Chicago Produce Exchange
- With the success of CBOT, they soon created a spinoff in 1874.
- This provided a market for perishable agricultural products
(butter, eggs, poultry, etc.)
- Renamed in 1919 as the Chicago Mercantile Exchange and
provided a futures market for commodities like pork bellies,
live cattle, live hogs, and feeder cattle.
- In 1982, it introduced a futures contract, and a Eurodollar
futures contract on the S&P 500 Stock Index.
Evolution Of Derivatives
International Monetary Market (IMM)
- Formed in 1972 as a division of the Chicago Mercantile
Exchange for futures trading in foreign countries.
- Foreign currencies like British Pound, the Canadian futures
Dollar, the Japanese Yen, the (Swiss Franc, the German mark)
European Euro and the Australian dollar.
Evolution Of Derivatives
Modern Day Derivatives
- The modern financial market have been patterned on the idea
of derivatives.
- A derivative for pretty much everything exists nowadays
including stocks, indices, commodities, real estate, etc.
- The reason behind this rapid expansion is that derivatives meet
the needs of a large number of individuals and businesses
worldwide.
in loving memory