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ͻ The growth in the financial derivatives market over

the last thirty years has been quite extraordinary.
ͻ From virtually nothing in 1973, when Black, Merton
and Scholes did their seminal work.
ͻ Derivatives contracts today has grown to several
trillion dollars.

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ͻ This phenomenal growth can be attributed to two

factors.
ͻ The first, and most important, is the natural need
that the products fulfill.
ͻ The second factor is the parallel development of the
financial mathematics needed for banks to be able
to price and hedge the products demanded by their
customers.

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ͻ  are financial contracts, or financial

instruments, whose values are derived from the
value of something else (known as the ).

ͻ The underlying value on which a derivative is based

can be an asset (e.g., commodities, equities (stocks),
residential mortgages, commercial real estate, loans,
bonds), an index (e.g., interest rates, exchange rates,
stock market indices, consumer price index (CPI)),
weather conditions, or other items.

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ͻ A derivative is a financial instrument that derives or

gets it value from some real good or stock.

ͻ It is in its most basic form simply a contract between

two parties to exchange value based on the action of
a real good or service.

ͻ Typically, the seller receives money in exchange for

an agreement to purchase or sell some good or
service at some specified future date.

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ͻ The largest appeal of derivatives is that they offer

some degree of leverage.
ͻ Leverage is a financial term that refers to the
multiplication that happens when a small amount of
money is used to control an item of much larger
value.
ͻ A mortgage is the most common form of leverage.
ͻ For a small amount of money and taking on the
obligation of a mortgage, a person gains control of a
property of much larger value than the small amount
of money that has exchanged hands.

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ͻ Derivatives offer the same sort of leverage or

multiplication as a mortgage.
ͻ For a small amount of money, the investor can
control a much larger value of company stock then
would be possible without use of derivatives.
ͻ This can work both ways, though. If the investor
purchasing the derivative is correct, then more
money can be made than if the investment had been
made directly into the company itself.
ͻ However, if the investor is wrong, the losses are
multiplied instead.

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ͻ Derivatives can be used to mitigate the risk of

economic loss arising from changes in the value of
the underlying.
ͻ hedge risks;
ͻ reflect a view on the future behavior of the market,
speculate;
ͻ lock in an arbitrage profit;
ͻ change the nature of a liability;
ͻ change the nature of an investment;

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ͻ Derivatives can be used to mitigate the risk of

economic loss arising from changes in the value of
the underlying. This activity is known as hedging.

ͻ Derivatives can be used by investors to increase the

profit arising if the value of the underlying moves in
the direction they expect. This activity is known as
speculation.

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Wheat

„"#"$ !
„ 
Cash

Both parties have reduced a future risk:

for the wheat farmer, the uncertainty of the price, and for the miller,
the availability of wheat.

there is still the risk that no wheat will be available due to causes
unspecified by the contract, like the weather, or that one party will
renege on the contract.

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ͻ Hedging also occurs when an individual or institution

buys an asset (like a commodity, a bond that has
coupon payments, a stock that pays dividends, and
so on) and sells it using a futures contract.

ͻ The individual or institution has access to the asset

for a specified amount of time, and then can sell it in
the future at a specified price according to the
futures contract.

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%

ͻ Forwards/Futures
ͻ Options
ͻ Swaps

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ͻ Futures/Forwards are contracts to buy or sell an

asset on or before a future date at a price specified
today.
ͻ A futures contract differs from a forward contract in
that the futures contract is a standardized contract
written by a clearing house that operates an
exchange where the contract can be bought and
sold, while a forward contract is a non-standardized
contract written by the parties themselves.

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ͻ The most basic forward contracta

ͻ It is a contract negotiated between two parties for
the delivery of a physical asset (e.g., oil or gold) at a
certain time in the future for a certain price fixed at
the inception of the contract.
ͻ No actual transfer of ownership occurs in the
underlying asset when the contract is initiated.
ͻ Instead, there is simply an agreement to transfer
ownership of the underlying asset at some future
delivery date.

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'!
Seller

())


*+))&,

ͻThe party that has agreed to buy has a

Buyer
 .
ͻThe party that has agreed to 

has a

 .

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Seller

It is essentially a forward contract that is traded on an

organized financial exchange
'
à ͻ Futures markets began with grains, such as corn, oats,
and wheat, as the underlying asset.
ͻ „ 
uu  are futures contracts based on a
financial instrument or financial index.
ͻ „  u  y uu  are futures contracts calling
Buyer for the delivery of a specific amount of a foreign
currency at a specified future date in return for a
given payment of U.S. dollars.
ͻ     uu  take a debt instrument, such as a
Treasury bill (T-bill) or Treasury bond (T-bond), as
their underlying financial instrument.
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ͻ With these kinds of contracts, the trader must deliver

a certain kind of debt instrument to fulfill the
contract.
ͻ In addition, some interest rate futures are settled with
cash.
ͻ Financial futures also trade based on financial indexes.
ͻ For these kinds of financial futures, there is no
delivery, but traders complete their obligations by
making cash payments based on changes in the value
of the index.

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ͻ A futures contract is a forward contract traded on an

organized exchange.
ͻ Biggest problems traders face in using forward
contracts:
ͻ credit risk exposure
ͻ the difficulty of searching for trading partners,
ͻ the need for an economical means of exiting a
position prior to contract termination

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ͻ A second problem with a forward contract is that the

heterogeneity of contract terms makes it difficult to
find a trading partner.

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ͻ A third and related problem with a forward contract is

the difficulty in exiting a position, short of actually
completing delivery.

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„ „





„"# „

Primary market Dealers Organized Exchange

Secondary market None the Primary market

Contracts Negotiated Standardized

Delivery Contracts expire Rare delivery

Collateral None Initial margin, mark-

the-market
Credit risk Depends on parties None [Clearing House]

Market participants Large firms Wide variety

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ͻ An  is the right to buy or sell, for a limited

time, a particular good at a specified price.

ͻ For example, if IBM is selling at $120 and an

investor has the option to buy a share at $100, this
option must be worth at least $20, the difference
between the price at which you can buy IBM ($100)
through the option contract and the price at which
you could sell it in the open market ($120).

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ͻ Options are contracts that give the owner the right,

but not the obligation, to buy (in the case of a call
option) or sell (in the case of a put option) an asset.

ͻ The price at which the sale takes place is known as

the strike price, and is specified at the time the
parties enter into the option.

ͻ The option contract also specifies a maturity date.

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ͻ 6 give the party with the long position one

extra degree of freedom:
ͻ she can exercise the contracts if she wants to do so;
whereas the short party have to meet the delivery if
they are asked to do so. This makes options a very
attractive way of hedging an investment, since they
can be used as to enforce lower bounds on the
financial losses.
ͻ In addition, options offer a very high degree of
gearing or leverage, which makes them attractive
for speculative purposes too.

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ͻ Prior to 1973, options of various kinds were traded

over-the-counter.

ͻ In 1973, the Chicago Board Options Exchange

(CBOE) began trading options on individual stocks.

ͻ Since that time, the options market has experienced

rapid growth, with the creation of new exchanges
and many kinds of new option contracts.

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ͻ 

 gives the owner the right to buy a

particular asset at a certain price, with that right
lasting until a particular date.
ͻ Ownership of a u  gives the owner the right
to sell a particular asset at a specified price, with
that right lasting until a particular date.

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ͻ Swaps are contracts to exchange cash (flows) on or

before a specified future date based on the
underlying value of currencies/exchange rates,
bonds/interest rates, commodities, stocks or other
assets.

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ͻ Three kinds of dealers engage in market

activities:
ͻ Hedgers
ͻ speculators
ͻ Arbitrageurs

Each type of dealer has a different set of objectives

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ͻ Hedging includes all acts aimed to reduce

uncertainty about future [unknown] price
movements in a commodity, financial security or
foreign currency.
ͻ This can be done by undertaking forward or futures
sales or purchases of the commodity security or
currency in the OTC forward or the organized
futures market.
ͻ Alternatively, the hedger can take out an option
which limits the holder's exposure to price
fluctuations.

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ͻ Speculation involves betting on the movements of

the market and try to take advantage of the high
gearing that derivative contracts offer, thus making
windfall profits.
ͻ In general, speculation is common in markets that
exhibit substantial fluctuations over time.
ͻ Normally, a speculator would take a ``bullish'' or
``bearish'' view on the market and engage in
derivatives that will profit her if this view
materializes. Since in order to buy, say, a European
call option one has to pay a minute fraction of the
possible payoffs, speculators can attempt to
materialize extensive profits.

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ͻ In economics and finance, / is the practice

of taking advantage of a price differential between
two or more markets:
ͻ Striking a combination of matching deals that
capitalize upon the imbalance, the profit being the
difference between the market prices.
ͻ When used by academics, an arbitrage is a
transaction that involves no negative cash flow at
any probabilistic or temporal state and a positive
cash flow in at least one state; in simple terms, a
risk-free profit.

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ͻ A person who engages in arbitrage is called an

/Ͷsuch as a bank or brokerage firm. The
term is mainly applied to trading in financial
instruments, such as bonds, stocks, derivatives,
commodities and currencies.

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