Chapter 1 Overview of Derivatives

Chapter 1Introduction

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What is a Derivative?A derivative is an instrument whose value depends on, or is derived from, the value of another asset.Examples: futures, forwards, swaps, options, exotics…

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Why Derivatives Are ImportantDerivatives play a key role in transferring risks in the economyThe underlying assets include stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, the weather, etcMany financial transactions have embedded derivatives

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How Derivatives Are TradedOn exchanges such as the Chicago Board Options Exchange in US market; Bursa Malaysia Derivatives Bhd in Malaysia marketIn the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contact each other directly

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How Derivatives are UsedTo hedge risksTo speculate (take a view on the future direction of the market)To lock in an arbitrage profitTo change the nature of a liabilityTo change the nature of an investment without incurring the costs of selling one portfolio and buying another

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The ExchangeBursa Malaysia Derivatives (BMD) offers 3 categories of derivatives:

- Commodity derivatives ( crude palm oil futures)- Equity derivatives (FTSE KLCI futures, FTSE KLCI

options, single stock futures)- Financial derivatives- 3-month KLIBOR futures, 3-

years MGS futures, 5-years MGS futures

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Clearing houseBMD clearing house clears and settles derivatives contract through derivatives clearing and settlement system (DCS)Allow market participants to deal freely with each other without credit risk constraints.

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Electronic TradingTraditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchangeThis has now been largely replaced by electronic trading and high frequency algorithmic trading is becoming an increasingly important part of the market

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Forward PriceThe forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)The forward price may be different for contracts of different maturities (as shown by the table)

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TerminologyThe party that has agreed to buy has what is termed a long positionThe party that has agreed to sell has what is termed a short position

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Futures Contracts Agreement to buy or sell an asset for a certain price at a certain timeSimilar to forward contractWhereas a forward contract is traded OTC, a futures contract is traded on an exchange

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Exchanges Trading FuturesCME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade)NYSE EuronextBM&F (Sao Paulo, Brazil)TIFFE (Tokyo)and many more (see list at end of book)

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Over-the Counter MarketsThe over-the counter market is an important alternative to exchangesTrades are usually between financial institutions, corporate treasurers, and fund managersTransactions are much larger than in the exchange-traded market

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Options

A call option is an option to buy a certain asset by a certain date for a certain price (the strike price)A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

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American vs European OptionsAn American option can be exercised at any time during its lifeA European option can be exercised only at maturity

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Options vs Futures/ForwardsA futures/forward contract gives the holder the obligation to buy or sell at a certain priceAn option gives the holder the right to buy or sell at a certain price

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Types of TradersHedgersSpeculatorsArbitrageurs

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Hedging Examples A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contractAn investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

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Value of Microsoft Shares with and without Hedging

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DangersTraders can switch from being hedgers to speculators or from being arbitrageurs to speculatorsIt is important to set up controls to ensure that trades are using derivatives in for their intended purpose.

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