What Are... Derivatives?

Prepared By
Robb Davis Robert McDaniel David Bolles Mike McLatcher Calvin Grogan Amanda Hodges

DERIVATIVES
A Financial Instrument That Derives Its Value From An Underlying Security

Derivatives Explanation
An easy way to think of derivatives is as a side bet on interest rates, exchange rates, commodity prices, and practically ANYTHING that you can think of.

Why Derivatives?
Not to raise capital Buy or sell to protect against adverse changes in external factors

Conventional Securities Market

Traditional Securities
Amount in Billio ns of $

20,000 15,000 10,000 5,000 0 Bonds Cash Types Stocks

Types of Derivatives
Forwards Futures Options Swaps

Forwards

Forwards Contracts
The agreement to pay for and pick up, Something at a pre-determined date and or time, for a pre-determined price. Usually traded off of the trading floor between two firms.

Terms
Taking Delivery: Physical reception of item. Deliverable Instrument: The item to be delivered Making Delivery: Turning over the item. Forwards are not options, they are obligations and should be considered as a cash transaction.

Forwards
Exchange Traded Derivatives "Forwards"
7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Interest-Rate Futures Stock-Index Futures Types Currency Futures

Amount in Billio ns of $

Forwards OTC
Over-The-Counter Derivatives "Forwards"
Interest-Rate Contracts 28%

Currency Contracts 72%

A Modest Example
An agreement on Monday to buy a book, (Fin 374c) from a bookstore on Friday for $1000.00. On Friday, you return to the bookstore and take delivery of the book and pay the $1000.00. The contract is actually the agreement.

Futures

Futures
Similar to forwards in length of time. However, profits and losses are recognized at the close of business daily, Mark-to-market. Transactions go through a clearinghouse to reduce default risk. 90% of all futures contracts are delivered to someone other than the original buyer.

Futures Example
On Monday we enter into a futures contract to buy our book on Friday. We are required to place a deposit for the book of 50% ($500.00). We are told that if the book appreciates in value we may be required to increase the deposit. If the book depreciates in value, we may take back some of the money. Wednesday the book goes to $1500.00. We must deposit another $250.00. On Thursday the book drops to $750.00. We can collect $375.00. On Friday the book value is $800.00, therefore we owe $425.00 on the remaining balance.

Options

Options
Options come in many flavors. To name a few: collar, cylinder, fence, mini-max, zero-cost tunnel and straddle. These are all newer forms of options. The most common options discussed are put and call. An OPTION is the right, not the obligation to buy or sell an underlying instrument.

Option Terms
Put: the right to sell @ a certain price Call: the right to buy @ a certain price Long: to purchase the option Short: to sell or write the option Bullish: feel the value will increase Bearish: feel the value will decrease Strike/Exercise Price: Price the option can be bought or sold.

Option Market
Exchange Traded Derivatives "Options"
Individual Stock Options
Types

Stock-Index Options Currency Options Interest-Rate Options 0 500 1,000 1,500 2,000 2,500 3,000 3,500

In Billions of $

Options Continued
Over-The-Counter Derivitaves "Options"
OTC Currency Options 29%

OTC Interest-Rate Options 71%

Calls
Long a call. Person buys the right (a contract) to buy an asset at a cretin price. They feel that the price in the future will exceed the strike price. This is a bullish position.

Short a Call. Person sells the right (a contract) to someone that allows them to buy a asset at a cretin price. The writer feels that the asset will devalue over the time period of the contract. This person is bearish on that asset.

PUTS
Long a Put. Buy the right to sell an asset at a pre-determined price. You feel that the asset will devalue over the time of the contract. Therefore you can sell the asset at a higher price than is the current market value. This is a bearish position. Short a Put. Sell the right to someone else. This will allow them to sell the asset at a specific price. They feel the price will go down and you do not. This is a bullish position.

Swaps

SWAPS
New in the market, late 70s early 80s Two Types: Interest Rate & Currency

Swaps
Over-The-Counter Derivatives "Swaps"
Currency Sw aps 12%

Interest-Rate Sw aps 88%

Swap Use
To smooth out interest rate payments in a cyclic environment. To secure and level out future interest payments. To secure foreign currency for loans when you are a visitor in that country and it would be too difficult to secure credit or the cost is prohibitive.

Derivative Securities
Mortgage Backed Securities: Fanny Mae, Freddie Mac Structured Notes: Sally Mae

Derivative Securities
Derivitave Securities

800 600 400 200 0 Mortgage Derivatives Structured Notes

Explanation
Freddie Mac & Fanny Mae: Both are derivative instruments used to pool Home Mortgage loans. This creates a secondary market which allows banks to sell the loans, therefore reducing their risk. It also reduces default risk for the holder. These are also known as pass through instruments.

Contd Explanation
Sally Mae: Same principal as the previous example except they use student loans. All of these also help to keep interest rates for the underlying asset low by keeping default risk down.

Pass Through
Derivitave Securities

800 600 400 200 0 Mortgage Derivatives Structured Notes

Standard Securities
Stocks Bonds Cash

Standard Securities
Traditional Securities
Amount in Billio ns of $
20,000 15,000 10,000 5,000 0 Bonds Cash Types Stocks

Total Market
The standard market is what most people think of when they think of the market. The truth is that derivatives are the fastest growing sector of the market. In fact, they are the largest section of the market. We did not consider mutual funds in this presentation. There are more mutual funds in the market than there are stocks. Again, the next graph does not account for mutual funds.

Total Market
Total Market: Traditional & Derivative

Total Derivatives 43%

Total Traditional 57%

Any Questions?

Seriously, Any Questions?