Financial Instruments

Money & Banking

- Derivatives -

Tim Mundhenke

Content Outline
1.

Introduction

2.

What is a derivative?

3.

Reasons to use derivatives

4.

Concepts to understand

5.

Futures

6.

Forwards

7.

Options

8.

Swaps

9.

Questions

Introduction (I)
In the financial marketplace some instruments are regarded as
fundamentals, while others are regarded as derivatives.

Financial Marketplace

Derivatives

Fundamentals

Simply another way to catagorize the diversity in the FM*.

*Financial Market

Introduction (II)
Financial Marketplace

Derivatives
Futures
Forwards
Options
Swaps

Fundamentals
Stocks
Bonds
Etc.

What is a Derivative? (I)

Options

Futures

The value of the

derivative instrument
is DERIVED from the
underlying security

Forwards

Swaps
Underlying instrument such as a commodity, a stock, a stock index, an
exchange rate, a bond, another derivative etc..

What is a Derivative? (II)

Futures

Forwards

The owner of a future has the OBLIGATION to sell or

buy something in the future at a predetermined price.

The owner of a forward has the OBLIGATION to sell or

buy something in the future at a predetermined price.
The difference to a future contract is that forwards are
not standardized.

Options

The owner of an options has the OPTION to buy or sell

something at a predetermined price and is therefore
more costly than a futures contract.

Swaps

A swap is an agreement between two parties to exchange

a sequence of cash flows.

Reasons to use derivatives (I)

Derivative markets have attained an overwhelming popularity for a
variety of reasons...

Hedging:

Interest rate volatility

Stock price volatility
Exchage rate volatility
Commodity prices volatility

VOLATILITY
Speculatio
n:

High portion of leverage

Huge returns

EXTREMELY RISKY

Reasons to use Derivatives (II)

Also derivatives create...
a complete market, defined as a market in which all identifiable
payoffs can be obtained by trading the securities available in the
market*.
and market efficiency, characterized by low transaction costs and
greater liquidity.

* Futures, Options and Swaps by R.W. Kolb

Concepts to Understand
Short Selling:

Short selling is the selling of a security that

the seller does not own.
Short sellers assume the risk that they will
be able to buy the stock at a more
favorable price than the price at which they
sold short.

Holding Long Position:

Investors are legally owning a security.
Investors are the legal owners of a security.

Future Contracts (I)

Futures

The owner of a future contract has the OBLIGATION to

sell or buy something in the future at a predetermined
price.

Scenario:
You are a farmer and you know that you will harvest corn in three months
from today on. How can you protect yourself from loosing if corn price
happens to drop until March by using corn forward contracts?

t
1/1

3/1
Harvest

Future Contracts (II)

You lock into a price by holding a short position in a corn future contract
with a maturity date a little bit longer than the harvest date.

Suppose the price drops...

You either take delivery and

lock in a price.

You close out the corn

contract and the gain in the
futures market will offset
the loss in the sport market

A futures contract makes unfavourable price movements less unfavourable and

a favourable price movements less favourable!

Future Contracts (III)

General Rule for Hedgers:
If you are going to sell something in the near future but want to lock
in a secured price, you take a short position.

If you are going to receive/buy something in the future but want to

lock in a secured price, you take a long position.

Future Contracts (IV)

The Role of Speculators:
As the name implies, speculators are involved in price betting and take
the risk of price movements against them.

Assume the following:

You, as hedger, believe that prices will raise. Thus, you are convinced
that a long position will benefit you.

Key Word: Zero-Sum-Gain

Large gains due to the concept of leverage

Forward Contracts (I)

Forwards

The owner of a forward has the OBLIGATION to sell or buy

something in the future at a predetermined price. The
difference to a future contract is that forwards are not
standardized.

A Forward Contract underlies the same principles as a future contract,

besides the aspect of non-standardization. Thus, a detail illustration is not
necessary as I already elaborated in the mechanism of the futures contract.

Options (I)
Options

The owner of an options has the OPTION to buy or sell

something at a predetermined price and is therefore
more costly than a futures.

Some terms to understand:

Call option
Put option
Excersice price / strike price
Option premium
Moneyness (in-the-money, at-the-money, out-of-money)
European vs. American Options

Options (II)
The four basic positions:
Call Option

Write
Purchase

Write
Put Option
Purchase

Options (III)
Write & Purchase Call Option:

Value

Long Call

x
Stock Price at Expiration

Short Call

Options (IV)
Write & Purchase Call Option:

Profit and Loss

Premium Earned
x

Long Call
Zero-SumGame
Stock Price at Expiration

Premium Paid
Short Call

Options (V)
Write & Purchase Call Option:

Profit and Loss

Long Put

Stock Price at Expiration

Short Put

Options (VI)
Write & Purchase Call Option:

Profit and Loss

Long Put
Premium Earned
Stock Price at Expiration

Short Put

Premium Paid

Swaps (I)
Swaps

A swap is an agreement between two parties to exchange

a sequence of cash flows.

Counterparties
Interest rate swaps
Currency swaps
Phenomenal growth of the swap market
Future and Option markets only provide for short term investment
horizon
Traded in OTC markets with little regulations
No secondary market
Market limited to institutional investors

Swaps (II)
A Plain Vanilla Interest Rate Swap:
An interest rate swap is an agreement between two parties to exchange a
sequence of fixed interest rate payments against floating interest rate
payments.

Terms to understand:
Fixed side
Receive-fixed side
Tenor
Notional amount

Swaps (III)
Example:
5 year tenor; notional amount $1 million; Party A is the fixed side paying
9%, Party B is the receive-fixed side, paying a LIBOR flat rate

Party A
0
Party B
0

Libor*$1m

Libor*$1m Libor*$1mLibor*$1m Libor*$1m

$90,000

$90,000

$90,000

$90,000

$90,000

$90,000

$90,000

$90,000

$90,000

$90,000

Libor*$1m

Libor*$1m Libor*$1mLibor*$1m Libor*$1m

QUESTIONS