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Introduction to Financial Derivatives
Ill fares the land, to hast‟ning ills a prey, Where wealth accumulates, and men decay. OLIVER GOLDSMITH, The Deserted Village (1770) Wealth is not without its advantages, and the case to the contrary, although it has often been made, has never proved widely persuasive. JOHN KENNETH GALBRAITH, The Affluent Society (1958)
Finance is about wealthaccumulating and preserving it. The effect of wealth on the lives of even the least avaricious man is enormous. When men decay in accumulating wealth, history proved Goldsmith right: look no further than the fall of Venice, Florence, Holland, and England as centers of international finance.
1.1. Wealth Before civilization, wealth was necessary: it meant the basic necessities (ie, food, clothing and shelter) that were hunted. Civilization brought in the concepts of family, progeny and leisure. Man had to hunt and hoard wealth because it was required for next day‟s consumption, for next generation‟s consumption. What had been a need became greed, too. Now and then there was an odd man, like Prince Siddhartha, who preached that wealth (and everything else) was misery. The great majority, however, thought that hoarding wealth was not misery but a virtue worthy of effort. Though philosophers, theologians and aristocrats did spurn wealth, they still had self-interest in it. Philosophers were a leisured class; theologians were propped up by the charity of the wealthy; and aristocrats were what they were because of their wealth. Wealth was even justified by a new branch of science called economics, which inquired into wealth. Assured thus that wealth is not a crime, vice or sin, we will proceed further to study it. 1.2. Physical Assets Hoarding wealth required storing it. The medium for storing wealth was different in different waves of civilization. In the first wave, marked by agriculture, wealth was stored in physical assets such as land, house and precious metals. Physical assets had visibility, which assured one of one‟s wealth. They had solidity, too, giving the possessor a feeling of permanence. Their disadvantage was that they were cumbersome for exchange and prone to loss from natural calamities or theft. Besides, they put a limit on the expansion of wealth. The situation led to the invention of fiduciary assets.
1.3. Fiduciary Assets Fiduciary assets were “paper money.” Whereas physical assets required none else, fiduciary assets required two counterparts to store wealth: the issuer and the holder. It made wealth a financial contract or claim between two counterparts. Fiduciary assets were handy to store, exchange, and transport wealth. They were not subject to risk from natural calamities and theft. More important, they were self-growing: wealth could earn interest
the higher return was an expectation. Derivative Assets The third wave of civilization.on its own. sitting separately on benches2. Derivative assets are so called because they derive their existence from that of another called the underlying asset. Despite an occasional mania or crisis. The problems sprang up more out of greed than dishonor. the contract had indefinite life. which had no such guarantee for return. which was the center of international finance during the 17th century. and were called risk-free assets1. not a promise. First. However. It traces its origin to the plains of Lombard during the 12th century. Over time. The value of the derivative asset depends on the value of the underlying asset on delivery date. Forward contract is the first derivative asset. The danger from fiduciary assets was the failure of the issuer to perform the promise. someone invented a new class of assets. they became established in an organized way and scale only in the postindustrial society. Fiduciary assets took different forms. A contract today to buy or sell SBI stock for delivery and settlement on a later day is a derivative asset: it is called a forward or futures contract. higher risk. the stock of State Bank of India (SBI) is the underlying asset. There were occasional problems between a Shylock and an Antonio. The Man of Property. fiduciary assets stuck as the predominant medium for wealth. building houses?I couldn‟t get four per cent. For example. would provide foreign exchange for merchants. The following passage from John Galsworthy‟s novel. were called risky assets. which took over the mantle from Holland during the 18th century. For. a bank is merely a bench to sit on! . for my money!” “What does that matter? You‟d get fresh air.” he said. “it would do you a lot of good. The former was tolerable: the latter was not. Without the underlying asset.” „Why?” began James in a fluster. However. The contract was held so sacred a covenant that the system of wealth was safe. The higher return. England. which brought in industrialization. Merchants from different countries would trade their goods in the cross-border fairs. It appeared as if the risk were the original sin and the return was born with it. of course. which is ignored here. Holland. which offered higher return than other fiduciary assets. Thus. avoiding her eye. there is no return without commensurate risk. shares and stocks.4. which is the present postindustrial society. The stocks and shares gave their holders high return and.” “Fresh air!” exclaimed James…“You don‟t know the value of money. default risk). Bonds and other fixed-income assets had guaranteed return. which was the second conceptual breakthrough with fiduciary assets. however. suffered the Tulip Mania in 1630s. 1 Any financial asset has credit risk (ie. “Buying landwhat good d‟you suppose I can do buying land. There were IOUs between counterparts who were slightly less honorable. aptly captures the attitude to wealth. Second. and were collectively called financial assets. had similar crisis in the South Sea Bubble in 1720. invented yet another medium for wealth: derivative assets. the system of wealth had always a Portia around to intelligently solve the problem. the derivative asset does not exist. which is the root word for bank in many European languages. demanded two concessions. Risk-free asset in this book is the one with fixed return. though not so less as to be dishonorable. There was paper money issued by central banker. In the second wave of civilization. This led to the birth of the secondary market where wealth could be traded by the wealthy. Stocks and shares. 1. “Why don‟t you go into country?” repeated June. History has recorded that the derivative assets had been in existence for long. who was more honorable than others. Italian moneychangers. 2 Italian word for bench is banca. honesty fell and greed rose among the wealth-seekers.
. and futures price. Nor does the market know about the price contracted.Legend has it that the moneychanger once explained to a merchant that franc was then costly because there was good demand for French wine. Futures contract is the first publicly traded derivative asset. he could have sold it to anyone in the market. The next derivative asset. if the merchant in the example above decides not to buy French wine. The price contracted may not be the market price. future price means the price that will prevail on a later date. and futures (plural) when referring to the derivative asset. An initial purchase (or sale) contract entered into with a counterpart can be unwound by a reversing sale (or purchase) with any other. 3 We use future (singular) when referring to time. which enables secondary market and provides liquidity. It also provides leverage: ability to buy without fully paying for it. the futures contract is standardized for amount and delivery dates. Further. Its disadvantage is that it is a private contract between two counterparts. The moneychanger again explained to the merchant that it was not necessary to buy franc in advance. addressed the twin problems of price transparency and liquidity. Accordingly. Had he bought francs in cash instead. we may say that forward contract removes price risk but creates liquidity risk. Such offsetting. the merchant had gone to the moneychanger to buy francs before the fair commenced. requires some common standards for the fungibility of futures contract. the futures3 contract. There being no secondary market for forward contract. And that was the first forward contract. he will have to cancel the forward contract with the same counterpart and with the same lack of transparency in price. he could commit to buy on a later date at a rate fixed today. or sell without owning or possessing it. Instead. Thus. the current price of the futures contract. During the next fair. Forward contract removes the uncertainty about the price in future. Buyers and sellers assemble at one place and openly transact business in buying and selling of the underlying asset for delivery on a future date.
structured notes. futures contract has margining and mark-to-market provisions. the sequence in the list is also the sequence of their appearance in markets. The change in value between the contract rate and the current rate is settled everyday between buyer and seller. Credit derivatives are the latest derivatives and have appeared in the 1990s. Credit risk is perhaps the oldest risk known in banking industry and yet assessed subjectively and differently by bankers. and the accumulated change in value is settled at maturity. the inverse floater gains in value when the interest rate falls. the standardization may result in imperfect hedge. Other structured notes include bonds that pay interest rate according to the level of market price of a specified commodity or stock index. asset-backed securities. Second. In contrast. the futures price is made to reflect the current market conditions. negative convexity. if the quantity of exposure to be hedged is 102 and the market lot is 100. options. Further. Range floater is a combination of simple floating-rate security with a ceiling and floor for the rate. Broadly. futures. and has become more popular than forward contracts. Structured notes are bonds whose yield is linked to a reference yield or the market price of an asset in a specified way. which are safeguards against credit risk. it also takes away something. which is not as risky as price risk. the futures contract converts price risk into basis risk. and traded separately in the market. For example. inverse floater is a floating-rate security that pays lesser interest as the reference market rate (such as LIBOR) goes up. These derivative assets behave like fixed-income securities with unusual properties (ie. swaps.Though the futures contract provides price transparency and liquidity. Asset-backed securities rolled out from the securitization of mortgages in the USA. the exposure remains unhedged on the 31st day. Alternatively. In other words. There are many kinds of derivative assets: forwards. Some such as dual currency bonds pay interest in a foreign currency. and trade the former. and a brief comment on other derivatives is given below. For example. and credit derivatives. A particular investor may indeed desire such unusual features given a particular outlook on interest rate changes or particular risk-return profile. Overall. a 6% mortgage with a face value of 100 may be split into a discount strip of 2% bond with a face value of 50 and a premium strip of 10% bond with a face value of 50. The underlying mortgage security is split into interest-only (IO) and principal-only (PO) strips. They separate credit risk from interest rate risk in a fixed-income security. the futures contract gives more than what it takes away. This book analyzes the option instrument in detail. First. if the exposure is due in 31 days and the delivery of futures contract is 30 days. negative duration) because of prepayment feature. Because of standardization. The price . the hedge is complete only for 100. In the mark-to-market process. the forward contract‟s price remains constant and its value changes everyday based on the current market conditions. Though it appears unusual or even irrational. the value is made zero everyday by changing the price.
bank guarantee and letter-ofcredit are off-balance-sheet items but not derivative assets. is against the covenant. and is accordingly called the option writer. The name “option” was coined later. and the writer “sells” the privilege and is the option seller. Leverage is both an advantage and a disadvantage. (2) Right to sell the asset. Obviously. 4 Options were originally called privileges. one can sell something when one possesses or produces it. For example. the backing out is provided in the contract itself so that it was honorable. At higher levels of leverage. For example. not the asset itself. For speculation. Option Contract The need for option contract stems from the dangers of leverage in forward and futures contract. In this case. The option seller does neither. If both were to possess it. We need to know only the current price of the underlying asset. In this case. he would be selling the asset. The same magnification applies to loss. And thus was born the option contract. he would be buying the asset. and the other who granted it. we can objectively fix the “fair” price of derivative asset. however.of a traded credit derivative is the price of credit risk perceived by the market. the grantor or writer. For hedging purpose. the holder “buys” the privilege and is the option buyer. and linkages in cashflowsnone of them is difficult or subjective. Thus. too. there would be no contract. 1. some element of subjectivity is apparent. it is a double-edged knife. It is important to recognize that the common element among all derivative assets is that they derive their existence from that of an underlying asset. which may be a better indicator than that assessed by a particular banker. The pricing of derivatives is. the option seller sells the right-to-buy or right-to-sell the underlying asset. More important. The backing out. time-value of money. surprisingly. Asset-backed securities and structured notes are not off-balance-sheet items and do not provide leverage. Since the price of derivative asset is contingent on the price of underlying asset. which obliges the option seller to buy the asset. With a leverage of 10. and may not be precise. (1) Right to buy the asset. a gain of one percent in the price of underlying asset will translate into a gain of 10 percent. which obliges the option seller to sell the asset. . the option seller is selling a right on the asset. it is an advantage because it does not lead to any cash outflow at the time of contract. The word “option seller” is a little confusing. Derivatives are often confused with off-balance-sheet items or with those providing leverage. The counterpart holding it is the holder. the risk will be so high and dangerous that it may overshadow the return and prompt the holder to back out of the contract.5. however. the “cross rates” in foreign exchange such as GBP/DEM or DEM/INR can be considered derivatives because they derive their existence from two underlying assets that are quoted against the numeraire USD. We can say that he underwrites the risk from the underlying asset. To let the higher risk coexist with higher return and yet safeguard the financial system. In these cases. easy and objective in most cases. The exception to this pricing principle is the pricing of long-dated interest rate swaps and credit derivatives. Nor do all off-balance-sheet items qualify to be derivatives. The right can be as follows. only one counterpart can possess this privilege4 of backing out. Thus. In other words.
its price would depend on the price of the underlying stock.2.2. and the limits on and relationship among prices of various options. The option writer. It introduces. and compares the option with other financial instruments. This is a breakthrough. The third concept is a trick to simplify the solution to a complex mathematical equation. on the other hand. risky assets) in value as time passes. therefore. it is also the chapter that involves stochastic calculus. three crucial concepts in option pricing. and is accordingly called a wasting asset (see sections 3. 1. the “art of reading is to skip judiciously. we will analyze the nature and components in option price. The option being a contingent claim. The next chapter introduces the basic option vocabulary. which is the pans asinorum of mathhaters. Chapter 6 describes the model for stock price changes. without mathematics. It is the part that involves mathematics. options on stocks are the most popular options. the option buyer pays the option writer the option price to secure the right-without-obligation. Stocks are the most popular financial assets. With intuition and without mathematics. Options: Distinctive Features and Ubiquity The option is distinct among the derivatives.G.6.” (P. The options pricing is used to value “real options” such as expenditure on R&D. Not only do various financial instruments but also financial activities have the option feature. Readers may safely skip them. is exposed to an unknown amount of loss. Structure of this Book This and the next chapter are the Part I of the book. the investors can still replicate their payoffs. Accordingly. expansion. Unfortunately. the option theory has been generalized and applied to corporate finance. Replicating options by buying and selling an appropriate quantity of underlying asset is illustrated. when appropriately combined. It is necessary. Strange as it may seem. The sections with complex mathematics or statistics marked MATH or STATISTICS. The first shows that two risky assets. Thus.5). One risky asset acts as a hedge against the other. Chapter 7 is a primer on pricing and an essential reading. will form a risk-free portfolio. We will see in later chapters that the option price is fair to both the counterparts. the option contract is ubiquitous despite being apparently unusual. etc. riskless assets) or expected to grow (eg. Hamerton) Chapters 9 and 10 examine the more important side of option pricing: hedging. namely. The loss to the buyer is always “limited”: he does not lose more than the option price. The option contract thus appears quite unfair to the option writer and very favorable to the option buyer. and the clue to the successful pricing of options. like basic principle of “like cures like” in homeopathy. Chapter 8 is the path-breaking work of Fischer Black and Myron Scholes on option pricing. Another feature is that it loses a part or whole of its value over time. even if the regulators ban options.1. The second concept shows that option can be replicated by buying an appropriate quantity of underlying asset with borrowed money. advertisement. which could be higher than the option price. Part III with seven chapters introduces option pricing and hedging. After all. risk-free hedge portfolio.Any buyer has to pay for what is bought no matter whether it is an asset or a right. Chapter 11 details .2 and 3. to discuss the model for stock price behavior. It is not necessary to master stochastic calculus to use options inasmuch as it is not necessary to master automobile engineering to drive a car. or short-selling an appropriate quantity and investing the short-sale proceeds. The other financial assets either grow (eg. It should be noted that price is different from pricing. and its hallmark is the right-without-obligation for its buyer and obligation-without-right for its writer. Therefore. In recent years. equivalent portfolio and risk-neutral valuation. Part II in three chapters examines the option price.
and volatile markets. the regulators require us to follow both. bearish. Chapter 20 examines the structure. investment and insurance. stocks. Chapters 15. and other instruments in corporate finance.” .” a concept that has gained some notoriety in the wake of US stock market crash in October 1987. sideways. functioning. For many. Chapter 21 reviews the approaches to market-making in options. Chapter 22 generalizes the option theory to price corporate liabilities like bonds. which is intuitive and without mathematics. Chapter 13 analyzes the risk and return from options in a proper perspective using the modern portfolio theory. Part VI is the last part of the book with three chapters. a curse. 16 and 17 analyze the various option exposures for speculation. The last chapter reviews “exotic options” and the field of “financial engineering. Whether we like it or not. uncertain. and how to select an exposure for bullish. Chapter 18 deals with “portfolio insurance. and Chapter 12 details the other pricing models. convertible bonds. Part V deals with the options market. the former is boredom and the latter. Chapter 19 deals with two topics: accounting and tax treatment. Part IV is the most practical part: use of options.the binomial method of option pricing. and practices of organized option markets. Chapter 14 discusses the basic option gear required for using options.
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