Lecture 1: Introduction to Derivatives

Outline

Introduction

What is a derivative?

An overview of financial markets

The development of derivatives

The role of financial markets

Ways to think about derivatives

Buying and short-selling

Introduction

Instructor Information
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Instructor: Dr. Ruoyan Huang

Email: ryhuang@hku.hk

Office: Room 1115 K K Leung Building

Office hour: by appointment only

Introduction

TA Information
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TA: Mr. Terrence Mak

Email: tmch@hku.hk

Office: TBA

Office hour and tutorial session: TBA

Introduction

Class Information
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Where to meet: MWT7 (Session B) / LE2 (Session C)

When to meet: Mon. 09:30-12:20 (Session B) / 14:30-17:20

(Session C)

Course website: MOODLE via HKU portal

Textbook: McDonald, Robert L., 2013, Derivatives Markets, 3rd

edition

Introduction

Exam Information
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1st Midterm: Oct. 24th, 2016

2nd Midterm: Nov. 14th, 2016

Final: TBD

Introduction

Grading
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In-Class and Tutorial Performance: 5%

Assignments: 20%

Mid-term Examination: 20%

Final Examination: 55%

Derivatives make headlines

Astounding growth since 1970s

Cause losses and make headlines

Do derivatives mostly threaten firms and the economy?

What Is a Derivative?

Definition
An agreement between two parties which has a value determined by
the price of something else

Types
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Options

Futures

Swaps

The trading of a financial asset involves ...

Four steps:
1. Striking a deal
2. Clearing
3. Settling
4. Maintaining records

Trading of financial claims can take place on ...

Organized exchanges

Over-the-couter (OTC) market

Measures of Market Size and Activity

Open interest: the total number of contracts that are open

(existing obligations)

Trading volume: the number of financial claims that change hands

Market value: the sum of the market value of the claims that could
be traded

Notional value: the scale of a position, referring to the underlying

asset

Example 1: Trading Volume versus Open Interest

Time

Trading Activity

Trading Volume

Open Interest

Day 1

A buys 1 option and B sells 1 option contract

Day 2

C buys 5 option and D sells 5 option contracts

Day 3

A sells his 1 option and D buys 1 option contract

Day 4

E buys 5 option from C who sells 5 option contracts

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Example 2: Market Value versus Notional Value

S&P index is traded at $2, 000

One S&P Index futures contract leverages 250 units of the

Market value of 1 unit of S&P index = $2, 000

Notional value of 1 unit of S&P futures contract = $2, 000 250

The Five Largest Stock Exchanges as of 31

January 2015

Rank

Exchange

Market Cap (billions of US$)

1
2
3
4
5

New York Stock Exchange

NASDAQ
London Stock Exchange Group
Japan Exchange Group Tokyo
Shanghai Stock Exchange

19,223
6,831
6,187
4,485
3,986

Increased Volatility: Oil price 19472006

Increased Volatility: DM/$ rate 19472006

Monthly change in 3-month Treasury bill rate,

19472006

Increased volatility led to new and big markets

Exchange-traded derivatives

Over-the-counter traded derivatives: even more!

Millions of futures contracts traded annually at the Chicago Board

of Trade (CBT), Chicago Mercantile Exchange (CME), and the New
York Mercantile Exchange (NYMEX), 19702006.

The CME and CBT merged in 2007.

Increased volatility led to new and big markets

Exchange Traded Contracts

Contracts proliferated in the last three decades

What were the drivers behind this proliferation?

Examples

CME/CBT
S&P 500 index
10-year U.S.
Treasury bonds
Eurodollar
Japanese yen
Corn
Soybeans
Heating and cooling
degree-days

Eurex
DJ Euro Stoxx 50 index
Euro-bond (10-year German
government bonds)
Euribor
DAX stock index
DAX index volatility
iTraxx 5-year index
Individual stocks

NYMEX
Crude oil
Natural gas
Heating oil
Gasoline
Gold
Copper
Electricity

Estimated year-end notional value of outstanding derivatives contracts, by category, in

billions of dollars.

The Role of Financial Markets

Insurance companies and individual communities/families have

traditionally helped each other to share risks

Markets make risk-sharing more efficient

Diversifiable risks vanish

Non-diversifiable risks are reallocated

Example: earthquake bonds by Walt Disney in Japan

Uses of Derivatives

Risk management

Speculation

Reduced transaction costs

Regulatory arbitrage

Three Different Perspectives

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End users
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Corporations

Investment managers

Investors

Intermediaries
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Market-makers

Traders

Economic Observers
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Regulators

Researchers

Financial Engineering

The construction of a financial product from other products

New securities can be designed by using existing securities

Financial engineering principles

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Facilitate hedging of existing positions

Enable understanding of complex positions

Allow for creation of customized products

Render regulation less effective

Basic Transactions

Buying and selling a financial asset

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Brokers: commissions

Market-makers: bid-ask (offer) spread

Example: Buy and sell 100 shares of XYZ

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XYZ: bid = $49.75, offer = $50, commission = $15

Buy: (100 x $50) + $15 = $5,015

Sell: (100 x $49.75) - $15 = $4,960

What is your transaction cost?

Short-Selling: Concept

When price of an asset is expected to fall

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First: borrow and sell an asset (get $$)

Then: buy back and return the asset (pay $)

If price fell in the mean time: Profit $ = $$ $

The lender must be compensated for dividends received (lease-rate)

Short-Selling: Example

Example: short-sell IBM stock for 90 days

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S0 : share price on day 0.

S90 : share price on day 90.

D: the short-seller must pay the dividend to the share lender.

Action
Security
Cash

Day 0
Borrow Shares
Sell shares
+S0

Dividend Ex-Day

Day 90
Return shares
Purchase shares
S90

Why Short-Selling?

Speculation

Financing

Hedging

Costs of Short-Selling

Credit risk in short-selling

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Collateral and haircut

Interest received from lender on collateral

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Scarcity decreases the interest rate

Repo rate in bond markets

Short rebate in the stock market