Unit 4: Derivatives Part 1

Derivatives
Back to Basics…
• Finance is the study of risk.
• How to measure it
• How to reduce it
• How to allocate it

• We can generally classify risk as being diversifiable or non-diversifiable:

• Diversifiable – risk that is specific to a specific investment – i.e. the risk that a
single company’s stock may go down (i.e. Enron). This is frequently called
idiosyncratic risk.
• Non-diversifiable – risk that is common to all investing in general and that
cannot be reduced – i.e. the risk that the entire stock market (or bond market,
or real estate market) will crash. This is frequently called systematic risk.
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Back to Basics…
• The market “pays” you for bearing non-diversifiable risk only – not for bearing
diversifiable risk.
• In general the more non-diversifiable risk that you bear, the greater the expected
One of the laws of investment:
return to your investment(s). More Risk… needs more return

• Many investors fail to properly diversify, and as a result bear more risk than they
have to in order to earn a given level of expected return.

• In this sense, we can view the field of finance as being about two issues:
• The elimination of diversifiable risk in portfolios;
• The allocation of systematic (non-diversifiable) risk to those members of society
that are most willing to bear it.
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Back to Basics…
• Indeed, it is really this second function – the allocation of systematic risk – that drives
rates of return.
• The expected rate of return is the “price” that the market pays investors for
bearing systematic risk.

Hence the development of Derivatives and the Derivatives market….

• So why do we have derivatives and derivatives markets?

• Because they somehow allow investors to better control the level of risk that they
bear.
• They can help eliminate idiosyncratic risk.
• They can decrease or increase the level of systematic risk.

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What is a Derivative? Basics
• A derivative (or derivative security) is a financial
instrument whose value depends
upon the value of other, more basic, underlying variables.

Basic Example
• It can also extend to something like a reimbursement program for college credit. Consider that if
your firm reimburses 100% of costs for an “A”, 75% of costs for a “B”, 50% for a “C” and 0% for
anything less.
• Your “right” to claim this reimbursement, then is tied to the grade you earn. The value of that
reimbursement plan, therefore, is derived from the grade you earn.
• We also say that the value is contingent upon the grade you earn. Thus, your claim for
reimbursement is a “contingent” claim.
• The terms contingent claims and derivatives are used interchangeably.

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 What is a Derivative?
• The term ‘derivative’ indicates that it has no independent value
• Value is entirely ‘derived’ from the value of an underlying asset
• It is therefore a Financial contract or a contingent claim the value of which depends
on the value of one or more ‘underlying’ assets
• References to an agreed rate or price
• Either purchase or sale of rights to transact at some point in the future
• Traded to acquire or sell rights that may result in a financial benefit arising from value changes in the
‘underlying’
DERIVATIVE

Derives value from …

Underlying asset Securities Commodities Gold Currency Weather

The underlying asset can be Bond Stock Market Index Live Stock
any of the following examples
Interest Rates

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Origins of Derivatives
• Can be traced back to:
• Early 17th Century – In the Netherlands, fortunes were made and lost after a speculative boom in
tulip futures collapses
• Late 17th Century – Rice futures were developed in Japan to protect producers from lower prices
as a result of excess production
• Late 18th Century – European nations began to trade in wheat and coffee derivatives

• In 1980s Financial Futures exceed those on commodities

• Involved buying and selling of futures and options on shares, bonds, currencies and benchmark
interest rates

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Derivative Basics
Positions
• In general if you are buying an asset – be it a physical stock or bond, or the right to
determine whether or not you will acquire the asset in the future (such as through an
option or futures contract) you are said to be “LONG” the instrument.
• If you are giving up the asset, or giving up the right to determine whether or not you will
own the asset in the future, you are said to be “SHORT” the instrument.

• In the stock and bond markets, if you “short” an asset, it means that you borrow it, sell the
asset, and then later buy it back.
• In derivatives markets you generally do not have to borrow the instrument – you can
simply take a position (such as writing an option) that will require you to give up the asset
or determination of ownership of the asset.
• Usually in derivatives markets the “short” is just the negative of the “long” position

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Derivatives
• So now we are going to begin examining the basic instruments of derivatives. In
particular we will look at:
• Forwards
• Futures
• Options
• The purpose is to:
• provide a basic understanding of the structure of the instruments and the basic
reasons they might exist
• provide a more in-detail examination of their properties, and their pricing

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Terminology used
Terminology: Dates
• Trade Date – the date on which parties agree to the terms of the contract
• Effective Date - is the date on which parties begin calculating accrued obligations [when the ‘contract’ comes
into effect, usually one or two days after the trade date, also referred to as “T +1” or “T + 2”
• Maturity (expiry) Date – expiration of the contract (the date by which the ‘rights purchased’ must be used
(also time specific)
• Settlement Date – the date on which cash settlement and/or the principal exchanged (underlying asset)
• Notional Principal
• A hypothetical underlying quantity or amount
• Used to calculate payments, obligations (such as payments) or interest values
• Is referred to as notional because this does not change hands between counterparties
• Cash Settlement
• Some derivative contracts are settled at maturity (or before maturity if ‘closed-out’ i.e. cancelled) by an
exchange of cash from the party who is out-of-the-money (in a loss) to the party who is in-the-money (in
profit)
• Amount is based on the notional principal

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Terminology: The ‘Underlying Asset’

• The ‘product’ from which a derivative derives its value is called its ‘underlying’

• Stock option derives its value from the value of a stock

Derivative Underlying

• Interest rate swap derives value from interest rate indices

Derivative Underlying

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Major Classifications
Major Classifications of Derivatives

• Forwards/Futures Vs Options
• OTC [over-the-counter] Vs Exchange Traded [traded on a registered securities
exchange0
• Linear Vs Non-linear
• Vanilla [plain, simple and basic] Vs Exotic [‘custom-made’]
• Different classes

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OTC Vs Exchange Traded

• OTC Derivatives
• A derivative contract that is negotiated between two counterparties
• Examples: forwards, forward rate agreements (FRAs), SWAPS (interest rate)

• Exchange Traded Derivatives

• Derivatives that trade on a formal exchange
• Underlying assets may include: shares, share indexes, commodities, currencies and interest rates

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Linear Vs Non-Linear
• Linearity refers to the fact that the derivative’s value reacts in a linear (or ‘straight
line’) fashion to changes in the value of the underlying item

• Linear Derivatives
• Pay-off profiles are linear or almost linear
• Example: Forwards

• Non-Linear Derivatives
• Pay-off profiles are entirely non-linear
• Non-linearity arises due to derivative either being an option or having an option embedded in its
structure
• Example: Currency options

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Vanilla Vs Exotic

• Vanilla Derivatives
• Simple and common in form
• ‘Plain’ and straight-forward
• Examples include: calls, puts, cap, floors, forward, futures and swaps

• Exotic Derivatives
• More complex and highly specialized in form
• Examples include: Asian options, basket options, barrier options, credit derivatives, quantos and
CDOs (collateralized debt obligations)

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Different Classes

• Interest Rate Derivatives

• Equity Derivatives
• Currency Derivatives
• Commodity Derivatives
• Credit Derivatives

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Reference list

• Bodie, Z, Kane, A, Marcus, AJ, 1999. Investments. Boston: McGraw-Hill/Irwin.

• Falkena, HB, et al., 1989. The futures market. Halfway House: Southern Book Publishers (Pty) Limited.
• Falkena, HB, et al., 1991. The options market. Halfway House: Southern Book Publishers (Pty) Limited.
• Faure, AP, 2005. The financial system. Cape Town: QUOIN Institute (Pty) Limited.
• Hull, JC, 2000. Options, futures, & other derivatives (4e). London Prentice-Hall International, Inc.
• SAFEX (Financial Derivatives and Agricultural Products Divisions of the JSE Securities Exchange South Africa), 2003. [Online]. Available: www.safex.co.za. [Accessed
October].
• Saunders, A, 2001. Financial markets and institutions (international edition) New York:
• McGraw-Hill Higher Education. Santomero, AM and Babbel, DF, 2001. Financial markets, instruments and institutions (2e). Boston:.McGraw-Hill/Irwin.
• Spangenberg, P, 2000. Forward rate agreements. The Southern African Treasurer. 14. September. 186
• Spangenberg, P, 1999. The mechanics of option-styled interest rate derivatives – caps and floors. The Southern African Treasurer. 11. December.
• Standard Bank., 2004. [Online]. Available: www.warrants.co.za. [Accessed June].
• Steiner, R, 1998. Mastering financial calculations. London: Financial Times Management.
• Investopedia
• The Economicst.com
• Wkipedia

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