CHAPTER 1: INTRODUCTION

What are derivatives?

 A contract between two counterparties, whose value derives from the price of something else,
referred to as the underlying.
 The underlying can be, for example, a physical asset such as a specified quantity of a certain kind
of wheat or a specified number of bonds or bank bills, or, a financial index or reference rate
(such as LIBOR)
 Traded on exchanges and in what are termed "over-the-counter" (OTC) markets.
o Exchanges: futures and options
o OTC: forwards, swaps, options.
--> The OTC market is 10 times as big as the exchange-traded market --> Size is measured in
terms of the underlying principal amounts or value of the underlying assets. (The OTC
market is about $600 trillion whereas the exchange-traded market is about $60 trillion.)
 Central clearing party: stands between two parties in the OTC market.
 
I. FUTURES CONTRACTS:
 A futures contract is an agreement to buy or sell an asset at a certain time in the future for a
certain price.
 A futures price can be contrasted with the spot price.
o Spot price is for immediate, or almost immediate, delivery.
o The futures price is the price for delivery at some time in the future.
--> The two are not usually equal.
 Who agrees to buy: long futures position
 Who agrees to sell: short futures position
 
III. THE OVER-THE-COUNTER MARKET:
 Main participants in OTC derivatives markets: bank, other large financial institutions, fund
managers, and corporations.
 Derivatives transactions per year in OTC markets is smaller than in exchange-traded markets,
but the average size of the transactions is much greater.
 
IV. FORWARD CONTRACTS:
 A forward contract is an agreement to buy or sell an asset at a certain time in the future for a
certain price.
 Traded in the OTC market.
 Popular in foreign exchange.
 Spot vs forward exchange traders:
o Spot traders are trading a foreign currency for almost immediate delivery.
o Forward traders are trading for delivery at a future time.
  The first column: the bank is prepared to buy. --> Seller looks at this column.
 The second column: the bank is prepared to sell. --> Buyer looks at this column.
 Can be used to lock in the exchange rate.
 
V. OPTIONS
 Traded both on exchanges and in the OTC markets.
 Two types of options: calls and puts.
o A call option gives the holder the right to buy an asset by a certain date for a certain
price.
o A put option gives the holder the right to sell an asset by a certain date for a certain
price.
 Exercise price/ strike price: the price in the contract
 Expiration date/ maturity date: the date in the contract
 European option: exercised only on the maturity date
 American option: exercised at any time during its life.
 The price of a call option decreases as the strike price increases; the price of a put option
increases as the strike price increases.
--> Both types of options tend to become more valuable as their time to maturity increases.

 
VII. TYPES OF TRADER
 Futures, forward, and options markets have been outstandingly successful. Reason:
o Attract many different types of trader and have a great deal of LIQUIDITY.
 Three broad categories of trader: hedgers, speculators, and arbitrageurs.
o Hedgers use futures, forwards, and options to reduce the risk that they face from
potential future movements in a market variable. --> Big users of derivatives.
o Speculators use them to bet on the future direction of a market variable --> Make
profit.
o Arbitrageurs take offsetting positions in two or more instruments to lock in a profit.
 
VIII. HEDGERS:
 Forward and options can be used by hedgers.
 Hedging using forward contracts:
 Have to buy/ pay in the futures --> Enter the derivatives market and buy forward contracts.
 Have to sell/ receive in the futures --> Enter the derivatives market and sell forward contracts
June 22: pay 10M pounds on Sep 22 --> Hedge its foreign exchange by buying pounds in the 3-mongth
forward market at 1.5585 exchange rate --> 3 months later, costs 10M x 1.5585 = $15,585,000
 TH1: No hedge, exchange rate is 1.5000 in Sep 22 --> payment = 1.5000 x 10,000,000 =
$15,000,000 < $15,585,000
 TH2: Exchange rate = 1.6000 --> 10M pounds costs = 1.6000 x 10,000,000 = $16,000,000 --> The
company will wish it had hedged.
--> TH mua: Future exchange rate < Forward exchange rate --> No hedge needed
Future change rate > Forward exchange rate --> Hedge needed
--> TH bán: Future exchange rate < Forward exchange rate --> Hedge needed
Future exchange rate > Forward exchange rate --> No hedge needed
 
IX. SPECULATORS
 Futures and options markers can be used by speculators
 Speculation using futures: