Lecture 01 Intro

About the course
Main types of derivatives

Derivative markets
Derivatives mishaps
Derivatives and Risk Management

Lecture 1 – Introduction
Charlotte Sun Clausen-Jørgensen and Søren Hesel
Department of Business and Management
Fall 2022
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About the course
Main types of derivatives
Derivative markets
Derivatives mishaps
Outline
1 About the course
2 Main types of derivatives
3 Derivative markets
4 Derivatives mishaps
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About the course Practical information
Main types of derivatives How to follow this course
Derivative markets What is the course about?
Derivatives mishaps Prerequisites
Introduction
• Lecturers:
I Charlotte Sun Clausen-Jørgensen (chcla@sam.sdu.dk)
I Søren Hesel (soren@sam.sdu.dk)
• 23 lectures
I Monday 16-18 and Friday 8-10 (not all weeks)
• Teaching assistant: Allan Lesley (alles18@student.sdu.dk)
• 13 tutorials with Allan
I See itslearning for the specific tutorial classes
• Course info on itslearning
• Teaching materials...
• Tentative schedule...
• Course description
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Exam
• Part 1 (1 ECTS):
I 6 home assignments (pass/fail)
I Can be done in groups of up to 3 students
I You have to pass 4 out of 6 assignments to pass part 1
∗ Only one of the group members needs to upload the assignment
I Oral re-exam in February
• Part 2 (9 ECTS):
I Written Exam in January
I Full-degree students: 5-hour written, open book
I Exchange students: 10-hour take home
I Oral re-exam in February
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You should...
• read (the syllabus but also the financial news)
• think
• go through calculations in the book/notes
• discuss with fellow students form study groups
• solve problems and assignments use the tutorials actively
• ask questions (during lectures, at tutorials, . . . )
• be critical
• go to the lectures
• be nice to your teachers
Remember:
• It is the daily work with the course that pays off in the end
• This course counts for 1/6 of a year’s workload ≈ 270 hours
I That’s 13 hours per week!
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We help you...
• Lectures
• Tutorials
• Home assignments
• Answer questions
I Charlotte – office hour: Friday 14.15-15.00 (V3-206a-2)
I Søren – via mail or online (only with an appointment)
Before you ask a question:

1 See if the answer already is in the course description or other
available material on itslearning
2 Ask a fellow student
3 Ask the TA
4 Send a mail with the question
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What is a “derivative”?
Definition (Derivative)
A derivative is a financial asset whose payoff depends on the value(s)
of one or several more basic underlying variables.
• Main types of derivatives: forwards, futures, swaps, options

• Underlying variables: stock price, index, interest rates, credit risk,
commodity price, energy price, weather, number of catastrophic
events, . . .
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Why are derivatives interesting?
• very actively traded

• useful for
I hedging and risk management,
I “speculation”; i.e., gamble on the future direction of the market,
I locking in a risk-free profit,
I asset allocation
• many financial contracts contain implicit derivatives
• many real investment projects contain options
• implicit derivatives show up in other areas; e.g., corporate
finance
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https://www.nobelprize.org/nobel_prizes/
economic-sciences/laureates/1997/press.html
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Learning objectives
At the end of this course you should...

• be familiar with the markets for and the characteristics of the
main types of derivatives
• know how derivatives can and should be used for risk
management
• know how to determine “fair” prices of some derivatives using
some models
I focus on standard derivatives on stocks, currencies, bonds and
interest rates
I focus on relatively simple models
• be familiar with modeling tools that you can use for valuing other
derivatives in similar models
(see the course description)
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About theory and practice...

• Theoretical and practical course
• Finance is an area where there is little difference between theory
and practice
Although some people think the following quote is closer to the

truth:
“In theory there is little difference between theory and practice. In
practice there is.”
• Necessary–also for practice–to develop models
• The models in this course involve some well-known mathematics
and statistics and some new stuff that will be introduced along
the way
• The models in this course also give a good introduction to the
models applied for the pricing of stocks and bonds and for
determining optimal investment policies
subsequent courses in your master
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Prerequisites
Finance: If you find the gap between your current knowledge and
Hull’s book to large, I suggest you upgrade your knowledge from the
relevant chapters of
• Hillier, Grinblatt, and Titman: Financial Markets and Corporate
Strategy, McGraw-Hill.
Math: Throughout the course we will be dealing with differentiation,

integration, and solving systems of (linear) equations with matrix
algebra. A good introductory text book with an economic focus is
• Sydsaeter and Hammond: Essential Mathematics for Economic
Analysis, Pearson Education
Statistics/probability theory: If you find yourself in need of a better

understanding of elementary statistics and probability theory a good
place to start is
• Larsen and Marx: Introduction to Mathematical Statistics and Its
Applications, Pearson
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About the course Forwards
Main types of derivatives Futures
Derivative markets Swaps
Derivatives mishaps Options
Forwards
Definition (Forward)
A forward is an agreement to buy (or sell) an asset S at maturity T for
a fixed price K .
• A long position: Buy the asset, payoff at T is ST − K

• A short position: Sell the asset, payoff at T is K − ST
• Normally K is set so that it costs nothing to enter into a forward
contract ⇒
Payoff = Total gain (or loss) from the contract
This value of K is called the forward price.
• Forwards are traded/agreed upon in the over-the-counter (OTC)
markets
• Fairly organized OTC-market for currency forwards and interest
rate forwards
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Futures
• Like a forward
I a future is an agreement to buy (or sell) an asset at maturity for a
fixed price, but . . .
• Unlike a forward
I can be traded on an organized exchange
I the exchange specifies certain standardized features of the
contract (size, expiry date, underlying(s), . . . ) (why?)
I gains and losses are settled each trading day (why?)
∗ FtT : futures price at time t with maturity T
∗ settlement payment at time t for a long position: FtT − Ft−1
T
∗ settlement payment at time t for a short position: −(FtT − Ft−1

T )
∗ the futures value immediately after settlement payment is zero
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Swaps
Definition (Swap)
A swap is an agreement to exchange two well-defined (wrt. time and
amounts) cash flows.
• “Plain vanilla” interest rate swap: exchange a cash flow based on

a predetermined fixed interest rate with a cash flow based on a
given floating interest rate
• Currency swap: exchange a cash flow in one currency with a
cash flow in another currency
• Many others: commodity swaps, equity swaps, volatility swaps
• Traded/agreed upon in the OTC-markets
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Options
Definition (Option)
An option gives the holder the right to buy (or sell) the underlying asset
S at maturity T for the exercise price K
• Call option:
I gives the holder the right to buy the underlying asset
I payment at T : max (ST − K , 0)
• Put option:
I gives the holder the right to sell the underlying asset
I payment at T : max (K − ST , 0)
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Options, cont’d
• With an option, two parties are involved:
I Long position: Has bought the option and has the right to decide on
exercise
I Short position: Has sold the option and must wait for the exercise
decision of the long position
• When can the option be exercised?
I European option: at maturity only
I American option: at any point in time up to maturity (but only once!)
• Note: whereas it costs nothing (or almost nothing) to enter into a
forward or futures contract, there is a cost to acquiring an option
• Options are traded both on exchanges (first on CBOE 1973) and
OTC
• European and American call and put options are called plain
vanilla options
• Options with more fancy payoff definitions are referred to as
exotic options
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About the course
Main types of derivatives Exchange markets
Derivative markets OTC markets
Derivatives mishaps
Exchange markets for derivatives
• Some futures and some options are traded on organized

exchanges
• Individuals trade standardized contracts that have been defined

by the exchange
• Open outcry system: Traders physically meet on the floor of the

exchange
• Electronic trading: Traders use a computer
http://www.youtube.com/v/M6mWd3EjtsQ?rel=0
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About the course
Derivatives mishaps
Exchange markets for derivatives, cont’d
• Typically the exchange is the counterpart in all trades little

credit risk
• Rules for providing margins/safety when trading on the exchange
• Size (according to BIS):
I $82.7 trillion (notional amounts outstanding) in March 2021, still
below $95.1 trillion in June 2007.
(GDP of Denmark is about $355 billion)
I Turnover in 1st quarter 2021: $700 trillion
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About the course
Derivatives mishaps
Exchange markets for derivatives, cont’d

A notional amount of $82.7 trillion corresponds to. . .
≈ 55,000 Burj Khalifas

≈ 4 million Bugatti La Voiture Noire
1
≈ 3 million Neymar
≈ 21,000 Great Belt

Bridges
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About the course
Derivatives mishaps
Categorization by products
(Notional principal in billions of US dollars)
Futures Dec 2020 Dec 2021 Mar 2022

Interest rate 28,668 33,816 40,401
Currency 326 313 336
All 28,995 34,129 40,737
Options Dec 2020 Dec 2021 Mar 2022

Interest rate 36,831 45,826 53,792
Currency 124 135 133
All 36,955 45,961 53,925
Source: Table D1 from http://www.bis.org (no longer statistics

for equity contracts).
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About the course
Derivatives mishaps
Categorization by location
(Notional principal in billions of US dollars)
Futures Dec 202 Dec 2021 Mar 2022
North America 18,839 23,518 30,645
Europe 8,065 8,584 7,965
Asia and Pacific 1,252 1,200 1,266
Other 839 828 861
All 28,995 34,12 40,737
Options Dec 2020 Dec 2021 Mar 2022

North America 23,713 30,057 36,907
Europe 12,112 15,065 16,447
Asia and Pacific 8 7 7
Other 1,122 838 564
All 36,955 45,961 53,925
Source: Table D1 from http://www.bis.org (only interest rates

and currency). 23 / 33
About the course
Derivatives mishaps
Main exchanges
• Chicago Board of Trade (CBOT), formed in 1848
I Trading was originally in forward contracts; the first contract (on
corn) was written on March 13, 1851.
I In 1865, standardized futures contracts were introduced.
I Futures and options on both commodities and financial variables.
• Chicago Mercantile Exchange (CME), formed 1874, recently
merged with CBOT to form “the CME Group.”
I Futures and options on both commodities, weather and financial
variables.
• Chicago Board Options Exchange (CBOE), formed 1973.
I Options and futures on financial variables.
• New York Mercantile Exchange (NYMEX), formed 1872 as “the
Butter and Cheese Exchange.”
I Now the World’s largest physical commodity futures exchange.
I Futures and options on commodities including electricity, natural
gas, and oil.
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About the course
Derivatives mishaps
Main exchanges, cont’d
• NYSE Euronext: operates various financial exchanges, including

exchanges on financial derivatives in e.g. New York, London, and
Paris
• Eurex: one of the world’s largest derivatives exchanges and the
leading clearing house in Europe. Based in Frankfurt. Mainly
electronic trading.
Futures and options on financial variables.
• Denmark? Stock index futures and futures and options on
leading stocks are traded on Nasdaq OMX Nordic.
• Many regional exchanges specialized in futures on a given
commodity, e.g. palmoil in Kuala Lumpur, rubber in Singapore,
and wool in Sydney.
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About the course
Derivatives mishaps
Over-the-counter (OTC) markets for derivatives

• Forwards and swaps and some futures and options are traded
OTC
• A telephone- and computer-linked network of dealers who do not
meet physically
• The trades are usually between two financial institutions or
between a financial institution and one of its clients
• Advantage: The terms of a contract do not have to be those
specified by an exchange
• Disadvantage: There is usually some credit risk
• Size (according to BIS):
I Has grown from $220.1 trillion in June 2004 to $632.6 trillion in
December 2012 (notional amounts outstanding)
I Gross market value as of December 2012: $24.7 trillion
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About the course
Derivatives mishaps
Categorization by product
(In billions of US dollars)
Product Jun 2020 Dec 2020 Jun 2021 Dec 2021

Foreign exchange 93,811 97,549 102,471 104,249
Interest rate 495,141 466,494 488,099 475,271
Equity 6,457 7,084 7,506 7,280
Commodity 2,099 2,051 2,453 2,218
Credit default swaps 8,809 8,359 8,813 8,800
Credit derivatives 9,050 8,649 9,121 9,061
Other 262 27 347 337
Total 606,821 582,055 609,996 598,416
Source: Table D5 from http://www.bis.org.
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About the course
Main types of derivatives Big losses
Derivative markets Lessons
Derivatives mishaps
Big losses by financial institutions
• Allied Irish Bank ($700 million)

• Amaranth ($6 billion)
• Barings ($1 billion)
• Daiwa ($1 billion)
• Enron’s Counterparties (Several over $1 billion)
• Kidder Peabody ($350 million)
• LTCM ($4 billion) – Merton and Scholes on the board
• Midland Bank ($500 million)
• Socit Gnrale ($7 billion)
• Subprime Mortgages (up to $40 billion)
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About the course
Derivatives mishaps
Big losses by non-financial corporations
• Allied Lyons ($150 million)

• Gibsons Greetings ($20 million)
• Hammersmith and Fulham ($600 million)
• Metallgesellschaft ($1.8 billion)
• Orange County ($2 billion)
• Procter and Gamble ($90 million)
• Shell ($1 billion)
• Sumitomo ($2 billion)
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About the course
Derivatives mishaps
Lessons for all users of derivatives
• Risk must be quantified and risk limits defined

I Nowadays each trader has a risk appetite
I Each trader has own capital charge
• Exceeding risk limits not acceptable even when profits result
• Do not assume that a trader with a good track record will always
be right
• Be diversified
• Scenario analysis and stress testing is important
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About the course
Derivatives mishaps
Lessons for financial institutions

• Do not give too much independence to star traders
• Separate the front, middle and back office

Front office Where trading, selling happens
Middle office Risk are calculated
Back office Reconciliation of trades, settling with traders and
clients
• Models can be wrong
I More regulation to get to use internal models for risk calculations
• Be conservative in recognizing inception profits
• Do not sell clients inappropriate products

I Has been made very illegal and it checked very carefulle
http://www.youtube.com/v/whlzFWwVv98?rel=0
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About the course
Derivatives mishaps
Lessons for financial institutions, cont’d
• Liquidity risk is important

• There are dangers when many are following the same strategy
• Beware of potential liquidity problems when long-term funding
requirements are financed with short-term liabilities
• Market transparency is important
• Manage incentives
• Never ignore risk management, even when times are good
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About the course
Derivatives mishaps
Lessons for non-financial corporations
• It is important to fully understand the products you trade

• Beware of hedgers becoming speculators
• It can be dangerous to make the Treasurers department a profit
center
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Lecture 01 Intro

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Lecture 01 Intro

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About the course

Main types of derivatives

Derivatives and Risk Management

Charlotte Sun Clausen-Jørgensen and Søren Hesel

Department of Business and Management

1 About the course

2 Main types of derivatives

Before you ask a question:

• Main types of derivatives: forwards, futures, swaps, options

Why are derivatives interesting?

• very actively traded

Why are derivatives interesting?

Why are derivatives interesting?

At the end of this course you should...

About theory and practice...

Although some people think the following quote is closer to the

Math: Throughout the course we will be dealing with differentiation,

Statistics/probability theory: If you find yourself in need of a better

• A long position: Buy the asset, payoff at T is ST − K

∗ settlement payment at time t for a short position: −(FtT − Ft−1

∗ the futures value immediately after settlement payment is zero

• “Plain vanilla” interest rate swap: exchange a cash flow based on

Exchange markets for derivatives

• Some futures and some options are traded on organized

• Individuals trade standardized contracts that have been defined

• Open outcry system: Traders physically meet on the floor of the

• Electronic trading: Traders use a computer

Exchange markets for derivatives, cont’d

• Typically the exchange is the counterpart in all trades little

Exchange markets for derivatives, cont’d

≈ 55,000 Burj Khalifas

≈ 21,000 Great Belt

Futures Dec 2020 Dec 2021 Mar 2022

Options Dec 2020 Dec 2021 Mar 2022

Source: Table D1 from http://www.bis.org (no longer statistics

Options Dec 2020 Dec 2021 Mar 2022

Source: Table D1 from http://www.bis.org (only interest rates

Main exchanges, cont’d

• NYSE Euronext: operates various financial exchanges, including

Over-the-counter (OTC) markets for derivatives

Product Jun 2020 Dec 2020 Jun 2021 Dec 2021

Source: Table D5 from http://www.bis.org.

Big losses by financial institutions

• Allied Irish Bank ($700 million)

Big losses by non-financial corporations

• Allied Lyons ($150 million)

Lessons for all users of derivatives

• Risk must be quantified and risk limits defined

• Exceeding risk limits not acceptable even when profits result

• Scenario analysis and stress testing is important

Lessons for financial institutions

• Separate the front, middle and back office

• Be conservative in recognizing inception profits

• Do not sell clients inappropriate products

Lessons for financial institutions, cont’d

• Liquidity risk is important

Lessons for non-financial corporations

• It is important to fully understand the products you trade

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