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What Are...

Derivatives?
Prepared By
Robb Davis
Robert McDaniel
David Bolles
Mike McLatcher
Calvin Grogan
Amanda Hodges
DERIVATIVES

A Financial Instrument That


Derives Its Value From An
Underlying Security
Derivatives Explanation

An easy way to think of derivatives is as


a “side bet” on interest rates, exchange
rates, commodity prices, and practically
ANYTHING that you can think of.
Why Derivatives?
• Not to raise capital
• Buy or sell to protect against adverse
changes in external factors
Conventional Securities
Market
Traditional Securities

20,000
Billions of $
Amount in

15,000
10,000
5,000
0
Bonds Cash Stocks
Types
Types of Derivatives
• Forwards
• Futures
• Options
• Swaps
Forwards
Forwards Contracts

The agreement to pay for and pick up,


“Something” at a pre-determined date
and or time, for a pre-determined price.
Usually traded off of the trading floor
between two firms.
Terms
• Taking Delivery: Physical reception of
item.
• Deliverable Instrument: The item to be
delivered
• Making Delivery: Turning over the
item.
Forwards are not options, they are
obligations and should be considered
as a “cash transaction.”
Forwards
Exchange Traded Derivatives "Forwards"

7,000
6,000
5,000
Billions of $
Amount in

4,000
3,000
2,000
1,000
0
Interest-Rate Stock-Index Currency
Futures Futures Futures
Types
Forwards “OTC”
Over-The-Counter Derivatives "Forwards"

Interest-Rate
Contracts
28%

Currency Contracts
72%
A Modest Example
An agreement on Monday to buy a book,
(Fin 374c) from a bookstore on Friday for
$1000.00.
On Friday, you return to the bookstore and
take delivery of the book and pay the
$1000.00.
The contract is actually the agreement.
Futures
Futures
Similar to forwards in length of time.
However, profits and losses are
recognized at the close of business
daily, “Mark-to-market.” Transactions
go through a clearinghouse to reduce
default risk. 90% of all futures
contracts are delivered to someone
other than the original buyer.
Futures Example
On Monday we enter into a futures contract to buy
our book on Friday. We are required to place a
deposit for the book of 50% ($500.00). We are told
that if the book appreciates in value we may be
required to increase the deposit. If the book
depreciates in value, we may take back some of the
money. Wednesday the book goes to $1500.00. We
must deposit another $250.00. On Thursday the book
drops to $750.00. We can collect $375.00. On Friday
the book value is $800.00, therefore we owe $425.00
on the remaining balance.
Options
Options
Options come in many flavors. To name a
few: collar, cylinder, fence, mini-max,
zero-cost tunnel and straddle. These are all
newer forms of options. The most
common options discussed are put and
call.
An OPTION is the right, not the obligation
to buy or sell an underlying instrument.
Option Terms
• Put: the right to sell @ a certain price
• Call: the right to buy @ a certain price
• Long: to purchase the option
• Short: to sell or write the option
• Bullish: feel the value will increase
• Bearish: feel the value will decrease
• Strike/Exercise Price: Price the option
can be bought or sold.
Option Market
Exchange Traded Derivatives "Options"

Individual Stock Options

Stock-Index Options
Types

Currency Options

Interest-Rate Options

0 500 1,000 1,500 2,000 2,500 3,000 3,500

In Billions of $
Options Continued
Over-The-Counter Derivitaves "Options"

OTC Currency
Options
29%

OTC Interest-Rate
Options
71%
Calls
Long a call. Person buys the right (a contract) to
buy
an asset at a cretin price. They feel that the price
in the future will exceed the strike price. This is a
bullish position.

Short a Call. Person sells the right (a contract) to


someone that allows them to buy a asset at a cretin
price. The writer feels that the asset will devalue
over the time period of the contract. This person is
bearish on that asset.
PUTS
Long a Put. Buy the right to sell an asset at a
pre-determined price. You feel that the asset will
devalue over the time of the contract. Therefore
you can sell the asset at a higher price than is the
current market value. This is a bearish position.

Short a Put. Sell the right to someone else. This


will allow them to sell the asset at a specific
price. They feel the price will go down and you
do not. This is a bullish position.
Swaps
SWAPS

New in the market, late 70’s early 80’s


Two Types: Interest Rate & Currency
Swaps
Over-The-Counter Derivatives "Swaps"

Currency Sw aps
12%

Interest-Rate Sw aps
88%
Swap Use
• To smooth out interest rate payments
in a cyclic environment.
• To secure and level out future interest
payments.
• To secure foreign currency for loans
when you are a visitor in that country
and it would be too difficult to secure
credit or the cost is prohibitive.
Derivative Securities
• Mortgage Backed Securities: Fanny
Mae, Freddie Mac
• Structured Notes: Sally Mae
Derivative Securities
Derivitave Securities

800
600
400
200
0
Mortgage Structured
Derivatives Notes
Explanation
Freddie Mac & Fanny Mae: Both are
derivative instruments used to pool Home
Mortgage loans. This creates a secondary
market which allows banks to sell the loans,
therefore reducing their risk. It also reduces
default risk for the holder. These are also
known as pass through instruments.
Cont’d Explanation

Sally Mae: Same principal as the


previous example except they use student
loans. All of these also help to keep
interest rates for the underlying asset low
by keeping default risk down.
Pass Through
Derivitave Securities

800
600
400
200
0
Mortgage Structured
Derivatives Notes
Standard Securities
• Stocks
• Bonds
• Cash
Standard Securities
Traditional Securities

20,000
Billions of $
Amount in

15,000
10,000
5,000
0
Bonds Cash Stocks
Types
Total Market
The standard market is what most people
think of when they think of the market. The
truth is that derivatives are the fastest growing
sector of the market. In fact, they are the
largest section of the market. We did not
consider mutual funds in this presentation.
There are more mutual funds in the market
than there are stocks. Again, the next graph
does not account for mutual funds.
Total Market
Total Market: Traditional & Derivative

Total Derivatives
43%

Total Traditional
57%
Any Questions?
Seriously,
Any Questions?