Derivatives Markets

Lecture 1: TRADABLE UNDERLYING

ASSETS AND THEIR DERIVATIVES

Rafał Łochowski

Spring 2011

Tangible and intangible assets

• Asset – any possesion that has value in an exchange

• Tangible asset – its value depends on particular physical properties (a house, a car, particular physical properties (a house, a car, etc.)

• Intangible asset – represents legal claims to some future benefit and their value bears no relation to the form, physical or otherwise, inwhich these claims are recorded

Main classes of tradable assets

• Bonds

• Stocks

• Indices

• Currencies• Currencies

• Commodities

• Funds certificates

Bonds

• Bonds are debt instruments, i.e. the claim is

for a fixed money amount

• Examples

– U.S. Treasury bond – the U.S. government (the– U.S. Treasury bond – the U.S. government (the

issuer) agrees to pay the holder or the investor

the interest payments every six months until the

bond matures, then at the maturity date repays

the amount borrowed.

– Zero coupon bonds, floating rate securities …

Stocks

• Common stocks – also called equity securities –

represent an ownership interest in corporation.

Holders of equity securities are entitled to the

earnings of the corporation when those earnings are

distributed in the form of dividends; they are alsodistributed in the form of dividends; they are also

entitled to a pro rata share of the remaining equity in

case of liquidation

• Preferred stock – typically preferred stockholders are

entitled to a fixed dividend, which they receive

before common stockholders receive any dividends

Stock trading

• Organized exchanges – trading floors – whererepresantives of buyers and sellers physicallymeet

– in US: NYSE (New York Stock Exchange) AMEX (theAmerican Stock Exchange)American Stock Exchange)

– in Poland: GPW (Giełda Papierów Wartościowych)

• OTC (over-the-counter) – no trading floor, via telecomunication systems (electronically)

In US: NASDAQ (the National Association of Securities Dealers Automated Quotation System)

Some aspects of trading mechanics

• Public orders

• Conditional orders

– limit order – buy/sell limit order,

– buy stop/sel stop order, stop limit order– buy stop/sel stop order, stop limit order

• Short selling, margin transactions, margin

requirements

• Trading costs

• Price limits and collars

Stock market indicators - indexes

• Variety of functions: benchmarks,

performance indicators of proffesional money

managers or just answer the question „how

did market do today”?did market do today”?

• Examples:

– US: DJIA (Dow Jones Industrial Average), Standard

& Poor’s 500 Composite, NYSE Composite,

NASDAQ Composite

– Poland: WIG, WIG20

Indexes – specification

• Dow Jones – consists of 30 stocks of mainAmerican companies like AT&T, Boeing, Coca-Cola, General Electric … – calculated as a sum of the prices of all these stocks

divided by Dow Divisor which currently equals0.132319125divided by Dow Divisor which currently equals0.132319125

• WIG20 –consists of 20 stocks of main Polishcompanies quoted at GPW– calculated as a weighted average of the prices of all

these companies, divided by some adjustmentcoefficient

Currencies

• Main tradable currencies– euro, dollar, yen, pound, australian dollar,…

• Forex (foregin exchange) - a worldwide decentralized OTC market for the trading of currenciescurrencies– huge trading volume, leading to high liquidity;

– geographical dispersion;

– continuous operation: 24 hours a day except weekends

– average daily turnover in global foreign exchange markets is estimated at $3.98 trillion

Commodities

• The oldest market:

– Agricultural

• CBOT (Chicago Board of Trade): corn, rice, soybean,

wheatwheat

• EURONEXT: corn, rapeseed

• ICE (Intercontinental Exchange): cocoa, coffee, cotton,

sugar, concentrated orange juice

– Livestock and meat

• Chicago Mercantile Exchange: Lean Hoghs, Frozen Pork

Bellies, Live Cattle, Feeder Cattle

Commodities, cont.

• Energy

– NYMEX (New York Mercantile Exchange): WTI Crude

Oil, Natural Gas, Heating Oil, Gasoline, Propane

– ICE: WTI Crude Oil, Brent Crude–

– CBOT: Ethanol

• Precious metals: gold, platinium, palladium, silver

(NYMEX)

• Industrial metals: copper, lead, zinc,… (London

Metal Exchange)

Other tradable assets

• Environmental commodities

– Carbon offsets,

– Renewable Energy Certificates

– White Certificates– White Certificates

• Freight

– transport of cargo

Derivatives

• Derivative instruments or simply derivatives

– contracts which derive their value from the behaviorof cash market instruments (stocks, stock indexes, bonds, currencies, commodities) that underline thecontractcontract

• The derivative contract may also be underlined by

– interest rates (in fact the largest derivatives market)

– credit agreements

– other underlying exchangeables: weather, freight, inflation, property …

Derivative contract types

• Common derivative contract types– Futures and Forwards

– Options

– Swaps

• Futures/forwards are contracts to buy or sell an asseton or before a future date at a price specified today. A

• Futures/forwards are contracts to buy or sell an asseton or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves

Derivative contract types, cont.

• Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset

• Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets

Purposes of derivative instruments

• Purposes of derivative instruments– Hedging

– Arbitrage

– Speculation

• Hedging• Hedging– Derivative may be considered as a type of insurance

and risk reducing instrument

– Examples: (1) A transport company takses a long position in the futures contract for crude oil. (2) An owner of 1000 Microsoft shares buys put option (theright to sell - execution of the option - for a fixedprice)

Hedging with futures and options -

comparison

• The fundamental difference between heding

with futures contracts and options is such that

– in the first case one fixes the price that the hedger

will pay or receive for the underlying assetwill pay or receive for the underlying asset

– in the second case investor protects

himself/herself from adverse price movements

but still may benefit from favorable price

movements

Purposes of derivative instruments -

arbitrage

• Arbitrage

– Arbitrage involves locking in a riskless profit by

simultaneoulsy entering into transations in two or

more marketsmore markets

– Example: a stock which is traded on two different

exchanges, with different currencies, in the case

when prices after applying exchange rate are not

equal

– Arbitrage opportunities can not last for long

Purposes of derivative instruments -

speculation

• Speculation

– Some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the insurance will be wrong about the future value of the underlying asset.

– Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.

Speculation - examples

• A speculator thinks the Euro will strengthen

relative to the US dollar over next 3 months.

– He/she takes long position in futures contracts on

Euro for the current priceEuro for the current price

• A speculator thinks Microsoft shares will fall in

next 3 months.

– He/she buys put options (the right to sell) for the

current price

Speculation with futures and options -

comparison

• Both - futures and options – provide a way in

which a type of leverage can be obtained.

• With the use of futures, the potential loss as

well as the potential gain is very largewell as the potential gain is very large

• With the use of options the loss is limited to

the amount paid for the options

Some spectacular loses due to

speculation on derivatives

• The need to recapitalize insurer American International Group (AIG) with US$85 billion of debt provided by the US federal government. An AIG subsidiary had lost more than US$18 billion over the preceding three quarters on Credit Default Swaps(CDS) it had written. It quarters on Credit Default Swaps(CDS) it had written. It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarters.

• The loss of US$7.2 Billion by Société Genérale in January 2008 through misuse of futures contracts.

Some spectacular loses due to

speculation on derivatives cont.

• The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted.

• The loss of US$4.6 billion in the failed fund Long –Term Capital Managment in 1998.Term Capital Managment in 1998.

• The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by MetallGesselshaft AG.

• The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.

History of derivatives markets

• The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardised contracts, which made them much like today's futures.

• The Chicago Board of Trade (CBOT), the largest • The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where forward contracts on various commodities were standarised around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today.