What Is a Derivative?

Financial instrument (or an agreement b’\v two people) that has a value determined by the price of something else It is not the contract itself, but how it is used, and who uses it, that determines whether or not it is risk-reducing

Uses of Derivatives

Risk managment – can use derivatives to hedge your loss

Speculation – derivatives can serve as investment vehicles

Reduced transaction costs – sometimes derivatives provide a lower-cost way to effect a particular financial transaction

Regulatory arbitrage -it is sometimes possible to circumvent regulatory restrictions, taxes, and accounting rules by trading derivatives

Derivatives provide an alternative to a simple sale or purchase, and thus increase the range of possibilities for an investor seeking to accomplish some goal

Perspectives on Derivatives

End-user perspective – corporations, investment managers, and inverters who enter into derivatives contracts

Market-maker perspective-intermediaries who will buy derivatives from customers who wish to sell, and sell derivatives to customers who wish to buy (they, of course, charge a spread)

Economic observer – for example, regulators often observe behaviour of derivative market participants when trying to decide how to regulate a certain activity or market participant

Financial Engineering and Security Design

It is generally possible to create a given payoff in multiple ways

Financial engineering – construction of a given financial product from other products Implications of financial engineering:

1 market-makers can hedge their position by creating an offsetting position to whatever he product he buys or sells

2 products can be customized

3 possible to improve intuition about a given derivative by realizing that is equivalent to something we already understand

4 regulatory arbitrage is difficult to stop

The Role of Financial Markets

Financial markets have an enormous impact on everyday life

Risk-Sharing

Lucky share with the unlucky

Insurance market makes formal risk-sharing possible

Insurance companies often use reinsurance market to buy insurance against large claims

Reinsures further share risks by issuing catastrophe bonds – bonds that the issuer need not repay if there is a specified event (e.g. earthquake)

Risk is diversifiable if it is unrelated to other risks

Risk that does not vanish when spread across many investors is a on diversifiable risk

Financial Markets in theory serve2 purposes:

1) Permit diversifiable risk to be widely shared

2) Permit non diversifiable risk to be held by those most willing to hold it

Derivatives in Practice

Growth in Derivatives Trading

Use of derivatives and variety of derivatives have grown over the last 30 years

Introduction of derivatives in a market often coincides with an increase in price risk in that market

Examples: oil market in 1973. US interest rates in the 70s. Deregulation of natural gas market singe 1978, deregulation of electricity during the 90s

There is no need to manage risk when there is no risk

When risk does exist, we expect that markets will develop to permit efficient risk-sharing

Investors with high risk tolerance will bear more risk, than those will low: risk tolerance

How Are Deriva tives Used?

Requirements for companies to report use of derivatives have increased, but how and to what extent companies use derivates is still mostly unknown

Banks use interest rate derivatives, currency derivatives and credit derivatives

Manufacturing firms use commodity and currency derivatives

Buying and Short-Selling Financial Assets

Buying an Asset

Things to consider when you buy a financial asset (e.g. bond or stock):

commission – can be a flat amount (e.g. $15 per trade) or percentage (e.g. 0.3% of the dollar amount of the transaction)

two prices:

1 offer or ask price – price at which investor can buy (price at which market-maker will sell or “offer’7)

2 bid price -price at which investor can sell (price at which market- maker will buy or “bid’7)

Difference b/’w bid price and offer price is called bid-ask spread

This spread is how market-marker earns a living

Bid-ask bounce- apparent price fluctuations because of the difference b/w the bid and ask price

Round-trip cost — difference between what you pay and what you receive from a sale (not including changes in bid and ask prices)

Round-trip Cost Example

A stock’s bid price is S29.75 and its ask price is $30. The commission is S10. If you buy 100 shares of the stock and immediately sell them, what is cost of this transaction (i.e., your round-trip cost)

Short-Selling

Long position – when you buy something, you have a long position

e.g: buy a share of XYZ stock which you can later sell

In essence you are lending-, you pay money now and get money back later

Short position – opposite of long position

Short-sale – e.g. borrow share of XYZ and sell it you receive the cash now and must buy the stock at a later date

When you buy the stock, it’s called closing or covering the position

In essence you are borrowing: you get money now and pay money later (price of the stock when you have to buy it)

Potential losses from short-selling are theoretically unlimited, while losses from taking a long position are limited to the amount you paid for the asset.

Short-Selling Stock Example 1

The bid and ask prices for a certain stock are as follows

	January 1	March 31
Bid	$55.75	S50.00
Ask	$56.00	S50.25

Bill sells short 100 shares on January I1′ and doses the position on March 31″‘. If the broker’s commission in S10 per transaction, how much does Bill make (or lose) on the short sale?

Reasons to short-sell

1 speculation — m ake money if the price goes down

2 financing – short-sale is a way to borrow money (common in bond market)

3 hedging – e.g. undertake a short-sale to offset the risk of owning the stock (frequently done by market-makers)

Risk and Scarcity in Short Selling

1) Credit risk – short-seller must return asset to lender. To ease the mind of the lender, he might require collateral until the asset is returned.

For example, if you short-sale stock:

Borrow stock and sell it immediately

Proceeds from sale go to 3m party to be held as collateral

Lender might require thai additional money be set aside in case the price of stock increase (called haircut)

Haircut protects the lender against short-sellers failure to purchase asset when price increases

2) Scarcity – how easy is it to find a lender of the asset9

From our short-sale stock example above, the rate earned on the collateral is paid to the lender of the asset. However, the money is actually the short- sellers, so he expects some of the interest. The short-sellers rate earned on the collateral is called repo rate in bond market and short rebate in stock market.

How much interest the lender gives to the short-seller depends on how scarce the asset is.

If lots of people want to short-sale the asset, then the lender can offer alow rate on the collateral and still find someone to borrow the asset. However, if no one wants to borrow the asset then tender might be required to offer a rate close to the rate earned on collateral.

The Lease Rate of an Asset

Lease rate — annualized payment required to borrow an asset

For example, amount equal to stock dividends must be paid by the short-seller to the lender (since the stock was soli neither the lender of short-seller will receive the dividends from the company)

These payments are taxable for the lender and tax-deductible to the short- seller

Short-Selling Stock Example2

The bi d and ask prices for a certain stock are as follows

	January 1	March 31
Bid	$55.75	$60.00
Ask	356.00	$60.25

Bill sells short 100 shares on January 1 and closes the position on March 31st. The broker ‘s commission is 0.2% per transaction. The haircut requirement is 50% of the proceeds received on the short sale. A dividend of $0.30 per share i s paid on March I5a\ The market rate of interest is 8% convertible quarterly. The short rebate rate is 6% convertible quarterly. Ignoring interest on the dividends, what is Bill’s economic profit (or loss)? Note, economic profit includes the lost cost of what Bill could have earned on the haircut.