CHAPTER 2 ome Fundamentals of Derivatives In this chapter, we will discuss some of the common derivatives products and the fundamentals relating to these instruments, Definition of derivatives ‘What is a derivative instrument? ‘A derivative instrument is a contract whose value depends on, or derives from, the value of an underlying asset or index. For example, te value of an option on IBM depends on the share price of IBM. If the share price of IBM rises, the value of the call option of IBM also rises, although not in the same proportion. Derivatives include a wide variety of financial contracts, including: furures, forwards, options, swaps, and various combinations and variations thereof, such as caps, floors, collars, structured debt obligations, collateralized mortgage obligations (CMO), pass through mortgage-backed securities (MBS), warrants, etc. Types of derivatives Derivatives can be classified into two types: forwards and options. Forward derivatives include mainly forwards, futures and swaps. The payoff pattem of these instruments is linear and symmetric. It means that the change in the value of the derivative is in the same direction and proportion as the change in value of the underlying. For example, counterparties A and B enter into an interest rate swap contract in which A. pays floating and receives fixed. If interest rates go up by one percent, A will lose, say $10,000, and B will gain $10,000. If interest rates go down by one percent, A will gain, say $10,000, and B will lose $10,000. (For simplification of presentation, we assume a parallel shift of the yield curve and no convexity.) The symmetric payoff pattern in this example is apparent. Option derivatives include options, caps, floors and all financial instruments with embedded options such as warrants, callable bonds, MBS and CMO. The payoff pattern of these instruments is non-linear and asymmetric. It means that the change in value of the derivative is not in the same proportion and may not be in the same direction as the change in value of the underlying. For options transactions, an option buyer's risk exposure is known and limited. This option buyer pays a premium for purchasing a call option. ‘The maximum amount he would lose is the premium he pays. The upside potential for him is unlimited, because the price of the underlying could theoretically go up by 10 times, 20 6times or even 100 times. ‘The option writer's situation is just the opposite. He receives a premium for selling the option. The maximum gain for him is the premium he receives. If the price of the underlying soars, his loss could be tremendous. Therefore, an option writer's risk exposure is unknown and unlimited. In the above discussion, you can also see how leverage comes into play in option transactions. The option buyer pays a relatively small premium to participate in the market. On the one hand, he could lose all the premium he pays. On the other hand, she could gain 10 or even 100 times of the premium he pays if the market soars. Some history about derivatives ‘The history of derivatives goes back as far as the Middle Ages. In those days, farmers and merchants used futures and forwards to hedge their risks. For instance, a farmer harvested rain in July. But in April, he was uncertain about what price of grain he would get in July. During the years of oversupply, the farmer bore tremendous price risk as the price of grain would be lower than he expected, and he might not recover the cost of production, A grain merchant also bore tremendous price risk during the years of scarcity when the price of grain was higher than expected. Therefore, it made sense for the farmer and the merchant to get together in April to agree upon a price in July for grain. This was how the futures and forwards market developed in grain hundreds of years ago; and then pork bellies. cotton, coffee, petroleum, soya bean, sugar. currencies, interest rates-~ and even garbage. The Chicago Board of Trade started trading three kinds of garbage - plastics, glasses and paper in October 1995. Participants in derivatives markets ‘Three kinds of people participate in derivatives markets: the hedgers, the speculators and the arbitrageurs. Hedgers are risk-averse. Like the farmer and the merchant in the above example, they want the future sales price of the merchandise to be known in advance and the transaction be consummated at this known sales price. In doing so, they may give up some upside potential. In the example, if the price of grain rose substantially in July, the farmer would not benefit from it because he had already sold the merchandise at a price determined in April. Hedgers do not care much about the future potential. All they want is to reduce their price risk. [lowever, now that both the merchant and the farmer had hedged their risks, this dose not mean that they had nothing to worry about. The farmer still worried that the price of grain in July would fall drastically and the merchant would not fulfil his promise to buy the grain at the agreed upon price. Or the merchant simply did not have the money (v pay fur the grain in July. This is what we call credit risk. Hedgers can hedge away their price risk, but they cannot eliminate credit risk. Contrary to hedgers who want to avoid uncertainty in price movements, speculators want to take the advantage of price movements. For example, if a speculator thinks that the 7stock market in Hong Kong will go up in the next several months, he can buy a three- ‘month Hang Seng Index (HSI) futures contract at the current index level of 14,500. If the stock market in Hong Kong does goes up and the HSI rises to 15,000, the speculator can sell the three-month futures contract at 15,000 and take a 500 point profit. But we know that the chance for the market to go up or down is 50/50 if the market follows a random walk. In other words, the speculator has a 50 percent chance of losing and a 50 percent chance of winning. The speculator may lose a substantial amount of money if his prediction of market does not materialise. ‘The third kind of participants are arbitrageurs. Arbitrageurs look for opportunities to lock in a riskless profit by simultaneously buying and selling the same (or similar) financial product in different markets. The fundamental behind arbitrage is that financial markets are not perfect. From time to time, price differential of the same product between different markets in different parts of the world at the same time does exist, especially combining the currency element. For us, arbitrage strategy will not work, because the transaction cost will probably wipe out the profit even if we do find an arbitrage chance. Big investment houses incur very little transaction cost. They are the major players in this market. But remember Barings, its management put the company to the ground using a supposedly riskless arbitrage strategy. ‘When bank regulators conduct examinations, it is sensible for them to find out what is the institution's strategic goal in derivatives business is. Is it a hedger, speculator or arbitrageur? Regulators can also review the institution's revenue report to identify the sources of treasury revenues. If 80 percent of an institution's treasury revenues are from position-taking activity, examiners usually would watch that institution's treasury operation a bit closer The reason is that position-takers in treasury instruments, both cash and derivatives, are speculators. In other word, they are gamblers. As we have just discussed, when you take an out-right position in any financial instrument, tere is a 50 percent chance that the price of that instrument will go up and a 50 percent chance it will go down. As soon as you have taken an out-right position, you have no control over what the price will be in the next minute. Should we criticise banks for engaging in position-taking business? Not really. All businesses involve in some degree of risk taking and speculation. Banking business is no exception. But it all depends on how much a bank speculates. Most banks conduct derivatives business because they have to serve their clients who either take or hedge their business risks. They come to banks for solution, In the process of serving these clients, it is inevitable for banks to take some out-right positions. Also, banks’ trading activities can facilitate liquidity which would reduce transaction cost for all market participants. In addition, banks take positions because they have to get the "market feel” to better serve their clients. Moreover, from time to time, banks have their own views on interest rate or exchange rate movements. It is perfectly all right for them to take out-right positions in those circumstances. When banks engage in position-taking activities, they have to consider # number of things, such as the capital level of the institution, business strategies, trading expertise, management's understanding of the markets, systems and controls, back- office supports, ete