24-07-2020

Financial Derivatives
Sessions 1-2

Dilip Kumar 1

What is a financial derivative?

“A financial contract is a derivative security, or a contingent claim,
if its value at expiration date T is determined exactly by the market
price of the underlying cash instrument at time T.”
- Ingersoll, 1987.
Contingent claim: A claim that can be made if certain specified outcomes occur.
Requirements for underlier
It can be quantified
Many buyers and sellers of derivatives exist based on this quantified measure.
Common underliers: Commodities, Financial securities (Equities and Bonds
(Interest rates)), Currencies.
Underliers that cannot be delivered: Weather conditions, creditworthiness, stock index.
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Who buy and sell derivatives?

End users:
Individuals, Companies, Financial institutions
• Buy and sell derivatives to hedge positions or to speculate.
Arbitrageurs (Take advantage of mis-pricing)
Not interested in owning derivatives.
Make small and (virtually) risk-free profits by simultaneously buying and selling
derivative instruments.
Intermediaries (Connect buyers and sellers)
Create innovative solutions for customer of financial derivatives.
Brokers, Banks, Exchanges and an army of financial wizards.
Revenue: Commissions, fees and difference between bid and ask rates on derivative
contracts they buy and sell.
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Derivative Markets
Exchange-traded futures and options
standardized products
trading floor (human outcry) or computerized trading
virtually no credit risk (counterparty is clearing house)
Contracts are directly between clearing members (brokers) and
clearing house.
Over-the-Counter forwards, options, & swaps
often non-standard (customized) products
Connected by global network of telephone, telex, fax, and high-speed
internet connections.
Credit risk is present
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Current size of derivatives market

You can get data on current size of derivatives market from BIS
website.
For Exchange traded contracts: See the following link
https://www.bis.org/statistics/extderiv.htm?m=6%7C32%7C616
For OTC contracts: See the following link
https://www.bis.org/statistics/derstats.htm?m=6%7C32%7C71

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The tale of AIG (American International Group)

AIG-FP (Financial Products)
Sold $500 billion worth insurance (jargon: CDS protection), with atleast $64 bn
tied to subprime mortgages. AIG, initially rated AAA, didn’t have even a fraction
of that amount in cash to cover the bets!.
September 2008 -- The Bailout Begins ($85 bn)
Just a week after the U.S. government let Lehman Brothers file for
bankruptcy, the Treasury Department steps in to rescue AIG, which
had been brought to its knees by a big move into risky financial
products like insurance-type contracts on mortgage-related securities.

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The Four Basic Derivatives

Forward Contracts

Futures Contracts

Options Contracts

Swaps Contracts

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Uses of Derivatives
To hedge or insure risks; i.e., shift risk.
To reflect a view on the future direction of the market, i.e., to
speculate.
To lock in an arbitrage profit

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Understanding the product space

We will first understand the payoffs from two popular class of
derivative instruments: forwards (or futures) and options
As we will see later, it is also instructive to classify these class of
instruments as below:
Linear derivatives
Non-linear derivatives

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Derivatives: Hedging
Let us now talk about a “textbook farmer”. His harvest is due
after three months. What are the risks he faces? How can he
hedge himself?
If he finds someone who promise to buy wheat at 100 (for 5 kg),
he has removed his price risk
?
up=120
Let us study the cash-flows
?

down=90
?
t=0 t=3m

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Derivatives: Hedging
If the farmer can find someone who promises to buy wheat at 100,
he has removed his price risk.
Note: the farmer is said to be short the wheat forward
Sell at 100
up=120

No Cash-flow

down=90
Sell at 100
t=0 t=3m
The farmer doesn’t pay/receive any premium upfront.
Who is likely to be a counterparty for this contract.
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Derivatives: Hedging
The counterparty could be a consumer of wheat, say a bread
manufacturer.
Note: the consumer here is said to be long the wheat forward.
Buy at 100
up=120

No Cash-flow

down=90
Buy at 100
t=0 t=3m

The counterparty could also be a trader taking speculative position

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Derivatives: Trading
The long counterparty could also be a trader who is merely speculating
on the price of wheat going up.
Profit=20
up=120

No Cash-flow

down=90
Loss=10
t=0 t=3m

If the price goes to 120, he can buy wheat in forward at 100, sell
it in spot market for 120, and make a profit of 20.

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Defining Forward Contracts

A Forward contract is an agreement to buy or sell an underlying
asset, for a specified price, at a specified time in the future.
Both parties are obliged to honour the contract
The person who has agreed to buy the asset in future is said to be
long.
The person who has agreed to sell the asset in future is said to be
short.
The price at which the parties agree to buy/sell is the forward
price.
They do not pay any premium for entering this contract.
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Distinguishing between Forwards and Futures

A Futures contract is similar to a forward contract in terms of
terminal payoffs; but there is a key difference
Futures are traded in exchange and are standardized
Forwards are traded over-the-counter and can be easily customized
While some people use the two terms interchangeably, it helps
to remember that they are not identical products.

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