Nature of Derivative Securities

A derivative security is a security whose value derives from an underlying variable; Frequently the underlying variable is the price of a traded asset; this traded asset is referred to as the underlying security, the underlying asset or the primitive asset.

Jose Correia Guedes

Master in Business - FCEE

Financial derivatives

Examples of underlying assets

Stocks and Stock Indexes; Bonds and Bond Indexes; Foreign Exchange Deposits; Risky corporate debt; Commodities:
Extractive: oil, natural gas, gold, silver, Agriculture&Forestry: wheat, soybeans, cotton, coffee, orange juice concentrate, pulp,
Jose Correia Guedes Master in Business - FCEE Financial derivatives

Examples of underlying variables that are not traded assets

Interest rates; Inflation rates; Credit ratings and indexes; Weather conditions (temperature, quantity of rain,..) Binary variables associated to the occurrence of particular events:
Corporate defaults; Hostile acquisitions attempts; Mergers; Natural Disasters.
Master in Business - FCEE Financial derivatives

Jose Correia Guedes

Examples of derivative securities

Forward contrats; Future contrats; Swaps; Options; Options on future contracts; Options on swaps (swaptions); Exotics (derivative structures that cannot be created from forward contracts plus options)
Examples: binary options, barrier options
Jose Correia Guedes Master in Business - FCEE Financial derivatives

Source: BIS (Trillions USD)

2004
Notional amounts Gross market value

2008
Notional amounts 80 26,8 0,2 1,1 44,3 0,1 8,1 9,1 4,8 0,03 0,5 1,34 0,5 520 272 22,8 52,3 36,7 9,2 43 11,1 5,3 0,04 0,7 1,1 1,1 0,7 Financial derivatives Gross market value

Exchange-Traded Instruments Interest rate futures Currency futures Equity index futures Interest rate options Currency options Equity index options OTC Instruments Interest rate swaps FRAs Options on interest rates (caps, loors, collars, swaptions...) Currency swaps, forwards & forex swaps Equity linked contracts Credit Default Swaps Jose Correia Guedes

47 18,2 0,1 0,6 24,6 0,06 3 248 147,4 12,8 27,2 23,4 4,4

0,15 8 Master in Business - FCEE

What are derivative securities used for?

To hedge risk; To speculate; To arbitrage disallignments of prices among related securities; What is the commonality among the three possible uses of derivative securities?
Jose Correia Guedes Master in Business - FCEE Financial derivatives

Types of hybrid securities

Hybrids composed of Debt and Derivatives
Debt plus a forward contract Dual -currency bonds Petrobonds Debt plus a swap Inverse floating-rate notes Adjustable-rate convertible notes Debt plus an option Bonds with warrants Equity warrants Commodity & foreign exchange warrants Convertible bonds Bonds with indexed principal Principal indexed to commodity prices Principal indexed to exchange rates (indexed currency option notes) Principal indexed to interest rates Principal indexed to equity indexes S&P index subordinated notes (Spins) Stack index growth notes (Signs) Option on issuers creditworthiness Puttable and extendible debt Liquid yield option note(LYON) Jose Correia Guedes Master in Business - FCEE Financial derivatives

Hybrids composed of Debt and Derivatives

Option on natural disaster Bonds with earthquake puts Debt plus a package of options Commodity interest-indexed bonds Copper interest-indexed notes Smart notes Equity interest-indexed bonds Suns Inflation rate interest-indexed bonds Packages of interest rates options Floored floating-rate options Step-up bonds Index amortising notes Range notes (corridor or accrual notes)

Hybrids composed of Equity and Derivatives

Equity plus a swap Adjustable-rate preferred stock Equity plus an option Convertible preferred Options on equity or on equity index Equity-linked preferred stock Pers/Elks/Decs Hybrids designed to decompose equity claims Prescribed right to income and maximum equity (Primes) Special claim on residual equity (Scores) Super Shares Unbundled stock units Other option types Option on management behaviour - puttable stock Option on the outcome of litigation

Derivatives are financial weapons of mass destruction

Warren Buffet, 2002 Annual Report of Berkshire Hathaway
1993 Metallgesellschaft
Oil futures trading resulted in losses of 1.3 billion

1994- Orange County

Investments in leveraged interest rate products generated losses of up to 1,7 billion USD

1995 - Barings
Trading in Nikkei-index contracts in Singapore & Osaka exchanges resulted in losses of 1,4 billion USD, wiping out the banks capital

1998 Long Term Capital Management

Hedge fund with massive positions in derivatives and facing liquidity shortages, taken over by consortium of creditors in a 3,5 billion rescue operation led by the NY FED.

2006 - Amaranth
Losses in natural gas futures of up to 6 billion USD. Positions in futures taken over by JPMorgan, Merril Lynch & Citadel at undisclosed prices.

2008 Bear Stearns

Fear of systemic risk stemming from massive positions in Credit Default Sawps (10 trillion of notional value), prompted FED to orchestrate purchase of bank by JPMorgan and open discount window to investment banks (for the first time ever). Bank lost over 10 billion USD in market value within less than 2 months.

Jose Correia Guedes

Master in Business - FCEE

Financial derivatives

Forward Contracts
Contract that stipulates the obligation to buy (long position) or to sell (short position) a specific asset (underlying asset), at a specific future date, for a specific price; A forward is a zero-sum game: the value of the long position is always the symmetrical of the value of the short position; Generally, forward contracts trade in the over-the-counter market.
Jose Correia Guedes Master in Business - FCEE Financial derivatives

Examples of forward contracts

purchase of 5000 ounces of gold @ USS400/oz., one year from today; Sale of 1,000,000 @ 1,5 USS/, 6 months from today; return of 4% on a 1,000,000 USD deposit, for a period of 3 months, starting in 6 months (FRA);

Sale of 1,000,000 barrels of crude @ USD 52/barrel, 9 months from today;

Jose Correia Guedes Master in Business - FCEE Financial derivatives

How does a forward work?

Two parties - the party who wants to buy at future date and party who wants to sell at future date - agree on a delivery price for the future transaction, such that the value of the contract is initially equal to zero. Hence, when the contract is initiated, no funds have to be exchanged between the two parties. Funds are exchanged only at the delivery or maturity date of contracts, to settle losses and gains.

Jose Correia Guedes

Master in Business - FCEE

Financial derivatives

Example
On January 5th of 2006 a company purchases S1,000,000 @ 1,17 (USD/Euro) forward at 3 months, to Bank B; The company takes a long position in USD and the bank takes a short position in USD; At maturity date (5th of April of 2006), the spot exchange rate is equal to 0,95: - the company must pay to the bank (1/1,17)*1,000,000 = 854.701 Euros; - the bank must pay to the company (1/0,95)*1,000,000 = 1,052,632 Euros The settlement of position is in favour of the company: the bank pays to the company 197.931 Euros

Jose Correia Guedes

Master in Business - FCEE

Financial derivatives

Future Contracts
Contracts traded in Derivatives Exchanges (EUREX, Liffe, CBOE-CBOT, COMEX....); Standardized Contracts:
Characteristics of underlying asset; N of units of underlying assets per contract; Maturity dates.

Jose Correia Guedes

Master in Business - FCEE

Financial derivatives

Dow Jones STOXX 50 Futures (FSTX) and Dow Jones Euro STOXX 50 Futures (FESX)
Underlying Index: 50 shares, prices weighed for the respective capitalization (it includes the impact of technical accidents but it excludes the impact on the value of the shares from conversion of warrants and convertible debt); Quote Method: points of the index, with no decimals; Value of the contract: Points of index * 10 Euros; Expirations: the three nearest months in the cycle March, June, September and December; Liquidation at expiration date: financial liquidation on the basis of the price of reference at expiration, to pay in the first working day after the last day of negotiation; Price of reference at the expiration: Arithmetic mean of the values of the index between 11h50 and 12h00 CET of the last day of negotiation; Tick: 1 point of the index (corresponds to 10 Euros); Last negotiation days: 3rd Friday of the expiration month; Margin: 250 points of the index (2500 Euros) per contract;
Jose Correia Guedes Master in Business - FCEE Financial derivatives

Euro-BUND Futures (FGBL)

Underlying Index: National classic long-term bond emitted by the German federal government, with the expiration date between 8, 5 and 10, 5 years and 6% coupon rate; Quote Method: % of the par, with two decimals; Contract Value: 100000 Euros; Expirations: 3 nearest months in cycle March, June, September and December; Liquidation at expiration: the short positions deliver Treasury bonds of the German federal government (Bundesanleihen) with term to maturity between 8,5 and 10,5 years and with an aggregate value of emission over 2 billions Euros. The delivery day corresponds to 2nd working day after the last day of negotiation; Notification: members of the exchange with open short positions must notify the EUREX, indicating the specific instruments to use for delivery, after the close of the negotiation in the last day of negotiation of the contract; Last day of negotiation: 2 working days before 1st working day from 10th day of calendar of the expiration month (inclusive); Reference Price at expiration: weighted mean per volumes of the prices registered in last 10 transactions until 12:30 of the last day of negotiation; Tick: 0,01% (Euros corresponds to 10 Euros); Margin: 1,6% (1600 Euros) per contract;
Master in Business - FCEE Financial derivatives

Jose Correia Guedes

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CBOT - gold
Transaction Unit: 100 troy ounces; Tick size: $10 per contract; Daily maximum variation: $5000 per contract relative to priors day closing price; Expiration Months: current month, following two months, plus February, April, June, August, October and December; Last day of negotiation: the 4th day before the last working day of the expiration month; Types of underlying accepted for delivery: Fine gold in bars of 100 ounces "assaying not less than 995 fineness"; Way of delivery: vault receipt emitted by the receiver entity in New York or Chicago duly authorized by the CBOT. Initial margin per contract: $2,000; Minimum maintenance margin: 75% of the initial margin.
Jose Correia Guedes Master in Business - FCEE Financial derivatives

Clearing House - CH
The purchaser and the seller of a future contract do not need to know each other. Once a buy order is matched with a sell order (through either an electronic trading platform or a trading pit), the CH takes over as the counterpart of each of the two trading parties.

Jose Correia Guedes

Master in Business - FCEE

Financial derivatives

11

Investor A
(wants to buy n contracts)

Investor B
(wants to sell n contracts)

Order to buy n contracts

broker is not a member of exchange

Order to buy n contracts Order executed: CH sells to A n contracts Order executed: CH buys to B n contracts

Order to sell n contracts

broker is a member of exchange

CH

broker is a member of exchange

Info. about executed orders

Negotiation system
Order to buy n contracts
Jose Correia Guedes

(orders are matched)

Master in Business - FCEE

Order to sell n contracts

Financial derivatives

The CH reduces the credit risk faced by investors trading future contracts:
The counterpart to all contracts is the CH; The CH has financial reserves (the capital of the members of the exchange) that guarantee the performance on its contracts;

How does the CH protects itself against credit risk?

The long and the short positions held by the CH balance each other; Only authorized agents are admitted to negotiation; Traders have to keep margin accounts with the exchange; Positions are adjusted daily.

Jose Correia Guedes

Master in Business - FCEE

Financial derivatives

12

Daily adjustment of positions

An investor purchases 10 future contracts on January 11th (CBOT-gold), at a futures price equal to $365 per ounce, with expiration in February. The initial margin is equal to $20,000 ($2,000*10) and the maintenance margin is equal to $15,000 (75% of the initial margin).

Jose Correia Guedes

Master in Business - FCEE

Financial derivatives

Hypothetical adjustment of position during the first 6 days of the life of the contract
Day Future Price Cash-flow Balance-MA Additions-MA Withdrawals-MA

1/11 1/12 1/13 1/14 1/15 1/16

365 362 359 364 365 367

0 -3,000 -3,000 +6,000 +1,000 +2,000

20,000 17,000 14,000 26,000 21,000 22,000

6,000 6,000 1,000 2,000

What happens if the investor, on January 13th, refuses to add funds to his margin account?
Jose Correia Guedes Master in Business - FCEE Financial derivatives

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Open interest
Most investors close their positions in futures before the maturity dates of contracts.
- Why? - How?

The open interest" consists of the number of positions that are open (either the sum of all long positions or all short positions), at a particular date; What happens to "open interest" when an investor trades a new contract?
Jose Correia Guedes Master in Business - FCEE Financial derivatives

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Can the market be manipulated?

Cornering the market
An investor "corners the market by simultaneously buying future contracts and the underlying asset, and then keeping his position in futures contracts open until the maturity of contracts. If the available supply of the underlying asset not controlled by the investor is scarce, then the short positions will have to buy the underlying asset (to be able to deliver it at the expiration date) from the investor at a high price. In this case, we say that the short positions had been "squeezed".

What it can the stock market make to prevent "cornering"?

- Force the long positions to close its positions; - Suspend negotiation, and force an agreement (between long and short positions) at a fair price.
Jose Correia Guedes Master in Business - FCEE Financial derivatives

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