Introduction

Derivatives Securities (MFFINTECH 6003)

Hugh Kim

The University of Hong Kong

What is a Derivative?
Definition
A derivative is a financial instrument whose value depends on (or
derives from) the value of an underlying asset or variable.

I Limited time to maturity

I Payoffs on or before maturity are a function of an observable
underlying variable
I Key ingredients that determine the current value:
I Characteristics of underlying variable: current level, volatility, etc
I Time to maturity
I Risk free interest rate
Examples of Derivatives
I Examples of derivatives:
I forward/futures
I options, warrants, convertible bonds
I interest rate swaps, foreign exchange swaps, credit default swaps
I asset back securities, mortgage back securities
I structured products
I The underlying variables can be almost anything:
I Stocks, bonds (or interest rates), foreign exchange rates
I Commodities: grains, livestock, meat, oil, metals, etc
I Credit risks, energy (electricity), weather, insurance payouts
I Even derivatives such as futures and swaps
Forward
I A forward contract is an agreement to trade the underlying asset
in the future (at maturity T ) for a fixed price specified today
(T )
(forward price Ft at the current time t)
I Party that agrees to buy the underlying (long position) makes a
profit if at maturity T the price of the underlying ST is higher
(T )
than the pre-specified forward price Ft , and makes a loss if at
(T ) (long forward) (T )
maturity ST < Ft ⇒ PayoffT = ST − Ft
I Party that agrees to sell the underlying (short position) makes a
profit if at maturity T the price of the underlying ST is lower
(T )
than the pre-specified forward price Ft , and makes a loss if at
(T ) (short forward) (T )
maturity ST > Ft ⇒ PayoffT = Ft − ST

I Typically, Ft(T ) is chosen such that no money is exchanged

between long and short position at time t
I Futures contracts are similar (more details later)
Forward: Example
I On June 4 the treasurer of a corporation enters into a long
forward contract with a bank to buy £1 million in six months at
an exchange rate of 1.55 £$
I Do the corporation and the bank have an obligation? If so, what
is it?
I Corporation: A long position obligates the corporation to pay
$1,550,000 to the bank and in exchange it receives £1 million on
December 4
I Bank: A short position obligates the bank to pay £1 million to
the corporation and in exchange it receives $1,550,000 on
December 4
Forward: Example
I What is the payoff of the forward contract if the exchange rate
on December 4 is 1.45 £$ , 1.55 £$ , or 1.65 £$ ?
I Corporation: a long position in the forward pays off
 
 
 current ex-
 
∗ £1million − $1,550,000 

 change rate
 | {z } 
| {z } pay $1,550,000
receive £1million

or −$100,000, $0, or $100,000

I Bank: a short position in the forward pays off
 
 
current ex-
 
 $| 1,550,000 − ∗ £1million
 
 {z } change rate 
receive $1,550,000 | {z }
pay £1million

or $100,000, $0, or −$100,000

Importance of Derivatives
I Derivatives play a key role in transferring risks in the economy
I Many financial transactions have embedded derivatives
I In corporate finance the concept of real options is essential for
the assessment of capital investment decisions
How do Investors Use Derivatives?
I "Hedgers": hedging risk
I "Speculators": betting on a view on the future direction of the
market
I "Arbitrageurs": locking in an arbitrage profit
Hedging Risk
I Hedging reduces or eliminates risk associated with potential
(unknown) future movements in a market variable - for instance,
price of an asset currently owned or potentially to be owned
I Hedging may increase or reduce future payoffs which at first
may seem undesirable (looks like gambling)
I But the uncertain payoff of a derivative is strongly correlated
with the uncertain payoff of the underlying, and an appropriate
(long or short) position in the derivative can offset the risk in
the underlying and thus, one can reduce risk
I Forward/futures contracts neutralize risk by fixing the price
I Options provide insurance against adverse price movement but
still profit from favorable price movements
Hedging Risk: Examples
I A firm which does business abroad may find it useful to trade
foreign exchange rate derivatives - hedge risk in FX market
I An airline may find it useful to trade oil derivatives - hedge risk
in jet fuel prices
I A stock trader may find it useful to trade derivatives on stock
indices - hedge market risk
I A farmer, a holiday resort or a theme park may find it useful to
trade weather derivatives - hedge against unfavorable weather
conditions
Hedging Risk: Illustration
I Suppose you produce corn
I You expect to harvest 20,000 bushels (500 metric tons, field of
125 acres) of corn by December and want to sell it in December
I The current price of corn per bushel is $5.63
I On the Chicago Mercantile Exchange corn futures contracts are
traded
I One futures contract is an agreement to trade 5,000 bushels of
corn in the future
I The current futures price for a contract with maturity in
December is $5.24 per bushel of corn, or $26,200 per contract
Hedging Risk: Illustration
I Why would you consider to trade in the futures market?
I Your skills/advantages lie in farming, not in the ability to
forecast market price movements

I What position would you take in the futures market? Long or

short? How many contracts?
Short sell 4 contracts to offset any risk and receive for sure $5.24
per bushel, or $104,800 for your entire harvest

I How much does your futures position payoff in December if the

price per bushel is $3, or $8?
Hedging Risk: Illustration
I The forward/futures payoff schedule is risky. Is it desirable to
take on this risk?
I The payoff is perfectly negatively correlated with the corn price
⇒ you can eliminate the corn price risk

I For how much can you sell your corn in the market conditional
on the above prices?
I You can sell your 20,000 bushels of corn for $60,000 or $160,000

I How much do you earn in December from your futures position

and selling your corn in the market?
I Independent of the corn price you earn $104,800
Speculation
I Taking risk by betting on a view on the future direction of a
market variable and use derivatives to get extra leverage
I Speculation on the gold price:
I A view: The price of gold is likely to increase in the near future
I One approach is to purchase gold in the spot market and sell it
later hoping the price goes up
I Another approach is to trade in the derivatives market
⇒ take a long position in a forward or futures contract to lock in
a price in the near future
I The second approach needs no down payment (or only a small
amount of cash as collateral or deposited in a “margin account”)
instead of a large investment to buy gold to take a speculative
position
Arbitrage
Definition
An arbitrage is a strategy that generates (today or in future) a
positive payoff with non-zero probability and a negative payoff with
zero probability

I In other words: locking in a riskless profit by taking offsetting

positions simultaneously
I Arbitrage across markets:
I In market A, 1 ounce of gold is traded for $1’640
I In market B, 1 ounce of gold is traded for $1’630

⇒ Buy gold in market B and sell it in market A

⇒ Receive instantly $10 for every ounce of gold traded
(Risky) Arbitrage
Dangers of Derivatives Trading
I Traders can switch from being hedgers to speculators or from
being arbitrageurs to speculators; it is important to set up
controls to ensure that traders are using derivatives for their
intended purpose
I Limits to arbitrage, financial constraints and liquidity risks are
very important issues in reality; however, they are often ignored
by hedgers and arbitrageurs!
Example of Barings Bank Disaster, 1995
Example of Barings Bank Disaster, 1995
I Nick Leeson, a trader in the Singapore office, was employed to
exploit arbitrage opportunities between the Nikkei 225 futures
prices traded on exchanges in Singapore and Japan
I He started to move from trading as an arbitrageur to become a
speculator without letting the head office in London know
I At some point he made some losses, which he was able to hide
from the head office for a while
I Subsequently he started to take bigger speculative positions in
the hope to recover his previous losses
I By the time his activity was uncovered his total loss accounted
for almost $1 billion
I Barings bank (over 200 years old) was bankrupt
I Nick Leeson was sentenced to 6.5 years in prison in Singapore
Other Examples
I Metallgesellschaft (oil futures, $1.3 billion, 1993)
I Procter and Gamble (derivatives trading through Bankers Trust,
$90 million, 1994)
I Orange County (interest rate derivatives, $2 billion, 1994)
I Barings Bank (Nikkei futures, $1 billion, 1995)
I LTCM (various derivatives, $4 billion, 1998)
I Amaranth (natural gas derivatives, $6 billion, 2006)
I Société Générale (Euro Stoxx 50 futures, $5 billion, 2008)
I and the list goes on and on...
Lessons to be learned
I Be diversified
I Risk must be quantified and risk limits well defined
I Exceeding risk limits is not acceptable even if high profits are
earned
I Never ignore risk management, even when times are good
I Scenario analysis and stress testing is important
I Liquidity risk is important
I Beware of potential liquidity problems when long-term funding
requirements are financed with short-term liabilities (e.g. credit
crisis 2007)
I Models can be wrong; be conservative in recognizing inception
profits (market vs model value)
I There are dangers when many are following the same strategy
Lessons to be learned
I It is important to fully understand the products you trade
I Do not sell clients inappropriate products
I Market transparency is important (e.g. complex structured
securities)
I Manage incentives
I Beware of hedgers becoming speculators
I It can be dangerous to make the Treasurer’s department a profit
center
I Do not assume that a trader with a good track record will
always be right
I Do not give too much independence to star traders
I Separate the front, middle and back office