Chapter 3 Introduction to Derivatives
3,1 Introduction to Derivative
A derivative is a financial instrument that has a value
determined by the price of something else. Options,
futures, and swaps are all examples of derivatives. A
bushel of corn is not a derivative; it is a commodity
with a value determined in the corn market. However,
you could enter into an agreement with a friend that
says: If the price of a bushel of corn in 1 year is
greater than $3, you will pay the friend $1. If the price
of corn is less than $3, the friend will pay you $1. This
is a derivative in the sense that you have an agreement
with a value depending on the price of something else
(corn, in this case).
You might think: “That doesn’t sound like
it’s a derivative; that’s just a bet on the price of corn.”
Derivatives can be thought of as bets on the price of
something, but the term “bet” is not necessarily
pejorative. Suppose your family grows corn and your
friend’s family buys corn to mill into cornmeal. The
bet provides insurance: You earn $1 if your family’s
corn sells for a low price; this supplements your
income. Your friend earns $1 if the corn his family
buys is expensive; this offsets the high cost of corn.
Viewed in this light, the bet hedges you both against
unfavorable outcomes. The contract has reduced risk
for both of you.
Investors who do not make a living growing
or processing corn could also use this kind of contract
simply to speculate on the price of corn. In this case
the contract does not serve as insurance; it is simply a
bet. This example illustrates a key point: It is not the
contract itself, but how it is used, and who uses it, that
determines whether or not it is risk-reducing. Context
is everything.
3.2 An Overview of Financial Markets
In this section we will discuss the variety of markets
and financial instruments that exist. You should bear
in mind that financial markets are rapidly evolving
and that any specific description today may soon be
out-of-date. Nevertheless, though the specific details
Chapter 3 Introduction to Derivatives
may change, the basic economic functions associated
with trading will continue to be necessary.
Trading of Financial Assets
The trading of a financial asset—i.e., the process by
which an asset acquires a new owner— is more
complicated than you might guess and involves at
least four discrete steps. To understand the steps,
consider the trade of a stock:
1. The buyer and seller must locate one another
and agree on a price. This process is what
most people mean by “trading” and is the
most visible step. Stock exchanges,
derivatives exchanges, and dealers all
facilitate trading, providing buyers and
sellers a means to find one another.
2. Once the buyer and seller agree on a price,
the trade must be cleared, i.e., the obligations
of each party are specified. In the case of a
stock transaction, the buyer will be required
to deliver cash and the seller to deliver the
stock. In the case of some derivatives
transactions, both parties must post collateral.
3. The trade must be settled, that is, the buyer
and seller must deliver in the required period
of time the cash or securities necessary to
satisfy their obligations.
4. Once the trade is complete, ownership
records are updated.
To summarize, trading involves striking a deal,
clearing, settling, and maintaining records. Different
entities can be involved in these different steps.
Much trading of financial claims takes place
on organized exchanges. An exchange is an
organization that provides a venue for trading, and
that sets rules governing what is traded and how
trading occurs. A given exchange will trade a
particular set of financial instruments. The New York
Stock Exchange, for example, lists several thousand
firms, both U.S. and non-U.S., for which it provides a
trading venue. Once upon a time, the exchange was
solely a physical location where traders would stand in
groups, buying and selling by talking, shouting, and
gesturing. However, such in-person trading venues
have largely been replaced by electronic networks that
provide a virtual trading venue.
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 After a trade has taken place, a clearinghouse
matches the buyers and sellers, keeping track of their
obligations and payments. The traders who deal
directly with a clearinghouse are called clearing
members. If you buy a share of stock as an individual,
your transaction ultimately is cleared through the
account of a clearing member.
With stock and bond trades, after the trade
has cleared and settled, the buyer and seller have no
continuing obligations to one another. However, with
derivatives trades, one party may have to pay another
in the future. To facilitate these payments and to help
manage credit risk, a derivatives clearinghouse
typically interposes itself in the transaction, becoming
the buyer to all sellers and the seller to all buyers. This
substitution of one counterparty for another is known
as novation.
It is possible for large traders to trade many
financial claims directly with a dealer, bypassing
organized exchanges. Such trading is said to occur in
the over-the-counter (OTC) market.
There are several reasons why buyers and sellers
might transact directly with dealers rather than on an
exchange.
1. It can be easier to trade a large quantity
directly with another party. A seller of fifty
thousand shares of IBM may negotiate a
single price with a dealer, avoiding exchange
fees as well as the market tumult and
uncertainty about price that might result from
simply announcing a fifty-thousand-share
sale.
2. We might wish to trade a custom financial
claim that is not available on an exchange.
3. We might wish to trade a number of different
financial claims at once. A dealer could
execute the entire trade as a single
transaction, compared to the alternative of
executing individual orders on a variety of
different markets.
Measure of Market Size and Activity
There are at least four different measures that you will
see mentioned in the press and on financial websites.
No one measure is “correct” or best, but some are
more applicable to stock and bond markets, others to
derivatives markets. The different measures count the
number of transactions that occur daily (trading
volume), the number of positions that exist at the end
of a day (open interest), and the value (market value)
Chapter 3 Introduction to Derivatives
and size (notional value) of these positions. Here are
more detailed definitions:
Trading volume. This measure counts the number of
financial claims that change hands daily or
annually. Trading volume is the number
commonly emphasized in press coverage, but
it is a somewhat arbitrary measure because it
is possible to redefine the meaning of a
financial claim. For example, on a stock
exchange, trading volume refers to the
number of shares traded. On an options
exchange, trading volume refers to the
number of options traded, but each option on
an individual stock covers 100 shares of
stock.
Market value. The market value (or “market cap”) of
the listed financial claims on an exchange is
the sum of the market value of the claims that
could be traded, without regard to whether
they have traded. A firm with 1 million
shares and a share price of $50 has a market
value of $50 million.5 Some derivative
claims can have a zero market value; for such
claims, this measure tells us nothing about
activity at an exchange.
Notional value. Notional value measures the scale of a
position, usually with reference to some
underlying asset. Suppose the price of a stock
is $100 and that you have a derivative
contract giving you the right to buy 100
shares at a future date. We would then say
that the notional value of one such contract is
100 shares, or $10,000. The concept of
notional value is especially important in
derivatives markets. Derivatives exchanges
frequently report the notional value of
contracts traded during a period of time.
Open interest. Open interest measures the total
number of contracts for which counterparties
have a future obligation to perform. Each
contract will have two counterparties. Open
interest measures contracts, not
counterparties. Open interest is an important
statistic in derivatives markets.
3.3 The Uses of Derivatives
We can think about derivatives and other financial
claims in different ways. One is a functional
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perspective: Who uses them and why? Another is an
analytical perspective: When we look at financial
markets, how do we interpret the activity that we see?
In this section, we discuss these different perspectives.
The Uses of Derivatives
What are reasons someone might use derivatives?
Here are some motives :
Risk management. Derivatives are a tool for
companies and other users to reduce risks.
With derivatives, a farmer—a seller of corn
—can enter into a contract that makes a
payment when the price of corn is low. This
contract reduces the risk of loss for the
farmer, who we therefore say is hedging.
Every form of insurance is a derivative: For
example, automobile insurance pays if you
have an accident. If you destroy your car in
an accident, your insurance is valuable; if the
car remains undamaged, it is not.
Speculation. Derivatives can serve as investment
vehicles. As you will see later in the book,
derivatives can provide a way to make bets
that are highly leveraged (that is, the
potential gain or loss on the bet can be large
relative to the initial cost of making the bet)
and tailored to a specific view. For example,
if you want to bet that the S&P 500 stock
index will be between 1300 and 1400 1 year
from today, derivatives can be constructed to
let you do that.
Reduced transaction costs. Sometimes derivatives
provide a lower-cost way to undertake a
particular financial transaction. For example,
the manager of a mutual fund may wish to
sell stocks and buy bonds. Doing this entails
paying fees to brokers and paying other
trading costs, such as the bid-ask spread,
which we will discuss later. It is possible to
trade derivatives instead and achieve the
same economic effect as if stocks had
actually been sold and replaced by bonds.
Using the derivative might result in lower
transaction costs than actually selling stocks
and buying bonds.
Regulatory arbitrage. It is sometimes possible to
circumvent regulatory restrictions, taxes, and
accounting rules by trading derivatives.
Derivatives are often used, for example, to
achieve the economic sale of stock (receive
cash and eliminate the risk of holding the
Chapter 3 Introduction to Derivatives
stock) while still maintaining physical
possession of the stock. This transaction may
allow the owner to defer taxes on the sale of
the stock, or retain voting rights, without the
risk of holding the stock.
These are common reasons for using
derivatives. The general point is that derivatives
provide an alternative to a simple sale or purchase,
and thus increase the range of possibilities for an
investor or manager seeking to accomplish some goal.
Obviously, for society as a whole, hedging may be
desirable while regulatory arbitrage is not. But it is
difficult to control trading on the basis of motive.
The Perspectives on Derivatives
How you think about derivatives depends on who you
are. In this section we will think about three distinct
perspectives on derivatives :
The end-user perspective. End-users are the
corporations, investment managers, and
investors who enter into derivative contracts
for the reasons listed in the previous section:
to manage risk, speculate, reduce costs, or
avoid a rule or regulation. End-users have a
goal (for example, risk reduction) and care
about how a derivative helps to meet that
goal.
The market-maker perspective. Market-makers are
intermediaries, traders who will buy
derivatives from customers who wish to sell
and sell derivatives to customers who wish to
buy. In order to make money, market-makers
charge a spread: They buy at a low price and
sell at a high price. In this respect market-
makers are like grocers, who buy at the low
wholesale price and sell at the higher retail
price. Market-makers are also like grocers in
that their inventory reflects customer
demands rather than their own preferences:
As long as shoppers buy paper towels, the
grocer doesn’t care whether they buy the
decorative or super-absorbent style. After
dealing with customers, market-makers are
left with whatever position results from
accommodating customer demands. Market-
makers typically hedge this risk and thus are
deeply concerned about the mathematical
details of pricing and hedging.
The economic observer. Finally, we can look at the
use of derivatives, the activities of the
market-makers, the organization of the
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 markets, and the logic of the pricing models
and try to make sense of everything. This is
the activity of the economic observer.
Regulators must often don their economic
observer hats when deciding whether and
how to regulate a certain activity or market
participant.
Financial Engineering and Security Design
One of the major ideas in derivatives—perhaps the
major idea—is that it is generally possible to create a
given payoff in multiple ways. The construction of a
given financial product from other products is
sometimes called financial engineering. The fact that
this is possible has several implications.
1. Since market-makers need to hedge their
positions, this idea is central in understanding
how market-making works. The market-
maker sells a contract to an end-user, and
then creates an offsetting position that pays
him if it is necessary to pay the customer.
This creates a hedged position.
2. The idea that a given contract can be
replicated often suggests how it can be
customized. The market-maker can, in effect,
turn dials to change the risk, initial premium,
and payment characteristics of a derivative.
These changes permit the creation of a
product that is more appropriate for a given
situation.
3. It is often possible to improve intuition about
a given derivative by realizing that it is
equivalent to something we already
understand.
4. Because there are multiple ways to create a
payoff, the regulatory arbitrage discussed
above can be difficult to stop. Distinctions
existing in the tax code, or in regulations,
may not be enforceable, since a particular
security or derivative that is regulated or
taxed may be easily replaced by one that is
treated differently but has the same economic
profile.
3.4 Bid-Ask Spread
Transaction Costs and the Bid-Ask Spread
Chapter 3 Introduction to Derivatives
Suppose you want to buy shares of XYZ stock. We
can calculate the cost to own 100 shares: If the price
to buy the stock is $50, 100 shares will cost $50 × 100
= $5000. However, we must also account for
transaction costs.
First, there is a commission, which is a
transaction fee you pay your broker. A commission
for the above order could be $15, or 0.3% of the
purchase price.
Second, the term “stock price” is,
surprisingly, imprecise. There are in fact two prices, a
price at which you can buy, and a price at which you
can sell. The price at which you can buy is called the
offer price or ask price, and the price at which you can
sell is called the bid price. To understand these terms,
consider the position of the broker.
To buy stock, you contact a broker. Suppose
that you wish to buy immediately at the best available
price. If the stock is not too obscure and your order is
not too large, your purchase will probably be
completed in a matter of seconds. Where does the
stock that you have just bought come from? It is
possible that at the exact same moment, another
customer called the broker and put in an order to sell.
More likely, however, a market-maker sold you the
stock. As their name implies, market-makers make
markets. If you want to buy, they sell, and if you want
to sell, they buy. In order to earn a living, market-
makers sell for a high price and buy for a low price. If
you deal with a market-maker, therefore, you buy for
a high price and sell for a low price. This difference
between the price at which you can buy and the price
at which you can sell is called the bid-ask spread. In
practice, the bid-ask spread on the stock you are
buying may be $49.75 to $50. This means that you can
buy for $50/share and sell for $49.75/share. If you
were to buy immediately and then sell, you would pay
the commission twice, and you would pay the bid-ask
spread.
Example 3.3.1 : Suppose XYZ is bid at $49.75 and
offered at $50, and the commission is $15. If you
buy 100 shares of the stock, you pay ($50 × 100) +
$15 = $5015. If you immediately sell them again,
you receive ($49.75 × 100) − $15 = $4960. Your
round-trip transaction cost—the difference between
what you pay and what you receive from a sale, not
counting changes in the bid and ask prices—is
$5015 − $4960 = $55.
Ways to Buy or Sell
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A buyer or seller of an asset can employ different
strategies in trading the asset. You implement these
different strategies by telling the broker (or the
electronic trading system) what kind of order you are
submitting.
A market order is an instruction to trade a
specific quantity of the asset immediately, at the best
price that is currently available. The advantage of a
market order is that the trade is executed as soon as
possible. The disadvantage of a market order is that
you might have been able to get a better price had you
been more patient.
A limit order is an instruction to trade a
specific quantity of the asset at a specified or better
price. A limit order to buy 100 shares at $47.50 can be
filled at $47.50 or below. A limit order to sell at
$50.25 can be filled at $50.25 or above. Having your
limit order filled depends upon whether or not anyone
else is willing to trade at that price. As time passes,
your order may or may not be filled. Thus, the
advantage of a limit order is obtaining a better price.
The disadvantage is the possibility that the order is
never filled.
There are other kinds of orders. For example,
suppose you own 100 shares of XYZ. If you enter a
stop-loss order at $45, then your order becomes a
market order to sell once the price falls to $45.
Because your order is a market order, you may end up
selling for less than $45.
In the earlier example we supposed that the
bid and ask prices for XYZ were $49.75 and $50. You
can think of those prices as limit orders—someone has
offered to buy at $49.75 and (possibly someone
different) to sell at $50.
3.5 Short-Selling
The sale of a stock you do not already own is called a
short-sale. In order to understand short-sales, we first
need to understand the terms “long” and “short.”
When we buy something, we are said to have
a long position in that thing. For example, if we buy
the stock of XYZ, we pay cash and receive the stock.
Some time later, we sell the stock and receive cash.
This transaction is a form of lending, in that we pay
money today and receive money back in the future.
For many assets the rate of return we receive is not
known in advance (the return depends upon whether
Chapter 3 Introduction to Derivatives
the stock price goes up or down), but it is a loan
nonetheless.
The opposite of a long position is a short
position. A short-sale of XYZ entails borrowing
shares of XYZ from an owner, and then selling them,
receiving the cash. Some time later, we buy back the
XYZ stock, paying cash for it, and return it to the
lender. A shortsale can be viewed as a way of
borrowing money. With ordinary borrowing, you
receive money today and repay it later, paying a rate
of interest set in advance. This also happens with a
short-sale, except that typically you don’t know in
advance the rate you will pay.
There are at least three reasons to short-sell:
1. Speculation: A short-sale, considered by
itself, makes money if the price of the stock
goes down. The idea is to first sell high and
then buy low. (With a long position, the idea
is to first buy low and then sell high.)
2. Financing: A short-sale is a way to borrow
money, and it is frequently used as a form of
financing. This is very common in the bond
market, for example.
3. Hedging: You can undertake a short-sale to
offset the risk of owning the stock or a
derivative on the stock. This is frequently
done by market-makers and traders.
Example: Short-Selling Wine.
Because short-sales can seem confusing, here is a
detailed example that illustrates how short-sales work.
There are markets for many collectible items,
such as fine wines. If you believe prices will rise, you
would buy the wine on the market and plan to sell
after the price rises. However, suppose there is a wine
from a particular vintage and producer that you
believe to be overpriced and you expect the price to
fall. How could you speculate based on this belief?
The answer is that you can engage in a short-sale.
In order to short-sell, you must first obtain
wine. You can do this by borrowing a case from a
collector. The collector, of course, will want a promise
that you will return the wine at some point; suppose
you agree to return it 1 week later. Having reached
agreement, you borrow the wine and then sell it at the
market price. After 1 week, you acquire a replacement
case on the market, then return it to the collector from
whom you originally borrowed the wine. If the price
has fallen, you will have bought the replacement wine
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for less than the price at which you sold the original, shares
so you make money. If the price has risen, you have
lost money. Either way, you have just completed a Security : –– Purchase
short-sale of wine. The act of buying replacement Sell shares shares
wine and returning it to the lender is said to be closing
or covering the short position. Cash : + S0 –D + S 90

Note that short-selling is a way to borrow

money. Initially, you received money from selling the Table 3.1 Cash flows associated with short-selling a
wine. A week later you paid the money back (you had share of IBM for 90 days. S0 and S9 0 are the share
to buy a replacement case to return to the lender). The prices on days 0 and 90. Note that the short-seller
rate of interest you paid was low if the price of the
must pay the dividend, D , to the share-lender.
replacement case was low, and high if the price of the
replacement case was high.

This example is obviously simplified. We The Lease Rate of an Asset

have assumed several points:
 It is easy to find a lender of wine.
 It is easy to buy, at a fair price, satisfactory
wine to return to the lender: The wine you
buy after 1 week is a perfect substitute for the
wine you borrowed.
 The collector from whom you borrowed is
not concerned that you will fail to return the
borrowed wine.
Example: Short-Selling Stock.
Now consider a short-sale of stock. As with wine,
when you short-sell stock you borrow the stock and
sell it, receiving cash today. At some future date you
buy the stock in the market and return it to the original
owner.
We have seen that when you borrow an asset it may
be necessary to make payments to the lender.
Dividends on short-sold stock are an example of this.
We will refer to the payment required by the lender as
the lease rate of the asset. This concept will arise
frequently, and, as we will see, it provides a unifying
concept for our later discussions of derivatives.
The wine example did not have a lease
payment. But under some circumstances it might be
necessary to make a payment to borrow wine. Wine
does not pay an explicit dividend but does pay an
implicit dividend if the owner enjoys seeing bottles in
the cellar. The owner might thus require a payment in
order to lend a bottle. This would be a lease rate for
wine.

Suppose you want to short-sell IBM stock for

90 days. Table 3.1 depicts the cash flows. Observe in
particular that if the share pays dividends, the short-
seller must in turn make dividend payments to the
share-lender. This issue did not arise with wine! This
dividend payment is taxed to the recipient, just like an
ordinary dividend payment, and it is tax-deductible to
the short-seller.

Notice that the cash flows in Table 3.1 are

exactly the opposite of the cash flows from purchasing
the stock. Thus, short-selling is literally the opposite
of buying

Dividend Ex-
Day 0 Day 90
Day
Action : –– Return shares
Borrow

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Chapter 3 Introduction to Derivatives