This chapter discusses:

• Expanding derivatives markets, its contributing factors

• Uses and abuses of derivatives and some controversies
surrounding it
• The Influence of Regulations, Taxes, and Transaction Costs
on Financial Innovation
• Diverse Views on Derivatives
• Applications and Uses of Derivatives
• A Quest for Better Models
⦁ Derivatives have been blamed for many crises
including the financial crisis of 2007.

⦁ Cause of the Great Recession of 2007-9, a period of

decreased economic output and increased
unemployment.

⦁ But what is a derivative?

A derivative security or a derivative is a financial
contract whose value is derived from an underlying
asset price.

A derivative can both reduce risk, by providing

insurance and magnify risk, by speculating on future
events.

Example: forward contracts, call options

⦁ Before 1970
◦ Derivatives markets were small.
◦ Only futures contracts had a well-functioning market.
◦ Financial derivatives were unknown.
◦ No satisfactory option pricing model existed.

⦁ Starting early 1970s

◦ These rapid changes reshaped derivatives trading:
Introduction of new derivative contracts
Opening of new exchanges
Consolidation and linking of exchanges
Introduction of computer technology
 Financial Innovation
⦁ Derivatives are versatile risk management tools.
They may be used for:

◦ Borrowing and lending

◦ Saving
◦ Insurance or hedging
◦ Investment
◦ Speculation or gambling
◦ Financial engineering
⦁ Many factors have fueled this growth:

⦁ include regulatory reforms, an increase in

international commerce, population growth,
political changes, the integration of the
world’s economy, and revolutionary strides in
information technology (IT).

⦁ Interrelated financial markets are now more

receptive to shocks and crises.
• More pronounced business cycles, default by sovereign
nations, high-risk leveraged bets by hedge funds, imprudent
investment in complicated securities by unsophisticated
investors, and fraudulent actions by rogue traders have the
potential to shake financial markets to their core.

• Regulators try to prevent these from happening.

• If used properly, derivatives can help.

⦁ Price volatility is the lifeblood of derivatives
trading.

⦁ Fed ( F e d e r a l R e s e r v e S y s t e m ) historically
used monetary policy tools to keep interest rates
stable.
⦁ It created double-digit inflation rates in the 1970s
and 1980s, which in turn led to double-digit US
interest rates.
⦁ During 1950s and 1960s: interest rates were low
and relatively stable.

⦁ During 1970s: supply shocks led to high inflation

rates.

⦁ In 1979: the Fed began targeting money supply

growth.

⦁ Developments during 1970s led to volatile, double

digit interest rates, which created a need for hedging
interest rate risk.
Chicago Board of Trade (CBOT) introduced:

◦ In 1975: Ginnie Mae futures

◦ In 1977: Treasury bond futures contracts

⦁ Currently, the Fed uses discretion rather than

rules for monetary policy.

⦁ Interest rates remain volatile.

⦁ Bretton Woods system of fixed exchange rates
(1944 till early 1970s)
◦ Currencies were pegged to US dollar.
◦ Dollar was convertible to gold at $35 per ounce.
◦ Conversion of currencies into dollars.
◦ Buying gold at $35.
◦ The dollar reserve declined.
◦ Bretton Woods system abandoned in 1971.

⦁ Rising gold prices helped other nations.

• Currencies started floating in free market
• Need arose for hedging currency risk.

⦁ Floating exchange rates are more volatile than

fixed exchange rates, and to hedge this newly
created currency risk, the huge foreign exchange
derivatives market was created

⦁ In 1972: Chicago Mercantile Exchange (CME or

Merc) introduced foreign currency futures.
⦁ During 1980s and 1990s: volatility of some key
macroeconomic variables declined. This new “era” of
greater stability was called The Great Moderation.

⦁ Ben Bernanke gave three explanations (2004):

◦ Structural change (changes in economic institutions, technology, or
other features of the economy)

◦ Improved macroeconomic policies

◦ Good luck (the shocks hitting the economy became smaller and more
infrequent).
• In 2007–09:Many nations got mired in the Great
Recession.

Stock market volatility shot up from 10 percent

to an astonishing 89.53 percent in October
2008.

⦁ Risk management remains on the center stage.

⦁ Nobel Laureate Merton Miller’s view (1986): Major
impulses to successful financial innovations have come
from regulations and taxes.
◦ A successful security can help save tax dollars.

◦ The desire to lower transactions costs also influences

financial innovation.

◦ This leads to the truth that:

“trading moves to those markets where transaction

costs and regulatory constraints are minimized.”
• In 1937, Ronald Coase, faculty member at the London
School of Economics, published “The Nature of the Firm”

The desire to lower transactions costs (TCs) also

influences financial innovation.
⦁ The argument extends to financial markets:

◦ Traders move where they can transact at minimum cost.

◦ Financial institutions (FIs) often devise securities and
shape markets to minimize TCs.
⦁ During the 1990s and the new millennium:
changes in the economic and political landscape
and the IT revolution lowered many transaction
costs.
◦ Fewer personnel
◦ Information sharing
◦ Internet trading

⦁ Traders migrated from Treasury securities to

Eurodollar markets to lower such costs.
⦁ A security, such as a stock or bond, gives its holder
ownership rights over some assets and cash flows.

⦁ Bonds are debts of the issuer:

◦ Most bonds repay a promised principal amount (par or
face value) at maturity.
◦ Some bonds pay interest (coupons) on a regular basis,
◦ Other bonds are zero coupon bonds.
⦁ Equities (or stocks) give investors equity (or
ownership rights) in the issuing company:

◦ Investment is never repaid.

◦ Stockholders usually get dividends.
◦ Stock prices can increase (or decrease) and create capital
gains (or losses) for investors.
⦁ Stocks and bonds can be used to create
derivatives, whose value is derived from an
underlying commodity’s price or a notional
variable’s value.

◦ Assets (real and financial) have tangible values.

◦ Notional variables exist as notions or ideas e.g.,

inflation rate. Interest rate, index.
• Difficult to understand, highly leveraged, and often
not backed by sufficient collateral.

• High leverage means that small changes in the

underlying security’s price can cause large swings
in the derivative’s value.
⦁ Legendary investor Warren Buffett opposed
derivatives that are neither guaranteed nor backed
by collateral.
◦ He characterized them (2002) as (financial) “time
bombs.”
⦁ Buffett declared derivatives as “financial weapons of
mass destruction, carrying dangers that, while now
latent, are potentially lethal.”

⦁ Peter Lynch (1989): that options and futures on

stocks should be banned.
⦁ Former Fed chairman Alan Greenspan
championed derivatives (1999).

◦ Derivatives play a useful role.

◦ They help efficiently allocate capital.

⦁ But; Greenspan reversed his strong support for

derivatives during a congressional testimony of
2008.
⦁ Merton Miller (1997): that “Contrary to the widely
held perception, derivatives have made the world a
safer place, not a more dangerous one.”

⦁ Miller claimed:
◦ “[. . .] world’s banks have blown away vastly more in bad
real estate deals than they’ll ever lose on their derivatives
portfolios.”
Derivatives trade in zero net supply markets. Where
each buyer has a matching seller.

Hedging and speculation are often two sides of the

same coin.

A derivative trade is a zero-sum game, because one

trader’s gain is the other’s loss.
⦁ Farmer Short plants corn in April (today),
expecting to sell his harvest in September.

◦ In April, everyone expects corn price to be $10.00 in

September (all prices are per bushel)

⦁ Long and Short create a forward contract, with a

forward price of $9.95.
⦁ Farmer Short acts as a hedger.
◦ Removed output price uncertainty

⦁ Trader Long acts as a speculator.

◦ Expects 5 cents profit
⦁ Derivatives have many applications and uses.
They include:

◦ Hedging output price risk

◦ Hedging input cost
◦ Hedging currency risk
◦ Hedging interest rate risk
◦ Protecting a portfolio against a market crash
◦ Avoiding market restrictions
⦁ Risk perspectives depend on the economic role
the individual or the organization plays.

⦁ In 1994the Basel Committee and the IOSCO issued

risk management guidelines.
 The Basel Committee’s Guidelines (1994):
Credit risk(including settlement risk) is the
risk that a counterparty will fail to perform
on an obligation.

Market risk (or price risk) is the risk to an

institution’s financial condition resulting
from adverse movements in the level or
volatility of market prices.

Chapter 1,
 ⦁ Liquidity riskcan be of two types:
◦ Liquidity risk related to specific products or markets
◦ Liquidity risk related to the general funding of the
institution’s derivative activities

Chapter 1,
 Operational risk(also known as operations risk) is
the risk that deficiencies in information systems
or internal controls will result in unexpected
loss.

Legal risk is the risk that contracts are not

legally enforceable or documented correctly.

Chapter 1,
 ⦁ Managing market or price risk is the subject of this
book. Other risks tend to appear in abnormal
market conditions.
◦ Credit risk is a subject of advanced research.
◦ Liquidity risk is a persistent problem for traders.
◦ Operational risk is a reality one has to live with.
◦ Legal risk isn’t a problem for exchange-traded contracts.

Chapter 1,
 ⦁ The Basel Committee report:
◦ Cited the need for appropriate oversight
◦ Emphasized the need for comprehensive internal control
and audit procedures.
◦ Urged national regulators to ensure that firms and banks
adopt good risk management practices.

Chapter 1,
 ⦁ Portfolio risk management is critical for
investment companies like hedge funds and
mutual funds.
◦ Mutual funds have more restricted investment policies
and lower management fees than do hedge funds.

⦁ These entities routinely use derivatives.

Chapter 1,
 ⦁ Modern portfolio theory suggests that to earn
higher expected returns, one has to accept higher
risks.
◦ A portfolio is a collections of securities.
◦ The price of a risky asset fluctuates.

⦁ Portfolio risk for a single security has two

components:
◦ Nondiversifiable risk
◦ Diversifiable risk

Chapter 1,
 ⦁ Modern portfolio theory recommends investment in
a top-downfashion. It has three steps:
◦ (1) Do an asset allocation
◦ (2) Do security selection
◦ (3) Periodically revisit these issues and rebalance the
portfolio accordingly.

Chapter 1,
 ⦁ Portfolio risk management is critical for
investment companies including mutual funds
and hedge funds.

⦁ Derivatives are often used by these investment

companies for portfolio risk management.

Chapter 1,
 ⦁ The balance sheet gives a snapshot of a firm’s
financial condition. It can help us understand
various risks that businesses face.
◦ An asset provides economic benefits.
◦ A liability is an obligation that requires payments at some
future date.

Chapter 1,
 ⦁ The difference between the assets and liabilities
accrues to the owners of the company as
shareholder’s equity. Hence the identity:

Assets = Liabilities + Shareholder’s equities

Chapter 1,
 TABLE 1.1 Risks That a Business Faces

Assets Liabilities
Current assets • Accounts payable (interest rate risk
• Cash and cash equivalents (interest and currency risk)
rate risk) • Financial liabilities (interest rate risk,
• Accounts receivable (interest rate currency risk)
risk, currency risk) • Pension fund obligations (interest rate
• Inventories (commodity price risk) risk, market risk)

Long-term assets
• Financial assets (interest rate risk, Equity
market risk, currency risk) • Ownership shares
• Property, plant, and equipment
(interest rate risk, commodity price
risk)

Chapter 1,
 ⦁ A typical company can face currency, interest rate,
and commodity price risks or manage them with
derivatives.
◦ Currency risk
◦ Interest rate risk
◦ Commodity price risk

Chapter 1,
 ⦁ But, some risks are difficult or impossible to
hedge.
◦ It is very hard to hedge operational risk.
◦ Other difficult or impossible-to-hedge risks

Chapter 1,
 ⦁ Annual report (2008) of consumer products giant
Procter & Gamble’s shows its derivative usage.

⦁ P&G’s approach to risk management

◦ P&G has commodity, currency, and interest rate risks.
◦ P&G consolidates these risks.
◦ P&G does not hold derivatives for trading.
Natural offset
◦ P&G does not hold derivatives for trading.

Chapter 1,
 ⦁ P&G trades
◦ Interest rate swaps
◦ Forwards and options
◦ Futures, options, and swaps

⦁ P&G grants stock options and restricted stock

awards to key managers and directors.

Chapter 1,
 ⦁ P&G designates some securities as hedges of
specific underlying exposures.
◦ Monitoring
◦ Techniques

⦁ Sometimes data are unavailable.

Chapter 1,
 ⦁ Ninety-five percent confident about no major
impact

⦁ Expects no significant risk from its commodity

hedging or credit risk exposure

Chapter 1,