Derivatives Introduction

DERIVATIVES

Bolong Cao Ph.D. CFA

Lecture 1

Lecture

1

Introduction to Derivatives

What Is a Derivative?



Definition



Definition

A financial instrument that has a value determined

by the price of something else

oSomething else: another asset, interest rates, an

index, weather etc.

o

Future forward options and swaps

o

Future

,

forward

,

options

and

swaps

.

An example

o

An

ag

r

ee

m

e

n

t

bet

w

ee

n

pa

r

ty

A

&

pa

r

ty

B

o

ag ee e t bet ee pa ty & pa ty

A gives $1 to B if the price of corn in 1 year > $3

B gives $1 to A if the price of corn in 1 year < $3

Udtt

o

U

sage: purpose an

d

manner ma

tt

e

r

Betting, or speculation



Insurance or hedging: output for A input for B

g

Cao. All ri

g

hts reserved. 2

Insurance

,

or

hedging:

output

for

A

,

input

for

B

Trading Terminologies



BiAti t iti



B

as

i

c

A

c

ti

ons on asse

t

pos

iti

ons

Initiation Termination

Long Buy to open Sell to close

Short Sell to open Buy to close

Trading Stocks

Initiation

Termination

Initiation

Termination

Long Buy shares at P0Sell Shares at PT

Short Borrow the shares

,

Bu

y

the shares at

,

sell at P0and

receive cash.

y

PTwith cash and

return the shares

to the lender

g

Cao. All ri

g

hts reserved. 3

to the lender

.

Trading Terminologies



Ft t t



F

u

t

ures con

t

rac

t

s

Standardized contracts to buy or sell the underlying

(commodities or financial assets) on a future date

(commodities

or

financial

assets)

on

a

future

date

,

T, at a pre-determined price P0T.

Th ft dt i th i ti / i dt

o

Th

e

f

u

t

ure

d

a

t

e

i

s

th

e exp

i

ra

ti

on

/

exp

i

ry

d

a

t

e.

oThe price P0T is the futures/forward price for the

t ti thti dt tk l dt

t

ransac

ti

on

th

a

t

i

s suppose

d

t

o

t

a

k

e p

l

ace on

d

a

t

e

Tand is pre-determined on date 0, the current

day

.

P00is the spot price (price to pay for immediate

deliver

y)

of the underl

y

in

g

on date 0 and

P

T

T is the

g

Cao. All ri

g

hts reserved. 4

y) y g

T

spot price of the underlying on date T.

Trading Terminologies



Tdi Ft



T

ra

di

ng

F

u

t

ures

Open Close

Long Will buy the

underlying on

date Tat P0T.

On date T, pay

P

0Tand receive

the underlying.

Before date T, short futures at

P

T

l

P

t

T

to

c

l

ose.

Short Will sell the

underlying on On date T, deliver the

underlying and receive P0T.

date Tat

P

0T. Before date T, long futures at

PtTto close.

Futures

p

rices known on

Time

0

t

T

P

0

T

P

t

T

p

different dates.

g

Cao. All ri

g

hts reserved. 5

Time

0

t

T

An Overview of Financial Markets



The trading of a financial asset involves at least



The

trading

of

a

financial

asset

involves

at

least

four discrete steps



A buyer and a seller must locate one another and



A

buyer

and

a

seller

must

locate

one

another

and

agree on a price

oThrough organized exchanges or dealers

The trade must be cleared, i.e. the obligations of

each party are specified

Fi il dli i ll l

o

Fi

nanc

i

a

l

assets to

d

e

li

ver or post

i

ng co

ll

atera

l

The trade must be settled, i.e. the buyer and the

seller must satisfy their obligations

in the required

seller

must

satisfy

their

obligations

in

the

required

period of time

o

Actual deliveries

g

Cao. All ri

g

hts reserved. 6

o

Actual

deliveries

Ownership records are updated

Trading and Clearing in Organized Exchanges



Organized Exchange Trading Today: a virtual trading



Organized

Exchange

Trading

Today:

a

virtual

trading

venue connected by electronic networks



Past: physical location



Past:

physical

location

Clearing: After a trade has taken place, a

clearinghouse matches the buyers and sellers,

keeping track of their obligations and payments.

Publicly traded securities in the U.S.

DTCC h D i T d Cl i C

o

DTCC

: t

h

e

D

epos

i

tory

T

rust an

d

Cl

ear

i

ng

C

orp.

NSCC: the National Securities Clearing Corp.



Di ti ithUS



D

er

i

va

ti

ves

i

n

th

e

U

.

S

.

oCME Clearing: Chicago Mercantile Exchange



CME Group: CME+CBT+NYME

g

Cao. All ri

g

hts reserved. 7



CME

Group:

CME+CBT+NYME

oICE Clear U.S.: Intercontinental Exchange

Trading and Clearing in Organized Exchanges



Clearing



Clearing

Clearing Derivatives means one party may have to

pay another in the future

pay

another

in

the

future

oTo facilitate these payments and to help manage

credit risk, a derivatives clearinghouse typically

imposes itself in the transaction, becoming the

buyer to all sellers and the seller to all buyers.

Known as

NOVATION

(in contract law and

o

Known

as

NOVATION

(in

contract

law

and

business law).

g

Cao. All ri

g

hts reserved. 8

Over-The-Counter Trading



Th

th

t (OTC) k t



Th

e over-

th

e-coun

t

er

(OTC)

mar

k

e

t

:

Large traders can trade many financial claims

directly with a dealer

directly

with

a

dealer

oThe dealer is the counter party

bi idh

o

b

ypass

i

ng organ

i

ze

d

exc

h

anges

Reasons for OTC trades

Li(blk)d

o

L

arge quant

i

ty

(bl

oc

k)

tra

d

es

Avoid exchange fees and market impact

oCustomized financial claims

oTrade several instruments in one transaction.

g

Cao. All ri

g

hts reserved. 9