Introduction to derivatives
Derivatives & the financial markets
This plot gives you an overview of how you can price every financial product. To compute the fair
value of a bond and stock, you use the NPV. So, you forecast the cash flows and you discount them.
When you discount the cash flows, you account for the risk related to the cash flow. The cash flow
for a stock is dividend, for a bond it’s the coupon. You also have derivatives (linear and non-linear).
The way we can price these derivatives, is through the no-arbitrage condition. It’s an equilibrium
state where the price is fair for everyone.
A derivative is a financial instrument whose value depends on the value of another more
fundamental assets (the underlying). The underlying can be a currency, a bond, a stock,… We use the
word derivative, because the value of the product is derived from the value of the underlying.
Derivatives have an important economic role:
1) risk hedging.
EX: when you have receivables in USD in 3 months and you don’t want to lose money on your
position.
2) to change the nature of an investment, without incurring the costs of selling one portfolio and
buying another one.
EX: you are a portfolio manager and you have a portfolio of 500 stocks. You expect the market to
crash. Your whole portfolio is long. As a portfolio manager, you can sell all your positions. You will
incur a lot of costs because of this. A better option is to take a position in derivatives to offset the
possible crash in the market. So when there’s a decrease in the market, it will be offset because of
the increase in value of derivatives.
3) to speculate.
EX: when you bet on a direction of the market and you want to leverage. With a few dollar in an
option, you can gain a lot.
4) to lock in an arbitrage profit.
EX: you can look at the market and try to exploit the value of some products where there is no
equilibrium. However, in the market this should not be possible.
, There are several different market players.
1) Hedgers.
These investors use derivatives to reduce the risk that they face from potential future movements in
a market variable. Something totally different than Hedge Funds!!! Hedge Funds take a lot of risk.
2) Speculators.
These investors use derivatives to bet on the future direction of a market variable. Risk exposure can
be increased via the leverage mechanism of derivatives.
3) Arbitrageurs.
These investors lock in riskless profit by simultaneously entering into transactions in two or more
instruments and thus exploit market inefficiency’s.
There are also different markets.
1) Exchange-traded markets.
Investors trade standardized contracts defined by market authorities, very electronically. Major
exchanged trading futures and options: CME group, NYSE, EUREX.
2) Over-The-Counter markets.
‘We do the trade together, very specialized and tailor-made’. These are thus bilateral trades. Main
participants are banks, other large financial institutions, fund managers and corporations. Significant
changes have occurred following the 2008 financial crisis, because credit risk was huge before!
There are different types of derivatives.
1) Forwards/futures on commodities, currencies, indices
2) Options on stocks or indices
3) Interest rate futures, options and swaps
4) Currency swaps
5) Credit derivatives
Imagine that you are a company that needs some money for a project. The company issues a bond
and I buy it. Every 6 months I will receive a coupon of 4% from the company and in 10 years I will get
my money back. However, the company is super risky. At some point, the company can crash and I
will lose my money. I can enter a credit derivative to reduce my risk, so I will get some of my money
back. ***Credit default swaps on Greece existed and were super expensive at some time, because
the likelihood of Greece to go bankrupt was real!
6) Weather derivatives
As a farmer, you can fear the weather to harvest.
7) Embedded options (convertible securities)
Forwards & Futures
A forward contract is a legal agreement under which an asset will be bought or sold at a future date
at a price that is determined at the moment the contract is made. This kind of contract is mostly
made between banks or financial institutions and corporate clients. The exercise price/delivery price
is the price that is fixed at the moment the contract is written for the delivery of the underlying. In
the case of a currency, the price is the Forward exchange rate.
Ex: I have a car and a friend wants to buy it for 10 000$ next year. There is no exchange now, but we
write it down on a contract. This contract has zero value, but it’s a formal agreement and he has to
fulfill it: in one year, my friend is going to buy the car for 10 000$. Imagine that the value of my car
suddenly goes to 20 000$. Then, in one year, my friend will be very happy, because he will buy the
car for 10K and he will be able to sell it for 20K. Imagine that the value of my car goes to 5K. then in
one year, my friend will have to buy it for 10K and I will be very happy.
