16-02-2011, 01:27 PM
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Introduction To Derivatives
Basics
This first lecture has four main goals:
1. Introduce you to the notion of risk and the role of derivatives in managing risk.
Discuss some of the general terms – such as short/long positions, bid-ask spread – from finance that we need.
2. Introduce you to three major classes of derivative securities.
Forwards
Futures
Options
3. Introduce you to the basic viewpoint needed to analyze these securities.
4. Introduce you to the major traders of these instruments
Finance is the study of risk.
1. How to measure it
2. How to reduce it
3. How to allocate it
All finance problems ultimately boil down to three main questions:
1. What are the cash flows, and when do they occur?
2. Who gets the cash flows?
3. What is the appropriate discount rate for those cash flows?
The difficulty, of course, is that normally none of those questions have an easy answer.
As you know from other classes, we can generally classify risk as being diversifiable or non-diversifiable:
Diversifiable – risk that is specific to a specific investment – i.e. the risk that a single company’s stock may go down (i.e. Enron). This is frequently called idiosyncratic risk.
Non-diversifiable – risk that is common to all investing in general and that cannot be reduced – i.e. the risk that the entire stock market (or bond market, or real estate market) will crash. This is frequently called systematic risk.
The market “pays” you for bearing non-diversifiable risk only – not for bearing diversifiable risk.
In general the more non-diversifiable risk that you bear, the greater the expected return to your investment(s).
Many investors fail to properly diversify, and as a result bear more risk than they have to in order to earn a given level of expected return In this sense, we can view the field of finance as being about two issues:
The elimination of diversifiable risk in portfolios;
The allocation of systematic (non-diversifiable) risk to those members of society that are most willing to bear it.
Indeed, it is really this second function – the allocation of systematic risk – that drives rates of return.
The expected rate of return is the “price” that the market pays investors for bearing systematic risk A derivative (or derivative security) is a financial instrument whose value depends upon the value of other, more basic, underlying variables.
Some common examples include things such as stock options, futures, and forwards.
It can also extend to something like a reimbursement program for college credit. Consider that if your firm reimburses 100% of costs for an “A”, 75% of costs for a “B”, 50% for a “C” and 0% for anything less.
Your “right” to claim this reimbursement, then is tied to the grade you earn. The value of that reimbursement plan, therefore, is derived from the grade you earn.
We also say that the value is contingent upon the grade you earn. Thus, your claim for reimbursement is a “contingent” claim.
The terms contingent claims and derivatives are used interchangeably.
So why do we have derivatives and derivatives markets?
Because they somehow allow investors to better control the level of risk that they bear.
They can help eliminate idiosyncratic risk.
They can decrease or increase the level of systematic risk
A First Example
There is a neat example from the bond-world of a derivative that is used to move non-diversifiable risk from one set of investors to another set that are, presumably, more willing to bear that risk.
Disney wanted to open a theme park in Tokyo, but did not want to have the shareholders bear the risk of an earthquake destroying the park.
They financed the park through the issuance of earthquake bonds.
If an earthquake of at least 7.5 hit within 10 km of the park, the bonds did not have to be repaid, and there was a sliding scale for smaller quakes and for larger ones that were located further away from the park.
Normally this could have been handled in the insurance (and re-insurance) markets, but there would have been transaction costs involved. By placing the risk directly upon the bondholders Disney was able to avoid those transactions costs.
Presumably the bondholders of the Disney bonds are basically the same investors that would have been holding the stock or bonds of the insurance/reinsurance companies.
Although the risk of earthquake is not diversifiable to the park, it could be to Disney shareholders, so this does beg the question of why buy the insurance at all.
This was not a “free” insurance. Disney paid LIBOR+310 on the bond. If the earthquake provision was not it there, they would have paid a lower rate.
This example illustrates an interesting notion – that insurance contracts (for property insurance) are really derivatives!
They allow the owner of the asset to “sell” the insured asset to the insurer in the event of a disaster.
They are like put options (more on this later.)
Basics
Positions – In general if you are buying an asset – be it a physical stock or bond, or the right to determine whether or not you will acquire the asset in the future (such as through an option or futures contract) you are said to be “LONG” the instrument.
If you are giving up the asset, or giving up the right to determine whether or not you will own the asset in the future, you are said to be “SHORT” the instrument.
In the stock and bond markets, if you “short” an asset, it means that you borrow it, sell the asset, and then later buy it back.
In derivatives markets you generally do not have to borrow the instrument – you can simply take a position (such as writing an option) that will require you to give up the asset or determination of ownership of the asset.
Usually in derivatives markets the “short” is just the negative of the “long” position
Commissions – Virtually all transactions in the financial markets requires some form of commission payment.
The size of the commission depends upon the relative position of the trader: retail traders pay the most, institutional traders pay less, market makers pay the least (but still pay to the exchanges.)
The larger the trade, the smaller the commission is in percentage terms.
Bid-Ask spread – Depending upon whether you are buying or selling an instrument, you will get different prices. If you wish to sell, you will get a “BID” quote, and if you wish to buy you will get an “ASK” quote.
The difference between the bid and the ask can vary depending upon whether you are a retail, institutional, or broker trader; it can also vary if you are placing very large trades.
In general, however, the bid-ask spread is relatively constant for a given customer/position.
The spread is roughly a constant percentage of the transaction, regardless of the scale – unlike the commission.
Especially in options trading, the bid-ask spread is a much bigger transaction cost than the commission