Overview:
Variety of Derivatives and Their
Uses
Key Concept
•  Volatility is a Commodity
•  People can buy, sell, or trade volatility
•  Financial engineers can “source” volatility in
the marketplace and use it to design custom
risk-management products
Derivatives
Derivative = obligation to accomplish a
transaction in the future
Forward Contract = basic derivative from which
all others have evolved
•  Repurchase Agreements
–  Reverse Repurchase Agreements
•  Futures Contracts
Derivatives
•  Swaps
–  Futures and Forward Contracts On Swaps
–  Options on Swaps (Swaptions)
•  Options
•  Currency Options
–  Swaptions
–  Options On Futures
–  Futures On Options
The futures game has a long history
–  In Europe
•  Futures trading existed in the early 17th Century
–  In North America
•  Commodity trading mechanisms originated in colonial
times
•  Today’s organized futures exchanges trace their roots
back to the early 19th Century
Large variety of futures contracts now
being traded
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•
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fungible agricultural commodities
petroleum products
metals (precious and otherwise)
T-bills, T-bonds, and other financial contracts
currencies
indices
Other possibilities in the next twenty
years:
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•
•
•
bulk freight rates
more stock market indices
inflation indices
GNP series, real estate indices, and other
economic indicators
•  perhaps even electronic components
What are options?
•  Options are financial contracts whose value is
contingent upon the value of some underlying asset
•  Such arrangements are also known as contingent
claims
–  because equilibrium market value of an option moves in direct
association with the market value of its underlying asset.
•  OPT measures this linkage
The basics of options
Calls and puts defined
•  Call: privilege of buying the underlying asset at
a specified price and time
•  Put: privilege of selling the underlying asset at
a specified price and time
The basics of options
American and European options defined
•  American options can be exercised anytime
before expiration date
•  European options can be exercised only on the
expiration date
•  Asian options are settled based on average
price of underlying asset
The basics of options
•  Options may be allowed to expire without
exercising them
•  Options game has a long history
–  at least as old as the “premium game” of 17th
century Amsterdam
–  developed from an even older “time game”
•  which evolved into modern futures markets
•  and spawned modern central banks
Creating Custom Options
•  Case 1: Shearson, Lehman, Hutton—Entry
into the Covered Warrant Business
•  Case 2: Goldman, Sachs, & Co: Nikkei Put
Warrants
Risk Management
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Forward Contracts
Futures Contracts
Options
Swaps
Other Interest Rate Risk Management (IIRM)
products
–  Caps
–  Floors
–  Collars
Risk Management Cases
•  Case 3: American Barrick Resources Corp.
–  Risk management for a mining company
•  Case 4: Enron Gas Co.
–  Risk management for an energy company
Portfolio Insurance
•  Case 5: Leyland, O’Brien, and Rubinstein
Associates Inc.: Portfolio Insurance
Enterprise Risk Management
•  Case 6: An Investment Linked to Commodity
Futures
–  Commodity-linked structures
–  Inflation hedges
Research Assignment
•  Bloomberg Derivatives Library
–  Useful resource for this course
–  Useful resource for your long-term activities
•  Accessible from the COBA Trading Room (1st
floor of BLB)
–  You can do your tutorial there at any time of your
choosing
–  At time specified in syllabus, you will have
compensatory time off from class so that you can do
this
Swaps
Floating-Fixed Swaps
Illustration of a Floating/Fixed Swap
Party
Variable
Variable
Underwriter
Fixed
Counterparty
Fixed
If net is positive, underwriter pays party. If net is negative, party pays underwriter.
Floating to Floating Swaps
Illustration of a Floating/Floating Swap
T-Bill
Party
T-Bill
Underwriter
LIBOR
Counterparty
LIBOR
If net is positive, underwriter pays party. If net is negative, party pays underwriter.
Parallel Loan
Illustration of a parallel loan
United States
Germany
Loan
guarantees
U.S. Parent
Principal
in $
Debt
service
in $
U.S. subsidiary of
German Firm
German Parent
Principal
in Euro
Debt service
in Euro
German subsidiary
of U.S. Firm
Currency Swap
Illustration of a straight currency swap
$1,500,000
$1,500,000
1
1
German rate x €1,000,000
German rate x €1,000,000
2
U.S. rate x $1,500,000
2
U.S. rate x $1,500,000
German Company
€ 1,000,000
Intermediary
U.S. Company
Borrow in
US, invest
in Europe
€ 1,000,000
€ 1,000,000
€ 1,000,000
3
3
$1,500,000
$1,500,000
Step 1 is notional
Steps 2 & 3 are net
Swaps
Illustration of an Equity Return Swap
Equity Index
Return*
Investor
Underwriter
Libor ± Spread
*Equity index return includes dividends, paid quarterly or reinvested
Borrow in
Europe,
invest in US
Swaps
Illustration of an Equity Asset Allocation Swap
Foreign Equity
Index Return* A
Investor
Underwriter
Foreign Equity
Index Return* B
*Equity index return includes dividends, paid quarterly or reinvested
Equity Call Swap
Illustration of an Equity Call Swap
Equity Index Price
Appreciation*
Investor
Underwriter
Libor ± Spread
* No depreciation—settlement at maturity
Equity Asset Swap
Asset
Income Stream
Equity Index
Return*
Investor
Underwriter
Income Stream
* Equity index return includes dividends, paid quarterly or reinvested