Derivatives

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Derivatives

• An Overview of Products and Markets

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Table of Contents

• I. History
• II. Markets
• III. Options
• IV. Futures
• V. Forwards
• VI. Swaps

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History

• A security contract whose price is derived from
  one or more underlying assets.
• Used to hedge risk
• E.X. Foreign investors buying ADR and currency
  future
• Speculative purposes
• Forwards-London Royal Exchange for tulip bulbs
  (1637)
• Futures-Yodoy rice market in Osaka (1640s)
• CBT 1848, Chicago Mercantile 1972
• anything but onions-1950s Michigan
• 1980s swaps and OTC

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II. Markets

• Exchange-Traded (344T)
• Korea Exchange
• Eurex
• Chicago Mercantile Exchange
• Chicago Board of Trade
• TOCOM (Tokyo Commodity Exchange)
• Intercontinental Exchange
• JADE (Joint Asian Derivatives Exchange)

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II. Markets (cont.)

• Over-the-Counter (OTC)
• Traded directly between two parties
• 298B
• Swaps, Forward Rate Agreements, Exotic Options
• Quanto FX
• Barrier, Range, Lookback, Down and In, Up and In,
  Rainbow, VIX, Asian Tail, Balloon,
  Outperformance, Chameleon, Greenshoe, Capped,
  Choose, Reload, Shout, Ladder, One Touch, Double
  No Touch, Knock-In, Caput, Basket Option,
  Russian, Mid-Atlantic, European, American,
  Bermuda, Evergreen, Spread, Naked, Abandonment,
  Look Up, Pop Up

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III. Options

• Contracts that give the buyer the right to buy or
  sell an asset at a specified future date
• Put Sell Call - Buy
• Put The buyer estimates that the underlying
  asset will drop below the exercise price before
  the expiration date
• Stock Option
• Bond Option
• FX Option
• LEAPs
• Created relatively recently and typically extend
  2 years
• Equity LEAPs always expire in January
• 1000 Companies trade LEAPS, Indices

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IV. Futures

• Contracts to buy or sell an asset at a future
  price and date (price determined on settlement
  date)
• Always traded on an exchange
• Hedgers are seeking to eliminate the risk of
  price changes
• Speculators seek to make a profit by predicting
  market moves and buying a commodity for which
  they have no practical use
• Stock Future
• Bond Future
• FX Future
• Commodities Future
• Freight Rate Future
• Weather Future

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V. Forwards

• Similar to future except price predetermined
• Forwards always trade OTC
• No cash flows until delivery
• In case of physical delivery, the forward
  contract specifies to whom to make the delivery.
• Commodities Forward
• FX Forward
• Forward Rate Agreement
• Interest Rate Cap
• Consider Real Estate examples

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VI. Swaps

• Two parties agree to exchange cash flows
• Equity Swap
• Interest Rate Swap
• normally 'fixed against floating'
• used by companies to alter their exposure to
  interest-rate fluctuations
• Currency Swap
• exchange a given amount of one currency for
  another and, after a specified period of time, to
  give back the original amounts swapped
• Not considered a loan by US accounting laws (not
  reflected on a company's balance sheet)
• Credit Default Swap
• Most widely used credit derivative (typical term
  is five years)
• designed to transfer the credit exposure of fixed
  income products between parties
• one counterparty is selling insurance and the
  other counterparty is buying insurance against
  the default of the third party (contingent put)

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• FIA Futures Industry Association
• ISDA Website of International Swaps and
  Derivatives Association
• OCC - Comptroller of the Currency, Administrator
  of National Banks
• Bank for International Settlements