Financial Derivatives

1
Financial Derivatives

• April 28, 2001

2
Derivative Product

• A contract or convertible security that changes
  in value in concert with price movements in a
  related or underlying security, future or other
  instrument or index.

3
Convertible Bond

• A bond that can be converted under prescribed
  circumstances into the common stock of a company.
• Conversion Price The share price at which a
  convertible bond is converted into stock.
• Conversion Premium The additional amount that a
  buyer pays over parity with the underlying.

4
Callable Bond

• A bond that gives the issuer of a bond the right
  to call the bond for redemption.
• Call risk the lenders potential opportunity
  cost. He may not be able to reinvest the funds
  in a similar bond with an equal yield.

5
Financial Futures

• Futures contracts written on securities, money,
  currencies, or various stock indices.
• Mostly settled in cash trades in futures are
  settled by entering into the offsetting position.

6
SP 500 Futures

• Buying and selling a basket of stocks at a future
  date.
• Cash settled quarterly
• Portfolio Insurance
• Triple Witching
• Circuit Breaker

7
Euro-dollar

• Any dollar on deposit outside of the U.S.
• Developed in the late 1950s as a way to avoid
  certain U.S. banking regulations.
• Cash settlement based on LIBOR for three-month
  eurodollar time deposit funds.
• Eurodollar futures traded on CME

8
Swaps

• An agreement to exchange a stream of periodic
  payments with a counterparty.
• Interest rate swap an exchange of fixed
  interest payments for floating rate payments.
• International Swap Dealers Association

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Arbitrage

• Buy a relatively underpriced item and sell a
  similar, relatively overpriced item, expecting to
  profit when the prices resume a more appropriate
  theoretical or historical relationship.

10
Volatility

• Change
• Measured by Standard Deviation, or delta, hence
  the name DERIVATIVE
• Historical Volatility
• Implied Volatility
• Black and Scholes Model
• Rocket Science vs Street-smart

11
Delta Hedge

• The change in option price for a given change in
  the price of the underlying.
• E.g. a delta of 0.5 means a 1 change in the
  price of the underlying will change the option
  price by 50 cents.
• Constantly rebalance the positions to stay
  neutral.

12
Risk Control

• Fiascos Proctor and Gamble, Lufthansa, Zhuzhou
  Zinc, Barings, Peregrine, Long-Term Credit
  Management
• Banks Risk Exposure How to measure it?
• Accounting nightmare

13
Financial Engineering

• New financial products designed to suit an
  investors risk appetite.
• Convertibles, callable bonds, etc
• In asset-backed securities, IO (interest only),
  PO (principal only).

14
Attempts at Regulation

• Dirty word
• Global free flow of capital
• Tobin Tax
• Blame the victim