INTRODUCING THE DERIVATIVES

INTRUMENTS AND MARKETS

Carlo Sala

ESADE Business School

Ms.C Finance

Spring 2021

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 Content

Introduction
Derivatives instruments, an overview
Derivatives markets, an overview

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 What you will learn from this chapter?

What is a derivative product

Main logic behind main products
How big is the overall derivatives market
How big are the different derivatives markets
Pros/cons of their use

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 What you will learn from this chapter?

Hull, “Options, futures and other derivatives”1

Introduction - All chapter, pp 1-20
McDonald, “Derivatives Markets”
Introduction to Derivatives - All chapter, pp 15-37

1
Depending on the edition, page numbers may differ. This is valid for both
books. Please, always double check with the material covered in class.
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 What is a Derivative?

A derivative is a financial asset whose value derives

from the value of another asset.

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 What is a Derivative?

Is a BET. Context is everything

Always at least n Ø 2 players
Zero sum game, not so for risk
If price of cotton in 1 year is greater than $1 you pay the
counterparty $0.50 and viceversa if it will be smaller than $1
Your family grows and sells cotton, the counterparty produces
and sells t-shirts
Both cases are hedged!
Most of your life decisions are derivatives: e.g. why are you
here?

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 Why do we need derivatives?

Why do we “need” derivatives?

Play a key role in transferring risks in the economy.

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 Types of derivatives

Both for historical evolution and economic properties derivative

securities can be classified under three main groups:
1 Forwards and Futures
2 Options (plain vanilla)
3 Advanced Products

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 Types of underlying

By construction, the variety of possible products

is potentially unlimited.

Most common underlying are:

1 Equity Linked (Stocks, Indexes)
2 Commodities
3 Interest rates (Bonds)
4 Currencies
5 Bitcoin

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 Example

Heating degreee-day and cooling degree-day futures contracts

make payments based on weather the temperature is abnormally
hot or cold.
Explain why the following business might be interested in such a
contract:
Soft-drink manufacters
Ski-resort operators
Electric utilities
Amusement park operators
(Hint) In answering the problem, it is useful to ask the question:
Which scenario hurts the company, and how can it protect itself?

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 Example

A soft drink manufacturer probably sells more drinks when it

is abnormally hot. She dislikes days at which it is
abnormally cold because people are likely to drink less, and
her business suffers. She will be interested in a
cooling-degree-day futures contract because it will make
payments when her usual business is slow. She hedges her
business risk.
A ski-resort operator may fear large losses if it is warmer than
usual. It is detrimental to her business if it does not snow in
the beginning of the season or if the snow is melting too fast
at the end of the season. She will be interested in a
heating-degree-day futures contract because it will make
payments when her usual business suffers, thus compensating
the losses.

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 Example
During the summer months, an electric utility company, such
as one in the south of the US, will sell a lot of energy during
days of excessive heat because people will use their air
conditioners, refrigerators, and fans more often, thus
consuming a lot of energy and increasing profits for the utility
company. In this scenario, the utility company will have less
business during relatively colder days, and the
cooling-degree-day futures offers a possibility to hedge such
risk. Alternatively, a utility provider in the northeast during
the winter months, a region where people use many additional
electric heaters. This provider makes more money during
unusually cold days and may be interested in a
heating-degree-day contract because that contract pays off if
the primary business suffers.
Risk: bad weather and cold days because people will abstain
from going to the amusement park. Protection: to buy a
cooling-degree-day future to offset her losses from ticket sales
with
Carlo gains from the futures contract.
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 Use of derivatives

1 Hedging (Risk management)

Use a finance contract to hedge an uncertain future business
situation
Changes in the price of jet fuel: Delta, United, Lufthansa
Chages in interest rates: Citigroup, BoA, Goldman
Changes in exchange rates: GE, GM, Nestle
2 Speculation
Exploit the leverage to boost profits through a directional bet
3 Arbitrage
To exploit possible mispricing (free lunches)
4 Finance Engineering
Combining different asset to obtain a given payoff
Weapons of mass destruction (W. Buffet)

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 Use of derivatives - Examples (Read at home)

Risk Management: add to the primary position a secondary

(financial) position that moves in the opposite way

Secondary goes ¿ when primary goes ø

Example

A US company will pay £10 million for imports from Britain in 3

months and decides to hedge using a long position in a forward
contract that trades at 1.4415
Primary: Short
Secondary: Long

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 Use of derivatives - Examples (Read at home)

The forward contract allows the firm to buy £ at 1.4415,

fixed.
The US company fixes the price will have to pay in 3 months
at 10 million · 1.4415 = $14,415,000
Assume, after 3 months that:
The exchange rate is 1.30: loss on forward
The exchange rate is 1.50: gain on forward
It clearly show the role of reducing the risk

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 Use of derivatives - Examples (Read at home)

Speculation:
Speculation: use derivatives to bet toward a direction

Example

The current price of a stock is $94, and a 3-month European call

option with a strike price of $95 currently sell for $4.70. An
investor who feels that the price of the stock will increase is trying
to decide between buying 100 shares and buying 2,000 call options
(=20 contracts).
Both strategies involve an investment of $9,400.
What advice would you give?

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 Use of derivatives - Examples (Read at home)

Solution:

St = $94
ct,95 = $4.7
Profit/loss of the two strategies at T = 3/12:
Equity: 100 (ST ≠ 94)
Options: 2000 (ST ≠ 95, 0)+ ≠ 9400

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 Use of derivatives - Examples (Read at home)

Equity strategy
Gives a positive profit if:

100 (ST ≠ 94) > 0 ∆ ST > 94 (1)

Options strategy
Gives a positive profit if:

2000 (ST ≠ 95)+ ≠ 9400 > 0 ∆ ST > 99.7 (2)

Comparing the two strategies

The first is more profitable if:

100 (ST ≠ 94) > 2000 (ST ≠ 95)+ ≠ 9400 ∆ ST < 100 (3)

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 Graphically:

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 Use of derivatives - Examples (Read at home)

Conclusion

If ST < 100 the strategy in stock is preferred

If ST = 100 both strategies are equally profitable
If ST > 100 the strategy in options is optimal.

Due to leverage: options is ø profitable as well as ø risky

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 Use of derivatives - Examples (Read at home)

Arbitrage:
Arbitrage (i): D and D pay the same but cost: D > D
Õ Õ

Strategy: Buy D and sell D

Õ

Arbitrage (ii): E pays more than E but costs: E = E

Õ Õ

Strategy: Buy E and sell E

Õ

Example

A stock price is quoted as £100 in London and $172 in New York

The current exchange rate is $1.7500

Strategy: Sell spot the stock in London just bought in NY

Profit: 100 · [($1.75 · 100) ≠ 172)] = $300

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What makes derivatives interesting (dangerous?)
Risk-return tradeoff
Value/pricing?
Leverage
To bet on an asset without owning it
Infinte combinations (engineering)

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 Introducing the role of elephants in finance

How big is the derivatives market?

What about the other markets?

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 Introducing the role of elephants in finance

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 Introducing the role of elephants in finance

http://money.visualcapitalist.com/worlds-money-markets-one-
visualization-2017/

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For more info:
Official BIS websites

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