Chapters on corporate applications, financial engineering, and real options illustrate the broad applicability of the tools and models developed in the book.
A rich array of examples bolsters the theory. Read: Criminal Investigation 11th Edition. This book offers computation-friendly approach. The options pricing functions used in the text are available in accompanying Excel spreadsheets. Visual Basic code for the pricing functions is included, and can be modified for your own use.
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Please select the latest edition according to the publishing know. Click here to sign up. Download Free PDF. Chapter 01 - Robert L. Mc Donald, Derivatives Markets, 3rd Edition. Max Landeros. A short summary of this paper. Download Download PDF. Translate PDF. Electronic processing, globalization, and deregulation have all transformed markets, with many of the most important changes involving derivatives.
Derivatives sometimes make headlines. It is almost impossible to discuss or perform asset management, risk management, credit evaluation, or capital budgeting without some understanding of derivatives and derivatives pricing.
This book provides an introduction to the products and concepts underlying deriva- tives. The size of these markets may leave you wondering exactly what functions they serve. We also discuss different perspectives on derivatives. Finally, we will discuss how trading occurs, providing some basic concepts and language that will be useful in later chapters.
Introduction to Derivatives 1. Options, futures, and swaps are all examples of derivatives. A bushel of corn is not a derivative; it is a commodity with a value determined in the corn market. This is a derivative in the sense that you have an agreement with a value depending on the price of something else corn, in this case. Viewed in this light, the bet hedges you both against unfavorable outcomes. The contract has reduced risk for both of you.
Investors who do not make a living growing or processing corn could also use this kind of contract simply to speculate on the price of corn. In this case the contract does not serve as insurance; it is simply a bet. This example illustrates a key point: It is not the contract itself, but how it is used, and who uses it, that determines whether or not it is risk-reducing.
Context is everything. You will come to a deeper understanding of derivatives as we progress through the book, studying different products and their underlying economics. To understand the steps, consider the trade of a stock: 1. The buyer and seller must locate one another and agree on a price. Once the buyer and seller agree on a price, the trade must be cleared, i. In the case of some derivatives transactions, both parties must post collateral.
The trade must be settled, that is, the buyer and seller must deliver in the required period of time the cash or securities necessary to satisfy their obligations. Once the trade is complete, ownership records are updated.
To summarize, trading involves striking a deal, clearing, settling, and maintaining records. Different entities can be involved in these different steps. An exchange is an organization that provides a venue for trading, and that sets rules governing what is traded and how trading occurs.
Once upon a time, the exchange was solely a physical location where traders would stand in groups, buying and selling by talking, shouting, and gesturing. However, such in-person trading venues have largely been replaced by electronic networks that provide a virtual trading venue.
The traders who deal directly with a clearinghouse are called clearing members. If you buy a share of stock as an individual, your transaction ultimately is cleared through the account of a clearing member. Other countries have similar institutions.
Derivatives exchanges are al- ways associated with a clearing organization because such trades must also be cleared and settled. With stock and bond trades, after the trade has cleared and settled, the buyer and seller have no continuing obligations to one another.
However, with derivatives trades, one party may have to pay another in the future. To facilitate these payments and to help manage credit risk, a derivatives clearinghouse typically interposes itself in the transaction, becoming the buyer to all sellers and the seller to all buyers.
This substitution of one counterparty for another is known as novation. Such trading is said to occur in the over-the-counter OTC 1. When trading occurs in person, it is valuable for a trader to be physically close to other traders. Traders make large investments to gain such speed advantages. Introduction to Derivatives market.
First, it can be easier to trade a large quantity directly with another party. A dealer could execute the entire trade as a single transaction, compared to the alternative of executing individual orders on a variety of different markets.
Most of the trading volume numbers you see reported in the newspaper pertain to exchange-based trading. Exchange activity is public and highly regulated. Over-the-counter trading is not easy to observe or measure and is generally less regulated.
Financial institutions are rapidly evolving and consolidating, so any description of the industry is at best a snapshot. Familiar names have melded into single entities. The different measures count the number of transactions that occur daily trading volume , the number of positions that exist at the end of a day open interest , and the value market value and size notional value of these positions.
For example, on a stock exchange, trading volume refers to the number of shares traded. On an options exchange, trading volume refers to the number of options traded, but each option on an individual stock covers shares of stock.
In an OTC trade, the dealer serves the economic function of a clearinghouse, effectively serving as counterparty to a large number of investors. Partly because of concerns about the fragility of a system where dealers also play the role of clearinghouses, the Dodd-Frank Act in required that, where feasible, derivatives transactions be cleared through designated clearinghouses.
When there are stock splits or mergers, individual stock options will sometimes cover a different number of shares. Notional value. Notional value measures the scale of a position, usually with reference to some underlying asset. The concept of notional value is especially important in derivatives markets.
Derivatives exchanges frequently report the notional value of contracts traded during a period of time. Open interest. Open interest measures the total number of contracts for which counter- parties have a future obligation to perform.
Each contract will have two counterparties. Open interest measures contracts, not counterparties. Open interest is an important statistic in derivatives markets. Typically they do so either by selling ownership claims on the company common stock or by borrowing money obtaining a bank loan or issuing a bond.
Some exchanges, such as the NYSE, designate market-makers, who stand ready to buy or sell to meet customer demand. In practice, most investors will not notice these distinctions.
The bond market is similar in size to the stock market, but bonds generally trade through dealers rather than on an exchange. Most bonds also trade much less frequently than stocks. Table 1. To provide some perspective, the aggregate value of publicly traded common stock in the U. By way of comparison, the gross domestic product GDP of the U. Market value changes with the price of the underlying shares. GDP, by contrast, represents output produced in the U. The market value and GDP numbers are therefore not directly comparable.
The comparison is nonetheless frequently made. A given exchange may trade futures, options, or both. The distinction between exchanges that trade physical stocks and bonds, as opposed to derivatives, has largely been due to regulation and custom, and is eroding.
The introduction and use of derivatives in a market often coincides with an increase in price risk in that market. The market for natural gas has been deregulated gradually since , resulting in a volatile market and the introduction of futures in The deregulation of electricity began during the s. To illustrate the increase in variability since the early s, panels a — c in Figure 1.
The link between price variability and the development of derivatives markets is natural—there is no need to manage risk when there is no risk. Investors who have the most tolerance for risk will bear more of it, and risk-bearing will be widely spread among investors. It is sometimes argued that the existence of derivatives markets can increase the price variability of the underlying asset or commodity.
However, the introduction of derivatives can also be a response to increased price variability. Change in 3-month T-bill rate 0. Louis Fed; c St. Interest rate year U. Treasury bond, year U. The point of this graph is that trading activity in futures contracts has grown enormously over this period.
Derivatives exchanges in other countries have generally experienced similar growth. Eurex, the European electronic exchange, traded over 2 billion contracts in There are many other important derivatives exchanges, including the Chicago Board Options Exchange, the International Securities Exchange an electronic exchange headquartered in the U. The OTC markets have also grown rapidly over this period. It is instructive to browse the websites of derivatives exchanges.
For example, the CME Group open interest report for April reports positive open interest for 16 different interest rate futures contracts, 26 different equity index contracts, 15 metals, hundreds of different energy futures contracts, and over 40 currencies.
Many of these contracts exist to handle specialized requirements. Foreign Interest Credit Exchange Rate Equity Commodity Default Total — — — — — — Source: Bank of International Settlements. We routinely see headlines stating that the Dow Jones Industrial Average has gone up points, the dollar has fallen against the euro, and interest rates have risen. But why do we care about these things?
Their income pays for their mortgage, transportation, food, clothing, and medical care. Here are a few:. The Averages invest their savings in mutual funds that own stocks and bonds from companies around the world. Introduction to Derivatives way is low. As a result, the Averages are not heavily exposed to any one company.
The Averages live in an area susceptible to tornadoes and insure their home. The local insurance company reinsures tornado risk in global markets, effectively pooling Anytown tornado risk with Japan earthquake risk and Florida hurricane risk.
This pooling makes insurance available at lower rates and protects the Anytown insurance company. The bank in turn sold the mortgage to other investors, freeing itself from interest rate and default risk associated with the mortgage.
Because the risks of their mortgage is borne by those willing to pay the highest price for it, the Averages get the lowest possible mortgage rate. XYZ Co. In addition to having property and casualty insurance for its buildings, it uses global derivatives markets to protect itself against adverse currency, interest rate, and commodity price changes.
By being able to manage these risks, XYZ is less likely to go into bankruptcy, and the Averages are less likely to become unemployed. A bank that sells a mortgage does not have to bear the risk of the mortgage. A single insurance company does not bear the entire risk of a regional disaster.
Risk-Sharing Risk is an inevitable part of our lives and all economic activity. Drought and pestilence destroy agriculture every year in some part of the world. Some economies boom as others falter. Given that risk exists, it is natural to have arrangements where the lucky share with the unlucky.
There are both formal and informal risk-sharing arrangements. On the formal level, the insurance market is a way to share risk. Total collected premiums are then available to help those whose houses burn down.
The lucky, meanwhile, did not need insurance and have lost their premium. This market makes it possible for the lucky to help the unlucky.
On the informal level, risk-sharing also occurs in families and communities, where those encountering misfortune are helped by others. There is one important risk that the Averages cannot easily avoid. This could be an important reason for the Averages to avoid investing in XYZ. If the dollar becomes expensive relative to the yen, some companies are helped and others are hurt.
It makes sense for there to be a mechanism enabling companies to exchange this risk, so that the lucky can, in effect, help the unlucky. Even insurers need to share risk. Consider an insurance company that provides earth- quake insurance for California residents.
Thus, insurance companies often use the reinsurance market to buy, from reinsurers, insurance against large claims. Reinsurers pool different kinds of risks, thereby enabling insurance risks to become more widely held. Bondholders willing to accept earthquake risk can buy these bonds, in exchange for greater interest payments on the bond if there is no earthquake.
An earthquake bond allows earthquake risk to be borne by exactly those investors who wish to bear it. Risk is diversifiable risk if it is unrelated to other risks.
Risk that does not vanish when spread across many investors is nondiversifiable risk. Financial markets in theory serve two purposes. Thus, the fundamental economic idea underlying the concepts and markets discussed in this book is that the existence of risk-sharing mechanisms benefits everyone.
Derivatives markets continue to evolve. A recent development has been the growth in prediction markets, discussed in the box on page One is a functional perspective: Who uses them and why? In this section, we discuss these different perspectives.
Uses of Derivatives What are reasons someone might use derivatives? Here are some motives: Risk management. Derivatives are a tool for companies and other users to reduce risks. With derivatives, a farmer—a seller of corn—can enter into a contract that makes a payment when the price of corn is low. This contract reduces the risk of loss for the farmer, who we therefore say is hedging. Introduction to Derivatives BOX 1.
See the box on occurrence of a natural disaster, or the value of a page As of this writing, a law outcome of presidential and other elections. For example, if the Re- Trading Commission. If you destroy your car in an accident, your insurance is valuable; if the car remains undamaged, it is not.
Derivatives can serve as investment vehicles. Reduced transaction costs. For example, the manager of a mutual fund may wish to sell stocks and buy bonds. Doing this entails paying fees to brokers and paying other trading costs, such as the bid-ask spread, which we will discuss later.
It is possible to trade derivatives instead and achieve the same economic effect as if stocks had actually been sold and replaced by bonds. Using the derivative might result in lower transaction costs than actually selling stocks and buying bonds. Regulatory arbitrage. It is sometimes possible to circumvent regulatory restrictions, taxes, and accounting rules by trading derivatives. This transaction may allow the owner to defer taxes on the sale of the stock, or retain voting rights, without the risk of holding the stock.
These are common reasons for using derivatives. The general point is that derivatives provide an alternative to a simple sale or purchase, and thus increase the range of possibilities for an investor or manager seeking to accomplish some goal.
Obviously, for society as a whole, hedging may be desirable while regulatory arbitrage is not. In recent years the U. Nevertheless, surprisingly little is known about how companies actually use derivatives to manage risk. The basic strategies companies use are well-understood—and will be described in this book—but it is not known, for example, what fraction of perceived risk is hedged by a given company, or by all companies in the aggregate.
They may have assets and liabilities in different currencies, with different maturities, and with different credit risks. Hence banks could be expected to use interest rate derivatives, currency derivatives, and credit derivatives to manage risks in those areas.
Perspectives on Derivatives How you think about derivatives depends on who you are. In this book we will think about three distinct perspectives on derivatives: The end-user perspective. End-users are the corporations, investment managers, and investors who enter into derivative contracts for the reasons listed in the previous section: to manage risk, speculate, reduce costs, or avoid a rule or regulation.
End- users have a goal for example, risk reduction and care about how a derivative helps to meet that goal. The market-maker perspective. Market-makers are intermediaries, traders who will buy derivatives from customers who wish to sell, and sell derivatives to customers who wish to buy. In order to make money, market-makers charge a spread: They buy at a low price and sell at a high price.
In this respect market-makers are like grocers, who buy at the low wholesale price and sell at the higher retail price. After dealing with cus- tomers, market-makers are left with whatever position results from accommodating customer demands.
Market-makers typically hedge this risk and thus are deeply con- cerned about the mathematical details of pricing and hedging. Introduction to Derivatives The economic observer. Finally, we can look at the use of derivatives, the activities of the market-makers, the organization of the markets, and the logic of the pricing models and try to make sense of everything.
This is the activity of the economic observer.
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