Lesson 7: Derivative Securities and Derivative Markets

Upon completion of this lesson, you should be able to do the following:

  • Describe the purpose of the derivatives market.
  • Explain the difference between spot and forward transactions.
  • Describe the difference between futures contracts and options contracts.
  • Describe the difference between hedging and speculation.

Introduction

This lesson introduces the derivatives market. As you know, derivatives have received bad publicity from two famous bankruptcies. In 1995, Orange County, California, had the biggest bankruptcy for a municipal government. The losses approximated $2 billion. The press concentrated on derivatives as the cause of the bankruptcy, but it really was bad decision making on behalf of the fund manager. Another famous case was Barings P.L.C. Barings was a London Investment firm that was founded in 1763. One trader, Nick Leeson, lost about $1 billion in the derivatives market, causing Barings to bankrupt.

Derivatives are simply a contract, where the transaction occurs today, but the actual good is exchange for money at a future date. Throughout this whole course, we assumed that transactions were spot transactions. When a buyer and seller completed a transaction, the money was exchanged for financial security immediately. However, forward transactions can occur. The buyer and seller can negotiate a price today, but the actual exchange occurs at a future date. For example, a bread company believes it will need 6 tons of flour in 6 months. Many things can occur within 6 months. A drought could occur which causes the price of wheat to increase or plenty of rain could cause a bumper crop, causing the price of wheat to decrease. The bread company wants to protect itself from fluctuating prices. The bread company enters into contracts with wheat farmers, where the price of wheat is negotiated today. However, the bread company will actually pay the farmers for the wheat when the wheat is harvested 6 months from now. The contract can protect the bread company from price fluctuations.

Purpose of the Derivatives Market

The price of derivatives receive (i.e. derive) their value from assets. The assets can be commodities like pork bellies, wheat, and crude oil, or the assets can be stock, bonds, certificates of deposit, Eurodollars, and T-bills. Derivatives are contracts. The contract is what is exchanged between buyers and sellers in the derivative markets and not the asset. Derivative securities come in two forms: Futures contract and options contract.

Futures contract - the buyer and seller agree on a price for an asset today and the exchange of money for the asset will occur on a specific date in the future. For example, you want to buy a Treasury bill one year from now. You can enter into a futures contract where you and the seller agree on the price today, but you actually pay for the T-bill one year from now. The futures contract is a legal document that assigns rights.

  1. Buyer - has the obligation to pay for the T-bill, which is called the long position.

  2. Seller - has the obligation to sell you the T-bill, which is called the short position.

These futures contracts can be sold on secondary markets. The majority of the futures contract use financial securities as the asset, such as stocks, bonds, and money market securities.

Interest Rate Risk

Derivatives can protect investors from interest rate risks. For example, a futures contract for CDs might specify that $1 million worth of CDs with a maturity of 3 months be delivered to the buyer on June 2002 for a 10% discount. You manage a money market mutual fund and now it is June 2000. You expect an inflow of $1 million in funds in June 2002. You can buy this futures contract now and guarantee a 10% return for your fund in June 2002. If interest rates decrease, you are guaranteed a10% return, so you are protected.

On the other side of the market, a bank grants a loan for $1 million to a customer for June 2002 at 12% interest rate. The bank issues CDs on the futures market at 10% and has a guaranteed source of funds for next year for this loan. If interest rates increase next year to 15%, then the bank is protected from interest rate risk, because the bank’s source of funds is locked at 10%. Buyers and sellers are protected from interest rate risk through the derivatives market.

The price of the futures contract is determined in the derivatives market. The futures price reflects the expectations of the investors and savers. For example, you buy a futures contract for 10,000 barrels of oil. You negotiated a price of $30 per barrel and the oil will be delivered in 6 months. You can sell your futures contract on the derivatives market. However, the market price can change for oil:

  • If investors and savers believe that oil will be $40 per barrel, then the market value of your futures contract will be high. You can either sell your futures contract for a higher price or wait until you receive the oil and sell the oil for $10 per barrel profit.

  • If investors and savers believe the price of oil will be $20 per barrel, then the market value of your futures contract will be low. You will end up buying oil for $30 per barrel, when it only will cost $20 in the future.

    As the date of the delivery approaches for your oil futures contract, the futures contract market price will approach the price of oil. On day of delivery, no one will buy a futures contract for oil when the market price of the futures contract is higher than the price of oil. No one will sell the futures contract, when the market price of the futures contract is lower than the price of oil.

Buyers and sellers do not know each other. The futures contract is sold through an exchange and the exchange requires the buyers and sellers to settle the gains and losses each day, when the market prices change. If you bought a futures contract for oil through the exchange for a market price of $30 per barrel and the next day the price of oil is $40 per barrel, the person who sold you the contract would have to pay you $10 per barrel to settle the account. This settling of the account is called marking to market.

The options contract is the second type of derivative instrument. The options contract is very similar to the futures contract. The only difference is the options contract gives you the option if you want to buy or sell. For example, you entered into a options contract, giving you the right to buy a barrel of oil for $30 per barrel in 6 months. On the day of delivery, if the price of oil is $20 per barrel, you do not have to honor the option contract. That is your option! If oil is $40 per barrel on the day of delivery, then you are most likely going to honor your options contract. The investor who sold you this contract is obligated to sell the oil for $30 per barrel to you. There are two type of options contracts.

  1. Call option - the contract gives you the right to buy an asset for a specific price in the future.

  2. Put option - this contract gives you the right to sell an asset for a specific price in the future.

The rights for the option exists until the expiration date. If you buy an option, you can exercise your right to buy or sell in the option anytime before the option expires. Options are not given freely. You are charged a fee, which is called the option premium.

The amount paid for an option premium depends on the probability that the buyer of the option will exercise his right. It is like insurance. For example, a driver with a history of car accidents will tend to have a higher probability of having future accidents. His car insurance company will charge a higher premium. There are three factors that influence the size of the option premium.

  1. If the asset's price fluctuates greatly, then there is a higher chance that the option will be exercise. For example, if you bought a call option to buy oil for $30 per barrel and the market price is $40 per barrel, you will cash in the call option. (Profit is $10 per barrel). If you bought a put option to sell oil for $30 per barrel and the market price is $20 per barrel, then you will also cash in on the put option. (Profit is still $10 per barrel).

  2. The time left before the expiration date. The premium will equal the difference between the amount specified in the option and the market price. If the price of oil is $30 per barrel in the option and the market value of oil is $20 per barrel, then the premium will equal about $10 for each barrel listed in the contract.

  3. Interest rates affect options just like bonds and money market instruments. A higher interest rate reduces the present value of the option, increasing the value of the call option (Cheaper for buyer) and decreasing the value of the put option (More expensive for the seller).

There are two broad principals for investing and it applies to all financial markets.

  1. Hedging - investors buy and sell securities in order to lower risk or use long-term investing strategies. The hedger protects himself in three ways by using derivatives. First, he locks in a future price today, protecting himself from price fluctuations. Second, derivatives are liquid markets. If a person need money now, he can easily sell his futures contract in a derivatives market. Finally, derivative exchanges are organized and the market price of derivatives are easy to monitor and gather information.

  2. Speculation - some investors buy or sell securities believing they can sell the securities for a higher price in the future. Speculators are looking for quick profits. As you guessed, an investor can gain or lose lots of money from the derivatives market. Speculators are important to the market, because their presence can increase the liquidity of the securities.

How did Nick Leeson cause the bankruptcy of Barings, P.L.C.? Nick Lesson made an observation about the Tokyo stock market. The market price of Tokyo stocks did not fluctuate much. Nick Leeson would issue an equal number of call and put options for the Tokyo stock market. Investors did not exercise the options, because the stock prices did not change much. Essentially, the premiums collected from the options were profits. The profits were so high, top management at Barings let Nick Leeson continue his speculation. Then an earthquake occurred in Kobe, Japan and stock prices fell on the Tokyo stock exchange. Leeson speculated that stock prices would increase and bought futures contracts. The stock prices continued to fall, resulting in a $1 billion loss for Barings. Barings was forced to buy Tokyo stock for a high price, when stock prices were low.

 

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