DERIVATIVES

A Financial Instrument That Derives Its Value From An Underlying

Security

Derivatives Explanation

An easy way to think of derivatives is as a “side bet” on interest

rates, exchange rates, commodity prices, and practically ANYTHING
that you can think of.

Why Derivatives?

•Not to raise capital

•Buy or sell to protect against adverse changes in external factors

Types of Derivatives
•Forwards

•Futures

•Options

•Swaps

Forwards Contracts

The agreement to pay for and pick up, “Something” at a pre-

determined date and or time, for a pre-determined price. Usually
traded off of the trading floor between two firms.

Terms

•Taking Delivery: Physical reception of item.

•Deliverable Instrument: The item to be delivered

•Making Delivery: Turning over the item.

Forwards are not options, they are obligations and should be

considered as a “cash transaction.”

A Modest Example

An agreement on Monday to buy a book,

(Fin 374c) from a bookstore on Friday for $1000.00.

On Friday, you return to the bookstore and take delivery of the book
and pay the $1000.00.

The contract is actually the agreement.

Futures

Similar to forwards in length of time. However, profits and losses

are recognized at the close of business daily, “Mark-to-market.”
Transactions go through a clearinghouse to reduce default risk. 90%
of all futures contracts are delivered to someone other than the
original buyer.

Futures Example

On Monday we enter into a futures contract to buy our book on

Friday. We are required to place a deposit for the book of 50%
($500.00). We are told that if the book appreciates in value we
may be required to increase the deposit. If the book depreciates in
value, we may take back some of the money. Wednesday the book
goes to $1500.00. We must deposit another $250.00. On Thursday
the book drops to $750.00. We can collect $375.00. On Friday the
book value is $800.00, therefore we owe $425.00 on the remaining
balance.

Options

Options come in many flavors. To name a few: collar, cylinder,

fence, mini-max, zero-cost tunnel and straddle. These are all newer
forms of options. The most common options discussed are put and
call.

An OPTION is the right, not the obligation to buy or sell an

underlying instrument.

Option Terms

•Put: the right to sell @ a certain price

•Call: the right to buy @ a certain price

•Long: to purchase the option

•Short: to sell or write the option

•Bullish: feel the value will increase

•Bearish: feel the value will decrease

•Strike/Exercise Price: Price the option can be bought or sold.

Calls

Long a call. Person buys the right (a contract) to buy an asset at a

cretin price. They feel that the price in the future will exceed the
strike price. This is a bullish position.
Short a Call. Person sells the right (a contract) to someone that
allows them to buy a asset at a cretin price. The writer feels that
the asset will devalue over the time period of the contract. This
person is bearish on that asset.

PUTS

Long a Put. Buy the right to sell an asset at a pre-determined price.

You feel that the asset will devalue over the time of the contract.
Therefore you can sell the asset at a higher price than is the current
market value. This is a bearish position.

Short a Put. Sell the right to someone else. This will allow them to
sell the asset at a specific price. They feel the price will go down and
you do not. This is a bullish position.
Swaps

New in the market, late 70’s early 80’s

Two Types: Interest Rate & Currency

Swap Use

•To smooth out interest rate payments in a cyclic environment.

•To secure and level out future interest payments.

•To secure foreign currency for loans when you are a visitor in that
country and it would be too difficult to secure credit or the cost is
prohibitive.

Derivative Securities

•Mortgage Backed Securities: Fanny Mae, Freddie Mac

•Structured Notes: Sally Mae

Explanation

Freddie Mac & Fanny Mae: Both are derivative instruments used to
pool Home Mortgage loans. This creates a secondary market which
allows banks to sell the loans, therefore reducing their risk. It also
reduces default risk for the holder. These are also known as pass
through instruments.

Sally Mae: Same principal as the previous example except they use
student loans. All of these also help to keep interest rates for the
underlying asset low by keeping default risk down.

Standard Securities
•Stocks

•Bonds

•Cash