2. • Learning derivatives entails climbing a steep learning
curve.
• Getting at least part of the way there with a
minimum amount of mental anguish is a major
accomplishment.
• Derivatives are instruments for managing/
transferring risks.
• Transferring risk should be cost effective.
• A buyer and seller. Buyer pays to transfer risk to
seller.
• Derivatives are high-powered instruments, which if
misused, can get an organization into a great deal of
trouble , if not completely destroy it.
5. Alan Greenspan Vs Warren Buffet
• “These new financial instruments are an increasingly important
vehicle for unbundling risks. They enhance the ability to
differentiate risk and allocate it to those investors most able and
willing to take it. A process that has undoubtedly improved
national productivity and standards of living.”- Alan Greenspan
(1999)
• “I view derivatives as time bombs, both for the parties that deal
in them and the economic system. These instruments will almost
certainly multiply in variety and number until some event makes
their toxicity clear. Central banks and governments have so far
found no effective way to control, or even monitor, the risks
posed by these contracts. In my view, derivatives are financial
weapons of mass destruction, carrying dangers that while now
latent, are potentially lethal.”- Warren Buffet (2002)
6. Financial losses and failures of the risk Process.
• Showa Shell Seikyu- ¥ 165 billion- Currency options
• Proctor and Gamble-$157 million- Swaps-Cur. & IRS
• Metallgsellschaft- $1.3 billion-Energy Futures.
• Orange County- $1.6 billion-Leveraged Repos.
• Barings(Rogue Trader)-£900 million-Index F & O.
• Sumitomo Corporation-$ 1.8 billion-Copper futures.
• Long Term Capital Management*- When genius
failed.
• Enron*-The smartest guys in the room.
• Allfirst.
• Sub-prime crisis.
8. Books on derivatives/calculator
• John Hull.
• Edward and Ma.
• Michael Durbin.
• Keith Redhead.
• Robert Kolb.
• Dubofsky and Miller.
• Don Chance
• Robert Jarrow & Arkadev Chaterjea.
• Options Strategies-NSE
9. Introduction to Derivatives
• What?
• Why should you study?
• Why are the used?/Who uses derivatives?
• Risk.
• Growth/explosion? $1,2,00,000,000,000,000 (2012)
(Bretton woods/Oil Crises 1973/79/Petrodollars and
Euro currency/low interest rates)
• Types-derivatives/underlying/Derivatives on
derivatives.
• Are they safe? (WB-WMD)
• Cutting edge/Option Pricing/Arbitrage
• Short/long.
• Economic functions.
12. Basic difference between Gold standard and Bretton Woods
GOLD STANDARD BRETTON WOODS
GOLD GOLD
USD
ALL ALL OTHER
CURRENCIES CURRENCIES
13. Bretton Woods(1944-1973)
1. Gets its name from the town where it was held in New
Hampshire(US).
2. After WW-II formation of a new international monetary
system.(IMF/ World Bank)
3. USA undertook to convert USD to gold at $35 per
ounce. (28.35 grams) -$25 billion. Gold 700 million
ounces.
4. Other countries to peg their currencies to US$ with (+/-
) 1% variation in parity. (indirect gold peg). If exceeded
buy/sell USD.
14. • What is your main concern when you make an
investment/take a loan?
• Risk heart of IM
• R-Vol,default
• PM identify, measure (sd/b),manage. R
• Asset Allocation-Stocks/ Bonds
• I
• D form of I
15. • Derivatives –The Wild beast of Finance- Alfred
Steinherr.
• Weapons of Mass Destruction-Warren Buffet.
• Hedging /speculating/Why called/how used/
markets/common underliers/price vs value/
mathematics/long vs short/payoff.
• Cannot be dumbed down-Paul Wilmott.
• Paul Samuelson.
16. What are Derivatives?
• Derivatives are instruments whose prices are
derived from the prices of other financial
instruments/commodities (underlying).
• Financial derivatives include forwards, futures,
swaps and options. Major difference?
• The underlying to which they relate include
stocks, bonds, interest rates ,currencies and
commodities.
• Purpose-Risk Management /Price discovery.
• RM is a process -Identify desired and actual
level, alter actual to equal desired. Hedging.
17. Using derivatives properly.
To use derivatives properly, you can go a long way
by just answering a few questions:
1. Do we have a formal policy that defines:
a. The risks we are exposed to?
b. The risks we are willing to take and the ones we are
unwilling to take?
c. Which derivatives we can use?
d. Under what circumstances we can use them?
e. The chain of command for their usage?
2. Are our personnel involved with derivatives sufficiently
knowledgeable?
3. Do we know what derivative positions we have in place
right now?
18. Using derivatives properly
4. Can we measure our risk?
5. Do we have controls in place so that the risk can
be quickly adjusted?
6. Are the personnel who engage in derivatives
transaction different from and not supervisory to
those who monitor the usage of derivatives?
7. Are senior managers and the board kept
apprised of our derivative activities.
19. What do we mean by derived from
other instruments / commodities.
20. • OTC and Exchange traded.
• Forward and contingent claim
21. Arbitrage-law of one price
• A process in which an investor can buy an asset
or a combination of assets at one price and sell it
at a higher price, thereby earning a profit
without investing any money or being exposed to
any risk.
• Eventually the two prices must come together so
that there is no arbitrage opportunity.
• Across space and time.
22. • Arbitrage (arb) is a chance to make riskless profits with no
investment.
• Arbitrage holds the markets together and is invaluable for
pricing derivative securities.
• The concept of arbitrage is invaluable for building pricing
models, which are mathematical formulas that price
derivatives in terms of related securities.
• Innovative derivatives have been created since the 1970s.
• The composite security’s price must equal the sum of the
prices of the simpler constituent derivatives.
• This observation leads us to the idea of the no-arbitrage
principle:
– In the absence of arbitrage, all portfolios or securities with identical
future payoffs must have identical values today.
Arbitrage
24. • “Short selling” is a term primarily used with
stocks and bonds.
• And means to borrow the asset and sell it in
the hope of buying it back at a later date at a
lower price.
Examples of arbitrage:
A fast-food restaurant distributing coupons for free sandwiches to the first one hundred customers of the day
A lottery ticket for a free vacation to Hawaii
A stock selling at two different prices in two different stock exchanges
Stephen A. Ross: “Paul Samuelson's textbook on economics has the following anonymous quote, ‘You can make even a parrot into a learned political economist—all he must learn are the two words “supply” and ”'demand.” [The idea goes back to the Scottish philosopher Thomas Carlyle.] By contrast, the intuition of neoclassical finance is quite different. The focus of finance is micro theoretic and the intuition of finance is the absence of arbitrage. To make the parrot into a learned financial economist, he only needs to learn the single word ‘arbitrage.’" (1987. “The Interrelations of Finance and Economics: Theoretical Perspectives.” American Economic Review 77(2): 29–34)
