Financial Derivatives: Pricing and Risk Management / Edition 1

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Overview

Financial derivatives -- financial instruments whose value depends on other basic instruments, such as stocks or bonds -- are one of the most important financial innovations of the last century. While they are unsurpassed as tools for speculation, financial derivatives have also emerged as important risk-management tools in the corporate world. If you want to understand derivatives without getting bogged down by the mathematics surrounding their pricing and valuation, Financial Derivatives, Third Edition is the book for you. Through in-depth insights gleaned from years of financial experience, Robert Kolb and James Overdahl clearly explain what derivatives are and how you can prudently use them within the context of your underlying business activities. Financial Derivatives, Third Edition will introduce you to the wide range of markets for financial derivatives. This invaluable guide offers a broad overview of the different types of derivatives -- futures, options, and swaps -- while focusing on the principles that determine market prices. This comprehensive resource also provides a thorough introduction to financial derivatives and their importance to risk management in a corporate setting. After each derivative is described and examined, Kolb and Overdahl address the practical applications of these instruments in the area of risk management.

Filled with helpful tables and charts, informative Q&A sections, and new chapters that reflect an increased emphasis on risk management, Financial Derivatives, Third Edition offers a wealth of knowledge on futures, options, swaps, financial engineering, and structured products. Through the process of financial engineering you will learn how to apply financial derivatives to numerous risk management scenarios. As a financial professional, if you are looking to minimize risk and maximize profits, you must understand how to use derivatives. Fully updated and completely revised to reflect today's ever-changing economic environment, Financial Derivatives, Third Edition will help you unlock the incredible potential of financial derivatives.

Financial Derivatives provides a thorough introduction to financial derivatives and their importance to risk management in the corporate setting. The book has two principal goals: to offer a broad overview of the different types of financial derivatives while focusing on the principals that determine market prices, and to present financial derivatives as a tool for risk management in a corporate setting rather than as instruments of speculation.

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Product Details

  • ISBN-13: 9780470499108
  • Publisher: Wiley
  • Publication date: 11/2/2009
  • Series: Robert W. Kolb Series , #5
  • Edition description: New Edition
  • Edition number: 1
  • Pages: 600
  • Product dimensions: 7.30 (w) x 10.00 (h) x 2.00 (d)

Meet the Author

Robert W. Kolb is the Frank W. Considine Chair of Applied Ethics and Professor of Finance at Loyola University Chicago. Before this, he was the assistant dean, Business and Society, and director, Center for Business and Society, at the University of Colorado at Boulder, and department chairman at the University of Miami. Kolb has authored over twenty books on finance, derivatives, and futures, as well as numerous articles in leading finance journals.

James A. Overdahl, a specialist in financial derivatives, is the Chief Economist of the United States Securities and Exchange Commission. He had previously served as chief economist of the Commodity Futures Trading Commission and has nearly two decades of experience in senior positions at various federal financial regulatory agencies. He has taught economics and finance at the University of Texas at Dallas, Georgetown University, Johns Hopkins University, and George Washington University. Overdahl earned his PhD in economics from Iowa State University.

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Read an Excerpt

FINANCIAL DERIVATIVES
Overview

A financial derivative is a financial instrument that is based upon another more elementary financial instrument, and the value of the financial derivative depends upon the more basic instrument. Usually, the base instrument is a cash market financial instrument, such as a bond or a share of stock. For example, a stock option gives its owner the right to buy or sell the shares of stock that underlie the stock option. In this sense, the stock option is based upon a share of stock. Because thc stock option cannot exist without the underlying stock, thc stock option is derived from the stock itself. Because the stock is a financial instrument, the stock option is a financial derivative.

This chapter briefly discusses thc major types of financial derivatives and explains thc basic applications of thc different types of derivatives. In succeeding sections, this chapter discusses three types of financial derivatives--futures, options, and swaps. We then turn to a brief consideration of financial engineering--the application of financial derivatives to manage risk. Thc chapter concludes with a discussion of the markets for financial derivatives and brief comments on the social function of financial derivatives.

Futures

Futures markets arose in the mid-1800s in Chicago. A futures contract is a type of forward contract--an agreement reached at one point in time calling for the delivery of some commodity at a specified later date at a price established at the time of contracting. For example, an agreement made today to deliver one ton of sugar a year from today a price of $.59 per lb., with the payment to be made upon delivery, is a typical kind of forward contract. A futures contract is a forward contract traded on an organized exchange with contract terms clearly specified by the rules of the exchange.

Futures markets began with grains, such as corn, oats, and wheat, as the underlying good. Financial futures are futures contracts based upon financial instruments. Today, financial futures based on currencies, debt instruments, and financial indexes trade actively. Foreign currency futures are futures contracts calling for the delivery of a specific amount of a foreign currency at a specified future date in return for a given payment of U.S. dollars. Interest rate futures take a debt instrument, such as a Treasury bill (T-bill) or Treasury bond (T-bond), as their underlying good. With these kinds of contracts, the trader must deliver a certain kind of debt instrument to fulfill the contract. In addition, financial futures trade based on financial indexes. For these kinds of financial futures, there is no delivery, but traders complete their obligations by making cash payments based on changes in the value of the index. Stock index futures are futures contracts that are based on the value of an underlying stock index, such as the S&P 500 index. For these futures, the gains and losses are determined by movements in the index. Rather than attempt to deliver a basket of the 500 stocks in the index, traders settle their accounts by making cash payments that are consistent with movements in the index. Table I. 1 lists the major futures exchanges and the types of financial futures that they trade. Financial futures were introduced only in the early 1970s. The first Financial futures contracts were for foreign exchange, with interest rate futures beginning to trade in the mid-1970s, followed by stock index futures in the early 1980s.

Forwards versus Futures
To understand the basic ideas underlying the concept of a financial derivative, and futures in particular, we consider the obligations and privileges involved in forward and futures contracting. In a typical forward contract, calling for the delivery of a commodity at a future time for a payment to be made upon delivery, two parties come together and agree to terms that they believe to be mutually beneficial. Though very desirable for both parties, this kind of contract has a number of characteristics which may be drawbacks, and these can be illustrated by using our example of the forward contract for the delivery of one ton of sugar in a year.

In the forward contract for sugar, both parties must trust each other to complete the contract as promised. The contract price was $.59 per lb., and that is the amount promised to be paid upon delivery of the sugar in one year. At the time of delivery, the price of sugar is quite likely to be different from $.59. Let us assume that the price of sugar at the time of delivery is $.69. This is the cash price or the spot price--the price for immediate delivery of a good. In this event, the seller is obligated to deliver the ton of sugar and to receive only $.59 per lb. for it. In the open market, however, the sugar could be sold for $.69 per lb. Obviously, the seller will be tempted to default on the forward contract obligation and to sell the ton of sugar in the open market at the spot price of $.69 per lb., giving rise to credit risk. The strong incentives to default on the contract are known in advance to both parties. Consequently, this kind of forward contract can reasonably take place only between two parties that know and trust each other to honor their commitments. If we restrict ourselves to doing business only with people we trust, there is likely to be very little commerce at all.

A second problem with this kind of forward contract is the difficulty of finding a trading partner. One party may wish to sell a ton of sugar for delivery in one year, but it might be difficult to find someone willing to contract now for the delivery of sugar one year from now. Not only must the timing be the same for both parties, but both parties must want to exchange the same amount of the good. These conditions can be quite restrictive and leave many potential traders unable to consummate their desired trades. Thus, without an organized exchange, there can be a lack of liquidity in a derivatives market.

A third and related problem with this kind of forward contract is the difficulty in fulfilling an obligation without actually completing delivery. In the example of the sugar contract, imagine that one party to the transaction decides after six months that it is undesirable to complete the contract by delivery. This trader has only two ways to fulfill his or her obligation. The first is to make delivery as originally agreed. The second is to ask the trading partner to settle the contract now, by early delivery or the payment of cash, for example. This could be difficult to arrange unless the trading partner is willing to cooperate. As we will see in Chapters 2 and 3, the existence of organized exchanges makes it easy for traders to complete their obligations without actually making or taking delivery.

Because of credit risk, the difficulty of finding a trading partner, heterogeneity of contract terms, and the need for a flexible means of settling the contract, forward markets have always been restricted in size and scope? Futures markets have emerged to provide an institutional framework that copes with these deficiencies of forward contracts. The organized futures exchange standardizes contract terms and guarantees performance on the contracts to both trading partners. As we will see in Chapter 2, an organized exchange also provides a simple mechanism that allows traders to complete their obligation at any time.

Options

As the name implies, an option is the fight to buy or sell, for a limited time, a particular good at a specified price. Such options have obvious value. For example, if IBM is selling at $120 and an investor has the option to buy a share at $100, this option must be worth at least $20, the difference between the price at which you can buy IBM ($100) and the price at which you could sell it in the open market ($120).

Prior to 1973, options of various kinds were traded over-the-counter. An over-the-counter market (OTC) is a market without a centralized exchange or trading floor. In 1973, the Chicago Board Options Exchange (CBOE) began trading options on individual stocks. Since that time, the options market has experienced rapid growth, with the creation of new exchanges and many different kinds of new option contracts. These exchanges trade options on goods ranging from individual stocks and bonds, to foreign currencies, to stock indexes, to options on futures contracts.

There are two major classes of options, call options and put options. Ownership of a call option gives the owner the right to buy a particular good at a certain price, with that right lasting until a particular date. Ownership of a put option gives the owner the right to sell a particular good at a specified price, with that right lasting until a particular date. For every option, there is both a buyer and a seller. In the case of a call option, the seller receives a payment from the buyer and gives the buyer the option of buying a particular good from the seller at a certain price, with that right lasting until a particular date. Similarly, the seller of a put option receives a payment from the buyer. The buyer then has the right to sell a particular good to the seller at a certain price for a specified period of time.

In all cases, ownership of an option involves the right, but not the obligation, to make a certain transaction. The owner of a call option may, for example, buy the good at the contracted price during the life of the option, but there is no obligation to do so. Likewise, the owner of a put option may sell the good under the terms of the option contract, but there is no obligation to do so. Selling an option does commit the seller to specific obligations. The seller of a call option receives a payment from the buyer, and in exchange for this payment, the seller of the call option (or simply, the call) must be ready to sell the given good to the owner of the call, if the owner of the call wishes. The discretion to engage in further transactions always lies with the owner or buyer of an option. Option sellers have no such discretion. They have obligated themselves to perform in certain ways if the owners of the options so desire.

As Table 1.2 shows, there are quite a few options exchanges in the United States trading a variety of goods. This list can be expected to expand in the future. The present is a time of expansion and experimentation in the options market, and there will be a continuing process of maturation.
In many respects, options exchanges and futures exchanges are organized similarly. In the options market, as in the futures market, there is a seller for every buyer, and both markets allow offsetting trades. To buy an option, a trader simply needs to have an account with a brokerage firm holding a membership on the options exchange. The trade can be executed through the broker with the same ease as executing a trade to buy a stock. The buyer of an option will pay for the option at the time of the trade, so there is no more worry about cash flows associated with the purchase. For the seller of an option, the matter is somewhat more complicated. In selling a call option, the seller is agreeing to deliver the stock for a set price if the owner of the call so chooses. This means that the seller may need large financial resources to fulfill his or her obligations. The broker is representing the trader to the exchange and is, therefore, obligated to be sure that the trader has the necessary financial resources to fulfill all obligations. For the seller, the full extent of these obligations is not known when the option is sold. Accordingly, the broker needs financial guarantees from option writers. In the case of a call, the writer of an option may already own the shares of stock and deposit these with the broker. Writing call options against stock that the writer owns is called writing a covered call. This gives the broker complete protection, because the shares that are obligated for delivery are in the possession of the broker. If the writer of the call does not own the underlying stocks, he or she has written a naked option, in this case a naked call. In such cases, the broker may require substantial deposits of cash or securities to insure that the trader has the financial resources necessary to fulfill all obligations.

The Option Clearing Corporation (OCC) oversees the conduct of the market and assists in making an orderly market. As in the futures market, the buyer and seller of an option have no obligations to a specific individual but are obligated to the OCC. Later, if an option is exercised, the OCC matches buyers and sellers and oversees the completion of the exercise process, including the delivery of funds and securities.
This management of the exercise process and the standardization of contract terms are the largest contributions of the OCC. Standardized contract terms have made it possible for traders to focus on their trading strategies without having to learn the intricacies of many different option contracts.

Swaps

A swap is an agreement between two or more parties to exchange sets of cash flows over a period in the future. For example, Party A might agree to pay a fixed rate of interest on $1 million each year for five years to Party B. In return, Party B might pay a floating rate of interest on $1 million each year for five years. The parties that agree to the swap are known as counterparties. The cash flows that the counterparties make are generally tied to the value of debt instruments or to the value of foreign currencies. Therefore, the two basic kinds of swaps are interest rate swaps and currency swaps.

A significant industry has arisen to facilitate swap transactions. This section considers the role of swap facilitators--economic agents who help counterparties identify each other and help the counterparties consummate swap transactions. Swap facilitators, who are either brokers or dealers, may function as agents that identify and bring prospective counterparties into contact with each other. Alternatively, swap dealers may actually transact for their own account to help complete the swap.

By taking part in swap transactions, swap dealers expose themselves to financial risk. This risk can be serious, because it is exactly the risk that the swap counterparties are trying to avoid. Therefore, the swap dealer has two key problems. First, the swap dealer must price the swap to provide a reward for his services in bearing risk. Second, the swap dealer essentially has a portfolio of swaps that results from his numerous transactions in the swap market. Therefore, the swap dealer has the problem of managing a swap portfolio. Chapter 4 explores how swap dealers price their swap transactions and manage the risk inherent in their swap portfolios.

The origins of the swap market can be traced to the late 1970s, when currency traders developed currency swaps as a technique to evade British controls on the movement of foreign currency. The first interest rate swap occurred in 1981 in an agreement between IBM and the World Bank. Since that time, the market has grown rapidly. Table 1.3 shows the amount of swaps outstanding at year-end for 1987-1991. By the end of 1991, interest rate swaps with $3.1 trillion in underlying value were outstanding, and currency swaps totaled another $807-billion. The total swaps market approached a principal amount of $4 trillion, with about 80 percent of the swaps being interest rate swaps and the remaining 20 percent being currency swaps. Of these swaps, about 50 percent involved the U.S. dollar.

Table 1.4 presents information about the initiation of swaps by semi annual periods and sustains the impression of phenomenal growth. For example, interest rate swaps grew at a compounded annual rate of 43 percent over the 1987-1991 period, and currency swaps grew at a 41 percent rate over the same period. In short, the growth of the swap market has been the most rapid for any financial product in history. With almost $4 trillion in outstanding principal, the figures in the swap market rival the U.S. federal debt and the swap market is growing even faster than federal debt.

Chapter 4 provides a basic introduction to the swap market. As we will see, the swap market is growing so rapidly because it provides firms that face financial risks with a flexible way to manage that risk. We will explore the risk management motivation that has led to this phenomenal growth in some detail.

Financial Engineering

One of the most important uses of financial derivatives is risk management. Some types of risk are simple to manage with financial derivatives, but others require custom solutions. Financial engineering generally refers to the creation of custom solutions to complex risk management problems. The financial engineer might use a combination of futures, options, and swaps, to tailor a solution to a specific risk management problem. In this section, we show a simple example of how to manage risks with financial derivatives. We then consider some of the complexities that may call for a custom solution by a financial engineer.

A Risk Management Example

Assume that a pension fund expects to receive $1,000,000 in three months to invest in stocks. If the fund manager waits until-the money is in hand, the fund will have to pay whatever prices prevail for the stocks at that time. This exposes the fund to risk because of the uncertainty of the value of stocks three months from now. By contrast, the fund manager could use financial derivatives to manage that risk. The manager could buy stock index futures calling for delivery in three months. If the manager buys stock index futures today, the futures transaction acts as a substitute for the cash purchase of stocks and immediately establishes the effective price that the fund will pay for the stocks it will actually purchase in three months. Let us say that the stock index futures trades for 100.00 index units, each unit being worth $1, and the fund manager commits to purchase 10,000 units. The manager now has a $1,000,000 position in stock index futures. (This futures commitment does not involve an actual cash purchase. As Chapter 2 explains in detail, purchasing a futures contract commits the buyer to a future exchange of cash for the underlying good.)

Three months later, let us assume that the index stands at 105.00, so the fund manager has a futures position worth $1,050,000 and a futures trading profit of $50,000. The manager can close this position and reap the $50,000 profit. At this time, the pension fund receives the anticipated $1,000,000 for investment. Because the index has risen 5 percent, the stocks the manager hoped to buy for $1,000,000 now cost $1,050,000. By combining the $50,000 futures profit with the $1,000,000 the fund receives for investment, the fund manager can still buy the stocks as planned. If the manager had not entered the futures market, the manager would not have been able to buy all of the shares that were anticipated, as the manager would have $1,000,000 in new investable funds, but the stocks would have risen in value to $1,050,000. By trading the futures contracts, the manager successfully reduced the risk associated with the planned purchase of shares, and the fund is able to buy the shares as it had hoped.

In this example of the pension fund, the stock market rose by 5 percent and the fund generated a futures market profit of $50,000 that offset this rise in the cost of stocks. However, the market could have just as easily fallen by 5 percent over this three-month period. If the stock index fell from 100.00 to 95.00, the fund's futures position would have generated a $50,000 loss. (The fund manager bought a $1 million position at an index value of 100.00, so a drop in the index to 95.00 means that the managers position is worth only $950,000, for a $50,000 loss.) In this case, the manager receives $1,000,000 for investment. The stocks the manager planned to buy now cost only $950,000 instead of the anticipated $1,000,000. Therefore, the manager pays $950,000 for the stocks and uses the remaining $50,000 to cover the losses in the futures market. With a drop in futures prices, the pension fund would have been better off to have stayed out of the futures market. Had it not traded futures, the fund could have bought the desired shares for $950,000 and still had $50,000 in cash.

By trading stock index futures in the way just described, the pension fund manager effectively establishes a price for the shares of $1,000,000. If the stock market rises, we saw that the pension fund reaps a futures profit and the stocks cost more than was anticipated. In this case, the gain on the futures offsets the increase in the cost of the shares, and the pension fund still pays out the $1,000,000 it receives in new funds plus its futures market gains in order to acquire the shares. If the stock market falls, the pension fund suffer a loss in the futures market and the stocks cost less than was anticipated. In the case of a falling market, the loss on the futures is offset by the decrease in the cost of the shares. The pension fund still pays out the full $1,000,000 it receives in order to acquire the shares and pay its loss in the futures market. Thus, the pension fund has used the futures market to secure an effective price of $1,000,000 for the shares. Once it enters the futures transaction, the pension fund knows that it will be able to buy the shares that it wants in three months when it receives the $1 million and that it will have no funds left over. Thus, the pension fund has used the futures market to reduce the risk associated with fluctuations in stock prices.

The example of the pension fund illustrates the usefulness of financial derivatives as a risk management tool. At the time the fund entered the market, it could not know whether stock prices would rise or fall. If the fund buys futures as described above and the stock market rises, the fund benefits by being in the futures market. However, if the fund buys futures and the stock market falls, the fund suffers by being in the futures market. By trading futures, the fund was effectively ensuring that it would pay $1,000,000 for the stocks it wished to purchase. This decision reduced risk. The decision protected against rising prices, but it sacrificed the chance to profit from falling stock prices.

Complexities in Risk Management

In our example of the pension fund, the risk management problem faced by the pension fund manager was quite simple. A single futures derivative served to provide a virtually complete solution to manage the risk of an anticipated purchase of stock. Risk management problems are often much more complex. This section introduces some of the complexities that frequently arise.
Exchange-traded futures and options typically have fairly brief horizons. Financial futures trade for maturity dates up to four years into the future. Exchange-traded stock options usually expire within one year. Financial risk faced by firms often has a much longer horizon. For example, a firm that issues a bond with a fixed rate of interest may be undertaking a commitment as long as 30 years. The longer the horizon, the less satisfactory are exchange-traded derivatives as risk management tools.

As we will see in more detail in Chapters 2 and 3 on futures and options, exchanges trade derivatives based on a limited array of instruments. Firms often face financial risks that are only partially correlated with the instruments that underlie financial futures or exchange-traded options. Faced with such a situation, trading a single financial derivative offers a poor solution to the risk management problem, and even a combination of exchange-traded instruments may not be satisfactory as well. For example, a U.S. auto firm might consider building a plant in Germany and financing it in German marks over the ten years it will require to build the plant. Such a transaction involves long-term interest rate risk and foreign exchange risk. It would be difficult to manage this risk with exchange-traded instruments alone.

Exchanges trade financial derivatives that are based on well-known and fairly simple single instruments. Many times, however, firms encounter financial risks that have complex payoff distributions over an extended period. For example, a firm might issue a callable convertible bond. Such an instrument can be retired upon demand by the issuer under the terms of the bond covenant. However, the same bond can be converted into stock at the discretion of the bondholder under other terms of the bond covenant. Such a complex security involves complex risks for both the issuer and the purchaser. To fully comprehend the various risks associated with such an instrument may require the services of a financial engineer. Managing the risks associated with the bond would likely require an assortment of exchange-traded financial derivatives and one or more swap agreements as well.

The Financial Engineer and Risk Management

Not all financial risk is bad, and not all financial risk should be avoided. However, prudence requires that investors understand the risks to which they are exposed and manage those risks wisely. Investing in financial instruments, borrowing, and raising funds through stock offerings all involve financial risk. When the amounts at risk are small and when the instruments employed are simple, the financial risks can be comprehended readily. However, complex risk exposures involving substantial sums of money can be very important, yet difficult, to manage, calling for the services of a financial engineer.

Markets for Financial Derivatives

As we have seen, futures exchanges arose to solve some of the problems associated with over-the-counter trading of forward contracts, and the futures market grew to dwarf the forward markets that had existed previously. Similarly, the establishment of exchange-traded options led to an explosion of option trading and resulted in option markets that are much larger and more robust than the over-the-counter option markets that came before.

The swap market, however, is newer than financial futures and exchange-traded options, yet it is strictly an over-the-counter market. Although only about 12 years old, it has grown tremendously and now poses a serious threat to the organized exchanges that trade financial derivatives. In a certain sense, these markets seem to have come full circle: over-the-counter markets gave way to organized exchange trading of futures and options, and the exchanges now appear to be giving way to a new over-the-counter market. Just as organized exchanges grew to avoid the limitations inherent in over-the-counter markets, the new over-the-counter market is emerging to overcome the limitations of exchange-based trading of financial derivatives. This section reviews the market forces that led to the introduction of trading on organized exchanges and now seem to be leading to an increasing role for over-the-counter markets.

Exchange versus Over-the-Counter Markets
We have seen that over-the-counter markets suffer from problems with credit risk when the trading parties do not know and trust each other. Further, liquidity can be low, due to the search costs in finding trading partners willing to take the other side of a desired transaction. Finally, over-the-counter contracts can be difficult to end before the prescribed date.

Organized exchanges have their own weaknesses. First, for some market participants, instruments traded on organized exchanges lack flexibility in the variety of instruments available and the horizon over which they trade. Second, futures and option exchanges are regulated by the government. While this regulation may provide some benefits, it also restricts the kinds of trading that can be conducted. Third, complying with the rules of the exchange and the regulations governing exchange trading raises the costs of trading. Fourth, some traders find fault with the public nature of exchange trading. By their very nature, futures and option exchanges are public institutions. Large traders who wish to maintain their privacy have difficulty in executing large transactions on exchanges without calling attention to their trading activity. We consider these issues in turn.

We have seen that organized exchanges for financial derivatives trade contracts that are based on popular cash market goods and that the futures and options contracts have rigid specifications. By creating this homogenous good, the exchange concentrates trading interest and promotes liquidity. Some traders will find the array of exchange-traded instruments unsatisfactory. The instruments available on the exchanges may not have the correct risk exposure characteristics or they may not have the appropriate horizon. Generally exchange-traded futures and options have only certain months in which they expire and they do not extend as far into the future as many traders would like. These traders have an incentive to turn to over-the-counter trading to tailor transactions to their exact needs.
Both futures and options exchanges are subject to regulation by the federal government. The Commodity Futures Trading Commission (CFTC) regulates the futures exchanges that trade all futures contracts and options on futures. The Securities Exchange Commission (SEC) regulates the options exchanges. In addition, traders on exchanges are subject to the rules of the exchange that constitute another layer of regulation. While these regulations may enhance the trustworthiness of the market and may make the market function better in some respects, complying with these regulations involves costs. Today, many large firms that trade financial derivatives actively are seeking to reduce their trading costs by using over-the-counter markets, particularly the swap market.

Futures and options exchanges require that all trades be publicly executed on the floor of the exchange. Traders at the exchange closely monitor the trading activity of large traders, particularly the trading of investment banking firms such as Salomon Brothers, Merrill Lynch, and Goldman, Sachs. If Merrill Lynch starts to buy, the market may recognize that Merrill is trading and anticipate a very large order. Prices would rise in anticipation of the large order, and the increase in prices would mean that Merrill would have to pay more than expected to complete its purchase. To avoid the price impact of their orders, many large firms seek to arrange privately negotiated transactions away from the exchange. By trading in the over-the-counter market, Merrill might be able to quietly contact a single counterparty that would consummate the entire transaction. By trading in the over-the-counter market, Merrill can potentially avoid the price impact of its large order, reduce its trading costs, and avoid indicating its trading intentions to the market.

The choice of executing a transaction on an exchange or in the over-the-counter market depends on the total costs of securing the desired position. With constantly improving communications and the presence of large firms that understand financial derivatives, many of the largest traders are finding that they can meet their trading objectives in the over-the-counter market. However, even after stressing the current trend of institutions to use the over-the-counter markets, they remain dominant traders on futures and options exchanges as well. The movement of financial institutions away from exchange trading allows smaller traders to have a role on the exchange that is much larger than it would be if institutions traded only on the exchanges.

The Social Role of Financial Derivatives

There are two traditional social benefits associated with financial derivatives. First, as we have already seen, financial derivatives are useful in managing risk. Second, trading financial derivatives generates publicly observable prices that provide information to market observers about the true value of certain assets and the furore direction of the economy. Society as a whole benefits from financial derivatives markets in these two ways. Thus, the financial derivatives markets are not merely a gambling den, as some would allege. While financial derivatives trading does provide plenty of opportunity for gambling, these markets confer real benefits to society as well.

From the point of view of society as a whole, the risk management and risk transference function of financial derivatives provide a substantial benefit. Because financial derivatives are available for risk management, firms can undertake projects that might be impossible without advanced risk management techniques. For example, the pension fund manager discussed earlier in this chapter may be able to reduce the risk of investing in stocks and thereby be able to improve the well-being of the pension fund participants. Similarly, the auto firm that seeks to build a plant in Germany might abandon the project if it is unable to manage the financial risks associated with it. Individuals in the economy also benefit from the risk transference role of financial derivatives. For example, most individuals who want to finance home purchases have a choice of floating rate or fixed rate mortgages. The ability of the financial institution to offer this choice to the borrower depends on the institution's ability to manage its own financial risk through the financial derivatives market.

Financial derivatives markets are instrumental in providing information to society as a whole. The existence of financial derivatives increases trader interest and trading activity in the derivatives instrument and the cash market instrument from which the derivative stems. As a result of greater attention, prices of the derivative and the cash market instrument will be more likely to approximate their true value. Thus, the trading of financial derivatives aids economic agents in price discovery--the discovery of accurate price information--because it increases the quantity and quality of information about prices. When parties transact based on accurate prices, economic resources are allocated more efficiently than they would be if prices poorly reflected the economic value of the underlying assets. Further, even mere observers of the markets gain information that is useful in making their own trading decision. As we will see in later chapters, the prices of financial derivatives gives some information about the future direction of interest rates, exchange rates, and the level of inflation. Firms and individuals can use the information discovered in the financial derivatives market to improve the quality of their economic decisions, even if they do not trade financial derivatives themselves.

Summary

This chapter has provided a brief overview of financial derivatives, their markets, and applications. We considered futures, forwards, options, options on futures, and swaps. All of these instruments play an important role in risk management, and we explored some simple examples of how traders can use derivatives to manage risks. Often these risks become complex. Financial engineering is the special branch of finance that creates tailor-made risk management techniques using financial derivatives as building blocks.

Financial derivatives trading began with over-the-counter markets. In the early 1970s, futures and options exchanges developed for financial derivatives and these exchanges provided a great impetus to the development of markets for financial derivatives. Currently, we are witnessing a re-emergence of over-the-counter markets. We compared the benefits and detriments of exchange trading versus over-the-counter markets. Finally, we considered the social role of financial derivatives and found that these markets contribute to social welfare by providing for a better allocation of resources and by providing more accurate price information on which market participants can base their economic decisions.

Questions and Problems

1. What is the essential difference between a forward contract and a futures contract?
2. Futures and options trade on a variety of agricultural commodities, minerals, and petroleum products. Are these derivative instruments? Could they be considered financial derivatives?
3. Why does owning an option only give rights and no obligations?
4. Explain the difference in rights and obligations between owning a call option and selling a put option.
5. Are swaps ever traded on an organized exchange? Explain.
6. Would all uses of financial derivatives to manage risk normally be considered an application of financial engineering? Explain
what makes an application a financial engineering application.
7. List three advantages of exchange trading of financial derivatives relative to over-the-counter trading.
8. List three advantages of over-the-counter trading of financial derivatives relative to exchange trading.
9. Consider again the pension fund manager example of this chapter. If another trader were in a similar position, except the trader anticipated selling stocks in three months, how might such a trader transact to limit risk?

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Table of Contents

Ch. 1 Introduction 1
Ch. 2 Futures 23
Ch. 3 Risk Management with Futures Contracts 69
Ch. 4 Options 96
Ch. 5 Risk Management with Options Contracts 140
Ch. 6 The Swaps Market 166
Ch. 7 Risk Management with Swaps 199
Ch. 8 Financial Engineering and Structured Products 224
Appendix 271
Questions and Problems with Answers 273
Notes 305
Index 313
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