Derivatives

What Are... Derivatives?

Prepared By Robb Davis Robert McDaniel David Bolles Mike McLatcher Calvin Grogan Amanda Hodges

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

Conventional Securities Market Amount in Billions of $

Traditional Securities 20,000 15,000 10,000 5,000 0 Bonds

Cash Types

Stocks

Types of Derivatives • • • •

Forwards Futures Options Swaps

Forwards

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.”

Forwards

Amount in Billions of $

Exchange Traded Derivatives "Forwards"

7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Interest-Rate Futures

Stock-Index Futures Types

Currency Futures

Forwards “OTC” Over-The-Counter Derivatives "Forwards" Interest-Rate Contracts 28%

Currency Contracts 72%

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

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 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.

Option Market Exchange Traded Derivatives "Options"

Types

Individual Stock Options Stock-Index Options Currency Options Interest-Rate Options 0

500

1,000

1,500

2,000

In Billions of $

2,500

3,000

3,500

Options Continued Over-The-Counter Derivitaves "Options" OTC Currency Options 29%

OTC Interest-Rate Options 71%

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

SWAPS New in the market, late 70’s early 80’s Two Types: Interest Rate & Currency

Swaps Over-The-Counter Derivatives "Swaps" Currency Sw aps 12%

Interest-Rate Sw aps 88%

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

Derivative Securities Derivitave Securities

800 600 400 200 0 Mortgage Derivatives

Structured Notes

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.

Cont’d Explanation 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.

Pass Through Derivitave Securities

800 600 400 200 0 Mortgage Derivatives

Structured Notes

Standard Securities • Stocks • Bonds • Cash

Standard Securities Amount in Billions of $

Traditional Securities

20,000 15,000 10,000 5,000 0 Bonds

Cash Types

Stocks

Total Market The standard market is what most people think of when they think of the market. The truth is that derivatives are the fastest growing sector of the market. In fact, they are the largest section of the market. We did not consider mutual funds in this presentation. There are more mutual funds in the market than there are stocks. Again, the next graph does not account for mutual funds.

Total Market Total Market: Traditional & Derivative

Total Derivatives 43%

Total Traditional 57%

Any Questions?

Seriously, Any Questions?