Essays in Derivatives E-Book

Don M. Chance

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 734

Veröffentlichungsjahr: 2011

Beschreibung

In the updated second edition of Don Chance’s well-received Essays in Derivatives, the author once again keeps derivatives simple enough for the beginner, but offers enough in-depth information to satisfy even the most experienced investor. This book provides up-to-date and detailed coverage of various financial products related to derivatives and contains completely new chapters covering subjects that include why derivatives are used, forward and futures pricing, operational risk, and best practices.

Leseprobe

Contents

Preface to the New Edition

Preface to the First Edition

SECTION ONE: Derivatives and Their Markets

ESSAY 1: The Structure of Derivative Markets

ESSAY 2: A Brief History of Derivatives

ESSAY 3: Why Derivatives?

ESSAY 4: Forward Contracts and Futures Contracts

ESSAY 5: Options

ESSAY 6: Swaps

ESSAY 7: Types of Risks

SECTION TWO: The Basic Instruments

ESSAY 8: Interest Rate Derivatives: FRAs and Options

ESSAY 9: Interest Rate Derivatives: Swaps

ESSAY 10: Currency Swaps

ESSAY 11: Structured Notes

ESSAY 12: Securitized Instruments

ESSAY 13: Equity Swaps

ESSAY 14: Equity-Linked Debt

ESSAY 15: Commodity Swaps

ESSAY 16: American versus European Options

ESSAY 17: Swaptions

ESSAY 18: Credit Derivatives

ESSAY 19: Volatility Derivatives

ESSAY 20: Weather and Environmental Derivatives

SECTION THREE: Derivative Pricing

ESSAY 21: Forward and Futures Pricing

ESSAY 22: Put-Call Parity for European Options on Assets

ESSAY 23: Put-Call Parity for American Options on Assets

ESSAY 24: Call Optionsas Insurance and Margin

ESSAY 25: A Nontechnical Introduction to Brownian Motion

ESSAY 26: Building a Model of Brownian Motion in the Stock Market

ESSAY 27: Option Pricing: The Black-Scholes-Merton Model

ESSAY 28: Option Pricing: The Binomial Model

ESSAY 29: Option Pricing: Numerical Methods

ESSAY 30: Dynamic Option Replication

ESSAY 31: Risk-Neutral Pricing of Derivatives: I

ESSAY 32: Risk-Neutral Pricing of Derivatives: II

ESSAY 33: It’s All Greek to Me

ESSAY 34: Implied Volatility

ESSAY 35: American Call Option Pricing

ESSAY 36: American Put Option Pricing

ESSAY 37: Swap Pricing

SECTION FOUR: Derivative Strategies

ESSAY 38: Asset Allocation with Derivatives

ESSAY 39: Protective Puts and Portfolio Insurance

ESSAY 40: Misconceptions about Covered Call Writing

ESSAY 41: Hedge Funds and Other Privately Managed Accounts

ESSAY 42: Spreads, Collars, and Prepaid Forwards

ESSAY 43: Box Spreads

SECTION FIVE: Exotic Instruments

ESSAY 44: Barrier Options

ESSAY 45: Straddles and Chooser Options

ESSAY 46: Compound and Installment Options

ESSAY 47: Digital Options

ESSAY 48: Geographic Options

ESSAY 49: Multi-Asset Options

ESSAY 50: Range Forwards and Break Forwards

ESSAY 51: Look back Options

ESSAY 52: Deferred Start and Contingent Premium Options

SECTION SIX: Fixed Income Securities and Derivatives

ESSAY 53: Duration

ESSAY 54: Limitations of Duration and the Concept of Convexity

ESSAY 55: The Term Structure of Interest Rates

ESSAY 56: Theories of the Term Structure: I

ESSAY 57: Theories of the Term Structure: II

ESSAY 58: Simple Models of the Term Structure: Vasicek and Cox-Ingersoll-Ross

ESSAY 59: No-Arbitrage Models of the Term Structure: Ho-Lee and Heath-Jarrow-Morton

ESSAY 60: Tree Pricing of Bonds and Interest Rate Derivatives: I

ESSAY 61: Tree Pricing of Bonds and Interest Rate Derivatives: II

ESSAY 62: Tree Pricing of Bonds and Interest Rate Derivatives: III

ESSAY 63: Tree Pricing of Bonds and Interest Rate Derivatives: IV

ESSAY 64: Tree Pricing of Bonds and Interest Rate Derivatives: V

SECTION SEVEN: Other Topics and Issues

ESSAY 65: Stock Options

ESSAY 66: Value at Risk

ESSAY 67: Stock as an Option

ESSAY 68: The Credit Risk of Derivatives

ESSAY 69: Operational Risk

ESSAY 70: Risk Managementinan Organization

ESSAY 71: Accounting and Disclosure of Derivatives

ESSAY 72: Worst Practices in Derivatives

ESSAY 73: Best Practices in Derivatives

Recommended Reading

Answers to End-of-Essay Questions

Copyright © 2008 by Don M. Chance. All rights reserved

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Chance, Don M.

Essays in derivatives : risk-transfer tools and topics made easy / Don M. Chance. – 2nd ed.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-470-08625-4 (cloth)

1. Derivative securities. 2. Risk management. 3. Investments. I. Title.

HG6024.A3C475 2008

332.64'57—dc22

2008008489

Preface to the New Edition

Those who are familiar with the first edition know that the book was a compendium of essays I wrote and posted on the Internet, back at a time when the Internet was just a toddler. Having labored over these essays and then given them away, I got this crazy idea to put them into a book and charge people money. Needless to say, the free essays were more popular than the book, but the publisher and I have been satisfied with the success of Essays in Derivatives, enough so that we have undertaken to update this book.

The first edition was published in 1998, and here we are about 10 years later. The derivatives business has gotten older, smarter, and more sophisticated. I have changed universities and at least gotten older. A lot of what I said in 1998 just won’t cut it today. And there are a lot of topics that aren’t quite as interesting today as they were in 1998, plus some that are important today that were not so back then. Thus, an updating seemed like an important thing to do.

My primary objective in a book like this is to create something about derivatives that is easy to read. Derivatives can be a painful subject to learn, and many legal pads are used up, sometimes frustratingly, in working through some of the principles covered in technical derivatives books. This book is different. While I do not advise that you curl up with it by a warm fire, a loyal dog, and a loved one, I do think you can relax in an easy chair and read it without pen and paper at your side. To that extent, this book is unique. Rarely will you find a derivatives book without equations. (OK. Technically there are some equations, but they are mostly buried within sentences and don’t jump out at you like those big offset monstrosities you see in most derivatives books.) Of course, the absence of equations comes at a cost. You cannot get yourself up to a sophisticated level in derivatives by reading this book, but you can make a great deal of headway. Learning derivatives entails climbing a steep learning curve. Getting at least part of the way there with the minimum amount of mental anguish is a major accomplishment and provides encouragement for taking the next and somewhat harder step.

For those who have read the first edition, I hope you will use this version as an opportunity to brush up. I have removed a few essays that seemed outdated, combined a few others, and added essays on why derivatives are used, volatility derivatives, weather derivatives, forward and futures pricing, risk management in organizations, worst practices in derivatives, and best practices in derivatives. Every essay has been at least partially polished if not substantially rewritten. In addition, at the end of each essay I have now provided a few practice questions so you can see if you remember what you read. (The answers are at the back of the book.) In addition, the seven major sections of the book now contain short overviews to alert you to what’s coming up. Reading lists have been updated to include material that has emerged in the last 10 years.

If you are already an expert in derivatives, this book will not teach you much. It is quite elementary. But if anyone has ever asked you where to get started (and I have certainly gotten that question many times), this book should be a good answer. Take it for what it is intended to be: an easy-to-read introduction. No more, no less. For those trying to learn the topic for the first time, read it and see if you don’t agree: A basic understanding of derivatives need not be hard, and it can be fun to read about. (OK. Maybe “fun” isn’t the word. Maybe it’s “enjoyable.”) And if it isn’t, you will at least have saved some money over the monster tome you probably would have bought if this book hadn’t come along.

As usual, many people contribute to the production of a book. I want to thank the Wiley folks: Bill Falloon, Emilie Herman, Laura Walsh, Pamela van Giessen, and Christina Verigan. I also want to thank Frank Fabozzi for his publishing of the first edition of this book and his encouragement for this revision. I also thank my family: Jan, Kim, Ashley, Michael, Joel, Kurt, Sadie, and Hunter. (Note: Some of these are dogs, and they do get credit. Writing a book is hard enough without a little laughter.)

As always, I invite your comments and suggestions. Send them to me at [email protected]. With enough praise for encouragement or complaints to fix, maybe there’ll be a third edition. But give me another 10 years, please.

DON M. CHANCE, PH.D., CFA

Baton Rouge, Louisiana

March 2008

Preface to the First Edition

This book had its origins on a sleepless night when I discovered that the Internet was a great place to convey ideas.1 I had found the UseNet group misc.invest.futures, which was the only user group whose discussions were focused on derivatives. Misc.invest.futures struck me as a group whose conversation was largely dominated by someone selling a new futures trading service, a discount brokerage firm, or someone with an opinion about whether a commodity had “bottomed out” according to some technical indicator. Even worse were those people offering astrological advice for futures trading. Amid all of this commercialism and hype, it appeared to me that the readership had a thirst for knowledge of another sort: simple, to the point, and not motivated by a big sale. I am, of course, as profit-oriented as anyone else, but being new to the Internet, I decided to make my entry on a pro bono basis, with the hope that down the road there might be some profits, however modest they are likely to be.2

Thus was born my weekly column on derivatives, which later was called Derivatives Research Unincorporated or DRU.3 Over the next 52 weeks, I posted a total of 41 essays to the misc.invest.futures group, simultaneously depositing them into an electronic filebox where they were available for downloading. The feedback I received was surprising, overwhelming, and, above all, gratifying. Virtually every week I received a new e-mail from a reader somewhere around the world, many asking how to obtain personal subscriptions, which I would not do. I was even getting requests for topics, making me feel somewhat like a disk jockey, spinning the platters of derivatives.

Soon others began placing pointers to DRU on their home pages, and DRU began to be mentioned in articles about sources available on the Internet in the area of derivatives. My readers ranged from individuals seeking a little extra knowledge, to technically skilled personnel of major financial institutions, to college students and professors. I seemed to have developed something of a cult following like the Rocky Horror Picture Show! People e-mailed to complain if I disappeared for a couple of weeks.

The second year I wrote another 20 or so essays. I finally quit writing them when it was taking too much time, I was getting too many e-mails from people with questions, and I was running out of topics that could be written up in simple, nontechnical language. When I posted my last essay in September 1996, I thought DRU had come to an end. The phone calls and e-mails continued to the point that I was beginning to feel like the Ann Landers of derivatives. Repeated efforts to discourage people from contacting me were mildly successful. What I wanted was that people would read the essays, perhaps refer to my main home page (www.cob.vt.edu/finance/faculty/dmc), and take advantage of any other writings, documents, or links that I had posted but, generally, leave me alone. At around the same time, I had reached an agreement with a major business publishing group to have the essays published in hard-copy form. A long and complicated story later, we broke off the arrangement. Since that time, I continued to be contacted by individuals and firms who enjoyed the essays.

About a year later, Frank Fabozzi found my web site. Frank and I had enjoyed a productive business relationship a few years back but had not talked in several years. One thing led to another, and Frank agreed to publish these essays in his own publishing venture, Frank J. Fabozzi Associates (www.frankfabozzi.com). I believe you will agree that Frank has done an excellent job with his own publishing venture, and I am pleased to now be a part of it.

The original essays all sounded like a conversation with an unidentified person, namely the Internet surfer. There were no charts or graphs, with the exception of a few figurelike tables necessary to illustrate binomial trees. There were no complex equations, and the number of simple equations was kept to an absolute minimum. The tone was informal and written in fairly nontechnical language. People told me repeatedly how beneficial this approach was to them. In this book version, each essay has been rewritten, maintaining the basic qualities that made them attractive, while simply polishing the language and removing references that suggested that this was a posting on an Internet site.

The level of knowledge I assume in the reader is pretty low. I would say that one should already know the definitions of options and futures. That’s about it. I have been told that the essays appeal to individuals at all levels of expertise. Beginners will particularly find them useful, and experts seem to appreciate the simple manner in which such seemingly complicated subjects can be presented. They have been used in college classes as well as in corporations, financial institutions, and government agencies in training employees, executives, and clients. With all of this given freely to the rest of the world, don’t you think I deserve to earn at least one hour at minimum wage?

In the original versions, the essays were written and posted in whatever order a topic came to me. Now they have been grouped into logical sections. In addition, 10 new essays have been added to fill in some gaps. In some of the essays there is a list of articles called For More Reading. I chose these articles very carefully. Any article mentioned in an essay is included. Otherwise, I tried to include only classic articles, articles that are pretty much standard references for these topics, and articles that are exceptionally well written and at a slightly higher level than that of these essays. Obviously some of you will disagree, especially with omissions. To this I say, you’re probably right, but you’ll have to write your own book.

At the end of this book is a reading list of books in derivatives, arranged in various groups, with some commentary about each group and a selected few of the titles. After reading these essays, this collection of books is where I would go next.4

Also be aware that I maintain a large collection of materials and links at my web site (www.cob.vt.edu/finance/faculty/dmc). Clicking on the “Courses” menu choice gives you free access to an extensive collection of lecture notes and a set of materials called “Teaching Notes,” which to some extent are more advanced versions of some of the essays in this book. You might also enjoy a site called DerivaQuote, which is a collection of quotations about derivatives, with a few others on finance in general. As with most sites, this one is dynamic, with new quotes added as I stumble on them. There is also a dynamic bibliography of all published articles I can find on modeling the term structure and pricing interest rate derivatives. Who knows what else there will be by the time you’re reading this.

Please send me your feedback on this book by e-mail ([email protected]) or snail mail (Department of Finance, Pamplin College of Business, Virginia Tech, Blacksburg, VA 24061), or give me a call at 540-231-5061 or a fax at 540-231-3155. Maybe there will be a second edition someday, and your input would be useful.

There is still a long way to go before people understand and appreciate derivatives as well as they do stocks and bonds. I hope these essays will contribute to the general knowledge level and help dispel the myths about derivatives. But please don’t send me your questions on how to solve your personal or corporate derivatives problems. I just cannot respond to all of the requests I receive of this type.

And please, don’t ask me to write any more articles for the Internet.

Don M. Chance, Ph.D., CFA

Blacksburg, VA

1998

1 Maybe this is because almost everything on the Internet is free or very inexpensive, and it’s hard for people to complain that they’re not getting their money’s worth.

2 If you’re reading this at a book store or library, please go out and buy the book. In fact buy an extra copy for a loved one. (Just kidding, unless you’re in love with a derivatives person.)

3 I cannot legally tell you what it was originally called, but many of you already know and others can guess.

4 Don’t forget to get my other book An Introduction to Derivatives, 4th ed., the Dryden Press (1998), ISBN 0-03-024483-8, which you can have ordered by any book store, or through www.amazon.com or by calling Harcourt Brace at 1-800-782-4479. It’s expensive, but so is everything else on this subject.

SECTION One

Derivatives and Their Markets

A derivative is a contract between two parties that provides for a payoff from one party to the other based on the performance of an underlying asset, currency, or interest rate. The payoff of the derivative is said to be “derived” from the performance of something else, which is often called the underlying asset or just the “underlying.” As noted all derivatives have two parties, who are typically known as the “buyer” and “seller” or sometimes the “long” and “short.” The short is even sometimes referred to as the “writer.” Derivatives almost always have a defined life. That is, they typically expire on a specific date. The payments made on a derivative are sometimes made partially at the start, sometimes made during the life of the derivative, and sometime made at the expiration. Some derivatives can be terminated early. Some derivatives have their payoffs made in cash and some have their payoffs made in the underlying or even in another asset. Derivative contracts can be informally negotiated between two parties or can be created on a derivatives exchange. Some types of derivatives are regulated and others are essentially unregulated.

The four basic types of derivatives are forward contracts, futures contracts, options, and swaps. Other types of derivatives can be created by blending some of these derivatives with the underlying. Some people also refer to asset-backed securities as derivatives and we will cover these in this book.

Understanding derivatives requires an understanding of what their payoffs would be given the payoff of the underlying. Options, for example, pay off either a given amount of money that is determined by the underlying or they pay off nothing. Forwards, futures, and swaps on the other hand almost always pay off something. Their payoffs are driven nearly one-for-one by what the underlying does. Understanding derivatives also requires an appreciation for the circumstances under which a derivative would be appropriately used. That is, why would someone use a derivative and if they would, why would they use one type of derivative instead of another? Finally and perhaps most importantly, understanding derivatives requires an understanding of how they are priced. If you pay $5 for an option on a stock or enter into an interest rate swap promising to pay a fixed rate of 6%, why $5 and 6%?

Grasping the basic ideas behind derivatives is not too difficult. I predict that you will have little trouble understanding the four basic types of derivatives and will know the kinds of situations in which one might be used and preferred over another. The hardest part is indeed understanding the pricing. All of this material is covered in this book. We work you up to it slowly and (hopefully) painlessly.

This first section covers the basics. Essay 1 describes how the derivatives markets are organized. The second essay is an update of paper I wrote years ago on the history of derivatives markets that proved to be very popular. It takes you from ancient times to today. The third essay explains why derivatives exist and what they are used for. Essays 4–6 introduce the four basic types of derivatives. Essay 7 then explains the types of risks that these instruments are designed to protect against.

ESSAY 1

The Structure of Derivative Markets

It has been said in the past that derivatives are kind of a sideshow, where the main event takes place in the money and capital markets. You could attend the sideshow without taking part in the main event and vice versa. With respect to derivative and money/capital markets, that is simply not true today. Derivatives are so widely used that even if you have no intention of using them, it is important to understand how they are used by others and what effects, positive and negative, they could have on money and capital markets.

As you probably know, the money market consists of the over-the-counter markets for various short-term securities, such as Treasury bills, bank certificates of deposit, and commercial paper. The capital market consists of organized stock exchanges, such as the New York Stock Exchange, the American Stock Exchange, the Philadelphia Stock Exchange, and the Midwest Stock Exchange, to name a few. In addition there is the well-known National Association of Securities Dealers, otherwise known as Nasdaq, which is the principal over-the-counter market for securities. A small amount of corporate bond trading occurs on the New York Stock Exchange and the American Stock Exchange. By far, however, the preponderance of corporate bonds and all government bonds and asset-backed securities trade on the over-the-counter markets, which are simply dealers who stand willing to trade on either side of the market.

From around the middle nineteenth century until around 1990, it was probably correct to say thought that the center of the derivatives industry was Chicago. This belief from 1973 on, was due to the futures trading at the Chicago Mercantile Exchange and the Chicago Board of Trade and, the options trading at the Chicago Board Options Exchange. From the early 1990s on, however, the explosive growth in the global markets for swaps and other over-the-counter derivatives created new centers in New York, London, and Tokyo. The over-the-counter derivatives market is quite simply any firm willing to do either side of a derivatives transaction. These dealers stand ready to buy and sell derivatives with a spread between their bid and ask prices. By hedging their remaining exposure, they would, with sufficient volume, generate a profit. The competition in this market grew, however, reducing profit margins to paper thin, but few players exited the market. Today it remains a large and active market.

On the other side of derivatives transactions are the parties called end users. These are primarily corporations that face certain types of risks. For example, firms engaged in multinational business nearly always have foreign exchange risk. Firms that use various commodities as raw materials, such as airlines using jet fuel, face exposure to price changes. Virtually all firms borrow money and are thus exposed to the risk of interest rate changes. Most end users are corporations hedging one or more of these types of risks. A typical corporation does not use derivatives heavily but selectively chooses to hedge a particular risk with which it feels uncomfortable. Such transactions typically come out of the corporation’s treasury department. Some corporate treasurers, however, engage in speculative trading, sometimes due to pressure to make money or reduce costs by trading. We will hear this point again in Essay 72.

In addition, investment managers face interest rate risk, foreign exchange risk, and the risk of stock price movements. Although investment managers are much more in the business of dealing with financial market risks than are corporate treasurers, derivatives are more widely used in the corporate world than in the investment world. This point is probably true because so many investment managers are either pension fund or mutual fund managers whose charters restrict their use of certain types of instruments like derivatives and require them to adhere to well-accepted fiduciary guidelines. Corporations, however, have far fewer restrictions placed on them by their shareholders and are not considered fiduciaries in the sense that a pension fund manager is.

Some state, local, and foreign governments are also active users of derivatives. The United States government, however, does not directly engage in derivative transactions. Some of its agencies, such as the Postal Service, have used derivatives. In addition the U.S. government at one time issued callable bonds, which are ordinary bonds with an embedded derivative.

The derivatives industry also consists of software and consulting firms. The financial software industry has grown rapidly from a few small firms to at least 50 firms, but in recent years has consolidated through mergers and acquisitions. Consulting firms perform studies and give advice on firms’ derivatives operations, typically with an eye toward ensuring that adequate controls are in place. When problems occur, consulting firms often assist firms in sorting out the problems and dealing with the fallout. In some cases these consulting firms are well-known public accounting firms.

Finally, whenever an industry grows as rapidly as has the derivatives industry, combined with the fact that the amounts of money at stake are large, a concomitant growth in the number of lawyers and law firms involved in derivative transactions can be expected. In the early stages of the growth of the exchange-listed derivatives industry, law firms primarily dealt with the occasional law suits between clients and brokers. As the over-the-counter industry grew, the legal aspects of derivatives came to include the importance of proper documentation of each contract. Lawyers were increasingly called on to assist those organizations experiencing derivatives losses in transactions with dealers to sue the dealers, claiming that they were misled and that they had viewed the dealers as advisors and not adversaries. And while all derivatives dealers have their own legal staff, most use outside attorneys to defend themselves when they are sued. Today derivatives attorneys continue to do this kind of work but also perform more due diligence and compliance work, meaning that they attempt to prevent legal problems before they occur rather than deal with them afterward.

Thus, we see that the derivatives industry has a diverse group of participants. It is a dynamic and exciting industry that has grown rapidly but still has much potential for becoming even larger and more diverse.

TEST YOUR KNOWLEDGE

1. Explain the difference between a dealer and an end user.

2. Why are derivatives used more by corporations than by investment funds?

3. How does the U.S. government use derivatives?

ESSAY 2

A Brief History of Derivatives

The history of derivatives is quite colorful and surprisingly a lot longer than most people think. A few years ago I compiled a list of the events that I thought shaped the history of derivatives. That list is published in its entirety in the Winter 1995 issue of Derivatives Quarterly, the full citation of which is at the end of this essay.1 What follows here is a snapshot of the major events that I think form the evolution of derivatives.

I would like to first note that some of these stories are controversial. Do they really involve derivatives? Or do the minds of people like myself and others see derivatives everywhere?

To start we need to go back to the Bible. In Genesis Chapter 29, believed to be about the year 1700 BC, Jacob purchased an option costing him seven years of labor that granted him the right to marry Laban’s daughter Rachel. His prospective father-in-law, however, reneged, perhaps making this not only the first derivative but the first default on a derivative. Laban required Jacob to marry his older and notably less attractive daughter Leah. Jacob married Leah, but because he preferred Rachel, he purchased another option, requiring seven more years of labor, and finally married Rachel, bigamy being allowed in those days. Jacob ended up with two wives and 12 sons who became the patriarchs of the 12 tribes of Israel, and a lot of domestic friction, which is not surprising. Some argue that Jacob really had forward contracts, which obligated him to the marriages, but that does not matter. Jacob did derivatives, one way or the other. Around 580 BC, Thales the Milesian purchased options on olive presses and made a fortune off a bumper crop in olives. So derivatives were around before the time of Christ.

The first exchange for trading derivatives appeared to be the Royal Exchange in London, which permitted forward contracting. The celebrated Dutch tulip bulb mania, which you can read about in Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, published in 1841 but still in print, was characterized by forward contracting on tulip bulbs around 1637. The first “futures” contracts are generally traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today’s futures, although it is not known if the contracts were marked to market daily and/or had credit guarantees.

Probably the next major event, and the most significant as far as the history of U.S. futures markets, was the creation of the Chicago Board of Trade in 1848. Due to its prime location on Lake Michigan, Chicago was developing as a major center for the storage, sale, and distribution of midwestern grain. Due to the seasonality of grain, however, Chicago’s storage facilities were unable to accommodate the enormous increase in supply that occurred following the harvest. Similarly, its facilities were underutilized in the spring. Grain prices rose and fell drastically.

To help stabilize prices, a group of grain traders created the “to-arrive” contract, which permitted farmers to lock in the price and deliver the grain later. This mechanism allowed the farmer to store the grain either on the farm or at a storage facility nearby and deliver it to Chicago months later. These to-arrive contracts proved useful as a device for hedging and speculating on price changes. Farmers and traders soon realized that the sale and delivery of the grain itself was not nearly as important as the ability to transfer the price risk associated with the grain. The grain could always be sold and delivered elsewhere at another time. These contracts were standardized around 1865, and in 1925 the first futures clearinghouse was formed. From that point on, futures contracts were pretty much of the form we know them today.

In the mid-1800s, famed New York financier Russell Sage began creating synthetic loans using the principle of put-call parity, which is discussed in more detail in Essays 22 and 23. Sage would buy the stock and a put from his customer and sell the customer a call. By fixing the put, call, and strike prices, Sage was creating a synthetic loan with an interest rate significantly higher than usury laws allowed.

One of the first examples of financial engineering was by none other than the beleaguered government of the Confederate States of America, which issued a dual-currency optionable bond. This instrument permitted the Confederate States to borrow money in sterling with an option to pay back in French francs. The holder of the bond had the option to convert the claim into cotton, the South’s primary cash crop.

Interestingly, futures/options/derivatives trading was banned numerous times in Europe and Japan and even in the United States in the state of Illinois in 1867, though the law was quickly repealed.

In 1874 the Chicago Mercantile Exchange’s predecessor, the Chicago Produce Exchange, was formed. It became the modern-day Merc in 1919. Other exchanges had been popping up around the country and continued to do so.

The early twentieth century was a dark period for derivatives trading, as bucket shops were rampant. Bucket shops are small operators in options and securities that typically lure customers into transactions and then flee with the money, setting up shop elsewhere.

In 1922 the federal government made its first effort to regulate the futures market with the Grain Futures Act. In 1936 options on futures were banned in the United States. All the while options, futures, and various derivatives continued to be banned from time to time in other countries.

The 1950s marked the era of two significant events in the futures markets. In 1955 the Supreme Court ruled in the case of Corn Products Refining Company that profits from hedging are treated as ordinary income. This ruling stood until it was challenged by the 1988 ruling in the Arkansas Best case. The Best decision denied the deductibility of capital losses against ordinary income and effectively gave hedging a tax disadvantage. Fortunately, this interpretation was overturned in 1993.

Another significant event of the 1950s was the ban on onion futures. Onion futures do not seem particularly important, though that is probably because they were banned, and we do not hear much about them. But the significance is that a group of Michigan onion farmers, reportedly enlisting the aid of their congressman, a young Gerald Ford, succeeded in banning a specific commodity from futures trading. To this day, the law in effect says, “you can create futures contracts on anything but onions.”

In 1972 the Chicago Mercantile Exchange (CME), responding to the now–freely floating international currencies, created the International Monetary Market, which allowed trading in currency futures. These instruments were the first futures contracts that were not on physical commodities. In 1975 the Chicago Board of Trade (CBOT), created the first interest rate futures contract, one based on Ginnie Mae (GNMA) mortgage-backed securities. While the contract met with initial success, it eventually died. The CBOT resuscitated it several times, changing its structure, but it never became viable. In 1975 the Merc responded with the Treasury bill (T-bill) futures contract. This contract was the first successful pure interest rate futures. It was held up as an example, either good or bad depending on your perspective, of the enormous leverage in futures. For only about $1,000, and later less than that, you received the price volatility of $1 million of T-bills. In 1977 the CBOT created the T-bond futures contract, which went on to be the highest-volume contract for about 200 years. In 1982 the CME created the Eurodollar contract, which has now surpassed the T-bond contract to become the most actively traded of all futures contracts. In 1982 the Kansas City Board of Trade launched the first stock index futures, a contract on the Value Line Index. The CME quickly followed with their highly successful contract on the Standard & Poor’s 500 index.

Now let us step back to 1973, which was a watershed year for the derivatives industry. Early in the year, the Chicago Board of Trade created the first options exchange, which was named the Chicago Board Options Exchange (CBOE). Prior to this time, options had been traded only in an over-the-counter market conducted by a handful of dealer firms. The CBOE provided the first organized options market. It created a set of standardized options on 16 individual stocks that would be offered by a group of dealers who would make markets in these options. Thus, investors could buy and sell options as easily as they bought and sold stocks. Also, during that year, the Journal of Political Economy published an article written by MIT economists Fischer Black and Myron Scholes that contained a formula for valuing an option. At almost the same time the Bell Journal of Economics and Management Science published a paper by Robert Merton that contained the same formula. The model initially became known as the Black-Scholes model, but given the significance of Merton’s contribution, I will call it the Black-Scholes-Merton model. It is covered in Essay 27. At the time of its publication, the model seemed a relatively minor contribution to academic discussions. It quickly became clear, however, that the model would be useful to those who trade options. In particular, the CBOE market makers could use the model not only to price options but to also hedge the transactions they were obligated to do as providers of liquidity.

Soon thereafter, options began trading at the American Stock Exchange, the Philadelphia Stock Exchange, and the Pacific Stock Exchange. The New York Stock Exchange also got into the act, but a little too late and eventually sold its small options business to the Pacific Exchange, which eventually sold it back to the New York Stock Exchange, where it operates today under the name of Arca-Ex.

In 1983 the Chicago Board Options Exchange (CBOE), decided to create an option on an index of stocks. Though originally known as the CBOE 100 Index, it was soon turned over to Standard & Poor’s and became known as the S&P 100, which for many years was the most actively traded exchange-listed option.

The 1980s marked the beginning of the era of swaps and other over-the-counter derivatives. Although over-the-counter options and forwards had existed previously, the corporate financial managers of that decade were the first to come out of business schools with exposure to derivatives. Soon virtually every large corporation, and even some that were not so large, was using derivatives to hedge and, in some cases, speculate on interest rate, exchange rate, and commodity risk. New products were rapidly created to hedge the now-recognized wide varieties of risks. As the problems became more complex, Wall Street turned increasingly to the talents of mathematicians and physicists, offering them new and quite different career paths and unheard-of money. The instruments became more complex and were sometimes even referred to as “exotic.”

In 1994 the derivatives world was hit with a series of large losses on derivatives trading announced by some well-known, and highly experienced firms.2 These and other large losses led to a huge outcry, sometimes against the instruments and sometimes against the firms that sold them. While some minor changes occurred in the way in which derivatives were sold, most firms simply instituted tighter controls and continued to use derivatives.

But everything that happened in 1994 was not bad. JP Morgan Co. launched an innovative Internet-based service called RiskMetrics. Risk-Metrics evolved out of the company’s own efforts to manage its risk. Several years earlier JP Morgan chairman Sir Dennis Weatherstone had asked his subordinates to create a report that would appear on his desk at 4:15 every day that would give an indication of the money that the bank could lose in its trading positions. This report, which came to be known as the “4:15 Report,” is said to have launched the use of a concept called “Value at Risk,” which is covered in Essay 66. Value at Risk or VaR requires an extensive amount of data on historical interest rates, exchange rates, commodity prices, and stock prices. In 1994 the bank made a bold decision to publish the data on its web site every day, thereby giving the data away for free. Many people criticized the bank, and others thought it had lost its notion that bank services do not come free. But the bank responded that giving the data away would encourage others to practice good risk management. Moreover, the bank would benefit from the consulting services it could provide to users of the data. The concept worked, and RiskMetrics was so successful that the company created another service called Credit-Metrics and eventually spun off the operation from the bank into its own successful entity.

In 1995 Fischer Black died. He had been one of the first academics to leave the ivory towers and go to Wall Street, setting the stage for a large flow of academics to Wall Street. His death precluded him from receiving the Nobel Prize in Economics that was awarded in 1997 to Scholes and Merton.

The year 1998 was a rough one for financial markets. A financial crisis related to Russia and several Asian countries led to the default of a large hedge fund, Long Term Capital Management (LTCM), which had been started by Scholes and Merton along with a former Federal Reserve governor and a veteran Wall Street bond trader. The Federal Reserve negotiated a large bailout from the fund’s creditors, a group of Wall Street banks, but the damage had long-term implications for derivatives markets. LTCM was a big user of derivatives, and its demise left everyone wondering once again if derivatives were tools that could be abused to the detriment of more than just the user. Other large derivatives losses occurred in 2002 with the National Australian Bank, in 2004 with China Aviation Oil Company, and in 2008 with Société Générale. But in comparison to the problems of the early 1990s, large and uncontrolled derivatives losses were much less common.

In the year 2000 the Financial Accounting Standards Board issued its rule FAS 133 that for the first time forced U.S. companies and companies listed on U.S. exchanges to record derivatives on the balance sheet and income statement. The international community responded with its own version of the rule, IAS (International Accounting Standard) 39, but this rule did not go into effect until 2005.3 The year 2000 also saw the creation of a new options exchange, the International Securities Exchange (ISE), which is a completely electronic exchange. The ISE has been a remarkable success and in a few short years, its volume of options on individual stocks surpassed that of the CBOE.

Several notable events occurred in 2002. The Chicago Mercantile Exchange became a publicly traded company, leading to a wave of new such conversions by derivatives exchanges. The CBOT and ISE went public in 2005. The large European exchanges of LIFFE (London International Financial Futures Exchange) and EuroNext merged to become a very large exchange that would threaten the competitive edge held by the three Chicago exchanges.

Futures on individual stocks had existed outside of the United States for a number of years, but in 2002 they began trading in the United States. Although two markets opened up, a consortium of the CBOT, CME, and CBOE called OneChicago is the only one that survived. Volume in single stock futures, however, has never lived up to expectations in the U.S.

In the fall of 2006 one of the most important announcements in the history of derivatives markets occurred. Crosstown rivals the Chicago Board of Trade and the Chicago Mercantile Exchange announced a $25 billion merger. The two exchanges had begun joint clearing several years earlier and had flirted with merger talks from time to time. But the marriage of these two mega-exchanges was the termination of a long history of rivalry and ushered in a new era for the derivatives industry.

As a final note, one of the most talked-about events in the derivatives business is the new set of bank capital regulations. Because banks are so heavily into derivatives market making, banking regulators have always been concerned about the risk to the banking system from the use of derivatives. The Basel Committee on Banking Supervision, which is sponsored by the Bank for International Settlements in Basel, Switzerland, first issued a set of advisory guidelines for global banking regulators in 1988, which was amended in 1996. These guidelines are an attempt to harmonize banking regulations around the world. In 1999 the Committee began work on new regulatory guidelines, which culminated in a document known as Basel II that went into effect in 2007. Although the guidelines are not mandatory, Basel II is considered to be a major improvement over the original guidelines, but it does remain controversial and will likely be scrutinized and amended in future years.

These stories hit the high points in the history of derivatives. Even my aforementioned “Chronology” cannot do full justice to its long and colorful history. The future promises to bring new and exciting developments. Stay tuned.

FOR MORE READING

Bernstein, Peter L. Against the Gods: The Remarkable Story of Risk. New York: John Wiley & Sons, 1996.

Bernstein, Peter L. Capital Ideas: The Improbable Origins of Modern Wall Street. New York: The Free Press, 1992.

Black, Fischer, and Myron Scholes. “The Pricing of Options and Corporate Liabilities.” The Journal of Political Economy 81 (1973): 637–653.

Chance, Don M. “A Chronology of Derivatives.” Derivatives Quarterly 2 (Winter 1995): 53–60,

Derman, Emanuel. My Life as Quant: Reflections on Physics and Finance. Hoboken, NJ: John Wiley & Sons, 2004.

Mackay, Charles. Extraordinary Popular Delusions and the Mdness of Crowds. New York: Harmony Books, 1841; reprint 1980.

Merhling, Perry. Fischer Black and the Revolutionary Idea of Finance. Hoboken, NJ: John Wiley & Sons, 2005.

Merton, Robert C. “Theory of Rational Option Pricing.” Bell Journal of Economics and Management Science 4 (Spring 1973): 141–183.

Tamarkin, Bob. The Merc: The Emergence of a Global Financial Powerhouse. New York: HarperBusiness, 1993.

TEST YOUR KNOWLEDGE

1. How did futures contracts begin in the United States?

2. What two events occurred in 1973 that revolutionized the options industry?

3. What were the first futures contracts not on commodities?

4. On what exchange and when was the first stock index futures contract created?

5. What landmark decision did JP Morgan Co. make in 1994 that facilitated greater transparency in risk management?

1 This article is out of print, but please do not ask me for a copy unless you are engaged in serious professional research on the history of derivatives. For anyone else, the high points are covered in this essay, and I would suggest that you do not spend a lot of time on the details of derivatives history. It’s not that important.

2 We cover some of these stories in Essay 72.

3 Accounting for derivatives is covered in Essay 71.

ESSAY 3

Why Derivatives?

In this essay we shall take a look at why derivatives exist. No, this is not some existentialist Monty Python “What is the meaning of derivatives?” treatise. It’s not really that profound. What we want to know is why derivatives exist, which is to say, why people use them and why they are not dominated by other instruments.

To understand this question, we must first look at what derivatives really are. Yes, we know they are instruments in which the performance is derived from some other instrument or asset. But more fundamentally, we need to see derivatives as instruments that permit the transfer of risk from one party to another. Each derivative transaction has two parties, a buyer and a seller. Typically the buyer pays to transfer the risk to the seller. The seller accepts payment to compensate for the assumption of risk.1 A description of this sort would apply to an insurance contract, and indeed derivatives should be viewed like insurance. One party pays or gives up something to get another party to accept the risk.

Derivatives are not the only means of transferring risk. For example, an investor could purchase a put option to protect a stock or portfolio against downside loss, a strategy known as a protective put, which we cover in Essay 39. As an alternative, the investor could just liquidate the portfolio and put the money in some other stock, index, bond, or a risk-free asset. In other words, transactions in the actual assets that are exposed to the underlying risk are possible. But transactions in assets can be extremely expensive. The cost of liquidating stocks and bonds is not terribly high, but moving the money to other assets does add another layer of cost. And then at a later date, you might want to reverse the transaction and return to the original position. And transacting in some assets can be quite expensive. Picture the owner of a million barrels of oil selling them. It is not just a matter of signing a few pieces of paper. That heavy oozy stuff has to be moved somewhere. But cost is not the only factor.