Financial Derivatives E-Book

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Robert W. Kolb Series
• Sprache: Englisch

Seitenzahl: 1215

Veröffentlichungsjahr: 2009

Beschreibung

Essential insights on the various aspects of financial derivatives If you want to understand derivatives without getting bogged down by the mathematics surrounding their pricing and valuation, Financial Derivatives 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 introduces 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, swaps, and structured products-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. Filled with helpful tables and charts, Financial Derivatives offers a wealth of knowledge on futures, options, swaps, financial engineering, and structured products. * Discusses what derivatives are and how you can prudently implement them within the context of your underlying business activities * Provides thorough coverage of financial derivatives and their role in risk management * Explores financial derivatives without getting bogged down by the mathematics surrounding their pricing and valuation This informative guide will help you unlock the incredible potential of financial derivatives.

Leseprobe

Table of Contents

Title Page

Copyright Page

Introduction

Acknowledgements

PART I - Overview of Financial Derivatives

CHAPTER 1 - Derivative Instruments

INTRODUCTION

A GENERALIST’S APPROACH TO DERIVATIVE CONTRACTS

STRUCTURED PRODUCTS AND AN APPLICATION TO DERIVATIVE CONTRACTS

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 2 - The Derivatives Marketplace

INTRODUCTION

STANDARDIZATION VERSUS CUSTOMIZED PRODUCTS: DIFFERENCES IN STRUCTURE AND APPROACH

COMPETITION AND CONSOLIDATION: IMPETUS FOR CHANGE

MOVING FROM BILATERAL TO MULTILATERAL RISK MANAGEMENT

TRANSPARENCY AND INFORMATION IN THE EXCHANGE AND OTC MARKETPLACES

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 3 - Speculation and Hedging

HEDGING TRANSACTIONS

SPECULATION

FROM HEDGING TO SPECULATION

INTERACTION BETWEEN HEDGERS AND SPECULATORS

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 4 - The Social Functions of Financial Derivatives

HEDGING AND RISK TRANSFER

PRICE DISCOVERY

INTERTEMPORAL RESOURCE ALLOCATION

ASSET FINANCE

SYNTHETIC ASSET ALLOCATION

ENDNOTES

FURTHER READING

REFERENCES

ABOUT THE AUTHOR

PART II - Types of Financial Derivatives

CHAPTER 5 - Agricultural and Metallurgical Derivatives

INTRODUCTION

COMMODITIES

SEASONALITY IN SPOT AND FUTURES PRICES

FUTURES PRICING

CONCLUSION

REFERENCES

SUGGESTED FURTHER READING

ABOUT THE AUTHOR

CHAPTER 6 - Agricultural and Metallurgical Derivatives

INTRODUCTION

COMMODITIES

DERIVATIVES

COMMODITY INVESTMENT STRATEGIES

HEDGING

SPREADS

CONCLUSION

REFERENCES

SUGGESTED FURTHER READING

ABOUT THE AUTHOR

CHAPTER 7 - Equity Derivatives

INTRODUCTION

STOCK OPTIONS

EQUITY FUTURES

EQUITY SWAPS

FUTURE OF EQUITY DERIVATIVES

REFERENCES

FURTHER READING

ABOUT THE AUTHORS

CHAPTER 8 - Foreign Exchange Derivatives

BASIC PRICING PRINCIPLES

FOREIGN EXCHANGE FORWARD AND FUTURES CONTRACTS

FOREIGN EXCHANGE OPTIONS

FX OPTION PRICING

PLAIN VANILLA FOREIGN EXCHANGE SWAPS

FLAVORED CURRENCY SWAPS

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 9 - Energy Derivatives

INTRODUCTION

PRODUCTS: AN OVERVIEW

HISTORY

PETROLEUM DERIVATIVES: DETAILS

NATURAL GAS DERIVATIVES: DETAILS

ELECTRICITY DERIVATIVES: DETAILS

PRICING

CLEARING

RECENT DEVELOPMENTS

REFERENCES

ABOUT THE AUTHOR

CHAPTER 10 - Interest Rate Derivatives

EXCHANGE-TRADED (LISTED) DERIVATIVES

OVER-THE-COUNTER DERIVATIVES

FURTHER READING

ABOUT THE AUTHOR

CHAPTER 11 - Exotic Options

OVERVIEW

FORWARD-START OPTIONS

COMPOUND OPTIONS

CHOOSER OPTIONS

BARRIER OPTIONS

BINARY OPTIONS

LOOKBACK OPTIONS

ASIAN OR AVERAGE PRICE OPTIONS

EXCHANGE OPTIONS

RAINBOW OPTIONS

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 12 - Event Derivatives

TYPES OF PREDICTION MARKETS

APPLICATIONS AND EVIDENCE

ACCURACY OF PREDICTION MARKETS

POSSIBILITIES FOR ARBITRAGE

CAN EVENT MARKETS BE MANIPULATED EASILY?

MARKET DESIGN

MAKING INFERENCES FROM PREDICTION MARKETS

INNOVATIVE FUTURE APPLICATIONS?

ACKNOWLEDGMENTS

ENDNOTES

REFERENCES

ABOUT THE AUTHORS

CHAPTER 13 - Credit Default Swaps

CREDIT DEFAULT SWAPS ON CORPORATE DEBT

CREDIT DEFAULT SWAPS ON ASSET-BACKED SECURITIES

CREDIT DEFAULT SWAPS ON COLLATERALIZED DEBT OBLIGATIONS

THE BASIS

CDS INDICES

TRANCHES OF CDS INDICES

TRADING STRATEGIES USING INDEXES AND TRANCHES

MARKET DYNAMICS: CDS AND CDOS

SYNTHETIC CDOS AND BESPOKES

CORRELATION

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 14 - Structured Credit Products

ASSET-BACKED SECURITIES

COLLATERALIZED DEBT OBLIGATIONS

COMMERCIAL MORTGAGE-BACKED SECURITIES

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 15 - Executive Stock Options

INTRODUCTION

BASIC FEATURES OF EXECUTIVE STOCK OPTIONS

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 16 - Emerging Derivative Instruments

ECONOMIC DERIVATIVES

REAL ESTATE DERIVATIVES

THE NEXT FRONTIER

ENDNOTES

REFERENCES

SUGGESTED FURTHER READING

ABOUT THE AUTHOR

PART III - The Structure of Derivatives Markets and Institutions

CHAPTER 17 - The Development and Current State of Derivatives Markets

INTRODUCTION: THE SITUATION IN THE 1960s

FINANCIAL FUTURES AND OPTIONS

FOREIGN MARKETS

OTC MARKETS

ENERGY DERIVATIVES

THE RISE OF ELECTRONIC TRADING

CURRENT CONDITIONS: CONSOLIDATION AND CRISIS

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 18 - Derivatives Markets Intermediaries Brokers, Dealers, Pools, and Funds

INTERMEDIARIES FOR EXCHANGE-TRADED DERIVATIVES

INTERMEDIARIES FOR OTC DERIVATIVES

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 19 - Clearing and Settlement

INTRODUCTION

FUNCTIONS OF CLEARINGHOUSES

CLEARING AND LIQUIDITY

COMPETITION BETWEEN EXCHANGES

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHORS

CHAPTER 20 - Counterparty Credit Risk

MEASURING COUNTERPARTY CREDIT RISK EXPOSURE

MANAGING COUNTERPARTY CREDIT RISK

INFRASTRUCTURE IMPROVEMENTS AIMED AT MITIGATING COUNTERPARTY CREDIT RISK

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 21 - The Regulation of U.S. Commodity Futures and Options

TIERED REGULATORY DESIGN

STATUTORY EXCLUSIONS FOR CERTAIN OTC DERIVATIVES

SECURITY FUTURES PRODUCTS

RETAIL FOREIGN CURRENCY FRAUD

EXEMPT COMMERCIAL MARKETS

CFTC REAUTHORIZATION ACT OF 2008

FUTURE LEGISLATIVE REFORMS

ENDNOTES

ABOUT THE AUTHOR

CHAPTER 22 - Accounting for Financial Derivatives

ALTERNATIVE ACCOUNTING CATEGORIES

CONCLUSION

REFERENCES

ABOUT THE AUTHOR

CHAPTER 23 - Derivative Scandals and Disasters

INTRODUCTION

ANATOMY OF DERIVATIVE-RELATED FAILURES

INVESTMENT STRATEGIES AND EXOGENOUS SHOCKS BEHIND OUR FIVE DERIVATIVE FIASCOS

LESSONS LEARNED FROM DERIVATIVE SCANDALS AND DISASTERS

BROADER IMPLICATIONS OF DERIVATIVE SCANDALS AND DISASTERS

CONCLUSION

ACKNOWLEDGMENTS

ENDNOTES

REFERENCES

SUGGESTED FURTHER READING

ABOUT THE AUTHOR

PART IV - Pricing of Derivatives: Essential Concepts

CHAPTER 24 - No-Arbitrage Pricing

FREE LUNCHES

THEORY OF PUT/CALL PARITY

BINOMIAL OPTION PRICING MODEL

PUT PRICING IN THE PRESENCE OF CALL OPTIONS: FURTHER STUDY

BINOMIAL PUT PRICING

BINOMIAL PRICING WITH ASYMMETRIC BRANCHES

EFFECT OF TIME

EFFECT OF VOLATILITY

INTUITION INTO BLACK-SCHOLES

ENDNOTES

REFERENCES

FURTHER READING

ABOUT THE AUTHOR

CHAPTER 25 - The Pricing of Forward and Futures Contracts

COST OF CARRY MODEL

CARRY RETURN

COMMODITY FUTURES

CONVENIENCE YIELD

DELIVERY OPTIONS

INTEREST RATE FUTURES AND FORWARDS: EURODOLLAR FUTURES AND FORWARD RATE AGREEMENTS

INTEREST RATE FUTURES AND FORWARDS: TREASURY BOND AND TREASURY NOTE FUTURES

SHOULD FUTURES AND FORWARD PRICES BE THE SAME?

EXPECTATIONS MODEL: AN ALTERNATIVE THEORY FOR THE PRICING OF FORWARDS AND FUTURES

ELECTRICITY FORWARDS AND FUTURES

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 26 - The Black-Scholes Option Pricing Model

INTRODUCTION

BRIEF HISTORY

BLACK-SCHOLES FORMULA

ASSUMPTIONS OF THE BLACK-SCHOLES MODEL

DISCUSSION OF ASSUMPTIONS

ITO PROCESS

EXAMPLE

EXCEL APPLICATION

SIMPLE DERIVATION OF BLACK-SCHOLES

NUMERICAL EXAMPLE

THE GREEKS

RISK-NEUTRAL PRICING

CONCLUSION

REFERENCES

ABOUT THE AUTHOR

CHAPTER 27 - The Black-Scholes Legacy Closed-Form Option Pricing Models

INTRODUCTION

THE BLACK-SCHOLES MODEL

FIRST GENERATION OF MODELS (ONE LOGNORMAL UNDERLYING)

SECOND GENERATION OF MODELS (TWO LOGNORMAL UNDERLYINGS)

THIRD GENERATION OF MODELS (ONE NONLOGNORMAL UNDERLYING)

FOURTH GENERATION OF MODELS

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 28 - The Pricing and Valuation of Swaps

INTRODUCTION

FRAMEWORK FOR PRICING AND VALUATION

STEPS FOR SWAP PRICING

OTHER SWAPS

ENDNOTES

REFERENCES

ABOUT THE AUTHORS

PART V - Advanced Pricing Techniques

CHAPTER 29 - Monte Carlo Techniques in Pricing and Using Derivatives

INTRODUCTION

PRICING A CLASSIC BLACK-SCHOLES OPTION

PRICING A RAINBOW OPTION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 30 - Valuing Derivatives Using Finite Difference Methods

INTRODUCTION

AN OVERVIEW

BASIC METHODS

HIGHER-DIMENSION PROBLEMS

THE PROS AND CONS OF FINITE DIFFERENCE METHODS

SUGGESTED FURTHER READING

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 31 - Stochastic Processes and Models

INTRODUCTION

STOCHASTIC PROCESSES

BASIC ELEMENTS OF STOCHASTIC CALCULUS

BINOMIAL TREE: ANOTHER WAY OF VISUALIZING A STOCHASTIC PROCESS

CONCLUSION

ENDNOTES

REFERENCES

APPENDIX: HEURISTIC DERIVATION OF ITO’S FORMULA

ABOUT THE AUTHORS

CHAPTER 32 - Measuring and Hedging Option Price Sensitivities

DELTA

GAMMA

THETA

VEGA

RHO AND OTHER OPTION SENSITIVITIES

HEDGING DELTA, GAMMA, AND VEGA

CONCLUSION

REFERENCES

ABOUT THE AUTHOR

PART VI - Using Financial Derivatives

CHAPTER 33 - Option Strategies

BUILDING BLOCKS

COVERED CALLS AND PROTECTIVE PUTS

SYNTHETIC POSITIONS

BULL AND BEAR SPREADS

CYLINDERS

STRADDLES, STRANGLES, STRIPS, AND STRAPS

RATIO SPREADS

BOX SPREADS

BUTTERFLIES, CONDORS, AND SEAGULLS

TIME STRATEGIES

MULTI-ASSET STRATEGIES

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 34 - The Use of Derivatives in Financial Engineering Hedge Fund Applications

INTRODUCTION

CONVERTIBLE BOND ARBITRAGE

CAPITAL STRUCTURE ARBITRAGE

ENDNOTES

REFERENCES

ABOUT THE AUTHORS

CHAPTER 35 - Hedge Funds and Financial Derivatives

INTRODUCTION

SURVEY OF DERIVATIVE USE BY HEDGE FUNDS

MODELING HEDGE FUND RISKS

DESCRIPTION OF SOME POPULAR HEDGE FUND STRATEGIES

SOME UNUSUAL DERIVATIVES TRADES MADE BY HEDGE FUNDS

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHOR

CHAPTER 36 - Real Options and Applications in Corporate Finance

INTRODUCTION

A BRIEF HISTORY OF REAL OPTIONS

DISTINCTION BETWEEN FINANCIAL OPTIONS AND REAL OPTIONS

TYPES OF REAL OPTIONS AND EXAMPLES IN THE ENERGY INDUSTRY

VALUING REAL OPTIONS

CONCLUSION

ENDNOTES

REFERENCES

ABOUT THE AUTHORS

CHAPTER 37 - Using Derivatives to Manage Interest Rate Risk

INTRODUCTION

FORWARD-BASED INSTRUMENTS

OPTION-BASED INSTRUMENTS

CONCLUSION

REFERENCES

SUGGESTED FURTHER READING

ABOUT THE AUTHOR

Index

The Robert W. Kolb Series in Finance provides a comprehensive view of the field of finance in all of its variety and complexity. The series is projected to include approximately 65 volumes covering all major topics and specializations in finance, ranging from investments, to corporate finance, to financial institutions. Each volume in the Kolb Series in Finance consists of new articles especially written for the volume.

Each Kolb Series volume is edited by a specialist in a particular area of finance, who develops the volume outline and commissions chapters by the world’s experts in that particular field of finance. Each volume includes an editor’s introduction and approximately 30 articles to fully describe the current state of financial research and practice in a particular area of finance.

The chapters in each volume are intended for practicing finance professionals, graduate students, and advanced undergraduate students. The goal of each volume is to encapsulate the current state of knowledge in a particular area of finance so that the reader can quickly achieve a mastery of that special area of finance.

Copyright © 2010 by John Wiley & Sons, Inc. All rights reserved.

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

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data:

Kolb, Robert W., 1949-

Financial derivatives : pricing and risk management / Robert W. Kolb,

James A. Overdahl.

p. cm. - (The Robert W. Kolb series in finance)

Includes bibliographical references and indexes.

eISBN : 978-0-470-54174-6

1. Derivative securities. 2. Financial engineering. I. Overdahl, James A. II. Title.

HG6024.A3K648 2010

332.64’57-dc22 2009017152

Introduction

In a time in which the finance industry is under attack and our entire financial system is under remarkable stress, financial derivatives are at the center of the storm. For the public at large, financial derivatives have long been the most mysterious and least understood of all financial instruments. While some financial derivatives are fairly simple, others are admittedly quite complicated and require considerable mathematical and statistical knowledge to understand fully.

With vast changes for our financial system in prospect, there has never been a time in which those engaged in setting public policy and the concerned general public have a greater need for a general understanding of financial derivatives. As the reader of this book will learn, financial derivatives are instruments of remarkable power and very justifiable uses. However, as this text also freely acknowledges and explains, the very power of these financial derivatives makes them subject to accident in the hands of the incautious and also makes them effective tools for mischief in the hands of the unscrupulous.

To contribute to an improved public understanding of these markets, Financial Derivatives explores the contemporary world of financial derivatives, starting with a presumption of only a general knowledge of undergraduate finance. These chapters have been written by many leading figures in academics, industry, and government for the benefit of advanced undergraduates, graduate students, practicing finance professionals, and the general public. As such, the chapters in this book provide a comprehensive understanding of financial derivatives. Financial Derivatives is comprised of 37 chapters organized into six parts:

Part One, “Overview of Financial Derivatives,” provides an introduction to and an overview of the types of financial derivatives, the markets in which they trade, and the way that traders use derivatives, and it also offers a broader perspective addressing the question of the social function of derivatives markets. Against that background, Part Two, “Types of Financial Derivatives,” explores the variety of derivatives, starting with the agricultural and metallurgical derivatives that were historically the first to be developed. This part also discusses financial derivatives based on stock indexes, foreign currencies, energy, and interest rate instruments. It continues by giving an overview of the variety of exotic options and a type of exotic options known as an event derivative. Two chapters focus on credit default swaps and structured credit products that have allegedly played a central role in the recent crisis in financial markets. Executive compensation is always controversial, it seems, and has generated particular outrage in the current crisis, so this part discusses executive stock options and concludes with an overview of some of the emerging financial derivatives that are likely to become prominent in the future.

After having introduced the markets and types of derivatives in Parts One and Two, Part Three turns to an examination of “The Structure of Derivatives Markets and Institutions.” Chapter 17 analyzes the development and current state of derivatives markets, and subsequent chapters take on issues such as a survey of the participants in the market and the way in which transactions are fulfilled. Fulfillment is a critical part of the market, because this issue concerns the honoring and completion of contracts, without which no viable market can persist. Closely related to this is the issue of counterparty credit risk—the risk that one party to the derivatives contract might default on contractual obligations. This part also surveys the regulation of derivatives markets, along with the principles of accounting as they pertain to derivatives. The part concludes with a brief account of some of the most famous derivatives disasters of recent decades.

Part Four, “The Pricing of Derivatives: Essential Concepts,” introduces the fundamentals of determining the price of derivatives. The part begins by introducing the principle of no-arbitrage pricing. The first condition of a well-performing market from the point of view of pricing is that prices in the market are such that arbitrage is impossible—where arbitrage can be defined as the securing of a riskless profit without investment. With this background, the discussion turns to the pricing of particular instruments, such as forward and futures contracts. Next the part introduces the famous Black-Scholes option pricing model and then considers the various ways in which this seminal model has been extended and enhanced to apply to other derivatives. The part concludes with an analysis of the pricing of swap contracts.

Part Five, “Advanced Pricing Techniques,” extends the pricing analysis initiated in Part Four. The chapters in this part are more technical, beginning with showing how Monte Carlo methods can be applied to price derivatives. The discussion of Monte Carlo techniques is immediately followed by a consideration of finite difference models, models that can be applied with great benefit when analytical models are not available. Much of the pricing of derivatives turn on the path that the underlying good is presumed to follow. When this path is described statistically, the description is known as a stochastic process, an understanding of which is necessary to more sophisticated analysis. Finally, this part explores how option prices respond to changes in their various input values.

Part Six, “Using Financial Derivatives,” concludes the book. By this time, the reader will be well aware that financial derivatives are very valuable for managing risks and for providing information about the future prices of underlying goods. Financial derivatives can also be used as tools of quite sophisticated speculation. This part begins with an exploration of option strategies used in speculation and shows how the same strategies can also be used to reduce risk. Next comes a discussion of how hedge funds use financial derivatives and, more exactly, how hedge funds use the techniques of financial engineering. Financial derivatives are powerful tools for managing interest rate risk, as this part also explores. Chapter 36 examines real options, options based on physical assets or opportunities that firms possess. The book concludes with a discussion of how firms can use financial derivatives to manage their own risks.

Acknowledgments

The editors would like to acknowledge the contribution of the many people who have made this volume possible. Our first debt is to the many scholars who shared their knowledge by writing the chapters that comprise this text. We would like to also thank George Lobell, editor at John Wiley & Sons, Inc., for his vision of the series in which this volume appears and his encouragement of the series in general and this text in particular. Also at John Wiley, we would like to offer our thanks to the editorial team of Pamela Van Giessen, William Falloon, and Laura Walsh for their continuing support of and commitment to this project.

PART I

Overview of Financial Derivatives

Part One consists of four introductory chapters intended to open the world of financial derivatives to the reader. In Chapter 1, “Derivative Instruments: Forwards, Futures, Options, Swaps, and Structured Products,” Gary D. Koppenhaver takes a generalist approach to forwards, futures, swaps, and options. He approaches these instruments from the point of view of their suitability to address a single problem: managing financial risk. Through this approach, he shows that these instruments obey common principles and are closely related from a conceptual point of view. Koppenhaver strives to emphasize the connections among these different types of derivatives in order to demystify derivatives in general.

One of the largest differences among derivatives turns on the manner in which they are traded—on exchanges or in the more informal and less structured over-the-counter market? Sharon Brown-Hruska contrasts these two models for trading derivatives in Chapter 2, “The Derivatives Marketplace: Exchanges and the Over-the-Counter Market.” In light of the financial crisis, many legislators are pressing to reduce or eliminate the over-the-counter market, which is actually much larger than the market for exchange-traded derivatives. However, many believe that trading derivatives on exchanges make them more transparent, easier to regulate, and less likely to lead to derivatives disasters.

From the point of view of derivatives, we might think of speculation as trading derivatives in a manner that increases the investor’s risk in order to pursue profit. Hedging by contrast is trading derivatives in order to reduce a preexisting risk. In Chapter 3, “Speculation and Hedging,” Gregory Kuserk shows how hedging and speculation differ but also explains how one might think of hedging and speculating as two sides of the same coin, with the relationship between the two activities being much closer than is generally recognized.

The editors of this volume believe that Chapter 4 by Christopher L. Culp, “The Social Function of Financial Derivatives,” is one of the most important in the entire volume. As discussed in the introduction to this book, there is a recurring impulse to eliminate derivatives markets through legislative action. Culp shows how derivatives markets serve society in a variety of ways, some of which are quite obvious and others of which are more sophisticated.

CHAPTER 1

Derivative Instruments

Forwards, Futures, Options, Swaps, and Structured Products

G. D. KOPPENHAVER

Professor and Chair, Department of Finance, Insurance and Law, Illinois State University

INTRODUCTION

The evolution of ideas in finance usually is driven by circumstances in financial markets. In the early 1980s, at the inception of cash-settled financial futures contracts, the term derivatives was most often associated with financial rocket science. Esoteric derivative contracts, especially on financial instruments, faced a public relations probem on Main Street. By the mid-1990s, the term derivatives carried a negative connotation that conservative firms avoided. High-profile derivative market losses by nonfinancial firms, such as Metallgesellschaft AG, Procter & Gamble Co., and Orange County, California, caused boards of directors to look askance at derivatives positions.1 In the early 2000s, however, derivatives and their use are a real part of a discussion of business tactics. While it is still the case that derivatives contracts are a powerful tool that could damage profitability if used incorrectly, the discussion today does not focus on why derivative contracts are used but how and which derivative contracts to use.

The goal of this chapter is to take a generalist approach to closely related instruments designed to deal with a single problem: managing financial risk.2 In the chapter, forwards, futures, swaps, and options are not treated as unique instruments that require specialized expertise. Rather the connection between each class of derivative contracts is emphasized to demystify derivatives in general. As off-balance sheet items, each is an unfunded contingent obligation of contract counterparties. Later in the chapter, the discussion returns full circle to consider the creation of funded obligations with derivative contracts, called structured products. Structured products are financial instruments that combine cash assets and/or derivative contracts to offer a risk/reward profile that is not otherwise available or is already offered but at a relatively high cost. The repackaging of off-balance sheet credit derivatives into an on-balance sheet claim is shown through a structured investment vehicle example.

Uncertainty is a hallmark of today’s global financial marketplace. Unexpected movements in exchange rates, commodity prices, and interest rates affect earnings and the ability to repay claims on assets. Great cost efficiency, state-of-the-art production techniques, and superior management are not enough to ensure firm profitability over the long run in an uncertain environment. Risk management is based on the idea that financial price and quantity risks are an ever-increasing challenge to decision making. In responding to uncertainty, decision makers can act to avoid, mitigate, transfer, or retain a commercial risk. Because entities are in business to bear some commercial risk to reap the expected rewards, the mitigation or transfer of unwanted risk and the retention of acceptable risk is usually the outcome of decision making. Examples of risk mitigation activities include forecasting uncertain events and making decisions that affect on-balance sheet transactions to manage risk. The transfer of unwanted risk with derivative contracts, however, is a nonintrusive, inexpensive alternative, which helps explain the popularity of derivatives contracting.