Financial Derivatives

Prof. Scott Joslin

USC Marshall

FBE 459
Spring 2020
Outline of the Lecture

Introduction to FBE 459

What are derivatives?
Futures and Forwards

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What is 459 about?
A framework to think about valuation of derivatives contracts
Use the tools to understand risk management and investment
decisions
1 Use the derivatives market to achieve certain business goals
2 Think about virtually all finance issues from the derivatives
point of view

Prerequisites
Knowledge of basic finance principles
Key concepts to know: how to discount (riskless and risky)
cash flows
Math (calculus) and basic statistics

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Course Materials:
Lecture Slides
Additional readings posted on Blackboard
Text:John C. Hull, Options, Futures, and other Derivatives,
10th edition, Prentice Hall.
Student solution manual available
Older editions have very similar content, but miss a few
sections [international versions are the same]
Note: all materials for quizzes and exams will be contained in
the slides. The book contains more information (especially
institutional details) that are good to know, but you will not
be tested on them.

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After class
Blackboard: downloads and announcements
Problem sets
You may collaborate but turn in assignments separately
Problem sets grades may be replaced by corresponding exams
No late problem sets!
Office hour: Mondays from 2:00–3:00 p.m.or by appointment
Email: [email protected]. Fastest way to get a response!

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Quizzes
Drop Lowest
No makeup quizzes
Announced or pop quizzes
Final Exam
Standard time arranged by USC

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Creative Contribution/Class Presentation

10% of the creative contribution

In class participation (quality not quantity) and positive
attitude
In class presentation
Groups of up to 4
Graded as a group not by individual
choose a topic in the news
e.g. Wall Street Journal of Financial Times
Finance blogs

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Definition and Uses

Definition
A derivative is a bilateral contract to exchange assets. Its value
depends on the value of some reference variable, possibly through
a contingency clause (for an option).

Bet on some realizations of the underlying

Basic types
Options, Forwards (futures), Swaps
Trading:
on markets if enough demand – or over-the-counter (OTC)

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Uses for Derivatives

Risk management: hedging, covered option

Speculation: naked option
Arbitrage
Saves on transaction costs for similar payoff patterns:
Stop loss, insurance, change nature of investment without cost
of trading underlying
(Regulatory) arbitrage: e.g., defer capital gains

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Some types of derivatives

Types of Contracts:
Stock forwards and futures; commodity forwards and futures;
currency forwards and futures
Interest rate forwards and futures; Swaps
European and American options
Equity linked notes
Convertible bond, warrants, callable bonds
Credit derivatives; credit default swaps, collateralized debt
obligations

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Other Applications

Hedging commodity and interest rate risk

Portfolio risk managment, dynamic hedging
Valuation of debt and equity, convertible bonds, cost of
warrant issuance
Optimal investment decision, timing of investment
Option trading strategies

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Notional Size of Derivative Markets

40 800
Exchange
OTC

30 600
Notional (Trillions of USD)

Notional (Trillions of USD)

20 400

10 200

0 0
1990 1995 2000 2005 2010

Source: Bank of International Settlements (Exchange and OTC)

Market cap of the US stock market in 2018: 30.4 Trillion USD c USC 11/49
Derivatives Users
End-users:
Corporation: hedge a future outlay, FX forward.
Hedge funds: Unlike Mutual funds
Low cost way to get in and out of asset classes
Danger of switching from hedging to speculation
Business sells production (buys input) at agreed forward price
rather than (wait for) the uncertain future spot price:
Orange producer
Miller
Intermediary
Market-Maker
Manages inventory, hedges risk due to underlying uncertainty.
Facilitate hedging of existing positions
Enable understanding of complex positions
Allow for creation of customized products
Render regulation less effective c USC 12/49
Example: Weather derivative

Bombardier offered Ski-Doo buyers a $1000 rebate if the snowfall

in several cities was less than half the average of last 3 years.
Sales increased by 38%.
Having to pay could have bankrupted Bombardier.
Hedged snow-rebate with an OTC (over-the- counter)
derivative.
Pays Enron $100 per Ski-Doo sold.
Enron pays the $1000 if needed.
Bombardier: user
Enron: market-maker
It snowed! (Enron was happy)

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This course

Financial forwards and futures (index, currency)

Commodity forwards and futures
Link between spot and forward markets
Hedging with futures
Interest rate forwards and futures
Options introduction
Option pricing: parity relations
American vs. European options

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This course

Binomial option pricing

Black Scholes option pricing
Hedging options: delta, gamma, vega hedging
Implied binomial trees
Real Options
Other extensions of Black Scholes

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Forwards and Futures

Main Issues for today:

Forwards and Futures
Forward and Futures Prices
Hedging Financial Risks Using Forwards/Futures

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Forward Contracts

Definition: forward contract

A forward contract is a commitment to purchase at a future date a
given amount of a commodity or an asset at a price agreed on
today.

The price fixed now for future exchange is the forward price.
The buyer obtains a “long position” in the asset/commodity.

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Features of forward contracts

traded over the counter (not on exchanges)

custom tailored
no money changes hands until maturity
non-trivial counter-party risk.

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Example

Consider a 3-month forward contract for 10,000 bushels of soybean

at a forward price of $3.50/bushel.

In three months, the long side is committed to:

buy 10,000 bushels of soybean from the short side
the price will be $3.50/bushel.
The short side is committed to sell

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Payoff from Forward Contract

$10000

$5000
Payoff of Forward

−$5000

−$10000
$2.50 $3.00 $3.50 $4.00 $4.50
Soybean Price at Expiration

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Spot vs. Forward Market

In the spot market, you buy the asset now.

In the forward market, you commit to buy the asset in the future.

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Notional vs. Market Value

Say in our example the current price of soybeans is $3.50/bushel

and when the contract is signed no money changes hand.
The market value of the contract is $0.
The notional value is $35,000.
The forward position has similar risk exposure as buying
$35,000 of soybeans

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Short Forward Position vs Shorting an Asset

When you enter the long side of the forward, you lock in the price
now and profit if the price is high in the future.
So this is a bet on the price going up

Your counterparty is on the short side of the forward. They profit

when the price goes down
They are making a bet on the price going down

It is a zero sum game: one person wins and one person loses
Betting vs. Hedging
A bet on down might be a hedge if you already have some risk
exposure!

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Short Forward Position vs Shorting an Asset

When you buy a stock, you are hoping the value you get in the
future (price + dividends) will rise
Bet on up

Your counterparty used to hold the stock but no longer cares if the
values goes up or down

It is not a zero sum game: there is a one share of stock and

whoever holds it will make or lose money

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Comparison with Shorting a Stock

You can still short a stock (or other asset) by:

Find someone who owns the stock
Borrow the stock for X days
They might require collateral
They might also require some interest
Especially if the asset on loan is rare
Sell the stock immediately
Buy the stock back in the market in X days
Hope the price of the stock falls in those X days!
Return the stock (and make any interest payments)

Shorting an asset or being on the short side of a forward (i.e.

promising to sell the asset in the future) are a bet on the assets
value going down

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Problems with Forward Contracts

Forward contracts have two limitations:

(a) illiquidity
(b) counter-party risk.

Futures contracts are designed to address these limitations.

Definition: Futures contract

A futures contract is an exchange-traded, standardized,
forward-like contract that is marked to the market daily. Futures
contract can be used to establish a long (or short) position in the
underlying commodity/asset.

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Features of futures contracts

Standardized contracts:
(1) underlying commodity or asset
(2) quantity
(3) maturity.
Traded on exchanges.
Guaranteed by the clearing house — little counter-party risk.
Gains/losses settled daily—marked to market.
Margin account required as collateral to cover losses.

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A Forward Contract

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A Futures Contract

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Example

Say today, you opened a long position in February live-cattle

contracts at CME, at the closing price of $0.9990/lb.
Contract size 40,000 lbs.
Agreed to buy 400,000 pounds of live cattle in February.
Value of position when opened:

(0.9990)(10)(40, 000) = $399, 600.

No money changed hands.

Initial margin required (5%-20% of contract value).

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Example (continued)

The next day, the futures price closes at $0.9970/lb, 0.20 cents
lower. The value of your position is

(0.9970)(10)(40, 000) = $398, 800

a loss of $800.
The clearinghouse will collect $800 from your margin account and
provide it to the short end of the contract.
Once the margin drops below a given maintenance level, you will
receive a margin call.

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Settlement

At expiration of a future or forward, delivery of a commodity or

asset is required.
As expiration approaches, the futures price converges to the spot
price. Often a reversing trade is entered so that no delivery
actually occurs.
Some contracts are specified to settle in cash rather with one final
marking-to-market rather than with physical delivery.

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Forwards and Futures are Derivatives

Forward and futures contracts are derivative securities because

payoffs determined by prices of the underlying asset
zero net supply.

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Trading of Forwards and Futures

Futures contract trade on central exchanges

Marking to market
Central clearing

Forward contract trade in over-the-counter (OTC) markets

Price and contract terms are the result of a negotiation
Clearing for some OTC contracts is now required by
Dodd-Frank Act

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Trading Futures

Another key advantage of trading a standardized contract like a

future is greater liquidity
At any time, many different market participants (and market
makers) are ready to trade
You can choose to submit a market order to transact now
Or you can submit a limit order to (possibly) transact later at
a better price
You can cancel at a later time if you change your mind

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Limit Order Book Example

Futures on the S&P 500 index (e-mini)

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Flash Crash

Flash Crash
In May 6, 2010, in the four-and-one-half minutes from 2:41 p.m.
through 2:45:27 p.m., prices of the E-Mini had fallen by more than
5%. Also, SPY suffered a decline of over 6%. Many individual
stocks had large declines such as Accenture trading at $0.01 and
Proctor and Gamble trading down 30%.

The SEC and Commodities Futures Trading Commision(CFTC)

issued a report several months later on ”Finding Regarding the
Market Events of May 6,2010”

An underlying cause was high frequency trading (HFT)

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High Frequency Trading: Strategy 1

High frequency traders run computer trading strategies

One strategy is to simply make a market:

If the bid is X and the ask is Y then we could make Y − X if
we execute once on each side
Potential problem: what if lots of buy orders come in
sequence with no sells?
Need to manage inventory
Need to watch for informativeness of order flow
Also need to be aware of incoming news

A public investor should appreciate the ability to transact with a

few seconds

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High Frequency Trading

Another strategy is to try to find arbitrage:

Say on 1/15/13, MSFT traded for $27.00 on the NASDAQ
Electronic market
NASDAQ is based in NYC
data center is in Carteret, NJ
Say also that the future with delivery ont 1/18/13 traded on
OneChicago for $28.00
Computers were in Chicago, now are in Secaucus, NJ

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Good Trading Opportunities

One idea here is just to buy for $27.00 in the spot market.
Spot is a good deal: buy low
Important detail: spot is a good deal relative to future

Another idea is to take $27.00 out of my pocket, buy MSFT on

NASDAQ and enter into short side of future.
I would make $1.00 on 1/18/13
Making 3.7% return in 3 days with no risk is great!
Buy low, sell high
low-spot market, high = forward market

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Arbitrage Opportunity

If I am a hedge fund, an even better option would be to:

Borrow $27.00 from someone
I can use my share of MSFT that I am going to buy as
collateral
Buy MSFT now on NASDAQ
Short MSFT future on OneChicago
Make $$$ on Friday

Arbitrage
An arbitrage is an investment strategy that requires no initial
investment and will make money in the future (or at least will
never have a loss and sometimes will have a gain)

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In practice, there would never be an opportunity this large, but a
few cents is possible.
Such opportunities won’t last long
Now the fact that the computers are in New Jersey matters.
800 miles at the speed limit of 186,000 miles/hour = 4
milliseconds
As an investor, won’t do I care about 4ms? High-frequency traders
do care about this

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Index Arbitrage

Another form of this type of arbitrage is index arbitrage:

There are futures on stock market indices
For example, the e-mini is a future set to 50 times the value of
the stocks in the S&P 500
If the e-mini price differs from the price of the bundle of
stocks, we can generate an arbitrage

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Exchange Traded Funds

There are also exchange traded funds (ETFs) that track indices
For example, SPY tracks the S&P 500 index
Initially, the fund (e.g. State Street) sells some shares
Later, these shares trade on the secondary market
You do not go to the fund directly and buy new shares, you
go to the exchange (e.g. NYSEarca) and find existing
shareholders

Different from a mutual fund:

In a mutual fund, when you buy share you go directly to the
fund and the net asset value (NAV) of the fund increases
When you sell, the fund sells shares of stock in the market
and the NAV goes down.

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Another HFT strategy

High frequency traders can also use order flow to predict future
trades.
Example
Say you want to sell 10 million shares of MSFT. Submitting a sell
order of this size is probably not a good idea. Instead, you can try
breaking it up into chunks and sell

Such a large transaction will move prices a little bit, so if the HFT
can figure this out from the order flow, he can front run you
Sell at the current high price
buy back later at a lower price after your price impact
profit
This will often work whenever HFT can predict order flow
A result is that the liquidity in the limit order book may evaporate
at times

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Flash Crash Findings

A large fundamental trader [Waddell & Reed] initiated a sell

order for 75,000 e-mini contract for hedging purposes due to
worries about Greek default
75, 000 × 50 × 1120 = $4.2 billion
This is 9% of the volume in e-minis on a normal day in 2006 ,
and 3% of the volume on that day
Entire market cap of S&P 500 around $13T
... markets were already under stress, the Sell Algorithm
chosen by the large trader to only target trading volume,
and neither price nor time, executed the sell program ex-
tremely rapidly in just 20 minutes.
This sell pressure was initially absorbed by ... cross-market
arbitrageurs who transferred this sell pressure to the equi-
ties markets by opportunistically buying E-Mini contracts
and simultaneously selling products like SPY, or selling in-
dividual equities in the S&P 500 Index

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 ”Hot potato” effect:
Furthermore, 16 (out of over 15,000) trading accounts that
were classified as HFTs traded over 1,455,000 contracts on
May 6, which comprised almost a third of the total daily
trading volume.

So we have a complicated chain of futures, ETFs, and stocks:

Waddell & Reed sold e-minis to HFTs who sold amongst
themselves
The HFTs arbitraged with SPY (or tried)
Also tried to arbitrage with underlying stock
This can cause S&P 500 stock problems to link to non S&P
500 stocks since stocks can be in multiple indices
Certainly some other dumb black boxes doing HFT besides
W&R

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Supplementary Readings

Readings from Hull:

Chapters 1 and 2
Also parts of Chapter 3 (rest covered later)

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