Lesson 7: Derivative Securities and Derivative Markets |
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Upon completion of this lesson, you should be able to do the following:
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IntroductionThis lesson introduces the derivatives market. As you know, derivatives have received bad publicity from two famous bankruptcies. In 1995, Orange County, California, had the biggest bankruptcy for a municipal government. The losses approximated $2 billion. The press concentrated on derivatives as the cause of the bankruptcy, but it really was bad decision making on behalf of the fund manager. Another famous case was Barings P.L.C. Barings was a London Investment firm that was founded in 1763. One trader, Nick Leeson, lost about $1 billion in the derivatives market, causing Barings to bankrupt. Derivatives are simply a contract, where the transaction occurs today, but the actual good is exchange for money at a future date. Throughout this whole course, we assumed that transactions were spot transactions . When a buyer and seller completed a transaction, the money was exchanged for financial security immediately. However, forward transactions can occur. The buyer and seller can negotiate a price today, but the actual exchange occurs at a future date. For example, a bread company believes it will need 6 tons of flour in 6 months. Many things can occur within 6 months. A drought could occur which causes the price of wheat to increase or plenty of rain could cause a bumper crop, causing the price of wheat to decrease. The bread company wants to protect itself from fluctuating prices. The bread company enters into contracts with wheat farmers, where the price of wheat is negotiated today. However, the bread company will actually pay the farmers for the wheat when the wheat is harvested 6 months from now. The contract can protect the bread company from price fluctuations. Purpose of the Derivatives Market |
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The price of the futures contract is determined in the derivatives market. The futures price reflects the expectations of the investors and savers. For example, you buy a futures contract for 10,000 barrels of oil. You negotiated a price of $30 per barrel and the oil will be delivered in 6 months. You can sell your futures contract on the derivatives market. However, the market price can change for oil:
Buyers and sellers do not know each other. The futures contract is sold through an exchange and the exchange requires the buyers and sellers to settle the gains and losses each day, when the market prices change. If you bought a futures contract for oil through the exchange for a market price of $30 per barrel and the next day the price of oil is $40 per barrel, the person who sold you the contract would have to pay you $10 per barrel to settle the account. This settling of the account is called marking to market . The options contract is the second type of derivative instrument. The options contract is very similar to the futures contract. The only difference is the options contract gives you the option if you want to buy or sell. For example, you entered into a options contract, giving you the right to buy a barrel of oil for $30 per barrel in 6 months. On the day of delivery, if the price of oil is $20 per barrel, you do not have to honor the option contract. That is your option! If oil is $40 per barrel on the day of delivery, then you are most likely going to honor your options contract. The investor who sold you this contract is obligated to sell the oil for $30 per barrel to you. There are two type of options contracts.
The rights for the option exists until the expiration date . If you buy an option, you can exercise your right to buy or sell in the option anytime before the option expires. Options are not given freely. You are charged a fee, which is called the option premium. The amount paid for an option premium depends on the probability that the buyer of the option will exercise his right. It is like insurance. For example, a driver with a history of car accidents will tend to have a higher probability of having future accidents. His car insurance company will charge a higher premium. There are three factors that influence the size of the option premium.
There are two broad principals for investing and it applies to all financial markets.
How did Nick Leeson cause the bankruptcy of Barings, P.L.C.? Nick Lesson made an observation about the Tokyo stock market. The market price of Tokyo stocks did not fluctuate much. Nick Leeson would issue an equal number of call and put options for the Tokyo stock market. Investors did not exercise the options, because the stock prices did not change much. Essentially, the premiums collected from the options were profits. The profits were so high, top management at Barings let Nick Leeson continue his speculation. Then an earthquake occurred in Kobe, Japan and stock prices fell on the Tokyo stock exchange. Leeson speculated that stock prices would increase and bought futures contracts. The stock prices continued to fall, resulting in a $1 billion loss for Barings. Barings was forced to buy Tokyo stock for a high price, when stock prices were low. |