Financial Markets - A Derivative-centric View

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					       Financial Markets –
    A Derivative-centric View

                QF 301

    Derivatives Tales

    IBM-World Bank Swap: The swap that
    started it all
       Swap is a financial transaction that involves
        swapping two assets/cashflows/etc.

       Swapping had been in existence before 1980s

       But it really took off after the IBM-World Bank swap
        of 1981

       These days, the swap market is a major financial
        market; swapping bid/ask spread is so thin that
        intermediaries arranging swap make profit through
        volume (commoditized)

    The Swap: World Bank’s situation
       World Bank had policy of raising funds in DEM, CHF
        and JPY

       Prolific borrower => cost of debt rising because its
        debt paper was flooding the market
        –   Too much of World Bank Bond => demand falls => need more
            enticement to get investors interested

    The Swap: IBM’s situation
       IBM had embarked on a world-wide funding programme some
        years earlier because rates were high in the US

       Raised Deutschemarks and Swiss Francs => had DEM and CHF
        debt obligations

       After funds in DEM and CHF are raised, need to be converted
        into USD => FX risk exposure

       Over years, USD strengthened => gain for IBM (as IBM needs to
        convert USD back into DEM and CHF to repay debt) ; IBM
        wanted to
        –   Lock in gain
        –   Remove future exposure
    The overall situation
       World Bank
         – needed DEM, CHF
         – Had relative ease of access to USD

       IBM
         – Had DEM, CHF debt obligations (coupons and principals)

       Solution (arranged by Salomon Brothers)
         –   World bank borrows in USD and swaps USD for DEM/CHF with IBM (IBM
             probably had to change their USD profits at spot into DEM/CHF)
         –   World bank receives periodic USD payments from IBM which they pass on to
         –   IBM receives periodic DEM/CHF payments which they pass on to investors

       Effectively, IBM was then paying USD coupons and World Bank was
        then paying DEM/CHF coupons
          The Swap: World Bank-IBM Swap
                Salomon Brothers made the following arrangement

                World Bank could still raise USD at relatively cheap
                 rates, so it would issue 2 Eurodollar bonds
                   –     One matched to IBM’s DEM liabilities
                   –     One matched to IBM’s CHF liabilities                                       World Bank effectively
                                                                                                    paying in DEM and CHF
                                                            USD coupons
IBM effectively paying
In USD                                                  DEM/CHF coupons                World
                                IBM                         USD principals             Bank
                                                        DEM/CHF principals
                             IBM liabilities                                       World bank liabilities
                             from earlier                                          From tthese 2 bonds
              DEM/CHF                          DEM/CHF                       USD                            USD
              coupons                          principals                    coupons                        principals
    Black Monday
       Monday, Oct 19, 1987

       Stock markets around the world fell
        –   US: 22.68%
        –   UK: 26.8%
        –   HK: 45.8%

       Who spooked the markets?

    Who’s the culprit?
       Program trading / Portfolio insurance

       Dispute in monetary policy among G7

       Great Storm of 1987 that hit UK

       …

     Black Monday: Options
        Two types: put and call

        Put option: right to sell underlying stock at
         strike price on maturity date
                          Sell at 100 buy at 50, profit = 50

                     50                                Stock price at maturity

     Black Monday: Risk of Option Writer

        If stock price stays above strike from initiation to
         maturity, then option writer will be unaffected

        If stock price falls below strike, option writer sells
         stock in the anticipation that he will buy it back at a
         lower price – profit made goes into option payoff

        More specifically, the option writer hedges the option
         risk by trading the underlying stock according to the
         Black-Scholes recipe

     Black Monday: From the investor’s

        Why would an investor buy a put option?

                         Sell at 100 buy at 50, profit = 50

                    50                                Stock price at maturity

     Black Monday: The downward-spiral
        Many investors bought put
         options for protection
         against price falls
        All the option writers do the
         same thing: in accordance
         with the Black-Schole delta-
         hedging algorithm –
         programmed trading
        An initial downward trend
         magnifies into a unstoppable
         downward spiral                                                        $55
          –   Black-Scholes says “sell”
              when stock price falls
          –   Selling causes stock price
              to fall even further                                $0.45

     In context:
     S&P 500 – history since 1970

     In context:
     Top 1-day changes in S&P 500

        Barings Bank (1762-1995)

        Nick Leeson came to Barings’ Singapore office to oversee
         settlement in Asia

        Soon after was given job of running bank’s futures brokerage
          –   Reported strong profit
          –   Poster boy for SIMEX’s annual report

        Clerical errors in settling accounts are usually closed ASAP
         according to strict rules

        Leeson was both trading and settling
          –   Maintained and traded an error account (the infamous “88888”
              account) on Nikkei 225
          –   End ’93: 24m pounds losses; Sept ’94: 56m pounds losses

     Barings: Straddle
        Early 1995, in last ditch effort to conceal his activities
         and make back losses, Leeson sold a vast amount
         of straddles

        A straddle is a combination of a put option and a call
         option Payoff

                                                   Stock price at maturity

        What does the investor hope will happen to the stock
17       price if he invests in a straddle?
     Barings: Earthquake!
        Leeson was hoping that stock prices did not move
         much – not quite volatile

        Jan 17, 1995 – Kobe earthquake, Richter 7.2

        Japanese stock market severely rocked

        Neeson’s straddles lost 69m pounds

        Barings 440m pounds capital was depleted by 860m

        ING acquired Barings for 1 pound
     Derivatives are bad?
        All the stories above are bad. They make it to
         the press and remain in our memories due to
         their infamy

        What evidence is there to show that
         derivatives are good?

        ….the fact that they are being sold – and the
         derivatives market is huge

        (“Good” as judged by there is a demand for
19       these things…are they good for the society?)
     Just take a look at CBOE



     Warren Buffett – the Sage of Omaha

     Context context!

     Source: 2007 Berkshire Hathaway’s Annual Letter

                                               Source: BT Mar 03, 2008
     Alan Greenspan – ex Fed Chairman

24   Source:
     A Fallen ‘Sage’

     From an old sage


     What are derivatives?
        Derivatives are financial instruments which
         guarantees cashflows that depend on the price of
         one or more underlying assets or the level of one or
         more reference indices

        Derivatives are used for risk management,
         investment and speculation

        The most basic derivatives
         –   Forwards/futures
         –   Swaps
         –   Options

     The concept of derivatives is quite
        …if you have a little bit of mercantile nature

        Thales of Miletus
          –   Greek philosopher, mathematician, scientist
          –   Used his prophetic skills to forecast a bumper olive crop
          –   Paid all who own olive presses for exclusive use in following season
          –   Made huge profit by charging high rental on olive presses when during
              bumper olive harvest

        Dojima Rice Market in Osaka was established around 1730 and traded
         in rice futures

        Chicago Board of Trade
          –   Established 1848; marketed first financial futures (1972 with the
              establishment of IMM)
          –   Started as futures exchange; now trade options as well
          –   In 19th century, Chicago was centre of transportation, distribution and trade
              of agricultural produce
          –   Gluts and shortages cause wild price fluctuations
          –   Forward contracts fix price in the future and help remove price
29            uncertainties for buyers and sellers alike
     Derivatives are bad…
        …if you do not see the big picture

        Chicago Mercantile Exchange
          –   1898:CBOT spinned off Chicago Butter and Egg Board
          –   1919: became CME
          –   1958: US congressional ban on onion futures
                  1955: onion futures contract rose in price, drew an avalanche of
                   onions to Chicago, which then caused onion price to fall drastically
                  Virtually worthless and thrown into Lake Michigan
                  National Onion Association calls for ban on onion futures, blaming the
                   speculation that it created

        But speculation and speculators are integral to the financial
          –   Trade is essential to human civilization
          –   Risk is part and parcel of trade
          –   Speculators and speculation act as “risk-transporting/tranferring”
     The rise of derivatives legitimacy and
     the derivatives market

        1969: Fisher Black wrote down the partial
         differential equation that came to be known
         as the Black-Scholes equation

        It expressed a “law” that relates the price of
         options to fundamental quantities: risk-free
         interest rate, initial stock price, maturity,
         strike price, volatility

     Black, Scholes and Merton
        Black and Scholes solved the PDE together
        Merton contributed to the understanding of the PDE
        First time sophisticated (= nonlinear) mathematics is
         used in finance
        In essence and in principle: the price of an option is
         the cost in hedging the risk of writing it
        Led to the explosive growth of the derivatives industry
         from the 1980s till now

     Gist of the BSM Theory in English
        When a market maker sells a derivative contract to
         her client, they agree to exchange cash flows at
         some time in the future

        Even though it appears that both parties bear
         opposite risks, this is not so

        The market maker does not bear a risk that is
         opposite to that of the client because she hedges
         away the risk

        The cost of hedging (plus a spread for insurance and
         profit) is charged to the client as premium of the
         derivative contract
     Where are derivatives traded?
                                              OTC market
        Exchanges
                                              Characteristics
        Characteristics                        –     Contract flexibility
          –   Standardized contracts                      ISDA
          –   Clearinghouse                                     – Chartered in 1985
                  Match trades                                 – Today has > 450 members
                  Central counterparty                             (mainly banks)
                  Take away credit risk                        – Promote derivatives business

          –   Margin trading                                    – ISDA Documentation

          –   Transparency                                                Definitions
                                                                          Master Agreements
          –   Regulation
                                                –     Largely unregulated
                  US: SEC, CFTC
                                                          Market discipline
        Trivia                                 –     Some degree of transparency
          –   1972 (CME) First futures                    ISDA and BIS surveys
              contract on a financial           –     Credit risk
              instrument (FX)
                                              Trivia
        Example instruments                    –     1991 Notional amount of OTC derivatives
          –   Stock options                           trading surpasses exchange-traded
          –   S&P 500 Futures                         derivatives
                                                –     1992 Credit derivatives begin trading in
          –   Eurodollar futures options              OTC market
                                              Example instruments
34                                              –     Plain-vanilla interest rate swaps
                                                –     Currency forwards
     The Derivatives Exchanges
        Europe
          –   Borsa Italiana (BI)
          –   Eurex
          –   NYSE-Euronext
          –   International Petroleum Exchange (IPE)
          –   London International Financial Futures Exchange      Emerging
              (LIFFE)                                                –   Bolsa de Mercado e Futuros (BMF)
          –   London Metal Exchange (LME)                            –   Mercado Mexicano de Derivados (Mexder)
          –   Mercado Espanol de Futuros Financieros (MEFF)          –   Korea Futures Exchange (KOFEX)
          –   OM/Stockholmsborsen (OM)                               –   Malaysian derivatives Exchange (MDEX)
                                                                     –   South African Futures Exchange (SAFEX)

        North America
                                                                   Electronic Exchanges and Electronic
          –   CME-CBOT                                              Communication Networkds
          –   CBOE                                                   –   Intercontinental Exchange (ICE)
          –   Montreal Exchange (MX)                                 –   BrokerTec Futures Exchange (BTEX)
          –   NYBOT                                                  –   OneChicago (OC)
                                                                     –   International Securities Exchange (ISE)
          –   NYMEX
                                                                     –   European Electricity Exchange (EEX)

        Asia-Pacific
          –   Hong Kong Exchanges and Clearing (HKEx)
          –   Osaka Securities Exchange (OSE)
          –   Singapore Exchange (SGX)
          –   Sydney Futures Exchange (SFE)
          –   Tokyo Commodity Exchange (TOCOM)
          –   Tokyo Grain Exchange (TGE)
          –   Tokyo International Financial Futures Exchange
35        –
              Tokyo Stock Exchange (TSE)
     The current derivatives OTC market

             Source: BIS Semiannual OTC derivatives statistics at end-June 2006

     Exchanges vs OTC
        OTC largely represented by

        Business thrives due to non-

        Subprime problem is created
         by securitization of credit risk
         using credit default swaps

        As crisis unfolded, nobody
         knew exactly how many CDSs
         were floating around and how
         many people were going to
         keep their obligations to the
         contracts – potential financial

        Regulators now want CDS to
         be traded on exchanges

     Usefulness of Derivatives
        Trading costs
          –   Trading costs of futures are about 1/20 of those of stocks
          –   Futures also allow views to be adopted

        Trading restrictions
          –   Restrictions may be from regulation or otherwise
          –   E.g. a farmer is unable to sell his crop until it is harvested
                   But he can sell futures
          –   E.g. short-selling in Australia and Hong Kong is permitted only for certain designated
              securities; derivatives have been introduced to circumvent these restrictions

        Hedging
          –   Farmer faces yield risk (quantity of harvest) and price risk
          –   Derivatives are used to hedge the risks, thereby reduce the uncertainty of the revenue
              at harvesting time

        Speculation
          –   Spot drop in sales in beer company
          –   Expect price to drop
          –   Want to short stocks but may not be possible due to regulation
          –   Short stock futures

     Evils of Derivatives
        More “leveraged” – P&L per unit capital invested is
         much higher than traditional investments into assets

        Derivatives are complex instruments
         –   Many don’t understand them even though they dabble with

        Derivatives are sometimes used to evade
         regulations/taxes – but regulations/taxes are for the
         upkeep of society

     The Structured Finance Jigsaw Pieces

                                                                      Mutual funds
     Securitization:                                                  Hedge funds
                                       Intermediaries:                                             Products
     ABS, CDO, REIT                                                   Government and agencies
                                                                      Individual investors

                                                         Accounting                  Settlement      Pricing and,
                          Liquidity                      Standards:                  Clearing        Hedging
     Computing                                                                       Custody         mathematics
                                                         FASB 133


                                                                              OTC vs Exchanges
       Credit risk
       Market risk
                                                   Supervision                Size
       Operational risk
                                                   Regulation                 Operations             Underlying
       Liquidity risk
                                                   Law                                               Assets and


     Financial Scale: How big?
        Top Hedge Fd Mgr 2006 pay =        1,000,000,000
        Bill Gates’ wealth          =     49,000,000,000
        Singapore’s GDP             =    121,500,000,000
        US Financial Rescue Package =    700,000,000,000
        FX Market Daily Turnover    = 2,000,000,000,000
        China’s GDP                 = 2,512,000,000,000
        US National Debt            = 10,000,000,000,000
        OTC Derivatives Gross Value = 10,074,000,000,000
        US’ GDP                     = 13,220,000,000,000

           Financial Scale: How long?

1 day: Professional traders                    Progress cards of all sorts:
daily battle against the market;               Countries’ economy, company AGMs,
Overnight bank lending/borrowing               Funds’ P&L
to meet reserve requirements                                                                Pension funds, life insurance
                                                                                            hedge long term risk has sparked
                      Money/cash      Bond/capital         Warren Buffett has held          demand for long maturity financial
                      market          market               Coca Cola for about this long    instruments and derivatives
                                                                       20 yr         30 yr           50 yr                 100yr

                                                                              US 30 year T bond
                                                                              Microsoft’s age
                           3 month:                                           Republic of Singapore’s age
                           repo, options and futures expiration
                                                                                       Age of established names in finance:
   30s: turbulent market                                                               CBOT, CBOE, NYSE
   may fall 10-20%                                                                     House of Morgan, HSBC, RBS,
                                                                                       Goldman Sachs
                                                                                       Lloyd’s of London (British insurance market
                                                                                       which began in Edward Lloyd’s coffee house
                                                                                       around 1688)

     Payoff vs P&L
        Payoff is as stipulated in the contract of the instrument

                      Call option payoff at maturity
        Profit and Loss (P&L) is the net value of the position
         including funding and payoff

44                     Call option P&L at maturity
        Comment on the following statement:
         “Speculators bet on the rising and falling of
         prices. What they do is not much different
         from the activities of gamblers in casinos.
         Therefore, financial markets and casinos
         are very much the same.”