Chapter 1: Introduction

What Is a Derivative?

A derivative is a financial instrument whose value depends on (derives from) the values of other, more basic underlying variables. The underlying can be almost anything — a stock price, a commodity price, an exchange rate, an interest rate, or even the amount of snow falling at a ski resort.

Derivatives involve two parties agreeing to a future transaction. The derivatives market is huge — the value of assets underlying outstanding derivatives is several times world GDP. As of December 2019, the OTC market was $558.5trillionandtheexchange-tradedmarketwas$96.5 trillion in notional principal.

Exchange-Traded Markets

A derivatives exchange is a market where standardized contracts are traded. The exchange clearing house stands between buyers and sellers, eliminating counterparty risk through margin requirements. Key exchanges:

• CME Group (formed from CBOT, CME, NYMEX, KCBT)
• CBOE (Chicago Board Options Exchange) — started trading call options in 1973, puts in 1977

Electronic trading has largely replaced the open outcry system, enabling high-frequency trading.

Over-the-Counter (OTC) Markets

In OTC markets, banks, financial institutions, fund managers, and corporations trade directly. Key characteristics:

• Trades are larger but less frequent than exchange-traded
• Can be cleared through Central Counterparties (CCPs) or bilaterally
• Post-2008 regulations require standardized OTC derivatives to trade on Swap Execution Facilities (SEFs) and use CCPs
• All trades must be reported to central repositories
• Large banks act as market makers, quoting bid and ask prices

Forward Contracts

A forward contract is an agreement to buy or sell an asset at a future time for a price agreed upon today. It is an OTC instrument (not exchange-traded).

• Long position: Agrees to buy at delivery price $K$
• Short position: Agrees to sell at delivery price $K$
• Payoff for a long position: $S_T-K$
• Payoff for a short position: $K-S_T$

where $S_T$ is the spot price at maturity.

Example: If you enter a 6-month forward to buy £1 million at $1.2230/\pounds ,andthespotrateatmaturityis$1.3000, your payoff is $77,000.Ifthespotrateis$1.2000, you lose $23,000.

Futures Contracts

A futures contract is like a forward contract but:

• Traded on an exchange with standardized features
• The exchange clearing house guarantees performance
• Traders post margin
• Positions are marked to market daily

Options

An option gives the holder the right (but not obligation) to buy/sell. There are two types:

Key parameters:

• Strike price $K$ (exercise price)
• Expiration date $T$ (maturity)
• Premium: The cost of the option (unlike forwards/futures which cost nothing to enter)

American options can be exercised anytime up to expiration. European options can only be exercised at expiration. Most exchange-traded equity options are American.

Option Payoffs

Let $S_T$ be the stock price at expiration:

• Call payoff: $\max (S_T-K,0)$
• Put payoff: $\max (K-S_T,0)$

Buying a call gives upside exposure with limited downside (the premium paid). Buying a put provides insurance against price declines.

Types of Traders

Hedgers

Use derivatives to reduce risk. Example: A US company that will receive £30 million in 3 months can short GBP futures to lock in the exchange rate.

Speculators

Use derivatives to bet on price movements. Futures provide leverage — a small margin deposit controls a large position. Options provide another avenue: buying calls to bet on price increases, puts for decreases.

Arbitrageurs

Lock in riskless profit by exploiting price discrepancies. Arbitrage ensures that prices across markets remain consistent (the "law of one price").

Example: If a stock trades at $60inNewYorkand\pounds 40inLondon,andtheexchangerateis$1.52/£, arbitrageurs would buy in London and simultaneously sell in New York for a risk-free profit.

Dangers

Derivatives can produce large losses when misused:

• Société Générale lost €4.9 billion in 2008 from unauthorized trading
• Barings Bank collapsed in 1995 after a trader lost £827 million on Nikkei futures
• The 2008 financial crisis highlighted systemic risk in OTC derivatives

Derivatives are tools — their risk depends on how they are used. Proper risk management, internal controls, and understanding of the instruments are essential.