17615668-Derivatives

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What Are...

Derivatives?

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Prepared By

Robb DavisRobert McDaniel

David BollesMike McLatcher

Calvin Grogan

Amanda Hodges

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DERIVATIVES

A Financial Instrument That

Derives Its Value From An

Underlying Security

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Derivatives ExplanationAn easy way to think of derivatives is as

a “side bet” on interest rates, exchange

rates, commodity prices, and practically

ANYTHING that you can think of.

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Why Derivatives?• Not to raise capital

•Buy or sell to protect against adversechanges in external factors

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Conventional Securities

Market

Bonds Cash Stocks0

5,000

10,000

15,000

20,000

Amount in

B

illions of $

Bonds Cash Stocks

Types

Traditional Securities

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Types of Derivatives• Forwards

• Futures

• Options

• Swaps

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Forwards

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Forwards Contracts

The agreement to pay for and pick up,

“Something” at a pre-determined dateand or time, for a pre-determined price.

Usually traded off of the trading floor between two firms.

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Terms

• Taking Delivery: Physical reception of

item.

• Deliverable Instrument : The item to bedelivered

• Making Delivery: Turning over the

item.Forwards are not options, they are

obligations and should be considered

as a “cash transaction.”

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Forwards

Interest-Rate

Futures

Stock-Index

Futures

Currency

Futures

01,000

2,000

3,000

4,000

5,000

6,000

7,000

Amount in

B

illions of $

Interest-Rate

Futures

Stock-Index

Futures

Currency

Futures

Types

Exchange Traded Derivatives "Forwards"

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Forwards “OTC”Over-The-Counter Derivatives "Forwards"

Currency Contracts

72%

Interest-Rate

Contracts

28%

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A Modest ExampleAn agreement on Monday to buy a book,

(Fin 374c) from a bookstore on Friday for

$1000.00.

On Friday, you return to the bookstore and

take delivery of the book and pay the

$1000.00.

The contract is actually the agreement .

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Futures

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Futures

Similar to forwards in length of time.

However, profits and losses are

recognized at the close of businessdaily, “Mark-to-market.” Transactions

go through a clearinghouse to reduce

default risk. 90% of all futurescontracts are delivered to someone

other than the original buyer.

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Futures ExampleOn Monday we enter into a futures contract to buy

our book on Friday. We are required to place a

deposit for the book of 50% ($500.00). We are told

that if the book appreciates in value we may be

required to increase the deposit. If the book depreciates in value, we may take back some of the

money. Wednesday the book goes to $1500.00. We

must deposit another $250.00. On Thursday the book drops to $750.00. We can collect $375.00. On Friday

the book value is $800.00, therefore we owe $425.00

on the remaining balance.

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Options

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Options

Options come in many flavors. To name afew: collar, cylinder, fence, mini-max,

zero-cost tunnel and straddle. These are all

newer forms of options. The mostcommon options discussed are put and

call .An OPTION is the right, not the obligation

to buy or sell an underlying instrument.

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Option Terms

• Put: the right to sell @ a certain price

• Call: the right to buy @ a certain price

• Long: to purchase the option• Short: to sell or write the option

• Bullish: feel the value will increase

• Bearish: feel the value will decrease

• Strike/Exercise Price: Price the option

can be bought or sold.

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Option Market

Interest-Rate Options

Currency Options

Stock-Index Options

Individual Stock Options

0 500 1,000 1,500 2,000 2,500 3,000 3,500

In Billions of $

Interest-Rate Options

Currency Options

Stock-Index Options

Individual Stock Options

Types

Exchange Traded Derivatives "Options"

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Options ContinuedOver-The-Counter Derivitaves "Options"

OTC Interest-Rate

Options

71%

OTC Currency

Options

29%

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Calls

Long a call. Person buys the right (a contract) tobuy

an asset at a cretin price. They feel that the price

in the future will exceed the strike price. This is a

bullish position.

Short a Call. Person sells the right (a contract) to

someone that allows them to buy a asset at a cretinprice. The writer feels that the asset will devalue

over the time period of the contract. This person is

bearish on that asset.

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PUTS

Long a Put. Buy the right to sell an asset at apre-determined price. You feel that the asset will

devalue over the time of the contract. Therefore

you can sell the asset at a higher price than is thecurrent market value. This is a bearish position.

Short a Put. Sell the right to someone else. This

will allow them to sell the asset at a specific

price. They feel the price will go down and you

do not. This is a bullish position.

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Swaps

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SWAPS

New in the market, late 70’s early 80’s

Two Types: Interest Rate & Currency

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Swaps

Over-The-Counter Derivatives "Swaps"

Interest-Rate Sw aps

88%

Currency Sw aps

12%

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Swap Use

• To smooth out interest rate payments

in a cyclic environment.

• To secure and level out future interest

payments.

• To secure foreign currency for loanswhen you are a visitor in that country

and it would be too difficult to secure

credit or the cost is prohibitive.

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Derivative Securities

• Mortgage Backed Securities: Fanny

Mae, Freddie Mac• Structured Notes: Sally Mae

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Derivative Securities

Mortgage

Derivatives

Structured

Notes

0

200

400

600

800

Mortgage

Derivatives

Structured

Notes

Derivitave Securities

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Explanation

Freddie Mac & Fanny Mae: Both are

derivative instruments used to pool HomeMortgage loans. This creates a secondary

market which allows banks to sell the loans,

therefore reducing their risk. It also reducesdefault risk for the holder. These are also

known as pass through instruments.

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Cont’d Explanation

Sally Mae: Same principal as the

previous example except they use student

loans. All of these also help to keep

interest rates for the underlying asset lowby keeping default risk down.

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Pass Through

Mortgage

Derivatives

Structured

Notes

0

200

400

600

800

Mortgage

Derivatives

Structured

Notes

Derivitave Securities

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Standard Securities

• Stocks

• Bonds

• Cash

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Standard Securities

Bonds Cash Stocks

0

5,000

10,000

15,000

20,000

Amount in

Billions of $

Bonds Cash StocksTypes

Traditional Securities

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Total Market

The standard market is what most people think

of when they think of the market. The truth is

that derivatives are the fastest growing sector

of the market. In fact, they are the largest

section of the market. We did not consider

mutual funds in this presentation. There are

more mutual funds in the market than there are

stocks. Again, the next graph does not

account for mutual funds.

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Total Market

Total Market: Traditional & Derivative

Total Derivatives

43%

Total Traditional

57%

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Any Questions?

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Seriously,

Any Questions?

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17615668-Derivatives