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P1: OTA/XYZ P2: ABCfm JWBT1419-Kolb September 18, 2014 11:45 Printer Name: Hamilton


FINANCIALDERIVATIVES


The Robert W. Kolb Series in Finance provides a comprehensive view of the fieldof finance in all of its variety and complexity. The series is projected to includeapproximately 65 volumes covering all major topics and specializations in finance,ranging from investments, to corporate finance, to financial institutions. Each vol-ume in the Kolb Series in Finance consists of new articles especially written for thevolume.

Each Kolb Series volume is edited by a specialist in a particular area of finance, whodevelops the volume outline and commissions chapters by the world’s experts inthat particular field of finance. Each volume includes an editor’s introduction andapproximately 30 articles to fully describe the current state of financial researchand practice in a particular area of finance.

The chapters in each volume are intended for practicing finance professionals,graduate students, and advanced undergraduate students. The goal of each volumeis to encapsulate the current state of knowledge in a particular area of finance sothat the reader can quickly achieve a mastery of that special area of finance.


FINANCIALDERIVATIVES

Pricing and RiskManagement

Robert W. KolbJames A. Overdahl

The Robert W. Kolb Series in Finance

John Wiley & Sons, Inc.


Copyright c© 2010 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Kolb, Robert W., 1949–Financial derivatives : pricing and risk management / Robert W. Kolb,

James A. Overdahl.p. cm. – (The Robert W. Kolb series in finance)

Includes bibliographical references and indexes.ISBN 978-0-470-49910-8 (cloth)1. Derivative securities. 2. Financial engineering. I. Overdahl, James A.

II. Title.HG6024.A3K648 2010332.64′57–dc22 2009017152

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

http://www.copyright.com

http://www.wiley.com/go/permissions

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To George G. Kaufman, friend, colleague, and professorial exemplar.R.W.K.

To the memory of Ray Beneke, teacher, scholar, and mentor whoenriched the lives of all who knew him.

J.A.O.


Contents

Introduction xxii

Acknowledgments xxiv

PART I Overview of Financial Derivatives 1

1 Derivative Instruments: Forwards, Futures, Options,Swaps, and Structured Products 3G. D. Koppenhaver

Introduction 3A Generalist’s Approach to Derivative Contracts 6

Forward Contracts 7Futures Contracts 9Swap Contracts 11Option Contracts 13

Structured Products and an Application to Derivative Contracts 16Conclusion 19Endnotes 19References 20About the Author 20

2 The Derivatives Marketplace: Exchangesand the Over-the-Counter Market 21Sharon Brown-Hruska

Introduction 21Standardization versus Customized Products: Differencesin Structure and Approach 22Competition and Consolidation: Impetus for Change 25Moving from Bilateral to Multilateral Risk Management 29

Collateral in Exchange and OTC Markets 29Netting and Novation in Exchange and OTC Markets 31

Transparency and Information in the Exchange andOTC Marketplaces 36Conclusion 39Endnotes 40

vii


viii Contents

References 41About the Author 42

3 Speculation and Hedging 43Greg Kuserk

Hedging Transactions 44Speculation 48From Hedging to Speculation 50Interaction between Hedgers and Speculators 52Conclusion 54Endnotes 54References 54About the Author 55

4 The Social Functions of Financial Derivatives 57Christopher L. Culp

Hedging and Risk Transfer 58Price Discovery 58

Price Discovery, Commoditization, and Market Structure 59Intertemporal Resource Allocation 60

Forward Contracts as Synthetic Storage 60Commodity Interest Rates 60

Asset Finance 61Commodities Lending 62Project Finance 63Trade Finance 64Financial Asset Inventory Management 65

Synthetic Asset Allocation 65Derivatives and Public Policy 66

Endnotes 67Further Reading 68References 69About the Author 71

PART II Types of Financial Derivatives 73

5 Agricultural and Metallurgical Derivatives: Pricing 77Joan C. Junkus

Introduction 77Commodities 77Seasonality in Spot and Futures Prices 78Futures Pricing 79

Theory of Storage 80Theory of Normal Backwardation 84


CONTENTS ix

Conclusion 85References 86Suggested Further Reading 86About the Author 87

6 Agricultural and Metallurgical Derivatives:Speculation and Hedging 89Joan C. Junkus

Introduction 89Commodities 89Derivatives 90Commodity Investment Strategies 90

Commodity Indexes 90Diversification and Inflation 91Passive Investment Strategies 91Active Strategies 94Measuring Investment Performance 94

Hedging 95Commodity Marketing 95Risk Management 97

Spreads 99Conclusion 100References 100Suggested Further Reading 101About the Author 101

7 Equity Derivatives 103Jeffrey H. Harris and L. Mick Swartz

Introduction 103Stock Options 104

Call Options 105Put Options 106Stock Options on an Index 106Employee Stock Options 107Convertible Bonds 107Warrants 108

Equity Futures 108Single-Stock Futures 108Futures on Stock Indexes 109

Equity Swaps 110Future of Equity Derivatives 111References 112Further Reading 112About the Authors 113


x Contents

8 Foreign Exchange Derivatives 115Robert W. Kolb

Basic Pricing Principles 115Purchasing Power Parity Theorem 115Interest Rate Parity Theorem 116

Foreign Exchange Forward and Futures Contracts 117Foreign Exchange Options 118FX Option Pricing 119Plain Vanilla Foreign Exchange Swaps 119Flavored Currency Swaps 121Conclusion 122Endnotes 123References 123About the Author 123

9 Energy Derivatives 125Craig Pirrong

Introduction 125Products: An Overview 125History 126Petroleum Derivatives: Details 127Natural Gas Derivatives: Details 128Electricity Derivatives: Details 129Pricing 129Clearing 131Recent Developments 132References 133About the Author 133

10 Interest Rate Derivatives 135Ian Lang

Exchange-Traded (Listed) Derivatives 135Over-the-Counter Derivatives 138

OTC Options 138Rate Locks 138Swaps and Swaptions 139Mortgage Derivatives 141

Further Reading 142About the Author 142

11 Exotic Options 143Robert W. Kolb

Overview 143Forward-Start Options 144


CONTENTS xi

Compound Options 144Chooser Options 145Barrier Options 146Binary Options 147Lookback Options 149Asian or Average Price Options 150Exchange Options 151Rainbow Options 151Conclusion 152Endnotes 153References 154About the Author 154

12 Event Derivatives 157Justin Wolfers and Eric Zitzewitz

Types of Prediction Markets 158Applications and Evidence 160Accuracy of Prediction Markets 160Possibilities for Arbitrage 164Can Event Markets Be Manipulated Easily? 168Market Design 168Making Inferences from Prediction Markets 170Innovative Future Applications? 173Acknowledgments 173Endnotes 174References 174About the Authors 176

13 Credit Default Swaps 177Steven Todd

Credit Default Swaps on Corporate Debt 177Credit Default Swaps on Asset-Backed Securities 178Credit Default Swaps on Collateralized DebtObligations 180The Basis 182CDS Indices 182Tranches of CDS Indices 186Trading Strategies Using Indexes and Tranches 188Market Dynamics: CDS and CDOs 189Synthetic CDOs and Bespokes 189Correlation 191Conclusion 196Endnotes 196References 197About the Author 198


xii Contents

14 Structured Credit Products 199Steven Todd

Asset-Backed Securities 202Collateralized Debt Obligations 204Commercial Mortgage-Backed Securities 208Endnotes 209References 210About the Author 210

15 Executive Stock Options 211Robert W. Kolb

Introduction 211Basic Features of Executive Stock Options 211

Rationales for ESOs 212Pricing of Executive Stock Options 214Executive Stock Options and Incentives 216

Conclusion 218Endnotes 218References 219About the Author 220

16 Emerging Derivative Instruments 221Steve Swidler

Economic Derivatives 222Real Estate Derivatives 224The Next Frontier 226Endnotes 228References 228Suggested Further Reading 229About the Author 230

PART III The Structure of Derivatives Marketsand Institutions 231

17 The Development and Current Stateof Derivatives Markets 233Michael A. Penick

Introduction: The Situation in the 1960s 233Financial Futures and Options 234Foreign Markets 236OTC Markets 237Energy Derivatives 238The Rise of Electronic Trading 240Current Conditions: Consolidation and Crisis 243


CONTENTS xiii

Endnotes 245References 247About the Author 248

18 Derivatives Markets Intermediaries: Brokers,Dealers, Pools, and Funds 249James L. Carley

Intermediaries for Exchange-Traded Derivatives 250Providers of Trade Execution Services 251Providers of Money Management Services 256

Intermediaries for OTC Derivatives 257Swap Brokers 258Swap Dealers 258Interdealer Brokers 258Next Step: Clearinghouse(s) for Swaps 259


19 Clearing and Settlement 263James T. Moser and David Reiffen

Introduction 263Functions of Clearinghouses 263

Contracts for Immediate Performance 264Contracts for Deferred Performance 265

Clearing and Liquidity 273Competition between Exchanges 275

Nature of the Clearing Organization 276Innovation and Clearing Structure 278

Conclusion 278Endnotes 279References 281About the Authors 282

20 Counterparty Credit Risk 283James Overdahl

Measuring Counterparty Credit Risk Exposure 284Presettlement versus Settlement Risk 284Replacement Cost, Current Exposure, and Potential Exposure 284Simulation Techniques and the Exposure Profile 285Wrong-Way and Right-Way Risk 287

Managing Counterparty Credit Risk 287Evaluating the Creditworthiness of Counterparties 287Using Counterparty Credit Risk Measures in the TradeAuthorization Process 288


xiv Contents

Other Tools to Manage Counterparty Credit Risk 289Netting 289Actual Default Experience in the OTC Market 289

Infrastructure Improvements Aimed at MitigatingCounterparty Credit Risk 290

Infrastructure and the Effectiveness of Counterparty CreditRisk Management 290Central Counterparty Clearing 291


21 The Regulation of U.S. Commodity Futuresand Options 295Walter L. Lukken

Tiered Regulatory Design 296Statutory Exclusions for Certain OTC Derivatives 297Security Futures Products 298Retail Foreign Currency Fraud 299Exempt Commercial Markets 300CFTC Reauthorization Act of 2008 300Future Legislative Reforms 301Endnotes 302About the Author 303

22 Accounting for Financial Derivatives 305Ira G. Kawaller

Alternative Accounting Categories 305Cash Flow Hedges 306Fair Value Hedges 309Hedges of Net Investments in Foreign Operations 311

Conclusion 312References 312About the Author 312

23 Derivative Scandals and Disasters 313John E. Marthinsen

Introduction 313Anatomy of Derivative-Related Failures 313Investment Strategies and Exogenous Shocks behind Our FiveDerivative Fiascos 315

MGRM’s Strategy 315LTCM’s Strategy 316Amaranth’s Strategy 317Barings’ and Societe Generale’s Speculative Traders 318


CONTENTS xv

Lessons Learned from Derivative Scandals and Disasters 319Controlling Risks Is Possible Only If They Can Be MeasuredEffectively 319Risk Management Systems Must Cauterize Losses Immediatelyafter the Initial Shocks 320Creative Ways Are Needed to Supply Liquidity duringTurbulent Times 321Risk Management Systems Must Control Traders andFund Managers 321Compensation Incentives and Promotion Criteria MustBe Scrutinized 323Risk Management Systems Are Only as Strong as Their WeakestRisk Managers 325

Broader Implications of Derivative Scandals and Disasters 326Conclusion 327Acknowledgements 328Endnotes 328References 330Suggested Further Reading 331About the Author 332

PART IV Pricing of Derivatives: Essential Concepts 333

24 No-Arbitrage Pricing 335Robert A. Strong

Free Lunches 335Theory of Put/Call Parity 336Binomial Option Pricing Model 341Put Pricing in the Presence of Call Options: Further Study 345Binomial Put Pricing 346Binomial Pricing with Asymmetric Branches 346Effect of Time 347Effect of Volatility 348Intuition into Black-Scholes 348Endnotes 349References 349Further Reading 349About the Author 350

25 The Pricing of Forward and Futures Contracts 351David Dubofsky

Cost of Carry Model 352Carry Return 354Commodity Futures 355Convenience Yield 356Delivery Options 357


xvi Contents

Interest Rate Futures and Forwards: Eurodollar Futuresand Forward Rate Agreements 358Interest Rate Futures and Forwards: Treasury Bondand Treasury Note Futures 360Should Futures and Forward Prices Be the Same? 362Expectations Model: An Alternative Theory for the Pricingof Forwards and Futures 363Electricity Forwards and Futures 364Conclusion 366Endnotes 367References 367About the Author 369

26 The Black-Scholes Option Pricing Model 371A. G. Malliaris

Introduction 371Brief History 372Black-Scholes Formula 372Assumptions of the Black-Scholes Model 373Discussion of Assumptions 374Ito Process 374Example 375Excel Application 376Simple Derivation of Black-Scholes 376Numerical Example 380The Greeks 381

Delta 381Gamma 381Theta 381Vega 381Rho 382

Risk-Neutral Pricing 382Conclusion 384References 384About the Author 385

27 The Black-Scholes Legacy: Closed-Form OptionPricing Models 387Antonio Camara

Introduction 387The Black-Scholes Model 388First Generation of Models (One Lognormal Underlying) 392Second Generation of Models (Two Lognormal Underlyings) 395Third Generation of Models (One NonlognormalUnderlying) 397Fourth Generation of Models 401Conclusion 402


CONTENTS xvii


28 The Pricing and Valuation of Swaps 405Gerald Gay and Anand Venkateswaran

Introduction 405Illustration 1: An End User Swap Application 406

Framework for Pricing and Valuation 407Illustration 2: A Simple Example 409

Steps for Swap Pricing 410Obtain Market Inputs 410Make Convexity Adjustments to Implied Futures Rates 411Build the Zero Curve 413Identify Relevant Swap Features 415Price/Value the Swap 415Illustration 3: Pricing an Interest Rate Swap 416Illustration 4: Valuing an Existing Interest Rate Swap 416

Other Swaps 417Currency Swaps 417Illustration 5: Pricing and Valuing a Currency Swap 418Commodity Swaps 419Illustration 6: Pricing a Commodity Swap 419

Endnotes 420References 421About the Authors 422

PART V Advanced Pricing Techniques 423

29 Monte Carlo Techniques in Pricingand Using Derivatives 425Cara M. Marshall

Introduction 425Pricing a Classic Black-Scholes Option 427

Simulation Results 432Price Return 432

Pricing a Rainbow Option 435Endnotes 439References 439About the Author 440

30 Valuing Derivatives Using Finite DifferenceMethods 441Craig Pirrong

Introduction 441An Overview 441


xviii Contents

Basic Methods 445Higher-Dimension Problems 449The Pros and Cons of Finite Difference Methods 451Suggested Further Reading 451Endnotes 452References 452About the Author 453

31 Stochastic Processes and Models 455George Chalamandaris and A. G. Malliaris

Introduction 455Stochastic Processes 456

Definitions and Properties 456Constructing the Continuous Time Model: Brownian Motion 458The Ito Process and the Need for Stochastic Calculus 459

Basic Elements of Stochastic Calculus 462Ito Integral 462Ito’s Lemma 464

Binomial Tree: Another Way of Visualizing aStochastic Process 468

Construction of a Binomial Tree and Properties 469Conclusion 472Endnotes 472References 472Appendix: Heuristic Derivation of Ito’s Formula 473About the Authors 475

32 Measuring and Hedging Option PriceSensitivities 477R. Brian Balyeat

Delta 477Example 1 479Example 2 479

Gamma 484Example 3 485

Theta 487Example 4 488

Vega 491Example 5 492

Rho and Other Option Sensitivities 493Example 6 493Example 7 494

Hedging Delta, Gamma, and Vega 496Conclusion 498References 499About the Author 499


CONTENTS xix

PART VI Using Financial Derivatives 501

33 Option Strategies 503Stewart Mayhew

Building Blocks 505Covered Calls and Protective Puts 507Synthetic Positions 509Bull and Bear Spreads 512Cylinders 515Straddles, Strangles, Strips, and Straps 516Ratio Spreads 518Box Spreads 518Butterflies, Condors, and Seagulls 519Time Strategies 522Multi-Asset Strategies 523Endnotes 523References 523About the Author 524

34 The Use of Derivatives in Financial Engineering:Hedge Fund Applications 525John F. Marshall and Cara M. Marshall

Introduction 525Convertible Bond Arbitrage 526Capital Structure Arbitrage 534Endnotes 538References 539About the Authors 539

35 Hedge Funds and Financial Derivatives 541Tom Nohel

Introduction 541Survey of Derivative Use by Hedge Funds 544Modeling Hedge Fund Risks 547Description of Some Popular Hedge Fund Strategies 548

Convertible Arbitrage 548Risk Arbitrage 549Global Macro 549Market Neutral/Relative Value 550Volatility Trades 550Correlation Trading 551Credit Hedge Funds 551Hedge Fund Activism 552

Some Unusual Derivatives Trades Made by Hedge Funds 552Empty Voting 552


xx Contents

Acquiring a Large Stake through Put Exercise 553Toeholds via Contingent Contracts 553Tax-Avoidance Strategies 554Using Structures to Create Leverage 555


36 Real Options and Applications in Corporate Finance 559Betty Simkins and Kris Kemper

Introduction 559A Brief History of Real Options 560Distinction between Financial Options and Real Options 561Types of Real Options and Examples in the Energy Industry 561

Option to Expand 563Option to Wait 563Option to Vary Production Inputs, Outputs, or Processes 564Option to Abandon or Temporarily Shutdown 566Hybrid Real Options 568

Valuing Real Options 568Decision Trees 569Monte Carlo Simulation 569Option Pricing Models 569

Conclusion 570Endnotes 570References 572About the Authors 573

37 Using Derivatives to Manage Interest Rate Risk 575Steven L. Byers

Introduction 575Forward-Based Instruments 575

Forward Rate Agreements 575Interest Rate Futures Contracts 577Basis Risk 578Futures Hedge Ratio 579Example of Hedging with Eurodollar Futures 580Hedging a Portfolio of Coupon Bonds with Interest Rate Futures 581Interest Rate Swaps 582

Option-Based Instruments 583Interest Rate Guarantees 584Interest Rate Caps and Floors 584Swaptions 586Mortgage Securitization Risk Management Using InterestRate Derivatives 586


CONTENTS xxi

Conclusion 588References 588Suggested Further Reading 589About the Author 589

Index 591


Introduction

In a time in which the finance industry is under attack and our entire financialsystem is under remarkable stress, financial derivatives are at the center of thestorm. For the public at large, financial derivatives have long been the most

mysterious and least understood of all financial instruments. While some financialderivatives are fairly simple, others are admittedly quite complicated and requireconsiderable mathematical and statistical knowledge to understand fully.

With vast changes for our financial system in prospect, there has never beena time in which those engaged in setting public policy and the concerned generalpublic have a greater need for a general understanding of financial derivatives. Asthe reader of this book will learn, financial derivatives are instruments of remark-able power and very justifiable uses. However, as this text also freely acknowledgesand explains, the very power of these financial derivatives makes them subject toaccident in the hands of the incautious and also makes them effective tools formischief in the hands of the unscrupulous.

To contribute to an improved public understanding of these markets, Finan-cial Derivatives explores the contemporary world of financial derivatives, startingwith a presumption of only a general knowledge of undergraduate finance. Thesechapters have been written by many leading figures in academics, industry, andgovernment for the benefit of advanced undergraduates, graduate students, prac-ticing finance professionals, and the general public. As such, the chapters in thisbook provide a comprehensive understanding of financial derivatives. FinancialDerivatives is comprised of 37 chapters organized into six parts:

Part One, “Overview of Financial Derivatives,” provides an introduction toand an overview of the types of financial derivatives, the markets in which theytrade, and the way that traders use derivatives, and it also offers a broader perspec-tive addressing the question of the social function of derivatives markets. Againstthat background, Part Two, “Types of Financial Derivatives,” explores the variety ofderivatives, starting with the agricultural and metallurgical derivatives that werehistorically the first to be developed. This part also discusses financial derivativesbased on stock indexes, foreign currencies, energy, and interest rate instruments.It continues by giving an overview of the variety of exotic options and a type ofexotic options known as an event derivative. Two chapters focus on credit defaultswaps and structured credit products that have allegedly played a central role inthe recent crisis in financial markets. Executive compensation is always controver-sial, it seems, and has generated particular outrage in the current crisis, so this partdiscusses executive stock options and concludes with an overview of some of theemerging financial derivatives that are likely to become prominent in the future.

xxii


INTRODUCTION xxiii

After having introduced the markets and types of derivatives in Parts Oneand Two, Part Three turns to an examination of “The Structure of DerivativesMarkets and Institutions.” Chapter 17 analyzes the development and current stateof derivatives markets, and subsequent chapters take on issues such as a surveyof the participants in the market and the way in which transactions are fulfilled.Fulfillment is a critical part of the market, because this issue concerns the honoringand completion of contracts, without which no viable market can persist. Closelyrelated to this is the issue of counterparty credit risk—the risk that one party to thederivatives contract might default on contractual obligations. This part also surveysthe regulation of derivatives markets, along with the principles of accounting asthey pertain to derivatives. The part concludes with a brief account of some of themost famous derivatives disasters of recent decades.

Part Four, “The Pricing of Derivatives: Essential Concepts,” introduces thefundamentals of determining the price of derivatives. The part begins by introduc-ing the principle of no-arbitrage pricing. The first condition of a well-performingmarket from the point of view of pricing is that prices in the market are such thatarbitrage is impossible—where arbitrage can be defined as the securing of a risk-less profit without investment. With this background, the discussion turns to thepricing of particular instruments, such as forward and futures contracts. Next thepart introduces the famous Black-Scholes option pricing model and then considersthe various ways in which this seminal model has been extended and enhancedto apply to other derivatives. The part concludes with an analysis of the pricing ofswap contracts.

Part Five, “Advanced Pricing Techniques,” extends the pricing analysis ini-tiated in Part Four. The chapters in this part are more technical, beginning withshowing how Monte Carlo methods can be applied to price derivatives. The dis-cussion of Monte Carlo techniques is immediately followed by a considerationof finite difference models, models that can be applied with great benefit whenanalytical models are not available. Much of the pricing of derivatives turn on thepath that the underlying good is presumed to follow. When this path is describedstatistically, the description is known as a stochastic process, an understanding ofwhich is necessary to more sophisticated analysis. Finally, this part explores howoption prices respond to changes in their various input values.

Part Six, “Using Financial Derivatives,” concludes the book. By this time, thereader will be well aware that financial derivatives are very valuable for managingrisks and for providing information about the future prices of underlying goods.Financial derivatives can also be used as tools of quite sophisticated speculation.This part begins with an exploration of option strategies used in speculation andshows how the same strategies can also be used to reduce risk. Next comes adiscussion of how hedge funds use financial derivatives and, more exactly, howhedge funds use the techniques of financial engineering. Financial derivatives arepowerful tools for managing interest rate risk, as this part also explores. Chapter36 examines real options, options based on physical assets or opportunities thatfirms possess. The book concludes with a discussion of how firms can use financialderivatives to manage their own risks.


Acknowledgments

The editors would like to acknowledge the contribution of the many peoplewho have made this volume possible. Our first debt is to the many scholarswho shared their knowledge by writing the chapters that comprise this text.

We would like to also thank George Lobell, editor at John Wiley & Sons, Inc., forhis vision of the series in which this volume appears and his encouragement of theseries in general and this text in particular. Also at John Wiley, we would like tooffer our thanks to the editorial team of Pamela Van Giessen, William Falloon, andLaura Walsh for their continuing support of and commitment to this project.

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PART I

Overview of Financial Derivatives

Part One consists of four introductory chapters intended to open the world offinancial derivatives to the reader. In Chapter 1, “Derivative Instruments:Forwards, Futures, Options, Swaps, and Structured Products,” Gary D.

Koppenhaver takes a generalist approach to forwards, futures, swaps, and op-tions. He approaches these instruments from the point of view of their suitabilityto address a single problem: managing financial risk. Through this approach, heshows that these instruments obey common principles and are closely relatedfrom a conceptual point of view. Koppenhaver strives to emphasize the connec-tions among these different types of derivatives in order to demystify derivativesin general.

One of the largest differences among derivatives turns on the manner in whichthey are traded—on exchanges or in the more informal and less structured over-the-counter market? Sharon Brown-Hruska contrasts these two models for trad-ing derivatives in Chapter 2, “The Derivatives Marketplace: Exchanges and theOver-the-Counter Market.” In light of the financial crisis, many legislators arepressing to reduce or eliminate the over-the-counter market, which is actuallymuch larger than the market for exchange-traded derivatives. However, many be-lieve that trading derivatives on exchanges make them more transparent, easier toregulate, and less likely to lead to derivatives disasters.

From the point of view of derivatives, we might think of speculation as tradingderivatives in a manner that increases the investor’s risk in order to pursue profit.Hedging by contrast is trading derivatives in order to reduce a preexisting risk.In Chapter 3, “Speculation and Hedging,” Gregory Kuserk shows how hedgingand speculation differ but also explains how one might think of hedging andspeculating as two sides of the same coin, with the relationship between the twoactivities being much closer than is generally recognized.

The editors of this volume believe that Chapter 4 by Christopher L. Culp,“The Social Function of Financial Derivatives,” is one of the most important in theentire volume. As discussed in the introduction to this book, there is a recurringimpulse to eliminate derivatives markets through legislative action. Culp showshow derivatives markets serve society in a variety of ways, some of which are quiteobvious and others of which are more sophisticated.

1

CHAPTER 1

Derivative InstrumentsForwards, Futures, Options, Swaps,and Structured Products

G. D. KOPPENHAVERProfessor and Chair, Department of Finance, Insurance and Law,Illinois State University

INTRODUCTIONThe evolution of ideas in finance usually is driven by circumstances in financialmarkets. In the early 1980s, at the inception of cash-settled financial futures con-tracts, the term derivatives was most often associated with financial rocket science.Esoteric derivative contracts, especially on financial instruments, faced a publicrelations probem on Main Street. By the mid-1990s, the term derivatives carried anegative connotation that conservative firms avoided. High-profile derivative mar-ket losses by nonfinancial firms, such as Metallgesellschaft AG, Procter & GambleCo., and Orange County, California, caused boards of directors to look askance atderivatives positions.1 In the early 2000s, however, derivatives and their use are areal part of a discussion of business tactics. While it is still the case that derivativescontracts are a powerful tool that could damage profitability if used incorrectly,the discussion today does not focus on why derivative contracts are used but howand which derivative contracts to use.

The goal of this chapter is to take a generalist approach to closely related in-struments designed to deal with a single problem: managing financial risk.2 Inthe chapter, forwards, futures, swaps, and options are not treated as unique in-struments that require specialized expertise. Rather the connection between eachclass of derivative contracts is emphasized to demystify derivatives in general.As off–balance sheet items, each is an unfunded contingent obligation of contractcounterparties. Later in the chapter, the discussion returns full circle to consider thecreation of funded obligations with derivative contracts, called structured prod-ucts. Structured products are financial instruments that combine cash assets and/orderivative contracts to offer a risk/reward profile that is not otherwise available oris already offered but at a relatively high cost. The repackaging of off–balance sheetcredit derivatives into an on–balance sheet claim is shown through a structuredinvestment vehicle example.

Uncertainty is a hallmark of today’s global financial marketplace. Unexpectedmovements in exchange rates, commodity prices, and interest rates affect

3

4 Overview of Financial Derivatives

earnings and the ability to repay claims on assets. Great cost efficiency, state-of-the-art production techniques, and superior management are not enough to ensurefirm profitability over the long run in an uncertain environment. Risk managementis based on the idea that financial price and quantity risks are an ever-increasingchallenge to decision making. In responding to uncertainty, decision makers canact to avoid, mitigate, transfer, or retain a commercial risk. Because entities are inbusiness to bear some commercial risk to reap the expected rewards, the mitigationor transfer of unwanted risk and the retention of acceptable risk is usually the out-come of decision making. Examples of risk mitigation activities include forecastinguncertain events and making decisions that affect on–balance sheet transactionsto manage risk. The transfer of unwanted risk with derivative contracts, however,is a nonintrusive, inexpensive alternative, which helps explain the popularity ofderivatives contracting.

Consider Exhibits 1.1 through 1.4 as part of the historical record of volatilityin financial markets. Exhibit 1.1 illustrates the monthly percentage change in theJapanese yen/U.S. dollar exchange rate following the breakdown of the BrettonWoods Agreement in the early 1970s. The subsequent exchange rate volatilityhelped create a successful Japanese yen futures contract in Chicago. In Exhibit 1.2,the monthly percentage change in a measure of the spot market in petroleum isillustrated. While significant spikes in price occur around embargos or conflict inthe Middle East, price volatility has not lessened over time for this important inputto world economies. U.S. interest rates are also a source of uncertainty. The changein Federal Reserve operating procedures in the late 1970s temporarily increasedvolatility, but significant uncertainty in Treasury yields has remained over time.

8Monthly

6

4

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0

% C

hang

e

–2

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Feb/71

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Feb/01

Feb/03

Feb/05

Exhibit 1.1 Percent Change in Yen/U.S. $ Exchange Rate

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