Derivatives Markets - Part A

What are Derivatives?
A derivative security is a financial instrument whose value (performance) is derived from the value (performance) of an underlying security.
- Are asset management products, e.g., mutual funds, derivatives?
  - No, mutual funds pass through returns of underlying securities to clients.
- What do we really mean by "derive"?
  - Transfer risk from one party to another.
  - The value of the underlying security is the source of risk.
Types of Instruments on Derivatives Markets
- Forward Commitments
  - Forward Contracts
  - Futures Contracts
  - Swaps (to be discussed in module "Ethics in Finance")
- Contingent Claims
  - Options
- Hybrids
Structures of Derivatives Markets
- Exchange Traded
- Over the Counter
Benefits and Criticisms of Derivatives
References: Kidwell Chapter 11, CFA curriculum 2020 Level I Reading 48

Example: S\&P 500 stock portfolio
- Suppose we are on January 5th, 2022.
- The S\&P 500 is currently at $4800. Its value may drop or increase in the future.
- Jenny has a stock portfolio worth $10.8 million, which tracks closely with the S\&P 500. She plans to sell her portfolio by March 2022 but fears that a big decline is coming.
- John plans to invest around $10.8 million into a stock portfolio tracking the S\&P 500 by March 2022. He fears that a big increase is coming and wants to buy within his budget.
- What choices do they have?
They can choose to:
- Do nothing now and sell/buy at spot price on March 31, 2022 (transaction price won't be known until March 31, 2022).
- Enter into a forward commitment:
  - Sign a forward contract with each other now (transaction price is fixed now).
  - Go to the futures market and take futures contracts now (transaction price is fixed now).
- Get a contingent claim:
  - Go to the options market and take options now (transaction price is at least as good as the fixed one).
- Swap is usually used to change between fixed and variable cash flow payments, therefore not applicable here.
Wealth impact of different choices:
- The chart shows Jenny's and John's profit/loss based on the S\&P 500 index price, comparing doing nothing, forward commitments, and contingent claims.
The gaps in wealth impact are different for Jenny and John based on their choices.

Forward Commitments: An obligation. Contracts entered into at one point in time that require both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start.
- Forward contracts, futures contracts, swaps (not covered in EFB201).
Contingent Claims: A right to make a final payment contingent on the performance of the underlying.
- Options.
Hybrids: E.g., callable bonds (issuers pay off earlier than maturity date), convertible bonds (bond holders convert bonds into shares).

Revisit S\&P 500 portfolio example in details
1. Do nothing
2. Enter into forward commitment
  - Forward contract:
    - Jenny and John sign a forward contract over the counter on Jan 5th 2022, in which John will purchase the entire stock portfolio tracking S\&P 500 index from Jenny on March 31st 2022 at the price of $10.8 million.
  - Futures contract (detailed in Derivatives Part B)
    - Jenny (John) goes to CME Globex and sell (buy) E-mini S\&P 500 (ESH2) MAR 2022 futures contracts on Jan 5th 2022.
3. Get a contingent claim
  - Jenny (John) go to the options market (detailed in Derivatives Part C)
Wealth impact of doing nothing
Wealth impact of forward commitments (forward & futures contracts)
In the previous S\&P 500 portfolio example
- Forward contract:
  - Jenny and John sign a forward contract over the counter on Jan 5th 2022, in which John will purchase the entire stock portfolio tracking S\&P 500 index from Jenny on March 31st 2022 at the price of $10.8 million.
- Futures contract (detailed in Derivatives Part B):
  - Jenny (John) goes to CME Globex and sell (buy) E-mini S\&P 500 (ESH2) MAR 2022 futures contracts on Jan 5th 2022.