Derivatives Demystified. A. Chisholm


This book is based on a series of seminars delivered over a period of many years to people working in the global financial markets. The material has expanded and evolved over that time. Participation on the seminars has covered the widest possible spectrum in terms of age, background and seniority, ranging all the way from new graduate entrants to the financial services industry up to very senior managing directors. What all these many and varied individuals had in common was a strong desire to understand how derivative products are used in practice, without becoming too involved in the more complex mathematics of the subject. The seminars (and this book) originated from the conviction that bankers, fund managers and other professionals in the modern financial markets must have a grasp of derivative products.

In fact the target audience broadened out over the years to include technology specialists, operations experts, finance professionals working in the corporate environment and their business advisers. It is estimated that over 90% of theworld’s largest 500 companies nowuse derivatives to help to manage their exposures to the risks arising from factors such as currency fluctuations, interest rate changes and unstable commodity prices. Derivatives are everywhere in the modern world, but sometimes are not easily detected except by those in the know. If you have the option to extend a loan or redeem a mortgage early, then you have a derivative product. If a company has the opportunity to increase its production facilities or exploit some new technology, then it has what is known in the world of derivatives as a real option. This has a value, and given certain assumptions its value can be measured.

It is my view that with a little application anyone can achieve a working knowledge of the key derivative products. It is not widely appreciated that many people in the financial markets who handle derivatives regularly are not specialists in higher mathematics. Nor is it important for them to be so, but they do need to understand how the products can be used in practice to create risk management, investment and trading solutions that are appropriate for particular organizations in certain market circumstances. The real strength of derivatives is that they offer a new set of tools with which to solve real-world problems. They are not a substitute for thought or creativity; quite the reverse. Human beings have to analyse the problems and learn how to use the appropriate tools to design the best possible solutions. Anumber of excellent textbooks are available that take a quantitative approach to this subject and explain in detail the pricing models used to value derivative products. At the end of this book there is a list of further reading for those who wish to delve more deeply into this subject.

The book is constructed as follows. Chapter 1 provides additional background about the derivatives industry and explains the basic building blocks used to create a myriad of derivatives solutions and structured products. Chapters 2 and 3 consider forward contracts, including forwards on shares, currencies and interest rates. Chapters 4 and 5 discuss futures contracts, which are the exchange-traded relatives of forwards. They explore futures on commodities,
bonds, interest rates, equity indices and individual shares. Chapters 6 and 7 concern a key product in modern finance, the swap transaction. The focus is on real-world applications of interest rate, cross-currency, equity and credit default swaps. Chapter 8 begins the discussion on option contracts by introducing the fundamentals of the subject. Some readers may already be familiar with this material although the chapter provides a useful platform of knowledge for the later development. Chapter 9 provides a wide range of examples of the practical applications of options in hedging and risk management.

The discussion is not confined to standard or ‘plain vanilla’ options but explores some of the newer products created in recent years. Chapter 10 covers exchange-traded equity options, on single shares and on indices, while Chapters 11 and 12 consider the applications of currency and interest rate contracts, including products such as caps, floors, collars and swaptions. Chapters 13 and 14 outline the basic concepts involved in option valuation and risk management, but the treatment here is intuitive rather than mathematical. They explain the idea of the expected payout of an option; and introduce the industry standard Black–Scholes option pricing model and its sensitivities, the so-called ‘Greeks’: delta, gamma, theta, vega and rho. Later, in Appendix A, there is an explanation of how the model can be set up on a simple Excel spreadsheet. Chapters 15 and 16 build on this discussion to consider how option traders manage the risks on their positions; and some key trading applications of options, including volatility trades and certain applications of non-standard or ‘exotic’ contracts, are presented.

These chapters are especially aimed at people who are likely to be involved with options from a dealer’s perspective rather than that of the ‘end-users’ who are simply using options to manage risk or enhance investment returns. Chapter 17 explores convertible and exchangeable bonds – securities whose returns are linked to the value of a share or a portfolio of shares. Chapter 18 contains an extended case study on structuring new types of investment products using standard and exotic options, and concludes with a discussion on a process known as securitization – one of the most significant
developments in modern finance. The chapter also presents an example of how credit default swaps are being used to create new families of securities. For those who wish to explore the mathematical aspect of the subject, Appendix A gives a brief review of the fundamental financial calculations that form the background to derivative products.

Appendix B contains an extensive glossary of the terms used in the industry, and Appendix C gives some suggestions for further reading, together with a list of useful websites. In writing this book, I have benefited enormously from the ideas, comments and suggestions made by many seminar participants over the years. I also owe a debt of gratitude to all the derivatives market practitioners who have deepened my understanding of the subject by allowing me to observe how they work and by sparing the time to discuss their activities. My hope is that some portion of their creativity and enthusiasm is transferred to the book, although, of course, I take full responsibility for all errors or omissions in the finished product. Finally, I give special thanks to Sir George Mathewson and John Davie who (no doubt inadvertently) started me off on this road so many years ago.

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