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This talk was given at the JAT Tokyo meeting, 20 April 2002.
Introduction
The subject of financial derivatives comes up frequently in both the news and literature translators are asked to handle. Derivative instruments also exist around us in a great variety of forms that usually go unrecognized. Nevertheless, as indicated by the questions raised at the presentation by a very bright group of people, the level of knowledge of this topic is very low. Hopefully, some of the information presented helped to close this gap.
Derivatives sometimes appear in the news at the heart of spectacular stories. Some examples are the destruction of Barings Bank in Singapore by a renegade derivatives trader, the Toyota Shoji fraud in the 1980s here in Japan and the huge loss to Sumitomo Mining and Metals in the copper market of the London Metals Exchange.
What They Are and What They Are Used For
In its most basic form a derivative instrument is a contract to buy, sell or exchange something in the future. The most common examples are futures and options, although there are a great many more such as swaps, convertible bonds, warrants, caps, floors and forwards. The term "derivative" is defined as 派生商品 in Japanese, i.e., product derived from something else.
The primary function of a derivative instrument is for "hedging." This refers to an insurance function of shifting risk to another party, usually against adverse price movement. They can also be used for speculation, which is often the objective of the party accepting the risk.
Parties Likely to Use Derivatives
One group of people likely to make use of derivative instruments is known as hedgers, who are seeking protection and insurance. Examples of hedge sellers are producers such as farmers and mining companies who can sell what they will have ready for sale in the future. Another group are hedge buyers who are users such as manufacturers, processors and consumers who can pay today for what they will have to buy in the future.
Opposite the hedger is the speculator who can be characterized as a gambler who is betting that the hedgers (or other speculators) are wrong. They fulfill an important role by providing the liquidity that makes the markets work efficiently.
Distinguished From a Routine Buy or Sell Transaction
In a routine buy or sell transaction, someone simply exchanges money for something and becomes the owner or delivers something in exchange for money. There is nothing more to be done in such cases. However, a derivative transaction requires some action in the future by offset or delivery. Here offset refers to an opposite sell or buy transaction resulting in the extinguishing of any possible risk or reward. Delivery refers to a buyer receiving delivery or a seller making delivery.
Where Derivative Transactions Are Conducted
Derivative transactions are conducted either on public exchanges or privately between parties. Some well-known exchanges listing such products are the Chicago Mercantile Exchange, Tokyo Financial Futures Exchange and Singapore Monetary Exchange. The private market is also referred to as the over-the-counter market (店頭市場) and the largest such market is the interbank market.
Definitions of Two Basic Derivative Instruments
(1) Futures Contract
A futures contract is the obligation to buy or sell something at a later
time. "Future" usually refers to such a vehicle listed on an exchange
whereas the same product in the OTC market may be referred to as a "forward,"
(先渡し), "exchange agreement" (為替予約) and others.
(2) Option
The most basic definition of an option is the right, but not the obligation,
to buy or sell something in the future.
In both of these cases, a financial "something" can be almost anything
such as foreign currency, bonds, stock indices, short or long term rates of
interest, etc. The term used to refer to this is the "underlying."
What Happens With the Buy or Sell of a Futures Contract?
Simply stated, two parties create a contract agreeing to complete the contract at some point in the future. While the contract is still "open," each party is exposed to possible risk and reward depending on how the price of the underlying moves in the market. The graph of this risk-reward potential is shown in Figure 1 with "price" referring to the contract price.
Why Futures Are Perceived as Dangerous Investments
Statistically, 90% or more of the small individual investors who engage in futures trading lose money. So naturally, the product has earned a bad reputation, especially when it also comes up in the context of a major fraud. The reason for this is the availability of high leverage not found in other markets. However, another relatively unknown fact is that the percent moves seen in the stock market are much greater than what is found in the futures market. The following example shows how leverage works to the severe disadvantage of an individual trading a gold future.
Example:
Gold is $300 per ounce. 1 gold contract is for 100 oz. Total Contract Value = $300 X 100 = $30,000
"A" buys 100 oz. for cash for $30,000. "B" deposits $3,000 and buys 1 contract.
Gold drops to $250 per ounce. Loss for both "A" and "B" is $50 X 100 = $5,000.
In percent terms, the loss for "A" is $5,000 / $30,000 = 16.7%.
The percent loss for "B" is $5,000 / $3,000 = ―166.7%. He owes money!
This is how one young man destroyed an entire bank in Singapore.
Margin as a "Security Deposit" to Guarantee Performance of a Futures Contract
Participants can enter transactions in the exchange market by making a deposit called margin (証拠金). Although similar to a "down payment," the function of this deposit is to guarantee performance of a futures contract. Margin is generally a very small percentage of the total contract value, and additional margin may be required depending on market conditions. This contrasts with the OTC market, where the ability to enter into transaction depends on credit rating. A similar concept in the stock market is margin trading (信用取引).
A Closer Look at Options
As mentioned above, options introduce a contingency into the derivative transaction. Restated, the buyer of an option pays the seller for a promise from seller to sell (or buy) something at a specific price if buyer wants to call in the promise before a stated time. However, the seller must perform the promise at the whim of the buyer. This means the risk for buyer is limited to cost of promise.
The following is a very brief list of key option terminology:
Profit and Loss Exposure with OptionsPremium: Cost of promise paid by buyer to seller.
Call: Right to buy (買い権利)
Put: Right to sell (売り権利)
Strike Price: Promised transaction price (行使価格)
Exercise: Forcing the transaction (行使)
Expiry: Deadline for exercise (満期)
Figure 2 shows the respective profit and loss exposures at expiration of the four basic positions that are possible with options. The key distinction between long and short options is the former have unlimited profit potential and limited risk of loss while the latter have exactly the opposite profile of unlimited risk of loss and limited profit potential.
Actions by Option Buyer
With a call option, if market price is below P, the buyer will do nothing, losing all of the premium paid for the call. Seller earns a profit equal to amount of premium. However, if the market price is above P, the buyer will exercise thereby recovering all or part of the premium paid in the process. The seller still keeps premium but must pay these profits to buyer. With a put option, the actions by the buyer are exactly the opposite. If the market price is above P, the buyer will do nothing and loses all of the premium paid for the option. The seller earns a profit equal to amount of the premium. Conversely, if the market price is below P, the buyer will exercise thereby recovering all or part of premium paid in the process. Seller still keeps premium but must pay these profits to buyer.
Determining the Price of an Option
Determining the price of an option at any time prior to expiration is no trivial matter and depends on a variety of factors. Ultimately, it is determined by the mathematics of probability, which is beyond the scope of this short introductory article. Some of the factors included in the calculation are:
Strike price relative to market price of the underlying (in-the-money, out-of-the-money, at-the-money)
How much time remains until expiration
Degree of volatility in the market.
Figure 3 shows an idealized curve for the price of a long call option prior to expiration. Some of the terms used in connection with option pricing, especially in connection with time value, are the following:
Out-of-the-Money: Option price is composed entirely of time value. Option price approaches 0 as market is further and further out-of-the-money. E.g., Strike price on Nikkei of 30,000.
At-The-Money: Option price is composed entirely of time value. It is here that time value is maximized. E.g., Strike price on Nikkei of 11,500.
In-the-Money: Option price is composed of time value and intrinsic value. The option prices approaches intrinsic value asymptotically as the market moves further and further in-the-money. E.g., Strike price on Nikkei of 1,000.
Intrinsic Value: Exercise Value = Amount that option is in-the-money.
Delta: Change in the option price relative to a unit change in the price of the underlying. This is the slope of the line tangent to the option price curve (first derivative). Range is between 0 and 1 (absolute value). At-the-money = 0.5.
Gamma: Change of delta relative to a unit change in the price of the underlying. This is the slope of the line tangent to the delta curve (second derivative of option price curve). Range is 0 to ∞ (absolute value). Gamma is most extreme at-the-money and rises as time to expiration approaches.
No matter what the case, all time value is captured by the seller upon exercise. Also, an option loses all time value at the end of the option contract.
What Happens When Options Are Combined With Each Other or Other Instruments?
It is this aspect of options that make them such versatile trading vehicles. Not only do they appear with an array of strike prices and expirations, they can also be combined in countless ways with interesting results. By way of introduction only, two very common combinations are shown in Figure 4. The first, the covered call, is the most common because it is widely used by securities traders as "revenue enhancement." It involves being long the underlying and short a call. The second is a position based on expected volatility of the market in either direction. It involves being either long or short both a call and put at the same time.
Special Option Combination: The "Insurance Company Spread"
This is the writer's own term for what is usually referred to in option circles as the "credit put spread." Here, option concepts are applied to the insurance business. For example, with insurance, the customer pays a premium to the company for a promise by the company to pay money if customer suffers damage during the life of the insurance policy. The damage can be characterized as a negative movement in value for the customer. The act of buying the policy can be characterized as the purchase of a put option by the customer, i.e., the company "wins" if nothing happens and loses if an "accident" occurs. Moreover, the customer must exercise his or her right under the policy to get paid. However, the company does not expose itself to unlimited claims but places maximum limits on the amount of a claim it will pay under the policy. This is analogous to the insurance company buying a put for itself at a lower strike price.
What flows from this are a pair of bold statements. First, everybody is involved in the options market (at least anybody with any form of insurance). Second, the argument can be made that the option concept (based on contract law) is what makes modern civilization possible: The capital markets would not function without the participation of insurance companies through the investment of insurance premiums.
