All about derivatives

Types of options

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There are two main types of options:

American options can be exercised at any time between the date of purchase and the expiration date. The example about Cory's Tequila Co. is an example of the use of an American option. Most exchange-traded options are of this type.
European options are different from American options in that they can only be exercised at the end of their lives.

The distinction between American and European options has nothing to do with geographic location.

Long-Term Options
So far we've only discussed options in a short-term context. There are also options with holding times of one, two or multiple years, which may be more appealing for long-term investors.

These options are called long-term equity anticipation securities (LEAPS). By providing opportunities to control and manage risk or even to speculate, LEAPS are virtually identical to regular options. LEAPS, however, provide these opportunities for much longer periods of time. Although they are not available on all stocks, LEAPS are available on most widely held issues.

Exotic Options
The simple calls and puts we've discussed are sometimes referred to as plain vanilla options. Even though the subject of options can be difficult to understand at first, these plain vanilla options are as easy as it gets!

Because of the versatility of options, there are many types and variations of options. Non-standard options are called exotic options, which are either variations on the payoff profiles of the plain vanilla options or are wholly different products with "option-ality" embedded in them.

How options work

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Now that you know the basics of options, here is an example of how they work. We'll use a fictional firm called Cory's Tequila Company.

Let's say that on May 1, the stock price of Cory's Tequila Co. is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example.

Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15.

When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount.

Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and take your profits - unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride.

By the expiration date, the price drops to $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315.

To recap, here is what happened to our option investment:

Date	May 1	May 21	Expiry Date
Stock Price	$67	$78	$62
Option Price	$3.15	$8.25	worthless
Contract Value	$315	$825	$0
Paper Gain/Loss	$0	$510	-$315

The price swing for the length of this contract from high to low was $825, which would have given us over double our original investment. This is leverage in action.

Exercising Versus Trading-Out
So far we've talked about options as the right to buy or sell (exercise) the underlying. This is true, but in reality, a majority of options are not actually exercised.

In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value.

However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE, about 10% of options are exercised, 60% are traded out, and 30% expire worthless.

Intrinsic Value and Time Value
At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value.

Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value. So, the price of the option in our example can be thought of as the following:

Premium =	Intrinsic Value	+	Time Value
$8.25 =	$8	+	$0.25

In real life options almost always trade above intrinsic value. If you are wondering, we just picked the numbers for this example out of the air to demonstrate how options work.

Why use options

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There are two main reasons why an investor would use options: to speculate and to hedge.

Speculation
You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The combinations of these factors means the odds are stacked against you.

So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.

Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way.

A Word on Stock Options

Although employee stock options aren't available to everyone, this type of option could, in a way, be classified as a third reason for using options. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, is between the holder and the company, whereas a normal option is a contract between two parties that are completely unrelated to the company

Options Basics

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Nowadays, many investors' portfolios include investments such as mutual funds, stocks and bonds. But the variety of securities you have at your disposal does not end there. Another type of security, called an option, presents a world of opportunity to sophisticated investors.

The power of options lies in their versatility. They enable you to adapt or adjust your position according to any situation that arises. Options can be as speculative or as conservative as you want. This means you can do everything from protecting a position from a decline to outright betting on the movement of a market or index.

This versatility, however, does not come without its costs. Options are complex securities and can be extremely risky. This is why, when trading options, you'll see a disclaimer like the following:

Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.

Despite what anybody tells you, option trading involves risk, especially if you don't know what you are doing. Because of this, many people suggest you steer clear of options and forget their existence.

On the other hand, being ignorant of any type of investment places you in a weak position. Perhaps the speculative nature of options doesn't fit your style. No problem - then don't speculate in options. But, before you decide not to invest in options, you should understand them. Not learning how options function is as dangerous as jumping right in: without knowing about options you would not only forfeit having another item in your investing toolbox but also lose insight into the workings of some of the world's largest corporations. Whether it is to hedge the risk of foreign-exchange transactions or to give employees ownership in the form of stock options, most multi-nationals today use options in some form or another.

What are options?

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

Still confused? The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.

Now, consider two theoretical situations that might arise:

1. It's discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).

2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.

This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index.

Calls and Puts
The two types of options are calls and puts:

A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market
There are four types of participants in options markets depending on the position they take:

1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers:
-Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.
-Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.

Don't worry if this seems confusing - it is. For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there are two sides of an options contract.

The Lingo
To trade options, you'll have to know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.

An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value.

The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility.

Derivatives

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What are derivatives?

Derivatives are financial instruments widely used by all economic agents to invest, speculate and hedge in financial markets. Derivative products, several centuries ago, emerged as hedging devices against fluctuations in commodity prices. Derivatives contracts are used to counter the price risks involved in assets and liabilities. Derivatives do not eliminate risks. They divert risks from investors who are risk averse to those who are risk neutral. The use of derivatives instruments is the part of the growing trend among financial intermediaries like banks to substitute off-balance sheet activity for traditional lines of business. Firms also make use of derivatives for multiple purposes. The market for financial derivatives has grown tremendously both in terms of variety of instruments and turnover. However, derivatives are a double edged weapon, they can result in huge losses due to the use of leverage or borrowing.

Derivatives are one of the most complex instruments. The word derivative comes from the word ‘to derive’. It indicates that it has no independent value. A derivative is a contract whose value is derived from the value of another asset, known as the underlying asset, which could be a share, a stock market index, an interest rate, a commodity, or a currency. The underlying is the identification tag for a derivative contract. When the price of the underlying changes the value of the derivative also changes. Without an underlying asset, derivatives do not have any meaning. For example, the value of a gold futures contract derives from the value of the underlying asset i.e., gold. The prices in the derivatives market are driven by the spot or cash market price of the underlying asset, which is gold in this example.

Derivative, speaking very broadly, is a” price Guarantee”. It is like you are being guaranteed a fixed price to pay for your bike today which you wish to purchase say, after six months. It may further be assumed that price of the bike today is Rs.45,000/-which after six months can move to Rs.50,000/- or can be available cheap at Rs.42,000/-(due to competition etc) .Even though price gap is not huge, but if one has limited resources, then one is most likely to opt for a definite(fixed)
price(simply because it can help one to arrange for the resources in time) . Now (again) broadly speaking, Derivatives do similar things, though in big variety of ways (there can be hundreds of ways) on a very large scale.

Derivatives are very similar to insurance. Insurance protects against specific risks, such as fire, floods, theft and so on. Derivatives on the other hand, take care of market risks - volatility in interest rates, currency rates, commodity prices, and share prices. Derivatives offer a sound mechanism for insuring against various kinds of risks arising in the world of finance. They offer a range of mechanisms to improve redistribution of risk, which can be extended to every product existing, from coffee to cotton and live cattle to debt instruments.

In this era of globalisation, the world is a riskier place and exposure to risk is growing. Risk cannot be avoided or ignored. Man, however is risk averse. The risk averse characteristic of human beings has brought about growth in derivatives. Derivatives help the risk averse individuals by offering a mechanism for hedging risks.

Derivative products, several centuries ago, emerged as hedging devices against fluctuations in commodity prices. Commodity futures and options have had a lively existence for several centuries. Financial derivatives came into the limelight in the post-1970 period. The basic difference between commodity and financial derivatives lies in the nature of the underlying instrument. In commodity derivatives, the underlying asset is a commodity; it may be wheat, cotton, pepper, turmeric, corn, orange, oats, Soya beans, rice, crude oil, natural gas, gold, silver, and so on. In financial derivatives, the underlying includes treasuries, bonds, stocks, stock index, foreign exchange, and Euro dollar deposits. The market for financial derivatives has grown tremendously both in terms of variety of instruments and turnover.

Presently, most major institutional borrowers and investors use derivatives. Similarly, many act as intermediaries dealing in derivative transactions. Derivatives are responsible for not only increasing the range of financial products available but also fostering more precise ways of understanding, quantifying and managing financial risk.

Derivatives contracts are used to counter the price risks involved in assets and liabilities. Derivatives do not eliminate risks. They divert risks from investors who are risk averse to those who are risk neutral. The use of derivatives instruments is the part of the growing trend among financial intermediaries like banks to substitute off-balance sheet activity for traditional lines of business. The exposure to derivatives by banks have implications not only from the point of capital adequacy, but also from the point of view of establishing trading norms, business rules and settlement process. Trading in derivatives differ from that in equities as most of the derivatives are market to the market.

EVOLUTION OF DERIVATIVES

A timeline of progression of derivatives is presented below :

12th Century

In European trade fairs sellers sign contracts promising future delivery of the items they sold.

13th Century

There are many examples contracts entered into by English Cistercian Monasteries who frequently sold their wool up to 20 years in advance to foreign merchants.

Early 17th Century

1634-1637 Tulip Mania in Holland: Fortunes are lost in after a speculative boom in tulip futures burst.

Late 17th Century

Dojima Rice Futures: In Japan at Dojima, near Osaka a futures market in rice is developed to protect sellers from bad weather or warfare.

19th Century

1868 Chicago Board of Trade: Trading in wheat, pork belly and copper futures starts.

20th Century

Late 1960s - Black and Scholes begin collaboration: Fischer Black and Myron Scholes tackle the problem of determining how much an option is worth. Robert Merton joins them in 1970.

April 1973 The Chicago Board Options Exchange opens.

May/June 1973 The Black-Scholes Model is Published. It appears in the Journal of Political Economy, one of the journals that had previously rejected it.

1994 Metallgesellshaft loses $1.5 billion on oil futures.

1995 Barings Bank goes bust: Nick Leeson loses $1.4 billion by gambling that the Nikkei 225 index of leading Japanese company shares would not move materially from its normal trading range. That assumption was shattered by the Kobe earthquake on the 17th January 1995 after which Leeson attempted to conceal his losses.

1997 Nobel Prize in Economics awarded to Robert Merton and Myron Scholes.

1998 Long Term Credit Management Bailout: The hedge fund is rescued at a cost of $3.5 billion because of worries that its collapse would have severe repercussions for the world financial system.

1999 The Flaming Ferraris: Some traders at CSFB are sacked following allegations of illegal trades in an attempt to manipulate the Swedish stock market index.

21st Century

2001 Enron goes Bankrupt: The 7th largest company in the US and the world's largest energy trader made extensive use of energy and credit derivatives but becomes the biggest firm to go bankrupt in American history after systematically attempting to conceal huge losses.

2002 AIB loses $750 million: John Rusnak uses fictitious options contracts to cover losses on spot and forward foreign exchange contracts.

2003 Terrorism Futures Plan Dropped: The US Defence Department had thought that such a market would improve the prediction and prevention of terrorist outrages.

January 2004 NAB admits losing A$180 million: Four foreign currency dealers at the National Australia Bank are said to have run up the losses in three months of unauthorised trades.

August 2004 Citigroup bear raid: Citigroup traders led by Spiros Skordos made €15 million by suddenly selling €11 billion worth of European bonds and bond derivatives, and buying many of them back at a lower price.

November 2004 China Aviation loses $550m in speculative trade: This loss is the largest amount a company in Singapore has lost by betting on derivatives since the case of Nick Leeson and Barings.

October 2005 Refco suspends trading: One of the world's largest derivatives brokers is forced to freeze trades.

September 2006 Amaranth Advisors loses $6 billion: the US-based hedge fund suffered enormous loses trading in natural gas futures.

DEFINING DERIVATIVES

A derivative is a financial instrument whose value is derived from the price of a more basic asset called the underlying. The underlying may not necessarily be a tradable product. Examples of underlying are shares, commodities, currencies, credits, stock market indices, weather temperatures, sunshine, results of sport matches, wind speed and so on.

Basically, anything which may have to a certain degree an unpredictable effect on any business activity can be considered as an underlying of a certain derivative.
All derivatives can be divided into two big classes.
1. Linear
2. Non-Linear
Linear are derivatives whose values depend linearly on the underlying’s value. This includes:
• Forwards and Futures
• Swaps
Non-linear are derivatives whose value is a non-linear function of the underlying. This includes:
• Options
• Convertibles
• Equity Linked Bonds
• Reinsurances

NEED FOR A DERIVATIVES MARKET

The derivatives market performs a number of economic functions:
1. They help in transferring risk from risk averse people to risk oriented people.
2. They help in the discovery of future as well as current prices.
3. They catalyze entrepreneurial activity.
4. They increase the volume traded in markets because of participation of risk averse people in greater numbers.
5. They increase savings and investment in the long run.

TYPES OF DERIVATIVES

There are mainly four types of derivatives i.e. Forwards, Futures, Options and swaps.

1. FORWARDS -

A contract that obligates one counter party to buy and the other to sell a specific underlying asset at a specific price, amount and date in the future is known as a forward contract. Forward contracts are the important type of forward-based derivatives. They are the simplest derivatives. There is a separate forward market for multitude of underlyings, including the traditional agricultural or physical commodities, as well as currencies and interest rates. The change in the value of a forward contract is roughly proportional to the change in the value of its underlying asset. These contracts create credit exposures. As the value of the contract is conveyed only at the maturity, the parties are exposed to the risk of default during the life of the contract. Forward contracts are customised with the terms and conditions tailored to fit the particular business, financial or risk management objectives of the counter parties. Negotiations often take place with respect to contract size, delivery grade, delivery locations, delivery dates and credit terms.

2. FUTURES -

A future contract is an agreement between two parties to buy or sell an asset at a certain time the future at the certain price. Futures contracts are the special types of forward contracts in the sense that are standardized exchange-traded contracts.

Equities, bonds, hybrid securities and currencies are the commodities of the investment business. They are traded on organised exchanges in which a clearing house interposes itself between buyer and seller and guarantees all transactions, so that the identity of the buyer or the seller is a matter of indifference to the opposite party. Futures contract protect those who use these commodities in their business.

Futures trading are to enter into contracts to buy or sell financial instruments, dealing in commodities or other financial instruments for forward delivery or settlement on standardised terms. The futures market facilitates stock holding and shifting of risk. They act as a mechanism for collection and distribution of information and then perform a forward pricing function. The futures trading can be performed when there is variation in the price of the actual commodity and there exists economic agents with commitments in the actual market. There must be a possibility to specify a standard grade of the commodity and to measure deviations from this grade. A futures market is established specifically to meet purely speculative demands is possible but is not known. Conditions which are thought of necessary for the establishment of futures trading are the presence of speculative capital and financial facilities for payment of margins and contract settlement. In addition, a strong infrastructure is required, including financial, legal and communication systems.

3. OPTIONS -

A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as ‘option’. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the ‘strike price’.

There are two types of options i.e., CALL OPTION AND PUT OPTION.

a. CALL OPTION :

A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a ‘Call option’. The owner makes a profit provided he sells at a higher current price and buys at a lower future price.

b. PUT OPTION :

A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a ‘Put option’. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.

4. SWAPS -

Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are:

a. INTEREST RATE SWAPS :

Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract.

For example say a Company has raised a loan for a million. Floating rate is determined with reference to a market determined rate, say e.g. LIBOR (London Inter Bank Offer Rate)

US$ at floating rate as at the time of borrowing, the interest rates were low and expected to be more or less at same level for entire tenure of loan. But if after some time interest rates are showing greater volatility, and company finds itself at a risky position .Now it wants to convert its floating rate loan to fixed rate loan what should the company do? It can switch to a fixed rate by converting existing loan, but that option may be costly as it involves transactions costs. Another possible alternative is that company enters into a swap arrangement to convert its floating rate loan into fixed. Thus company can hedge its interest rate risk effectively.

b. CURRENCY SWAPS :

Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates.

c. FINANCIAL SWAP :

Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

The other kind of derivatives, which are not, much popular are as follows :

5. BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets.

6. LEAPS -

Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities.

7. WARRANTS -

Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

8. SWAPTIONS -

Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

Some common examples of derivatives are:

UNDERLYING	CONTRACT TYPES
UNDERLYING	Exchange-traded futures	Exchange-traded options	OTC swap	OTC forward	OTC option
Equity Index	DJIA Index futureNASDAQ Index future	Option on DJIA Index future Option on NASDAQ Index future	Equity swap	Back-to-back	n/a
Money market	Eurodollar future Euribor future	Option on Eurodollar future Option on Euribor future	Interest rate swap	Forward rate agreement	Interest rate cap and floor Swaption Basis swap
Bonds	Bond future	Option on Bond future	Total return swap	Repurchase agreement	Bond option
Single Stocks	Single-stock future	Single-share option	Equity swap	Repurchase agreement	Stock option Warrant Turbo warrant
Credit	n/a	n/a	Credit default swap	n/a	Credit default option

TRADING PARTICIPANTS

1.] HEDGERS

The process of managing the risk or risk management is called as hedging. Hedgers are those individuals or firms who manage their risk with the help of derivative products. Hedging does not mean maximising of return. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the risk.

2.] SPECULATORS

Speculators do not have any position on which they enter into futures and options Market i.e., they take the positions in the futures market without having position in the underlying cash market. They only have a particular view about future price of a commodity, shares, stock index, interest rates or currency. They consider various factors like demand and supply, market positions, open interests, economic fundamentals, international events, etc. to make predictions. They take risk in turn from high returns. Speculators are essential in all markets – commodities, equity, interest rates and currency. They help in providing the market the much desired volume and liquidity.

3.] ARBITRAGEURS

Arbitrage is the simultaneous purchase and sale of the same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets. Arbitrage involves activity on several different instruments or assets simultaneously to take advantage of price distortions judged to be only temporary.

Arbitrage occupies a prominent position in the futures world. It is the mechanism that keeps prices of futures contracts aligned properly with prices of underlying assets. The objective is simply to make profits without risk, but the complexity of arbitrage activity is such that it is reserved to particularly well-informed and experienced professional traders, equipped with powerful calculating and data processing tools. Arbitrage may not be as easy and costless as presumed.

B.} INTERMEDIARY PARTICIPANTS:

4.] BROKERS

For any purchase and sale, brokers perform an important function of bringing buyers and sellers together. As a member in any futures exchanges, may be any commodity or finance, one need not be a speculator, arbitrageur or hedger. By virtue of a member of a commodity or financial futures exchange one get a right to transact with other members of the same exchange. This transaction can be in the pit of the trading hall or on online computer terminal. All persons hedging their transaction exposures or speculating on price movement need not be and for that matter cannot be members of futures or options exchange. A non-member has to deal in futures exchange through member only. This provides a member the role of a broker. His existence as a broker takes the benefits of the futures and options exchange to the entire economy all transactions are done in the name of the member who is also responsible for final settlement and delivery. This activity of a member is price risk free because he is not taking any position in his account, but his other risk is clients default risk. He cannot default in his obligation to the clearing house, even if client defaults. So, this risk premium is also inbuilt in brokerage recharges

5.] MARKET MAKERS AND JOBBERS

Even in organised futures exchange, every deal cannot get the counter party immediately. It is here the jobber or market maker plays his role. They are the members of the exchange who takes the purchase or sale by other members in their books and then square off on the same day or the next day. They quote their bid-ask rate regularly. The difference between bid and ask is known as bid-ask spread. When volatility in price is more, the spread increases since jobbers price risk increases. In less volatile market, it is less. Generally, jobbers carry limited risk. Even by incurring loss, they square off their position as early as possible. Since they decide the market price considering the demand and supply of the commodity or asset, they are also known as market makers. Their role is more important in the exchange where outcry system of trading is present. A buyer or seller of a particular futures or option contract can approach that particular jobbing counter and quotes for executing deals. In automated screen based trading best buy and sell rates are displayed on screen, so the role of jobber to some extent. In any case, jobbers provide liquidity and volume to any futures and option market.

RISKS ASSOCIATED WITH DERIVATIVES MARKETS

Risk is in general the possibility of some unpleasant happening or the chance of encountering loss. The same in the context of financial markets can be termed as uncertainty in future cash flows. The major risks are as follows:

INTEREST RATE RISK

The possibility of reduction in the value of asset resulting due to interest rate fluctuations is referred to as interest rate risk. Interest rates affect a firm in two ways- by affecting the profits and by affecting the value of its assets and liabilities. For example, a firm that has borrowed money on a floating rate basis faces the risk of lower profits in an increasing interest rate scenario. Similarly, a firm having fixed rate assets faced the risk of lower value of investments in an increasing interest rate scenario.

Interest rate risk becomes prominent when the assets and liabilities of a firm do not match in their exposure than a firm having fixed rate borrowings and floating rate investments for the same term. It can also be defined as the risk arising due to sensitivity of the interest income/expenditure or values of assets/ liabilities to the interest rate fluctuations.

EXCHANGE RATE RISK

The volatility in the exchange rates will have a direct bearing on the values of the assets and liabilities that are denominated in foreign currencies. While appreciation of home currency decreases the value of an asset and liability in terms of home currency, depreciation of home currency will increase the values of assets and liabilities. While increase in the value of asset and decrease in the value of liability has a positive impact on the corporate, increase in the value of liabilities and decrease in the value of assets has a negative impact.

MARKET RISK

Market risk is the risk of the value of a firm’s investments going down as a result of market movements. It is also referred to as ‘price risk’. Market risk cannot be distinctly separated from other risks, as it results from the interplay of all the risks. In addition to interest rate risk and exchange risk, adverse movements in equity prices and commodity prices also contribute to the market risk. An instance wherein equity price risks played havoc is the stock market crash of 1929 in the United States.

USES OF DERIVATIVES

Derivative markets help investors in many different ways :

1. RISK MANAGEMENT

Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put option can always be exercised.

Derivatives markets help to reallocate risk among investors. A person who wants to reduce risk can transfer some of that risk to a person who wants to take more risk. Consider a risk-averse individual. He can obviously reduce risk by hedging. When he does so, the opposite position in the market may be taken by a speculator who wishes to take more risk. Since people can alter their risk exposure using futures and options, derivatives markets help in the raising of capital. As an investor, you can always invest in an asset and then change its risk to a level that is more acceptable to you by using derivatives.

2. PRICE DISCOVERY

Price discovery refers to the market’s ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources in a free market economy. Options markets provide information about the volatility or risk of the underlying asset.

3. OPERATIONAL ADVANTAGES

As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot markets.

4. MARKET EFFICIENCY

The availability of derivatives makes markets more efficient; spot futures and options markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values.

5. EASE OF SPECULATION

Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the amount of capital required to take a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated risks. A speculator will accept a level of risk only if he is convinced that the associated expected return is commensurate with the risk that he is taking.

CRITICISMS

Derivatives are often subject to the following criticisms:

Possible large losses

The use of derivatives can result in large losses due to the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly.

Derivatives Time Bomb: A number of well-known hedge funds have imploded in recent years as their derivative positions declined dramatically in value, forcing them to sell their securities at markedly lower prices to meet margin calls and customer redemptions. One of the largest hedge funds to collapse in recent years as a result of adverse movements in its derivatives positions was Long Term Capital Management (LTCM).

Investors use the leverage afforded by derivatives as a means of increasing their investment returns. When used properly, this goal is met. However, when leverage becomes too large, or when the underlying securities decline substantially in value, the loss to the derivative holder is amplified. The term "derivatives time bomb" relates to the speculation that the large number of derivatives positions and increasing leverage taken on by hedge funds and investment banks could lead to an industry-wide meltdown. There have been several instances of massive losses in derivative markets, such as:

The need to recapitalize insurer American International Group (AIG) with $85 billion of debt provided by the US federal government. An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written. It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarters.
The loss of $7.2 Billion by Société Générale in January 2008 through misuse of futures contracts.
The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted.
The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.
The Nick Leeson affair in 1994

Counter-party risk

Derivatives (especially swaps) expose investors to counter-party risk.

For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate.

Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Unsuitably high risk for small/inexperienced investors

Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, a reason why some financial planners advise against the use of these instruments. Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it.

Large notional value

Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway's annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression.

KEY TERMS

Arbitrage: The act of taking advantage of differences in price between markets. For example, if a stock is quoted on two different equity markets, there is the possibility of arbitrage if the quoted price (adjusted for institutional idiosyncrasies) in one market differs from the quoted price in the other.

Currency Swap: An exchange of interest rate payments in different currencies on a pre-set notional amount and in reference to pre-determined interest rate indices in which the notional amounts are exchanged at inception of the contract and then re-exchanged at the termination of the contract at pre-set exchange rates.

Equity Swap: A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is an equity index.

Exchange Traded Contracts: Financial instruments listed on exchanges such as the Chicago Board of Trade

Forward Contracts: An over-the-counter obligation to buy or sell a financial instrument or to make a payment at some point in the future, the details of which were settled privately between the two counterparties. Forward contracts generally are arranged to have zero mark-to-market value at inception, although they may be off-market. Examples include forward foreign exchange contracts in which one party is obligated to buy foreign exchange from another party at a fixed rate for delivery on a pre-set date.

Forward Rate Agreements (FRAs): A forward rate agreement is a cash-settled obligation on interest rates for a pre-set period on a pre-set interest rate index with a forward start date. A 3x6 FRA on US dollar LIBOR (the London Interbank Offered Rate) is a contract between two parties obliging one to pay the other the difference between the FRA rate and the actual LIBOR rate observed for that period. An Interest Rate Swap is a strip of FRAs.

Futures Contracts: An exchange-traded obligation to buy or sell a financial instrument or to make a payment at one of the exchange's fixed delivery dates, the details of which are transparent publicly on the trading floor and for which contract settlement takes place through the exchange's clearinghouse.

Hedge: A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk. It may consist of cash instruments or derivatives.

Interest Rate: An exchange of cash flows based upon different interest rate indices denominated in the same currency on a pre-set notional amount with a pre-determined schedule of payments and calculations. Usually, one counterparty will received fixed flows in exchange for making floating payments.

Mark to Market Accounting: A method of accounting most suited for financial instruments in which contracts are revalued at regular intervals using prevailing market prices. This is known as taking a "snapshot" of the market.

Netting: When there are cash flows in two directions between two counterparties, they can be consolidated into one net payment from one counterparty to the other thereby reducing the settlement risk involved.

Option: The right but not the obligation to buy (sell) some underlying cash instrument at a pre-determined rate on a pre-determined expiration date in a pre-set notional amount.

Over-the-Counter: Any transaction that takes place between two counterparties and does not involve an exchange is said to be an over-the-counter transaction.

Speculation: Taking positions in financial instruments without having an underlying exposure that offsets the positions taken.

Volatility: In finance, a statistical measure of dispersion of a time series around its mean; the expected value of the difference between the time series and its mean; the square root of the variance of the time series.

ANALYSIS OF CASES: DERIVATIVES TIMEBOMB

1. CASE: BEAR STEARNS
Following is the timeline of the events that led Bear Stearns to suffer huge losses.
YEAR 2007
JUNE 22
Bear Stearns commits $3.2bn in secured loans to bail out one of its hedge funds. It says its troubles are 'relatively contained'.
JULY 17
Bear Stearns reveals that one of its hedge funds has lost all of its value. Another worth 9 per cent of its value at the end of April.
AUGUST 5
Co-president Warren Spector resigns after the collapse of the two exposed hedge funds. He was seen as the favourite to succeed chief executive Jimmy Cayne.
AUGUST 17
Bear Stearns slashes 240 jobs in two mortgage origination units. In early October, the bank culls over 300 more jobs.
OCTOBER 22
Bears Stearns secures a share-swap deal with Citic, China's largest securities firm. Citic pays $1bn for about 6 per cent stake in Bear Stearns. The US bank agrees to eventually pay the same for about 2 per cent of Citic.
NOVEMBER 1
A US newspaper suggests that Cayne was out of touch during the collapse of the two hedge funds. He dismisses the media concerns as "noise".
DECEMBER 7
Joe Lewis, Bahamas-based billionaire, up his stake to 8 per cent, showing that he believes the Bear Stearns shares are undervalued.
DECEMBER 20
The bank reports its first-ever quarterly loss. The loss is nearly four times analysts' forecasts, and includes a $1.9bn writedown on its holdings of mortgage assets.
2008
JANUARY 7
CEO Cayne retires under pressure, but stays on as non-executive chairman. Alan Schwartz becomes president and chief executive.
FEBRUARY 14
In reaction to the fall in the bank's share price since the share-swap deal, it emerges that Citic has been renegotiating the agreement.
FEBRUARY 28
Rebel investors in Bear Stearns seize two of the bank's failed hedge funds in an attempt to regain some of the $1.6bn lost in the previous summer's collapse.
MARCH 7
Carlyle Capital Corporation sees its shares suspended in Amsterdam.
The $22bn hedge fund suffered exposure to mortgage backed securities, and had received substantial additional margin calls and default notices from its lenders.
Bear Stearns is seen as heavily exposed to Carlyle Group, founder and 15 per cent owner of CCC.
MARCH 13
CCC collapses. Bear Stearns shares fall 17 per cent as investors grow anxious about its exposure to CCC. Schwartz comments: "Our balance sheet is not weakened at all."
MARCH 14
JP Morgan and the New York Federal Reserve rush to the rescue of Bear Stearns. Shares crash almost 50 per cent.
MARCH 16
JP Morgan agrees to buy Bear Stearns in a deal that values the stricken bank's shares at $2 each, with JP Morgan exchanging 0.05473 of each of its shares for one Bear share.
MARCH 22
A powerful group of shareholders including British billionaire Joe Lewis plot a legal challenge against the $2 a share, cut-price offer.
MARCH 23
It emerges that JP Morgan is in talks with the US Federal Reserve and Treasury Department about a possible increased offer for Bear Stearns.
MARCH 24
JP Morgan raises its offer for Bear Stearns to $10 a share in a bid to quell shareholder dissent about the discounted nature of the takeover.
MARCH 25
March 25 Jimmy Cayne, Bear Stearns’ chairman and former chief executive, sells his 5pc stake for $61m.
Bear Stearns losses in derivatives first became evident when two Bear Stearns hedge funds collapsed in July 2007
Now we'll first examine how unrestricted use of derivatives caused the implosion of two prominent Bear Stearns hedge funds, the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund.
Bear Stearns had some compensation structures which encouraged greedy, risk-taking behaviour that normally involves leverage to generate sufficient returns to justify the enormous management and incentive fees. Both of Bear Stearns' troubled funds fell well within this generalization.
In fact, as it was this derivatives leverage itself that primarily precipitated their failure.

Investment Structure

The strategy employed by the Bear Stearns funds was actually quite simple and would be best classified as being a leveraged credit investment. In fact, it is formulaic in nature and is a common strategy in the hedge fund universe:
Step #1: Purchase collateralized debt obligations (CDOs) that pay an interest rate over and above the cost of borrowing. In this instance 'AAA' rated tranches of subprime, mortgage-backed securities were used.

Step #2: Use leverage to buy more CDOs than you can pay for with capital alone. Because these CDOs pay an interest rate over and above the cost of borrowing, every incremental unit of leverage adds to the total expected return. So, the more leverage you employ, the greater the expected return from the trade.

Step #3: Use credit default swaps as insurance against movements in the credit market. Because the use of leverage increases the portfolio's overall risk exposure, the next step is to purchase insurance on movements in credit markets. These "insurance" instruments are called credit default swaps, and are designed to profit during times when credit concerns cause the bonds to fall in value, effectively hedging away some of the risk.

Step #4: Watch the money roll in. When you net out the cost of the leverage (or debt) to purchase the 'AAA' rated subprime debt, as well as the cost of the credit insurance, you are left with a positive rate of return, which is often referred to as "positive carry" in hedge fund lingo.

In instances when credit markets (or the underling bonds' prices) remain relatively stable, or even when they behave in line with historically based expectations, this strategy generates consistent, positive returns with very little deviation. This is why hedge funds are often referred to as "absolute return" strategies.

Can't Hedge All Risk
However, the caveat is that it is impossible to hedge away all risk because it would drive returns too low. Therefore, the trick with this strategy is for markets to behave as expected and, ideally, to remain stable or improve.

Unfortunately, as the problems with subprime debt began to unravel the market became anything but stable. To oversimplify the Bear Stearns situation, the subprime mortgage-backed securities market behaved well outside of what the portfolio managers expected, which started a chain of events that imploded the fund.

First Inkling of a Crisis

To begin with, the subprime mortgage market had recently begun to see substantial increases in delinquencies from homeowners, which caused sharp decreases in the market values of these types of bonds. Unfortunately, the Bear Stearns portfolio managers failed to expect these sorts of price movements and, therefore, had insufficient credit insurance to protect against these losses. Because they had leveraged their positions substantially, the funds began to experience large losses.

Problems Snowball

The large losses made the creditors who were financing this leveraged investment strategy uneasy, as they had taken subprime, mortgage-backed bonds as collateral on the loans. The lenders required Bear Stearns to provide additional cash on their loans because the collateral (subprime bonds) was rapidly falling in value. This is the equivalent of a margin call for an individual investor with a brokerage account. Unfortunately, because the funds had no cash on the sidelines, they needed to sell bonds in order to generate cash, which was essentially the beginning of the end.

Demise of the Funds

Ultimately, it became public knowledge in the hedge fund community that Bear Stearns was in trouble, and competing funds moved to drive the prices of subprime bonds lower to force Bear Stearns' hand. Simply put, as prices on bonds fell, the fund experienced losses, which cause it to sell more bonds, which lowered the prices of the bonds, which caused them to sell more bonds - it didn't take long before the funds had experienced a complete loss of capital.

The Mistakes Made and Conclusion

The Bear Stearns fund managers' first mistake was failing to accurately predict how the subprime bond market would behave under extreme circumstances. In effect, the funds did not accurately protect themselves from event risk.

Moreover, they failed to have ample liquidity to cover their debt obligations. If they'd had the liquidity, they wouldn't have had to unravel their positions in a down market. While this may have led to lower returns due to less leverage, it may have prevented the overall collapse. In hindsight, giving up a modest portion of potential returns could have saved millions of investor dollars.

Furthermore, it is arguable that the fund managers should have done a better job in their macroeconomic research and realized that subprime mortgage markets could be in for tough times. They then could have made appropriate adjustments to their risk models. Global liquidity growth over recent years has been tremendous, resulting not only in low interest rates and credit spreads, but also an unprecedented level of risk taking on the part of lenders to low-credit-quality borrowers.

Since 2005, the U.S. economy has been slowing as a result of the peak in the housing markets, and subprime borrowers are particularly susceptible to economic slowdowns. Therefore, it would have been reasonable to assume that the economy was due for a correction.

Finally, the overriding flaw for Bear Stearns was the level of leverage employed in the strategy, which was directly driven by the need to justify the utterly enormous fees they charged for their services and to attain the potential payoff of getting 20% of profits. In other words, they got greedy and leveraged the portfolio to much.
The fund managers were wrong. The market moved against them, and their investors lost everything. The lesson to be learned, of course, is not to combine excessive derivatives leverage and greed.
2. CASE: THE FALL OF BARINGS BANK
Background Note:
Barings was founded in 1762, by Francis Baring who set up a merchant banking business in Mincing Lane in London, UK. The business grew rapidly during the period 1798 to 1814.
It became one of the most influential financial houses during the 1830s and 1840s. The British government paid Barings commissions to raise money to finance wars against the US and France during the mid 1800s.
During 1860-1890, Barings raised $500 mn for the US and Canadian governments and was regarded as London's biggest 'American House.' Barings was also involved in providing loans to Argentina during this period. In 1890, Barings was on the verge of bankruptcy when Argentina defaulted on bond payments. However, the Bank of England and several other major banks in London came forward to bail out the bank.
This crisis had a major impact on Barings and led the bank to withdraw all its business on the North American continent. Barings then took up the business of providing consultancy to small firms and wealthy people, including the British royal family.
Barings advised the royal family on the management of their assets, and also gave advice to small British firms on investing in stocks and bonds. For the next several decades, the bank grew well and earned significant profits. In the 1980s, the bank started operating in the US again. In 1984, Barings acquired the stock broking arm of Henderson Crosthwaite,5 which later became BSL.
Prior to its merger with the banking business (Baring Brothers & Company) in 1993, BSL was run as a separate company Incorporated in September 1986, BFS held a non-clearing membership6 of SIMEX.
FALL OF BARINGS BANK
On February 26, 1995, Barings Bank (Barings) - the United Kingdom's (UK) oldest and one of its most reputed banks - declared it was bankrupt.
The bank with a total net worth of $900 mn had suffered losses in excess of $1 bn.
These losses were result of the gross mismanagement of the bank's derivatives trading operations by Nicholas William Leeson (Leeson), the General Manager of Barings Future in Singapore (BFS).
BFS had been established to look after the bank's Singapore International Monetary Exchange (SIMEX) trading operations. Leeson's job was to make arbitrage profits by taking the advantage of price differences of similar contracts on the SIMEX (Singapore) and Osaka stock exchanges.
In spite of not having the authority, he traded in options and maintained un-hedged positions. He acted beyond the scope of his job, and was able to conceal his unauthorized derivatives trading activities.
Due to the senior management's carelessness and lack of knowledge of derivatives trading, the bank landed up in a major financial mess.
Events Leading to the Fall:
Soon after joining BSL, Leeson applied and got a transfer to Jakarta, Indonesia. Due to his excellent performance, Barings management promoted Leeson to General Manager of BFS in Singapore in April 1992.
In BFS, Leeson's job was to leverage on the arbitrage opportunities on similar equity derivatives between SIMEX and the Osaka stock exchange (OSE). To take the advantage of the arbitrage opportunity, Leeson had to adopt the following strategy - if Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX . The arbitrage trading strategy required Leeson to buy at a lower price on one exchange and sell simultaneously at a higher price on the other, reversing the trade when the price difference had narrowed or become zero. The market risk in arbitrage was minimal because positions were always matched. Leeson was not given any authority to trade in options or maintain any overnight un-hedged positions.
Industry analysts felt that the fall of Barings served as a classic example of poor risk management practices. The bank had completely failed to institute a proper managerial, financial and operational control system.
Due to the lack of effective control and supervision, Leeson got an opportunity to conduct his unauthorized derivatives trading activities and was able to reduce the likelihood of their detection.
CONCLUSION AND END RESULT:
The fall of Barings not only shocked the financial markets world over, it also exposed their vulnerability. On February 26, 1995, Barings was declared insolvent under the UK Insolvency Act, 1986.
Administrators were appointed to take control of the assets of the bank and its subsidiaries. A week later, all the assets and liabilities of Barings Bank and its subsidiaries (except BFS) were acquired by the Internationale Nederlanden Groep NV (ING).
ING was looking to expand its investment banking business especially in Asia, where Barings had an extensive business network involving merchant banking activities such as investment banking, corporate banking, venture capital and capital markets operations, together with securities trading and asset management. ING paid one pound for Barings and took on the responsibility of paying the entire $1 bn debts that Barings had accumulated.
Thus, we saw how unregulated exposure to trading in derivatives caused huge losses in Barings Bank which ultimately led to its downfall.
3. CASE OF A FALLING GIANT: AIG
What was once the unthinkable occurred on September 16, 2008. On that date, the federal government gave the American International Group - better known as AIG - a bailout of $85 billion. In exchange, the U.S. government received nearly 80% of the firm's equity. For decades, AIG was the world's biggest insurer, a company known around the world for providing protection for individuals, companies and others. But in September, the company would have gone under if it were not for government assistance.

EVENTS LEADING TO THE FALL

High Flying

The epicenter of the near-collapse of AIG was an office in London. A division of the company, entitled AIG Financial Products (AIGFP), nearly led to the downfall of a pillar of American capitalism. For years, the AIGFP division sold insurance against investments gone awry, such as protection against interest rate changes or other unforeseen economic problems. But in the late 1990s, the AIGFP discovered a new way to make money.

A new financial tool known as a collateralized d ebt o bligation (CDO) became prevalent among large investment banks and other large institutions. CDOs lump various types of debt - from the very safe to the very risky - into one bundle. The various types of debt are known as tranches. Many large investors holding mortgage-backed securities created CDOs, which included tranches filled with subprime loans.
The AIGFP was presented with an option. Why not insure CDOs against default through a financial product known as a credit default swap. The chances of having to pay out on this insurance were highly unlikely, and for a while, the CDO insurance plan was highly successful. In about five years, the division's revenues rose from $737 million to over $3 billion, about 17.5% of the entire company's total.

One large chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches comprised of subprime loans. AIG believed that what it insured would never have to be covered. Or, if it did, it would be in insignificant amounts. But when foreclosures rose to incredibly high levels, AIG had to pay out on what it promised to cover. This, naturally, caused a huge hit to AIG's revenue streams. The AIGFP division ended up incurring about $25 billion in losses, causing a drastic hit to the parent company's stock price.
Accounting problems within the division also caused losses. This, in turn, lowered AIG's credit rating, which caused the firm to post collateral for its bondholders, causing even more worries about the company's financial situation.

It was clear that AIG was in danger of insolvency. In order to prevent that, the federal government stepped in. But why was AIG saved by the government while other companies affected by the credit crunch weren't?
Too Big To Fail
Simply put, AIG was considered too big to fail. An incredible amount of institutional investors - mutual funds, pension funds and hedge funds - both invested in and also were insured by the company. In particular, many investment banks that had CDOs insured by AIG were at risk of losing billions of dollars. For example, media reports indicated that Goldman Sachs had $20 billion tied into various aspects of AIG's business, although the firm denied that figure.
Money market funds - generally seen as very conservative instruments without much risk attached - were also jeopardized by AIG's struggles, since many had invested in the company, particularly via bonds. If AIG was to become insolvent, this would send shockwaves through already shaky money markets as millions of investors - both individuals and institutions - would lose cash in what were perceived to be incredibly safe holdings.
However, policyholders of AIG were not at too much risk. While the financial-products section of the company was facing extreme difficulty, the vastly smaller retail-insurance components were still very much in business. In addition, each state has a regulatory agency that oversees insurance operations, and state governments have a guarantee clause that will reimburse policyholders in case of insolvency.

While policyholders were not in harm's way, others were. And those investors - from individuals looking to tuck some money away in a safe investment to hedge and pension funds with billions at stake - needed someone to intervene.
Stepping In

While AIG hung on by a thread, negotiations were taking place among company and federal officials about what the next step was. Once it was determined that the company was too vital to the global economy to be allowed to fail, the Federal Reserve struck a deal with AIG's management in order to save the company.

The Federal Reserve was the first to jump into the action, issuing a loan to AIG in exchange for 79.9% of the company's equity. The total amount was originally listed at $85 billion and was to be repaid over two years at the LIBOR rate plus 8.5 percentage points. However, since then, terms of the initial deal have been reworked. The Fed and the Treasury Department have loaned even more money to AIG, bringing the total up to an estimated $150 billion.

Conclusion

AIG's bailout has not come without controversy. Some have criticized whether or not it is appropriate for the government to use taxpayer money to purchase a struggling insurance company. In addition, the use of the public funds to pay out bonuses to AIG's officials has only caused its own uproar. However, others have said that, if successful, the bailout will actually benefit taxpayers due to returns on the government's shares of the company's equity.

No matter the issue, one thing is clear. AIG's involvement in the financial crisis was important to the world's economy. Whether the government's actions will completely heal the wounds or will merely act as a bandage remedy remains to be seen.

4. CASE : Long Term Capital Management (LTCM)

Summary

In 1994, John Meriwether, the famed Salomon Brothers bond trader, founded a hedge fund called Long-Term Capital Management. Meriwether assembled an all-star team of traders and academics in an attempt to create a fund that would profit from the combination of the academics' quantitative models and the traders' market judgement and execution capabilities. Sophisticated investors, including many large investment banks, flocked to the fund, investing $1.3 billion at inception. But four years later, at the end of September 1998, the fund had lost substantial amounts of the investors' equity capital and was teetering on the brink of default. To avoid the threat of a systemic crisis in the world financial system, the Federal Reserve orchestrated a $3.5 billion rescue package from leading U.S. investment and commercial banks. In exchange the participants received 90% of LTCM's equity.
Overview

LTCM seemed destined for success. After all, it had John Meriwether, the famed bond trader from Salomon Brothers, at its helm. Also on board were Nobel-prize winning economists Myron Scholes and Robert Merton, as well as David Mullins, a former vice-chairman of the Federal Reserve Board who had quit his job to become a partner at LTCM. These credentials convinced 80 founding investors to pony up the minimum investment of $10 million apiece, including Bear Sterns President James Cayne and his deputy. Merrill Lynch purchased a significant share to sell to its wealthy clients, including a number of its executives and its own CEO, David Komansky. A similar strategy was employed by the Union Bank of Switzerland.

LTCM's main strategy was to make convergence trades. These trades involved finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones. There were four main types of trade:
§ Convergence among U.S., Japan, and European sovereign bonds;
§ Convergence among European sovereign bonds;
§ Convergence between on-the-run and off-the-run U.S. government bonds;
§ Long positions in emerging markets sovereigns, hedged back to dollars.

Because these differences in values were tiny, the fund needed to take large and highly-leveraged positions in order to make a significant profit. At the beginning of 1998, the fund had equity of $5 billion and had borrowed over $125 billion — a leverage factor of roughly thirty to one. LTCM's partners believed, on the basis of their complex computer models, that the long and short positions were highly correlated and so the net risk was small.

Events
1994: Long-Term Capital Management is founded by John Meriwether and accepts investments from 80 investors who put up a minimum of $10 million each. The initial equity capitalisation of the firm is $1.3 billion.

End of 1997: After two years of returns running close to 40%, the fund has some $7 billion under management and is achieving only a 27% return — comparable with the return on US equities that year.
Meriwether returns about $2.7 billion of the fund's capital back to investors because "investment opportunities were not large and attractive enough"

Early 1998: The portfolio under LTCM's control amounts to well over $100 billion, while net asset value stands at some $4 billion; its swaps position is valued at some $1.25 trillion notional, equal to 5% of the entire global market. It had become a major supplier of index volatility to investment banks, was active in mortgage-backed securities and was dabbling in emerging markets such as Russia.

17 August 1998: Russia devalues the rouble and declares a moratorium on 281 billion roubles ($13.5 billion) of its Treasury debt. The result is a massive "flight to quality", with investors flooding out of any remotely risky market and into the most secure instruments within the already "risk-free" government bond market. Ultimately, this results in a liquidity crisis of enormous proportions, dealing a severe blow to LTCM's portfolio.

1 September 1998: LTCM's equity has dropped to $2.3 billion. John Meriwether circulates a letter which discloses the massive loss and offers the chance to invest in the fund "on special terms". Existing investors are told that they will not be allowed to withdraw more than 12% of their investment, and not until December.

22 September 1998: LTCM's equity has dropped to $600 million. The portfolio has not shrunk significantly, and so its leverage is even higher. Banks begin to doubt the fund's ability to meet its margin calls but cannot move to liquidate for fear that it will precipitate a crisis that will cause huge losses among the fund's counterparties and potentially lead to a systemic crisis.

23 September 98: Goldman Sachs, AIG and Warren Buffett offer to buy out LTCM's partners for $250 million, to inject $4 billion into the ailing fund and run it as part of Goldman's proprietary trading operation. The offer is not accepted. That afternoon, the Federal Reserve Bank of New York, acting to prevent a potential systemic meltdown, organises a rescue package under which a consortium of leading investment and commercial banks, including LTCM's major creditors, inject $3.5-billion into the fund and take over its management, in exchange for 90% of LTCM's equity.

Fourth quarter 1998: The damage from LTCM's near-demise was widespread. Many banks take a substantial write-off as a result of losses on their investments. UBS takes a third-quarter charge of $700 million, Dresdner Bank AG a $145 million charge, and Credit Suisse $55 million. Additionally, UBS chairman Mathis Cabiallavetta and three top executives resign in the wake of the bank's losses. Merrill Lynch's global head of risk and credit management likewise leaves the firm.

April 1999: President Clinton publishes a study of the LTCM crisis and its implications for systemic risk in financial markets, entitled the President's Working Group on Financial Markets.

Analysis and Conclusive findings:

The Proximate Cause: Russian Sovereign Default

The proximate cause for LTCM's debacle was Russia's default on its government obligations (GKOs). LTCM believed it had somewhat hedged its GKO position by selling rubles. In theory, if Russia defaulted on its bonds, then the value of its currency would collapse and a profit could be made in the foreign exchange market that would offset the loss on the bonds.

Unfortunately, the banks guaranteeing the ruble hedge shut down when the Russian ruble collapsed, and the Russian government prevented further trading in its currency. While this caused significant losses for LTCM, these losses were not even close to being large enough to bring the hedge fund down. Rather, the ultimate cause of its demise was the ensuing flight to liquidity described in the following section.

The Ultimate Cause: Flight to Liquidity

The ultimate cause of the LTCM debacle was the "flight to liquidity" across the global fixed income markets. As Russia's troubles became deeper and deeper, fixed-income portfolio managers began to shift their assets to more liquid assets. In particular, many investors shifted their investments into the U.S. Treasury market. In fact, so great was the panic that investors moved money not just into Treasurys, but into the most liquid part of the U.S. Treasury market -- the most recently issued, or "on-the-run" Treasuries. While the U.S. Treasury market is relatively liquid in normal market conditions, this global flight to liquidity hit the on-the-run Treasuries like a freight train. The spread between the yields on on-the-run Treasuries and off-the-run Treasuries widened dramatically: even though the off-the-run bonds were theoretically cheap relative to the on-the-run bonds, they got much cheaper still (on a relative basis).

What LTCM had failed to account for is that a substantial portion of its balance sheet was exposed to a general change in the "price" of liquidity. If liquidity became more valuable (as it did following the crisis) its short positions would increase in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk factor.

As an aside, this situation was made worse by the fact that the size of the new issuance of U.S. Treasury bonds has declined over the past several years. This has effectively reduced the liquidity of the Treasury market, making it more likely that a flight to liquidity could dislocate this market.

Systemic Risk: The Ripple Effect

The preceding analysis explains why LTCM almost failed. However, it does not explain why this near-failure should threaten the stability of the global financial markets. The reason was that virtually all of the leveraged Treasury bond investors had similar positions: Salomon Brothers, Merrill Lynch, the III Fund (a fixed-income hedge fund that also failed as a result of the crisis) and likely others.

There were two reasons for the lack of diversity of opinion in the market. The first is that virtually all of the sophisticated models being run by the leveraged players said the same thing: that off-the-run Treasuries were significantly cheap compared with the on-the-run Treasuries. The second is that many of the investment banks obtained order flow information through their dealings with LTCM. They therefore would have known many of the actual positions and would have taken up similar positions alongside their client.

CONCLUSION
Derivatives remain a type of financial instruments that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by investing in a Mutual Fund whose underlying assets may include derivative products. Even, the financial derivatives have changed the face of finance by creating new ways to understand, measure and manage financial risks.
The lessons to be learned from this current crisis of derivatives are:
Ø Market values matter for leveraged portfolios.
The firms, in the cases mentioned above, depended on exploiting deviations in market value from fair value. And it depended on "patient capital" -- shareholders and lenders who believed that what mattered was fair value and not market value. That is, these fund managers convinced their stakeholders that because the fair values were hedged, it didn't matter what happened to market values in the short run — they would converge to fair value over time.
The problem with this logic is that capital is only as patient as its least patient provider. The fact is that lenders generally lose their patience precisely when the funds need them to keep it — in times of market crisis. As seen in this case, the lenders are the first to get nervous when an external shock hits. At that point, they begin to ask the fund manager for market valuations, not models-based fair valuations. This starts the fund along the downward spiral: illiquid securities are marked-to-market; margin calls are made; the illiquid securities must be sold; more margin calls are made, and so on. In general, shareholders may provide patient capital; but debt-holders do not.
In other words, you can take liquidity bets, but you cannot leverage them much.

Ø Liquidity itself is a risk factor.
As explained in the cases above, most of these firms fell victim to a flight to liquidity. This phenomenon is common enough in capital markets crises that it should be built into risk models, either by introducing a new risk factor — liquidity — or by including a flight to liquidity in the stress testing. This could be accomplished crudely by classifying securities as either liquid or illiquid. Liquid securities are assigned a positive exposure to the liquidity factor; illiquid securities are assigned a negative exposure to the liquidity factor. The size of the factor movement (measured in terms of the movement of the spread between liquid and illiquid securities) can be estimated either statistically or heuristically.
Using this approach, these firms might have classified most of its long positions as illiquid and most of its short positions as liquid, thus having a notional exposure to the liquidity factor equal to twice its total balance sheet. A more refined model would account for a spectrum of possible liquidity across securities; at a minimum, however, the general concept of exposure to a liquidity risk factor should be incorporated in to any leveraged portfolio.
Ø Models must be stress-tested and combined with judgement.
Another key lesson to be learnt from these debacles is that even (or especially) the most sophisticated financial models are subject to model risk and parameter risk, and should therefore be stress-tested and tempered with judgement. While we are clearly privileged in exercising 20/20 hindsight, we can nonetheless think through the way in which judgement and stress-testing could have been used to mitigate, if not avoid, this disaster.

Ø Financial institutions should aggregate exposures to common risk factors.
One of the other lessons to be learned is that it is important to aggregate risk exposures across businesses.
As seen in our analysis of the Long Term Capital Management (LTCM)case, many of the large dealer banks exposed to a Russian crisis across many different businesses only became aware of the commonality of these exposures after the LTCM crisis. For example, these banks owned Russian GKOs on their arbitrage desks, made commercial loans to Russian corporates in their lending businesses, and had indirect exposure to a Russian crisis through their prime brokerage lending to LTCM. A systematic risk management process should have discovered these common linkages ex ante and reported or reduced the risk concentration.

Financial derivatives should be considered for inclusion in any organisation’s risk-control arsenal. Using derivatives allows risk to be broken into pieces that can be managed independently. The viability of financial derivatives rests on the principle of comparative advantage i.e. the relative cost of holding specific risks. Whenever comparative advantage exists, trade can benefit all parties involved. From a market-oriented perspective financial derivatives offer free trading of individual risk components. As there is always an other side of the coin, derivatives also have a darker side. As we have seen, organisations like Bear Stearns, Washington Mutual, Barings Bank, etc. experienced huge losses from derivatives trading. Barings Bank lost around $1 billion just because one trader whose job was to carry out low risk arbitrage switched from being an arbitrageur to a speculator. The hedge fund named Long Term Capital Management lost about $4 billion in 1998. The treasury department of Procter & Gamble lost about $90 million trading highly exotic interest rate derivatives contracts. These losses warn the users against excessive use of financial derivatives. Without a clearly defined risk management strategy, excessive use of financial derivatives can be risky. They can cause serious losses and can threaten the firm’s long-term objectives. Hence it is important that users of derivatives fully understand the complexity of financial derivative contracts and accompanying risks. Derivatives being an important risk management tool necessitate its users to understand the intended function and the safety precautions before being put to use. The use of derivatives should be integrated into an organisation’s overall risk-management strategy and should be in harmony with its objectives. Hence the users of derivatives can use these instruments for their benefit and for the benefit of the society at large.