Introduction
In the last 30 years, derivatives have become increasingly important in finance. Futures
and options are actively traded on many exchanges throughout the world. Many
different types of forward contracts, swaps, options, and other derivatives are entered
into by financial institutions, fund managers, and corporate treasurers in the over-the-
counter market. Derivatives are added to bond issues, used in executive compensation
plans, embedded in capital investment opportunities, used to transfer risks in mortgages
from the original lenders to investors, and so on. We have now reached the stage where
those who work in finance, and many who work outside finance, need to understand
how derivatives work, how they are used, and how they are priced.
Whether you love derivatives or hate them, you cannot ignore them! The derivatives
market is huge-much bigger than the stock market when measured in terms of
underlying assets. The value of the assets underlying outstanding derivatives trans-
actions is several times the world gross domestic product. As we shall see in this chapter,
derivatives can be used for hedging or speculation or arbitrage. They play a key role in
transferring a wide range of risks in the economy from one entity to another.
A derivative can be defined as a financial instrument whose value depends on (or
derives from) the values of other, more basic, underlying variables. Very often the
variables underlying derivatives are the prices of traded assets. A stock option, for
example, is a derivative whose value is dependent on the price of a stock. However,
derivatives can be dependent on almost any variable, from the price of hogs to the
amount of snow falling at a certain ski resort.
Since the first edition of this book was published in 1988 there have been many
developments in derivatives markets. There is now active trading in credit derivatives,
electricity derivatives, weather derivatives, and insurance derivatives. Many new types
of interest rate, foreign exchange, and equity derivative products have been created.
There have been many new ideas in risk management and risk measurement. Capital
investment appraisal now often involves the evaluation of what are known as real
options. The book has kept up with all these developments.
Derivatives markets have come under a great deal of criticism because of their role
in the credit crisis that started in 2007. Derivative products were created from
portfolios of risky mortgages in the United States using a procedure known as
securitization. Many of the products that were created became worthless when house
prices declined. Financial institutions, and investors throughout the world, lost a huge.amount of money and the world was plunged into the worst recession it had

experienced for many generations. Chapter 8, new to this edition, explains how

securitization works and why such big losses occurred. As a result of the credit crisis,

derivatives markets are now more heavily regulated than they used to be. For example,

banks are required to keep more capital for the risks they are taking and to pay more

attention to liquidity.

In this opening chapter, we take a first look at forward, futures, and options

markets and provide an overview of how they are used by hedgers, speculators, and

arbitrageurs. Later chapters will give more details and elaborate on many of the points

made here.

1.1 EXCHANGE-TRADED MARKETS

A derivatives exchange is a market where individuals trade standardized contracts that

have been defined by the exchange. Derivatives exchanges have existed for a long time.

The Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and

merchants together. Initially its main task was to standardize the quantities and

qualities of the grains that were traded. Within a few years, the first futures-type

contract was developed. It was known as a to-arrive contract. Speculators soon became

interested in the contract and found trading the contract to be an attractive alternative

to trading the grain itself. A rival futures exchange, the Chicago Mercantile Exchange

(CME), was established in 1919. Now futures exchanges exist all over the world. (See

table at the end of the book.) CME and CBOT have merged to form the CME Group

(www.cmegroup.com), which also includes the New York Mercantile Exchange.

The Chicago Board Options Exchange (CBOE, www.cboe.com) started trading call

option contracts on 16 stocks in 1973. Options had traded prior to 1973, but the CBOE

succeeded in creating an orderly market with well-defined contracts. Put option

contracts started trading on the exchange in 1977. The CBOE now trades options on

over 2,500 stocks and many different stock indices. Like futures, options have proved to

be very popular contracts. Many other exchanges throughout the world now trade

options. (See table at the end of the book.) The underlying assets include foreign

currencies and futures contracts as well as stocks and stock indices.

Electronic Markets

Traditionally derivatives exchanges have used what is known as the open outcry system.

This involves traders physically meeting on the floor of the exchange, shouting, and

using a complicated set of hand signals to indicate the trades they would like to carry

out. Exchanges are increasingly replacing the open outcry system by electronic trading.

This involves traders entering their desired trades at a keyboard and a computer being

used to match buyers and sellers. The open outcry system has its advocates, but, as time

passes, it is becoming less and less used.

Electronic trading has led to a growth in algorithmic trading (also known as black-

box trading, automated trading, high-frequency trading, or robo trading). This

involves the use of computer programs to initiate trades, often without human intervention.
Business Snapshot 1.1 The Lehman Bankruptcy

On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protec-

tion. This was the largest bankruptcy filing in US history and its ramifications were

felt throughout derivatives markets. Almost until the end, it seemed as though there

was a good chance that Lehman would survive. A number of companies (e.g., the

Korean Development Bank, Barclays Bank in the UK, and Bank of America) expressed interest in buying it, but none of these was able to close a deal. Many people thought that Lehman was ''too big to fail'' and that the US government would have to bail it out if no purchaser could be found. This proved not to be the case.

How did this happen? It was a combination of high leverage, risky investments, and

liquidity problems. Commercial banks that take deposits are subject to regulations on

the amount of capital they must keep. Lehman was an investment bank and not subject to these regulations. By 2007, its leverage ratio had increased to 31:1, which means that a 3-4% decline in the value of its assets would wipe out its capital. DickFuld, Lehman's Chairman and Chief Executive Officer, encouraged an aggressive

deal-making, risk-taking culture. He is reported to have told his executives: ''Every day

is a battle. You have to kill the enemy.'' The Chief Risk Officer at Lehman was competent, but did not have much influence and was even removed from the executive

committee in 2007. The risks taken by Lehman included large positions in the

instruments created from subprime mortgages, which will be described in Chapter 8.

Lehman funded much of its operations with short-term debt. When there was a loss of

confidence in the company, lenders refused to roll over this funding, forcing it into

bankruptcy.

Lehman was very active in the over-the-counter derivatives markets. It had hundreds

of thousands of transactions outstanding with about 8,000 different counterparties.

Lehman's counterparties were often required to post collateral and this collateral had

in many cases been used by Lehman for various purposes. It is easy to see that sorting

out who owes what to whom in this type of situation is a nightmare!