Derivatives | Marketplace Whiteboard
Summary
TLDRThe video explains derivatives in simple terms, using a relatable example of buying turkeys for Thanksgiving. It describes three main types of derivatives: futures (agreements to buy or sell an asset at a future date), options (the right, but not the obligation, to buy or sell), and swaps (exchanging one set of cash flows for another). The speaker emphasizes how derivatives are contracts based on underlying assets, like commodities or interest rates, and discusses trading, risks like leverage, and counterparty risks. The goal is to simplify a complex financial concept for a broad audience.
Takeaways
- 📈 Derivatives are financial contracts that derive their value from an underlying asset.
- 🍗 A simple example of a derivative is a future contract for the delivery of 20 turkeys before Thanksgiving.
- 📜 The essence of a derivative is an agreement or contract based on something else, like turkeys in this case.
- ⏳ A future or forward contract involves delivering or receiving something at a set time in the future.
- 📊 An option gives the holder the right, but not the obligation, to buy or sell an asset at a predetermined price within a certain timeframe.
- 🔄 A swap involves exchanging one kind of financial obligation, such as a floating interest rate, for another, like a fixed rate.
- 💰 Derivatives can be based on a variety of underlying assets, including commodities (like turkeys), interest rates, credit, and even weather conditions.
- 🏛 Derivatives can be traded on exchanges or over-the-counter (OTC), where agreements are made directly between parties.
- ⚠️ Leverage is often used in derivatives, meaning people can borrow money to trade, which increases both potential profits and risks.
- 🤝 Counterparty risk is a key concern with derivatives, as one party may default on their obligations, leaving the other party exposed to loss.
Q & A
What is a derivative, according to the script?
-A derivative is a financial contract whose value is based on an underlying asset or instrument, such as commodities, interest rates, or currencies.
What is the first type of derivative mentioned in the script?
-The first type of derivative mentioned is a future or forward contract, where an agreement is made to deliver an asset (like turkeys in the example) at a future date.
How does a forward contract work in the example provided?
-In the example, Terry pre-pays $300 to Mr. Bailey for 20 turkeys at $15 each, to be delivered before Thanksgiving. This agreement is the forward contract, where the underlying asset is the turkeys.
What is the second type of derivative mentioned?
-The second type of derivative mentioned is an option, which gives the buyer the right, but not the obligation, to buy or sell an asset at a specified price before a certain date.
How does Terry use an option in the example?
-Terry buys an option from Mr. Jones, paying $50 for the right to buy 20 turkeys at $15 before November 23rd. This acts as a hedge in case Mr. Bailey cannot deliver his turkeys.
What is the third type of derivative discussed?
-The third type of derivative discussed is a swap, where two parties exchange financial instruments, such as swapping a floating interest rate for a fixed one.
What is meant by 'underlying' in the context of derivatives?
-The 'underlying' refers to the asset or instrument on which a derivative is based. In the examples, the underlying assets include turkeys, interest rates, and commodities like gold or wheat.
Why do people use leverage with derivatives?
-Leverage is used with derivatives to amplify potential returns by borrowing money. However, it also increases the risk of losing more than the initial investment if the contract value decreases.
What is counterparty risk in derivatives trading?
-Counterparty risk refers to the possibility that one party in the derivative contract may default or fail to fulfill their obligation, as in the case of Mr. Bailey potentially not delivering the turkeys.
How can derivatives be traded, according to the script?
-Derivatives can be traded on exchanges, where prices are transparent and regulated, or over-the-counter (OTC), where contracts are negotiated directly between parties without an exchange.
Outlines
📉 Introduction to Derivatives
In this opening segment, Patty Hersh introduces herself and the topic of derivatives, emphasizing the large scale and perceived risk of the derivatives market. She reassures the audience that although the concept of derivatives is simple, it covers a wide range of financial instruments. The core idea of derivatives is based on an underlying asset or value, making each derivative unique but bound by common principles.
🦃 The Turkey Contract Example: Explaining Futures and Forwards
Patty uses a story about a man named Terry MacLeod, who purchases turkeys in advance for Thanksgiving, to explain how a forward or future contract works. Terry arranges to buy turkeys from a farmer, Mr. Bailey, at a set price to ensure his supply. This agreement is a forward contract, where Terry secures his purchase at a predetermined price, with the turkeys being the underlying asset. This demonstrates how futures and forwards are contracts based on the future delivery of a product.
📜 Options Explained: Hedging with Another Farmer
Patty continues Terry's story, introducing the concept of an option. Terry, worried about Mr. Bailey's farm failing, pays Mr. Jones, another farmer, $50 for the option to buy turkeys at the same price. This option allows Terry to buy turkeys if needed but isn’t obligated to do so. The option is a form of insurance or a hedge against the failure of the original contract. If he doesn’t exercise the option, he loses the $50.
🔄 Swaps: Interest Rates and Financial Instruments
The third type of derivative Patty discusses is a swap. In this case, a floating interest rate on a loan or bond is exchanged for a fixed interest rate to provide certainty. For example, a bank may agree to a 5% fixed rate, regardless of fluctuations in market interest rates. This section introduces the concept of swapping financial obligations, where one party takes on the risk of fluctuating rates in exchange for a fixed payment.
🌾 The Wide Variety of Underlying Assets
Patty explains that derivatives can be based on various underlying assets such as commodities (turkeys, gold, wheat), interest rates, foreign exchange, or even weather patterns. She emphasizes that derivatives are not limited to physical goods but can involve complex financial metrics, including credit and equity derivatives. The underlying asset is key to understanding the value and purpose of a derivative.
💼 Trading Derivatives: Exchanges and Over-the-Counter Markets
Derivatives can be traded on formal exchanges or over-the-counter (OTC) between two parties. Patty uses Terry’s turkey contract as an example to explain how derivatives are traded. If Terry decides not to host Thanksgiving, he can sell his contract to a neighbor, who may offer less or more depending on market conditions. This ability to trade contracts is a key feature of derivatives, and prices can fluctuate based on supply and demand.
⚠️ Leverage and Counterparty Risk
Patty highlights two major risks associated with derivatives: leverage and counterparty risk. Leverage involves borrowing money to trade derivatives, which can lead to large losses if prices move unfavorably. Counterparty risk occurs when the party responsible for delivering the underlying asset (such as Mr. Bailey) fails, leaving the contract holder exposed. These risks are the reasons why derivatives are viewed as potentially dangerous in the financial system.
🍸 Conclusion: The Need for a Thanksgiving Drink
Patty wraps up with a lighthearted remark, suggesting that after dealing with the complexity and risks of derivatives, Terry might need a drink to cope with the stress. This humorous conclusion underscores the potential difficulty and high stakes involved in managing derivative contracts.
Mindmap
Keywords
💡Derivative
💡Futures/Forward Contract
💡Option
💡Swap
💡Underlying Asset
💡Commodity
💡Leverage
💡Counterparty Risk
💡Hedge
💡Over-the-Counter (OTC)
Highlights
Introduction to derivatives, a seemingly simple concept but encompasses an enormous world of financial instruments.
The concept of a derivative: a contract derived from something underlying, such as commodities, interest rates, or equities.
First type of derivative: Future or forward contracts, exemplified by Terry pre-buying 20 turkeys at a fixed price for future delivery.
Explanation of futures: A contract to deliver something (turkeys in this case) at a later date for a pre-agreed price.
Second type of derivative: Options, which give the buyer the right, but not the obligation, to buy or sell something at a certain price within a specified time frame.
Example of an option: Terry hedging his turkey purchase with a second turkey farmer in case the first supplier fails to deliver.
Third type of derivative: Swaps, where two parties exchange financial instruments, like swapping a floating interest rate for a fixed interest rate.
Swaps allow parties to manage interest rate risk, where a fixed rate offers stability compared to a fluctuating rate.
Underlying assets in derivatives: Includes commodities like turkeys, interest rates, foreign exchange, credit, mortgages, and even weather conditions.
Trading derivatives: Derivatives can be traded on exchanges or over-the-counter markets, depending on the type of contract and agreement between parties.
Derivatives trading does not always involve the underlying asset directly; traders often focus on the contract itself for profit.
Risk in derivatives: Leverage increases risk, as traders often use borrowed money, which can result in losing all invested funds if the trade goes poorly.
Counterparty risk: The risk that the other party in a derivative contract may default, leaving the contract holder exposed.
Example of counterparty risk: If Terry's turkey supplier goes bankrupt, his pre-purchased turkeys may never be delivered.
Hedging with options: Terry mitigates counterparty risk by purchasing an option with another supplier, ensuring he can still get turkeys if the first deal falls through.
Transcripts
hi my name is patty Hersh I'm a senior
does your marketplace today I want to
talk about derivatives and it was been
reading Business News or listening to it
on the radio who have been hearing about
this enormous market and derivatives
threatens to drag the whole financial
system down so of course the question
arises well what exactly is this
derivative that everyone's talking about
well there's good news and bad news the
good news is that a derivative is is at
its essence a very simple concept but
the bad news is that it in sort of
encompasses this enormous world of
financial instruments
so each derivative is kind of slightly
different although it does have a single
kind of binding element that makes it
similar so what exactly is a derivative
let's see if we can there spell I'd as
simply as possible okay so here's a very
simple example and it's based around our
good friend Terry remember him here he
is now Terry is Terry MacLeod his name
is he's actually the head of the clan
MacLeod okay and every year at around
Thanksgiving the clan descends on
Terry's home we're talking about
hundreds of people and he has to buy
turkeys to feed them all usually costs
him about 20 turkeys okay we're talking
big old turkeys there 20 Turkish it
takes now in the past Terry used to go
to the supermarket that week before
Thanksgiving and he'd say excuse me 20
turkeys and the the butcher would say no
problems here's 20 turkeys no problems
but a couple of years ago he went to the
store and they were out of Turkey store
nothing it was a big problem for him
because his family kind of revolted he
had to serve them ham which was a
complete nightmare anyway so he decided
after that very traumatic event that he
was going to try and prearranged the
delivery of his turkeys so he went out
and he tried to find the biggest turkey
farm that he could
this is bailey's farms and it's a way
out in the countryside there and his old
mr. Bailey is a very nice chat very
accommodating and he said to mr. Bailey
oh it's really way that you can kind of
ensure that I get delivered 20 turkeys
at Thanksgiving mr. Wace oh well I'll
just guarantee that you know but I'll
tell you what I can do I can allow you
to kind of pre buy the turkeys you know
if you pay me a certain amount of money
now then I'll deliver you 20 turkeys you
know any time you like before
Thanksgiving the week before
Thanksgiving it's always like that
sounds like a good idea so he says not
sure how much turkeys come in some years
they're cheap thirteen dollars and years
are expensive like 25 bucks how about we
split the difference and say $15 $20 20
turkeys at $15 all right is mr. Bailey a
science fair enough so Terry provides
him with $300 that's 20 turkeys at a
princely price of $15 and that money
across mr. Bailey provides a note so
like an IOU so I owe you 20 turkeys to
pick up at any time
before Thanksgiving and what we've got
is a contract and this contract
okay this agreement is derived from
something underlying okay and what's
underlying it are the turkeys gets this
element underlying it but essentially
what this is is a contract to deliver 20
turkeys before Thanksgiving paid for
already by our friend Terry okay and
this is the first okay of what one of
three types of derivatives but it's it
basically shows you what a derivative is
a derivative is essentially a contract
it's based on something else in
agreement based on something else in
this case turkeys so this is the first
type so three types really of derivative
and this is the first which is the
future or forward okay because in the
future mr. Bailey will be delivering
twenty turkeys to Terry hence it's a
future or forward contract okay the
second type we have is called an option
and an option is the option gives the
buyer the option to buy or sell
something okay so say in this case
turkeys a little Terry's a little
worried about mr. Bailey he's worried
that mr. Bailey's farm might fail okay
so it says very small chance of course
tiny chance but it's possible so thinks
will do is I'll hedge this contract by
taking out an option okay what it is is
he finds another turkey farmer all the
way out here in the countryside and this
is the Jones farm
okay mr. Jones he's a nice enough chat
but you know not as reliable but what he
does is he says to mr. Jones or to what
I'll give you 50 dollars 50 bucks for
the right to buy 20 turkeys at $15 okay
at any time before say the 23rd of
November
okay so what he's doing is is buying the
option to buy cost him $50 in return he
gets this note it's an option okay for
20 turkeys $15
right so he has the right to exercise
that option at any point before say the
23rd of November okay so what he's done
in total to secure to make sure that
he's going to get his 20 turkeys
absolutely sure he's paid $300 to mr.
Eyre took to mr. Bailey here but in case
there's a problem he's got this hedge
okay which is his option to buy $20 or
20 turkeys at $15 which he's Chuck he's
paid $50 for okay but that option can
expire or will expire on the 23rd if he
doesn't exercise it if he doesn't buy
those turkeys doesn't exercise it he's
paid $50 which he never sees again and
he is there but he's actually secured
his right to to get 20 turkeys should
mr. Bailey not deliver okay so that's an
option often often used by as a hedge by
people okay so that's the second type of
third type is called a swap okay and
that's when you have say an instrument
that has a floating interest rate so
months to month depending on where the
underlying interest rate is say LIBOR or
whatever you don't know what the
interest rate is going to be on the loan
that you have or the bond and what a lot
of people like to do is they later to
take that floating rate where there's
uncertainty and swap it for a fixed rate
so say a bank will say okay well then
you just pay you know 5% a month and
we'll take the risk that one month it
might be three and a half percent or one
might one month it might be seven and
half percent and we'll pay the
difference so you know obviously they're
gambling that so we're going to be lower
or at about the same rate so that's how
there's where the swap comes in where
you swap a floating rate for a fixed
rate okay but again it's a contract
that's based on the underlying
instrument which is in fact the bond or
the loan that you're talking about so
hence once again we're talking about
this underlying and there are various
things that can underlie these various
contracts okay whoops underlying okay
oops
Angie I can't even spell so what have we
got underlying well in this case we've
got turkeys and turkeys are a commodity
okay in commodities can include gold
silver soybeans wheat whatever in the
swap case wheat the underlying was an
interest rate and interest rates in fact
one of the the biggest underlying sand
in the business in the business of
derivatives
so interest rates what else have you got
well you got two we have M we have
credit derivatives default swaps so
credit isn't underlying what else we got
there we had can have foreign exchange
for X we can have M we can have the
weather okay what are the weathers in
there
equities mortgages and on and on and on
and on there's all sorts of things that
you can have as your underlying
instrument in your derivative but
essentially once again was all the
derivative is is this contract that's
written based on the underlying and
here's the great thing about derivatives
because of this contract you can trade
them okay employment derivatives are
traded in two places they're either
traded on an exchange
okay so traded on an exchange kind of
like you know the exchanges in Japan or
the exchanges or the sp500 any of these
exchanges or they can be traded
over-the-counter and the
over-the-counter caters whenever it's an
agreement between one person and another
so in an exchange you have this exchange
that's working where you use the
exchange trade through and you can see
the prices listed in an over-the-counter
market it's just an agreement in this
case it's an agreement between Terry and
mr. Bailey in this case of agreement
between Terry and mr. Jones now how does
this trade well say for example Terry's
grandmother gets sick in Canada he
decides to go to Canada and he has to
yester bail on the whole Thanksgiving
thing he can't have the clan MacLeod at
his house what does he do
well he cancels it obviously everyone
who gets irritated him but he's the
worst thing is he's got his paid $300
for these turkeys but he can trade this
note he can go to his neighbor and say
look the week before Thanksgiving I said
look you know I need to sell this I
thought these turkeys coming but I can't
use them can you use them and the
neighbor might say okay well you know I
can use them I'll pay you $150 for it
okay so clearly he's losing money on the
deal but on the other hand he might go
to that his neighbor and say if there's
like a a problem with turkey supply that
year as there was the year that he went
to the supermarket he can go to his
neighbor and he can say you know there's
not very many turkeys this year how
about I sell you these 20 turkeys give
this note for these 20 turkeys and you
can you can pay me $400 for it and the
guy might say oh absolutely because then
he can go to the supermarket and sell
them for even more okay because there's
so much demand
so in that case Terry can see he can
actually trade his note here's his
contract
or more than its face value at $300 and
that's what happens with these contracts
is that is that most of the people who
are trading them aren't really
interested in what's underlying at all
they aren't interested in the interest
rate they aren't interested in the
commodities they were interested in the
contract and the fact that they can
trade that contract up or trade that
contract down so what's the problem with
this why are people worried about it
there are basically two reasons firstly
because people use a leverage when they
took when they're using their
derivatives okay which means you're
using borrowed money which means that
you know if you if the price of the the
contract goes up then you know you make
money there's no problems but if the
price of the contract goes down it means
you can lose all of your money because
you borrowed a whole bunch means you can
lose all of your principal very very
quickly the second is because of the
counterparty risk we talked about mr.
Bailey's problems here clearly Terry is
not a risk to mr. Bailey because mr.
Bailey's already got his $300 so that
counterparty is taken care of but mr.
Bailey is a risk to Terry which is way
to get this option because if mr. Bailey
goes if mr. Bailey has a problem or as
far as his farm goes under it means that
Terry's got this note for 20 turkeys
he's got a feed 200 people okay he's got
no turkeys coming in because mr. Bailey
is not going to be surprised supplying
him perhaps he hasn't covered himself
with an option in that situation that
counterparty risk is caught Terry and
that means it's going to leave him very
badly needing a Thanksgiving drink
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