Derivative Essentials

Mr. Deriva

November 24, 2001

The term gDerivativesh appears on newspapers often in negative connotation. Does the trading systems really harm society? Before we express an opinion to them, let us look at where they came from. Let us also examine some simplified examples to see how they work.

Origin of Derivatives

In Japanfs Edo-era, successful merchants such as Mr. Kinokuniya, Mr. Yodoya, and so on demonstrated strong influence to local leaders, Daimyo. In Osaka, main rice market took place Kitahama along the Tosahori River, southern branch of Yodo River. In 1697 the market moved to Dojima located north shore of Dojima River, northern branch of Yodo River. Today, Dojima became well known as gBirthplace of Futuresh. Do you know why?

See the website: www.ncs.co.jp/nakanoshima/index.htm

www.krf.or.jp/nakanoshima/komeichiba.htm

Rice was traded at a house called Kurayashiki where rice was auctioned. A guy whose got a deal was to give a currency as a payment until next day. Kurayashiki then issues a rice ticket, like a note. With the ticket, the guy can pick up actual rice, but he did not have to do until certain period. Sometimes those guys sold the ticket to somebody else. However, the trade bases current market price called gspot price.h

Later, a new trade system appeared which enabled traders to agree now in price, other than spot price. And the rice delivery came in agreed timing, 6 months later for instance. The buyer knows now how much to pay in the timing and so do the seller to get the money. This trade system was called Nobebaibai, the origin of futures, kind of derivatives.

Cash Market

Suppose you are a gentle buyer of gold working at your companyfs procurement department. I, Mr. Deriva, am a gentle seller of gold at a gold producer. You want to buy a chunk of gold at price as low as possible but I like higher price, of course. So what can we do about it?

Spot Trading

In this market, gold delivery and its settlement occur immediately after the trade agreement between you and me reaches through a place called gexchangeh at a price based on current supply and demand. This price is called gspot price.h You would need to pay for entire transaction, and I have to deliver gold soon after the agreement.

Let us say you already have an amount of gold for next 3 months. Thinking of price of 3 months ahead, you may wonder if it is to buy now gold more or wait until then. If you guess the price is going to be higher in the future, you may buy some now. But you would wait if you guess the other way. You are facing risk of price increase.

I am a producer so I need to produce a gold and sell it for living. But if the price goes down in the future, I better not to produce so much. What risk do I face?

Forward Contract

This market is similar to gfuturesh mentioned later. The market enables you and me to set now, if agreed, price for settlement later, say 3 months later for agreed amount of gold. The agreement is called gforward contract.h I deliver the gold 3 months later at the agreed price to you, and you pay me for all then.

Knowing the price in advance, you can prepare your company to do a good business. I also feel better to decide how much to invest for producing gold to keep profit. This makes you and me happy so it looks a win-win situation.

Some say No! You may be lucky if spot price 3 months later ends up with higher than the agreed price but must be unlucky if the spot price does the other way. From my position, guess what? But as long as you prepare in the way that your company can withstand the agreed price, you can avert the risk of unexpected loss, a sort of ghedging.h So do I.

Arbitrage

This refers simply to play with two different markets, say spot and forward markets for example. Then let us examine the following example. Keep in mind that you and I so far has been gentlemen, but no longer so from now on. This means you and I may trade gold more than necessary and can be a buyer or a seller or even both for profit.

    1. Current gold spot price is 1000 yen/g.
    2. You have gold in stock for next 6 months, 6000g, but not much cash.
    3. You have a policy not to face shortage of gold for your business.
    4. I offer 3000g at 900yen/g as 3-month forward contract.
    5. Do not consider any delivery and settlement fees, interest, inflation, etc.

So, do you take my offer? What if my offer were 1100yen/g for 3000g as 3-month forward contract? If you take actions leading a profit without risk of loss, you are thought to be working on an garbitrage.h

Futures

In a forward contract, a trade in bilateral, you and me. So I, a producer, am afraid that you may not be able to pay for entire settlement in the agreed timing. That risk is mine. Surely, your risk is that I do not deliver agreed amount of gold by agreed timing. Trading system called gfuturesh involves collective actions, not bilateral, of sell and buy at a place called gexchange.h Like Tokyo Stock Exchange, many sellers and buyers meet so you do not know whom you are trading with.

In futures, like forward contracts, a seller and a buyer make a contract at agreed price for settlement later, say 3 months later. But unlike forward contracts, futures do not require you to have money for entire settlement if you take a reverse action called goffsetting.h However, you need to put a deposit called gmarginh, which is smaller than amount for all. The margin may be from 2% to 5% of the entire amount upon its contract. This means you and I can make a big deal with little margin.

Let us check the example below.

    1. You have ordered a buy of 500g at 1000 yen/g of 3-month future.
    2. I have ordered a sell of 300g at 1000yen/g and someone else does the same but at 200g.
    3. At the exchange, the above 1) and 2) has been in effect. So you paid a margin of 25000yen (5%).

Suppose the price of the future declined to 900yen/g when 2 months passed. Then you felt the price would not go up before the ending period so you have decided to execute offsetting. So what is the ratio of loss per investment?

Quiz:

How about combination of gfuturesh and gspot tradingh? Can you reduce risk?

Options

Derived from futures, options gained interest. See the following simplified example.

Example:

Suppose current price of gold is 1000yen/g. You wish to have a privilege to buy 3000g at 900yen/g during a 3-month period from now. And you want the privilege to execute only when only the time spot price is higher than 900yen/g.

I, Mr. Deriva, would say gNo way, you are greedy trying to make money without taking any risk like garbitrage.h

You might say, gNo, I am not greedy. I have only gold for next 3 months in stock so I wanted to secure some gold during the period.h

I would respond, gin that case, you should pay me 100yen/g, which is the difference between the spot price and your price. Otherwise, even if spot price ends up with lower than 900yen/g, you do not lose at all. But you would make unlimited profit beyond 900yen/g.h

(You get gold at 900yen/g and sell immediately it at then spot price higher than 900yen/g.)

You say, gOK, you make a deal!h You pay me 100yen/g, total 300,000yen, and you get a gright to buyh 3000g at 900yen/g during a 3-month from now. But you are not obligated to execute the right. However, I am gobligated to sellh it to you at the conditions if you execute the right.

If this deal is available through an exchange, it is called gcall option.h In call option, you, a buyer, get right to buy at conditions with payment called gpremiumh, while I, a seller, gets obligation to sell at the conditions and your premium. The price, 900yen/g, is called gstrike price.h So what are your risk and my risk to take?

Let us examine the following case. Suppose I am not a producer but just a seller.

Case 1: Spot price has reached 1100yen/g and you execute your right.

    1. I get 100yen/g X 3000g = 300,000yen (premium)
    2. I pay 1100yen/g X 3000g = 3,300,000yen (to provide gold to you)
    3. I get 900yen/g X 3000 = 2,700,000yen

1), 2), and 3) = - 300,000yen (my loss)

Did I invest any money to make this miserable deal? This deal is clearly risky for me. I just may be attracted with 300,000yen of premium to get, and I face unlimited risk of loss. Suppose the spot price soars much higher than 1100yen/g.

On the other hand, your risk is only maximum 100yen/g. This means you invest 300,000yen and might lose to that limit in worst case but have a chance of unlimited profit. If I have a feeling that the spot price increases so much during the period, I would not take this deal at 100yen/g of premium. I need more and I would have taken an action of hedge. If not, I am walking to a state of suicide.

There are many other things regarding options. But here you know what the essence is. Certainly, it is an amazing trading system, isnft it?