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Introduction
Chapter 1
1
Prelude
• Some theories that arise in a special field, because of
their deep insight and analytical power, become the
foundation of much broader fields.
• Since the seminal work of Black and Scholes, the option
theory, starting as a “derivative” theory on shares and
other securities, has been applied to many different
areas.
• Financial engineering will become the foundation of
finance, economics, and biology. The Black-Scholes
based theory will fundamentally change the way we
understand the world, which has been dominated by the
Newtonian theory for several hundred years.
History in parallel
• Newtonian mechanics, initially developed
to understand the movements of several
planets, eventually exert dominant
influence over physics, biology, economics
and finance.
General background
• Financial engineering is often regarded as
a technical and narrow field
• The following quote from Fischer black,
the main founder of financial engineering,
may give us a different impression
Quote from Fischer Black
• I like the beauty and symmetry in Mr. Treynor’s
equilibrium models so much that I started designing
them myself. I worked on models in several areas:
•
Monetary theory
•
Business cycles
•
Options and warrants
• For 20 years, I have been struggling to show people the
beauty in these models to pass on knowledge I received
from Mr. Treynor.
•
• In monetary theory --- the theory of how money is related
to economic activity --- I am still struggling. In business
cycle theory --- the theory of fluctuation in the economy -- I am still struggling. In options and warrants, though,
people see the beauty. (p. 93)
• Fischer Black and the Revolutionary Idea
of Finance by Perry Mehrling
• Why Mehrling, a monetary economist,
wrote about Black, whose main
recognized contributions are in financial
derivatives?
• In this course, we will show that the option
theory that Black and others pioneered
has much broader impacts.
• Develop a general theory of economics
inspired by the option theory
• Present a new monetary theory and
business cycle theory by extending the
ideas of Fischer Black.
The Nature of Derivatives
A derivative is an instrument whose
value depends on the values of other
more basic underlying variables. Or A
derivative is an instrument whose value
is a function the values of other more
basic underlying variables
Examples of Derivatives
•
•
•
•
Forward Contracts
Futures Contracts
Swaps
Options
Derivative use and financial crisis
• Mortgage backed securities: Complex
derivatives difficult to value
– Prepayment risk
– Default risk
• MBS: enabling the dramatic increase of
mortgage businesses for financial
institutions, which increases the building of
houses.
Derivative use and financial crisis
• CDS (Credit Default Swap)
– Measured by the spread from risk free bonds
– Provide a natural tool to bet on bond yields
– AIG CDS bailout and payments
•
•
•
•
Goldman Sachs: 12.9 billion
Societe Generale; 11.9 billion
Deutsche Bank: 11.8 billion
http://www.reuters.com/article/2009/03/18/us-aiggoldmansachs-sb-idUSTRE52H0B520090318
– The large positions show that these banks were
confident about the impending collapse of the
mortgage market and take advantages of it.
The advantages of derivative
trading
• Derivative securities are very flexible.
They can be designed to take advantages
of any scenarios.
What can we get out of this
• Historically, destructive forces precede
constructive forces
• Guns precede internal combustion engines
• Nuclear bombs precede nuclear reactors
• Floods precede hydra dams
• Oxygen as a poison precedes oxygen as an
energy source
• How about derivative securities?
• One purpose of this course is to develop
theories that can be used constructively.
Derivatives in a broader sense
• Insurance policy
function of age, job, health condition,
amount to insure
– GEICO
• Share price
function of assets, revenue, profit, interest
rate, competitors, pension liability
– Jack Treynor, one of the earliest to point out
the importance of pension liability
Derivatives in a broader sense
(Continued)
• Bank loans
– Uncertainty of repayment
• The ability to value different businesses in
a unified framework eased the integration
of different types of financial institutions
– Citigroup
• Travelers
• Salomon Brothers
• CitiBank
Derivatives in a broader sense
(Continued
• Project finance
– Whether to proceed depends on the price
movement of the products and company’s
own structure
• Cost of production
– Influenced by raw material prices, labor cost,
borrowing rate, uncertainty in demand, fixed
cost investment and duration of projects
• Profit of a ski resort
– Snow condition, general economic condition
History of Derivative markets
• Metal coins
– Content of precious metal
– Value of metal coins
– Gradual debasing of metal coins
• Paper currency: Song dynasty
– In Sichuan Province of China lacking bronze, iron was
used to make coins, which was very heavy
– Paper money start to circulate
History of Derivative markets
(Continued)
• Modern paper currency
– 1945 Brenton Wood system
– 35 USD equals 1 ounce of gold
– Breakdown at 1970, when Nixon closed the
exchange window.
– Quantitative easing
• Rice futures in Japan
• Chicago
– Farmers and merchants
• OTC markets
Derivatives Markets
• Exchange traded
– Traditionally exchanges have used the open-outcry system,
but increasingly they are switching to electronic trading
– Contracts are standard there is virtually no credit risk
– Example of default: HKFE in October, 1987
Derivatives Markets (Continued)
• Over-the-counter (OTC)
– A computer- and telephone-linked network of dealers at financial
institutions, corporations, and fund managers
– Contracts can be non-standard
– credit risk, especially during crises
• In 1998, US federal reserve organized rescue of LTCM, helping it unwind
many contracts
• In 2008, US government bailed out many contracts, such as AIG’s CDS
contracts.
• Discussion: If federal reserve didn’t rescue LTCM in 1998, will 2008 financial
crisis occur at the same magnitude?
– Much bigger than exchanged based
Ways Derivatives are Used
• To hedge risks
– Commodity producers and large
commodity consumers, such as
airliners
– Pro and con of hedging
– Some of the largest losses are due
to hedging. How? Mismatach of
maturity and other properties
Some examples
• A German oil supply company signed fixed price
contracts with many clients. To hedge risk, it long futures
contracts. Later oil prices dropped, which generates
massive margin call. But oil supply contracts are long
term, which do not provide immediate large cash inflows.
What happened next?
• The company closed the futures contract at huge loss.
The it exposed huge risk of the rise of oil prices. So it
canceled all the hugely valuable long term oil supply
contracts with its clients, free of charge.
• Reason behind this failure: Conflict between Deutsche
Bank, the majority owner, and the oil supply company
Some examples (Continued)
• In 2008, at the peak of oil price, many Chinese airlines
bought massive oil futures. At that time, it was widely
circulated that Chinese bought over 90% of the oil
futures world wide.
– Results: Many Chinese airlines posted record loss in 2009
• Goldcorp http://www.goldcorp.com/
– It used to hedge all its gold production. As gold prices rise
relentlessly, its profit was flat. In the end, it closed all its short
positions in gold futures at huge cost.
– In its company slide show: 100% unhedged gold production
• New consensus: In most cases, more harm than benefit
in hedging
Ways Derivatives are Used
(Continued)
• To speculate (take a view on the future direction
of the market)
– To gain leverage or utilize information more precisely.
For example, how one can make money in a stable
market?
– Futures trading and the scarcity of commodities
• To lock in an arbitrage profit
– E.g. Arbitrage between index components and index
futures
– For many years, Morgan Stanley was the dominant
player in the index arbitrage market.
Ways Derivatives are Used
(Continued)
• To change the nature of a liability or asset
– Most deposits, as short term deposits, are
floating rate liability. Most mortgages are fixed
rate assets.
– Interest rate swap to reduce mortgage risk in
banks
Discussion
• If you need to get a mortgage, which type
you will choose, floating rate or fixed rate
– Note: In floating rate mortgages, monthly
payments are actually fixed. What is floating is
the payment period.
• If you are a bank employee, which type of
mortgage you will recommend to your
customer: floating or fixed rate?
Ways Derivatives are Used
(Continued)
• To change the nature of an investment
without incurring the costs of selling one
portfolio and buying another
Ways Derivatives are Used
(Continued)
• To bypass regulations and laws
– Forward contract: Influence share prices
without violating legal requirements. It is very
helpful in M&A.
– CDS: Insurance contract without regulatory
constraints. This is how AIG can put up large
positions in CDS.
– Striped bonds: Reduce tax liability
Information advantage and trading
strategies
• Derivative securities provide endless possibilities in
trading strategies. With so many possibilities, one might
expect sophisticated strategies would guarantee high
rate of return. To answer this question, we will turn to a
general result derived from information theory, which is
called Kelly formula. From Kelly formula, when you do
not have information advantage, no trading strategy will
provide return higher than a passive benchmark. Indeed,
more active trading will only lower your expected rate of
return. Derivative trading can only leverage your
information advantage, but cannot substitute information
advantage.