Introduction Chapter 1

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IntroductionChapter 1
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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.

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History in parallel

• Newtonian mechanics, initially developed to
  understand the movements of several planets,
  eventually exert dominant influence over physics,
  biology, economics and finance.

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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

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Quote from Fischer Black

• I like the beauty and symmetry in Mr. Treynors
  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)

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• 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.

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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

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Examples of Derivatives

• Forward Contracts
• Futures Contracts
• Swaps
• Options

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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.

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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
• Society General 11.9 billion
• Deutsche Bank 11.8 billion
• http//www.reuters.com/article/2009/03/18/us-aig-g
  oldmansachs-sb-idUSTRE52H0B520090318
• The large positions show that these banks were
  confident about the impending collapse of the
  mortgage market and take advantages of it.

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The advantages of derivative trading

• Derivative securities are very flexible. They can
  be designed to take advantages of any scenarios.

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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.

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Derivatives in a broader sense

• Insurance policyfunction of age, job, health
  condition, amount to insure
• Share pricefunction of assets, revenue, profit,
  interest rate, competitors
• Bank loans
• Uncertainty of repayment
• Bonus An option on performance

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Derivatives in a broader sense (Continued

• Project finance
• Whether to proceed depends on the price movement
  of the products and companys own structure
• Cost of production
• Influenced by raw material prices, labor cost,
  borrowing rate and uncertainty in demand
• Bank bailout
• Depends on the performance of banks

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History of Derivative markets

• Metal coins
• Content of precious metal
• Value 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
• Rice futures in Japan
• Chicago
• Farmers and merchants
• OTC markets

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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
• 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
• Much bigger than exchanged based

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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

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Some examples

• An 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?
• 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.
• Goldcorp http//www.goldcorp.com/
• In its company slide show 100 unhedged gold
  production
• New consensus more harm than benefit in hedging

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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

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Ways Derivatives are Used (Continued)

• To change the nature of a liability
• Interest rate swap to reduce mortgage risk in
  banks
• To change the nature of an investment without
  incurring the costs of selling one portfolio and
  buying another
• To bypass regulations and laws
• Forward contract disguise identities of traders
• CDS Insurance contract without regulatory
  constraints