INWORLDFINANCIALMARKETS(MrJohnThompson)

DERIVATIVESINWORLDDERIVATIVESINWORLDFINANCIALMARKETSFINANCIALMARKETSAugust14August14--18,200618,2006AsiaAsia--PacificFinanceandDevelopmentPacificFinanceandDevelopmentCenterCenterShanghai,P.R.ChinaShanghai,P.R.ChinaJohnK.Thompson,Ph.D.JohnK.Thompson,Ph.D.SeniorFellowSeniorFellowBostonInstituteforDevelopingEconomiesBostonInstituteforDevelopingEconomies((formerlyFinancialCounselor,OECDformerlyFinancialCounselor,OECD))WHATAREDERIVATIVES?WHATAREDERIVATIVES?““……aderivativeinstrumentisonewhosevaluedependsaderivativeinstrumentisonewhosevaluedepends(i.e.is(i.e.isderivedderivedfrom)thevalueofsomethingelsefrom)thevalueofsomethingelse..””(RobertW.Kolb(RobertW.KolbFuturesOptions&SwapsFuturesOptions&Swaps))¾¾AderivativeinstrumentisacontracttoexchangeAderivativeinstrumentisacontracttoexchangeassetsatsomefuturetimeataspecifiedprice,orassetsatsomefuturetimeataspecifiedprice,orwhichentitlesoneofthepartiestoexecutethewhichentitlesoneofthepartiestoexecutetheexchangeathis/herowndiscretion.exchangeathis/herowndiscretion.¾¾Theunderlyingassetmaybephysicalorfinancial.Theunderlyingassetmaybephysicalorfinancial.¾¾ThetransactionmaytakeplaceonanexchangeThetransactionmaytakeplaceonanexchangewithformaltradingrulesorinanOverwithformaltradingrulesorinanOver--thethe--Counter(OTC)MarketCounter(OTC)MarketCOMMONFORMSOFCOMMONFORMSOFDERIVATIVESDERIVATIVES„„TraditionalTraditional••ForwardsForwards••FuturesFutures••OptionsOptions••OptionsonFuturesOptionsonFutures••SwapsSwaps„„RecentInnovationsRecentInnovations••CollateralizedDebtObligationsCollateralizedDebtObligations••CreditDefaultSwapsCreditDefaultSwapsFINANCIALDERIVATIVESFINANCIALDERIVATIVES„„FixedincomeassetsFixedincomeassets••BondsBonds••TreasuryBillTreasuryBill••CDsCDs„„ForeignCurrenciesForeignCurrencies„„Equities(includingindices)Equities(includingindices)„„CreditCredit„„Manyderivativecontractshavebeentried,Manyderivativecontractshavebeentried,buthavenotattractedenoughinterestbuthavenotattractedenoughinterest••Example:CPIfuturesExample:CPIfuturesDERIVATIVESREALLOCATEDERIVATIVESREALLOCATERISKRISK„„TraditionalCommodityDerivativeTraditionalCommodityDerivative••FarmerHedgesbySellingWheatFuturesFarmerHedgesbySellingWheatFuturesContractContract••BakeryHedgesbyBuyingWheatFuturesBakeryHedgesbyBuyingWheatFuturesContractContract••ArbitrageurSeeksRiskFreeOpportunitiesArbitrageurSeeksRiskFreeOpportunities••SpeculatorTakesAPositionInWheatFuturesSpeculatorTakesAPositionInWheatFutures99EveryparticipantisinabetterEveryparticipantisinabetterpositionthanwithoutpositionthanwithoutderivativesderivativesADVANTAGESOFDERIVATIVESADVANTAGESOFDERIVATIVES„„MarketParticipantsCanAdjustMarketParticipantsCanAdjustRisk/RewardPositionRapidlyRisk/RewardPositionRapidly„„PriceDiscovery:OngoingIncorporationofPriceDiscovery:OngoingIncorporationofAllAllInformationintoPricesInformationintoPrices„„PracticalApplicationsofPriceDiscovery:PracticalApplicationsofPriceDiscovery:••FarmersDecideWhetherToPlantWheatorFarmersDecideWhetherToPlantWheatorCornCorn••InvestorsDecideWhethertoOpenaMineInvestorsDecideWhethertoOpenaMineFINANCIALRISKMANAGEMENTFINANCIALRISKMANAGEMENTDerivativesDiminishorIncreaseDerivativesDiminishorIncreaseExposuretoanAssetClassExposuretoanAssetClass••ExampleGovernmentSecuritiesTraderExampleGovernmentSecuritiesTrader„„EarnsIncomeThroughShortEarnsIncomeThroughShort--termTradingtermTradingonSmallPriceMovements.onSmallPriceMovements.„„MustHoldVeryLargeInventoriesMustHoldVeryLargeInventories••GovernmentBonds1GovernmentBonds1--30Years30Years„„LargeExposuretoPriceMovementsLargeExposuretoPriceMovementsSolution:UseFuturestoHedgeSolution:UseFuturestoHedgePortfolioPortfolioWHYDERIVATIVES&NOTCASH?WHYDERIVATIVES&NOTCASH?„„LeverageEffectLeverageEffect••UseofMarginUseofMargin••MarkingtoMarketsMarkingtoMarkets„„OftenMoreLiquidthanCashMarketOftenMoreLiquidthanCashMarket••LessMarketImpactLessMarketImpact••LowerTransactionsCostLowerTransactionsCost„„RatioofCashDerivativesTendstoBeRatioofCashDerivativesTendstoBeLowerinIlliquidMarketsLowerinIlliquidMarkets„„FinancialEngineering:SyntheticSecuritiesFinancialEngineering:SyntheticSecuritiesCanEnhanceYieldCanEnhanceYieldHISTORICALPERSPECTIVEHISTORICALPERSPECTIVE„„Futures&OptionsMarketsHaveExistedonFutures&OptionsMarketsHaveExistedonLimitedScalesforCenturiesLimitedScalesforCenturies„„MostlyinPhysicalCommodities(Soybeans,PorkMostlyinPhysicalCommodities(Soybeans,PorkBellies,Sugar,Cotton)Bellies,Sugar,Cotton)„„LinkedtoCashCommoditiesMarketLinkedtoCashCommoditiesMarket„„TradingonOrganizedExchangesTradingonOrganizedExchanges••Chicago(CBOT1848)Chicago(CBOT1848)••NewYorkNewYork••LondonLondon„„ForwardTradinghasbeenpartoftheforeignForwardTradinghasbeenpartoftheforeignexchangemarketfordecadesexchangemarketfordecades••InterestArbitrageInterestArbitrage••AnInterbank(OTC)MarketAnInterbank(OTC)MarketINITIALPOSTWARSITUATIONINITIALPOSTWARSITUATION„„DerivativesTradingLimitedDerivativesTradingLimited„„CommoditiesmostProminentCommoditiesmostProminent„„USPositionDominantUSPositionDominant„„SomeCountries(e.g.German