Week 7: Banking and Finance

Wednesday 9th March

Mr. Niall Douglas

Schedule for today

9am-10.30am: Study missing paper 10.30am-11am: Derivatives

11.20-12pm: Pronunciation 12pm-12.40pm: TOEIC prep 12.40pm-1pm: Explain tonight’s

reading 1pm-1.20pm: Group Work Plan

Study missing paper

Study the reading that you would have received tonight

Derivatives

You seemed to struggle yesterday with the concept of the financial tool derivatives

Derivatives are absolutely essential to modern Business

They are used by practically every Business which must deal with large variations (i.e. Volatility) in levels of uncertainty within its Business

Derivatives

What is a derivative?

From Wikipedia: In finance, a derivative is a financial instrument

(or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked—called the underlying asset—such as a share or a currency. There are many kinds of derivatives, with the most common being swaps, futures, and options. Derivatives are a form of alternative investment.

Derivatives

Continued: A derivative is not a stand-alone asset,

since it has no value of its own. However, more common types of derivatives have been traded on markets before their expiration date as if they were assets. Among the oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.

Derivatives

What does this mean? Derivatives are simply a commodity form of

insurance

There are three main types: (i) swaps (ii) futures (iii) options

Swaps are where two parties swap part of the predicted profit from their profit bearing assets such as loans, equities, or currencies, so both gain a more stable rate of return. You can also swap commodities (almost always oil)

Derivatives

Futures are simply a contract to buy or sell something at some specified date in the future for some prespecified price. If you want 1kg of potatoes next year at a guaranteed price, you would use a future derivative. Buy futures are called a “long position”, sell futures are called a “short position”

Options are like futures except that there is a built in escape clause e.g. I have the right to buy 1kg of potatoes in six months time at €1/kilo (i.e. You would exercise this right if the world price of potatoes is more than €1/kilo) – a “call option”. If I had the right to sell it would be a “put option”

Derivatives

The KEY to derivatives (and why they are different to normal insurance contracts) is that they can be bought and sold on a market for a price different to what you paid for it

For example, if I buy a future on 1kg of potatoes at €1/kilo (the strike price) in six months time, I can later sell that future to somebody else at any stage between now and six months from now

The person who buys the future from me then gets the right to buy 1kg of potatoes at €1/kilo on the same expiration date as when I first bought the future

Derivatives

Obviously the price of derivatives goes up and goes down as new information arrives

For potatoes, if as we get closer to the expiration date the weather prediction becomes worse, its derivatives would rise in price

If the weather prediction becomes better, they would drop in price

Derivatives

An example: If you grow potatoes, the most input

factors affecting your profitability are levels of sunshine, rainfall and the price of diesel locally and the world price of potatoes that year

Most farmers would prefer a steady and slightly lower income to an income which varies wildly each year

Derivatives

So, what a farmer would do is to hedge their risks

They would take out derivatives (insurance) on the future price of potatoes and the future price of oil. You can also take out derivatives on future levels of sunshine and rainfall.

Typically you might use options rather than futures here – i.e. if the world price of potatoes is less than 90% of expected, cap my losses at 10%

Derivatives

You can take out derivatives on practically anything you can think of so long as their risk can be standardised (i.e. There are lots of them and they can be compared over time). Even football games!

In fact, when you insure your house or car, all the insurance company does is repackage all its customers into derivative contracts and sell the risk to somebody else

Derivatives

You can take out derivatives on derivatives i.e. Take out insurance on another insurance being claimed or never claimed

Or derivatives on derivatives on derivatives ...

This is how the global financial collapse happened recently

Derivatives

What happened was that Credit Default Swaps (CDSs) – the derivative (insurance) against a company failing to pay its bondholders (i.e. Pay its debts) – were called upon as the economy slowed down

As CDSs had been used to insure against CDSs, this created a domino effect which rippled around the world

So much money was demanded at once that banks couldn’t keep up with the speed of repayments i.e. They ran out of cash flow

Derivatives

So some banks collapsed (Lehman Brothers). Now a whole load of CDSs have no one to pay them

This caused a further domino effect as some other CDSs activated while others failed. Even more banks were overwhelmed – remember, CDSs alone were worth US$62 trillion per year (same as the entire global economy)

Thus governments had to rescue banks with taxpayer’s money so insurance would be paid out to ordinary people and banks wouldn’t become bankrupted

Derivatives

Nevertheless, derivatives are absolutely essential to the modern Business They enable you to insure against risk and

uncertainty just like car insurance They enable you to restrict how much your

losses could be if everything suddenly goes wrong

They are an excellent tool for guaranteeing minimum cash flow in a Business – and unexpected lack of cash flow is the primary killer of all companies!

Derivatives

They are also highly standardised commodities (i.e. They are cheap)

They also have excellent theoretical underpinnings:▪ The most important piece of theory is called “The

Black-Scholes Option Pricing Formula”▪ Anyone good at partial differential calculus can use

this formula to calculate most derivative prices For small businesses, it’s easier just to buy them

off the internet though ... Loads of companies offer very affordable insurance e.g. Insuring valuable packages delivered to customers

Pronunciation

Pronunciation exercises

TOIEC prep

TOIEC prep

Tonight’s reading

Explain Tonight’s reading

Group Task Work Plans

Check Group Task Work Plans