demystifying derivatives warren edwardes we@dc3.co.uk 1 demystifying derivatives warren edwardes...

1Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Demystifying Derivatives

Warren Edwardes

ceo, Delphi Risk Management Limited

2Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Author of

• Key financial instruments: – understanding and innovating in the world of

derivatives

3Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Famous cases:

• Barings – founded in 1763

– crashed through lack of control of derivatives

4Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Famous cases:

• Equitable Life– founded in 1762

– crashed through not using derivatives to manage interest rate risk

– boards have been successfully sued for not using derivatives to manage risk

5Demystifying DerivativesWarren Edwardes we@dc3.co.uk

So what’s a derivative?

• a financial market derivative instrument is derived from other cash market instruments or other derivatives.

• the majority of financial instruments are not new instruments.

• They are merely combinations of derivatives and/or standard cash market instruments

• the building block approach

6Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - commodities

• orange juice futures

7Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - commodities

• Oil

• futures have liquid trading

• homogenous product

8Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - commodities

• Coffee

• a liquid market

• fairly standardised

9Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - commodities

• wine ??

• Not homogeneous

• not customer needs driven

• Paris market unlikely to survive

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - commodities

• property / real estate ??

• Not homogeneous

• FOX property market failed in 1991

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - shares?

• A share is an option on the assets of a firm

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - retail financial products

• foreign exchange notes

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - retail financial products

• fixed rate mortgages

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - retail financial products

• equity index linked savings

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Examples of derivatives - retail financial products

• Insurance?

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

4 key financial building blocks

• spot– the now contract - like exchanging

Pounds for Pesetas in the high street

• forward– you could buy your Euros in the forward

market; payment and delivery next year.

• deposit– you could borrow money, buy the Euros

now (spot) and deposit the Euros.

• option– Equitable Life gave interest rate

guarantees - but didn’t manage the risk!

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Conclusion: what’s a derivative?

• a financial market derivative instrument is derived from other cash market instruments or other derivatives.

• the majority of financial instruments are not new instruments.

• They are merely combinations of derivatives and/or standard cash market instruments

• remember the building block approach

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

And finally!

• Beware of insider trading

• underlying price manipulation– credit derivatives

• terrorists selling put options on American Airlines!

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Demystifying DerivativesWarren Edwardes we@dc3.co.uk

Demystifying derivatives by Warren Edwardes