1. 1 Introduction Chapter 1

2. 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.

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

4. 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

5. 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)

6. Fischer Black and the Revolutionary Idea of Finance by Perry MehrlingFischer Black and the Revolutionary Idea of FinancePerry Mehrling Why Mehrling, a monetary economist, wrote about Black, whose main recognized contributions are in financial derivatives?

7. 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.

8. 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

9. Examples of Derivatives Forward Contracts Futures Contracts Swaps Options

10. 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.

11. 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-aig- goldmansachs-sb-idUSTRE52H0B520090318 –The large positions show that these banks were confident about the impending collapse of the mortgage market and take advantages of it.

12. The advantages of derivative trading Derivative securities are very flexible. They can be designed to take advantages of any scenarios.

13. 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.

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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/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

24. 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.

25. 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

26. 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?

27. Ways Derivatives are Used (Continued) To change the nature of an investment without incurring the costs of selling one portfolio and buying another

28. 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

29. 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.