Some random musings on derivatives

PSU SBA brownbag presentationMay 14, 2010

A bit on my background

• Petroleum products purchasing in early 1990s.– Jet fuel in airline industry– Diesel fuel for wholesaler

• Designed “fixed-price” diesel fuel program for fuel wholesaler in 1992-94.

• Managed company’s fuel price risk by trading in crude oil and heating oil futures and options.

• Academic career: research on corporate hedging since 1995.

Some general overview

• Derivative– Major types of derivatives

• Forward contracts• Swap contracts• Futures contracts• Option contracts

– Trading environment• Exchanges

– Clearinghouse bears credit risk• Over-the-counter (OTC)

– Historically, each counterparty bears the credit risk of other counterparty.

Where do contracts trade?

• Forwards → OTC• Swaps → OTC• Futures → Exchanges• Options → Both

What types of “underlying assets” trade in derivative markets?

• YOU NAME IT!– Currencies– Interest-rate– Commodities– Credit– Equity– Arcane contracts (weather, carbon, etc.)

Current Issues

• Do derivatives pose “systemic risk” to economies?– Basis for AIG bailout → counterparty in many

credit default swaps (more on this idea later)

• Derivatives markets will ultimately be more regulated.

• Should all derivatives be cleared through central clearinghouse?