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ABN AMROFutures Capabilities

Prepared for theChina Futures Association

May 22, 2005

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Overview:ABN AMRO Futures

Global capabilities - Local presence and expertise

Membership on all major futures exchanges around the world

450 Futures professionals in nine offices (Paris, London, New York, Chicago, Singapore, Sydney, Hong Kong, Tokyo and Seoul)

Regulatory capital of ABN AMRO Incorporated over $1 billion

Full product range including: interest rates, equity indices, energy, metals, grains, soft commodities as well as O-T-C metals and energy products

First rate technology for trading and automation of back-office functions.

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ABN AMRO Futures is Connected to the Following Exchanges

New YorkNYMEX

SingaporeSGX

SydneySFE

ParisEURONEXT

LondonLIFFE

TokyoOSETSE

SeoulKSE

EurexUS

Hong KongHKFE

Exchanges Connection StatusExisting ExchangesComing in 2006

Futures Offices

FrankfurtEUREX

RomeIDEM

AmsterdamAEX

ChicagoCBOTCME

OneChicago

IPE

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Overview:ABN AMRO Futures

Global capabilities - Local presence and expertise

Membership on all major futures exchanges around the world

450 Futures professionals in nine offices (Paris, London, New York, Chicago, Singapore, Sydney, Hong Kong, Tokyo and Seoul)

ABN AMRO Incorporated has capital of over $1 billion

Full product range including: interest rates, equity indices, energy, metals, grains, soft commodities as well as O-T-C metals and energy products

First rate technology for trading and automation of back-office functions.

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Key Areas of Futures ExpertiseExceptional Customer Service− Designated customer service rep assigned to each account

− Customer service reps have expertise in client’s product, for example: fixed income, metals, stock indices.

− Customer service rep backed up by a team to ensure continuous coverage

Open outcry and electronic execution of all major U.S. and non-U.S. equity futures

Electronic access to all major electronic markets and automated web-based back-office access.

Client-focused access to global futures markets, including our 24-hour desk, access to our local specialists around the world, and electronic execution where available

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Our Option clientsMany of our clients are option market makers in futures-options markets.

We have extensive experience in managing the risk of such clients.

Option market makers are essential to successful option markets.

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Market Makers

There are many more option contracts than futures contracts.− Both puts and calls at all the different strike prices

All successful option markets have market makers to ensure liquidity.

ABN AMRO Futures group specializes in serving option market making clients.

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The Current Situation

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Global Futures Volume (ex-China) US-NonUS

16.43%3,487.562,995.45Total Futures Volume

9.75%2,163.531,952.48Non-U.S. Futures

26.95%1,324.031,042.97U.S. Futures

% ChangeJan-Dec 04Jan-Dec 03(In millions)

Source: Futures Industry Association

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Global Option Volume (ex-China)U.S.-NonUS

8.86%8,858.638,137.63Grand Total Futures & Options

4.45%5,371.075,142.18Total Options Volume

-2.76%3,901.944,012.63Non-U.S. Options

30.06%1,469.131,129.55U.S. Options

% ChangeJan-Dec 04Jan-Dec 03(In millions)

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Global (ex-China) Options on Cash Securities

3.5%4,935,570,3874,769,310,588Total Securities Options

27.3%1,914,482,9901,503,340,868Individual Equity Options

-7.5%3,020,766,0103,265,600,633Equity Indexes

-17.2%230,779278,649Foreign Currency/Index

0.2%90,60890,438Interest Rate

% Change20042003

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Financials vs. Non-Financials ex-China(Futures & options, excluding options on individual equities)

4.35%6,863.216,576.80Total

7.99%711.16658.51Non-financials

3.95%6,152.055,918.29Financials

% ChangeJan-Dec 04Jan-Dec 03(In millions)

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Interest Rates, Equities, Currencies

3.95%6,152.055,918.29Total

35.36%105.3777.85Currency

20.73%2,271.251,881.27Interest Rates

-4.64%3,775.433,959.17Equity Indices

% ChangeJan-Dec 04Jan-Dec 03(In millions)

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Agricultural, Metals & Energy

7.99%711.16658.51Total

11.90%243.46217.56Energies

7.06%165.79154.85Metals

5.53%301.91286.1Agriculturals

% ChangeJan-Dec 04Jan-Dec 03(In millions)

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Options IntroductionOptions have grown enormously in recent years.

Options are popular with those averse to risk to benefit from price changes without risking large losses.− Such traders can buy puts or calls

Options are popular because they provide a flexible tool for hedgers to create more kinds of hedges.

Options have made it possible for institutions, such as banks, to offer customers many more kinds of products.− Examples: Savings deposit with principal guaranteed but

payoff linked to performance of equity market, or gold, or crude oil, etc.

Options typically result in higher volumes in the underlying market, such as futures.

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Developing TrendsOptions strategies started out relatively simple.

Over the years, as individuals, professional traders, and institutions became more familiar with them, more complex strategies developed.

Today, simple strategies continue to be used, but more sophisticated strategies are also used by professionals traders, market makers, and institutions.

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Key Option Strategies

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Long short the underlying; long, short puts and calls.

Long Call

Short Call Short Put

Long PutLong Underlying

Short Underlying

P

L

spot

P

L

spot

P

L

spot

P

L

spot

P

L

spot

P

L

spot

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Option PricingTime Value Declines--Theta

9 4 1 0

TIME-REMAINING UNTIL EXPIRATION (MONTHS)

TIM

E VA

LUE

PREM

IUM Both buyers and sellers want to be

aware of theta. Theta good for sellers, bad for buyers.

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Bull Spread Hedge Strategy:

− Hedger with need for product concerned that prices will rise and desires protection from price rise.

− Hedger does not expect a large price rise.

− To reduce the cost of the hedge, hedger buys call at a lower strike price and sells at a higher strike price to reduce the cost of the hedge.

− Risk to hedger: price could rise more than expected.

Trader strategy:

− Desires to profit from a price rise but reduce the cost of the trade by selling a call at the higher strike price.

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Bull Spread Using Calls

$80 $90

Profit

$8

$2Option premiums

The bold line is a combination of the two

Long call at low strike price

Short call at higher strike price

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Example: Bull call

Stock price: $85

Strike 80: premium $8

Strike 90: premium $2

What is:− Maximum profit?

− Maximum loss?

− Breakeven?

Profit if stock is at $79 at expiration?

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Bull Call SpreadCost (net premium): 8-2=$6 outflow

Possible profit:

− Difference in strike prices – cost

− (90-80) – 6 = 4

− Breakeven: lower strike plus cost:

− 80 + 6 = $86

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Profit at $92, 100At 92: − Profit on 80 strike: 12− Profit on 90 strike: -2− Gross profit: 12-2= $10− Cost: $6− Net profit: $4

At 100− Profit on 80 strike: 20− Profit on 90 strike: -10− Gross profit: 20-10= $10− Cost: $6− Net profit: $4

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Bull Spread Using Puts:Similar payoff; choose strategy with best cost/payoff characteristics

K1 K2

Profit

ST

Short put at high strike price

Long put at lower strike price

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Bear Spread Using Puts

$50 $58

Profit

ST$7

$1

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Example: Bear Put spreadStock price: $55

Strike 58: premium $7 (Buy)

Strike 50: premium $1 (Sell)

What is:− Maximum profit?

− Maximum loss?

− Breakeven?

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Bear Put spreadWhat is:− Maximum profit?

− Difference between strikes minus cost

− (58-50) – 6 = $2

− Maximum loss?

− Investment

− Premium 7-1 = $6

− Breakeven?

− Get back investment

− Upper strike – net outlay

− 58 – 6 = 52

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Bear Spread Using Calls

K1 K2

Profit

ST

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ButterflyLong butterfly:

− Buy one option at high and low strikes, sell two at middle strike.

− Profitable if the market remains stable.

− But risk is very limited.

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Long Butterfly Spread Using Calls: buy one high strike, one low strike, sell two middle

$94.00 104.00

Profit

ST98.00

$94.56 strike premium: $6.88

98.86 premium: $4.30

103.16 Prem: 2.58

Premum $4.15 x 2 = 8.30

Premium $6.85

Premium $1.85

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ButterflyYou can see where your max profit is from the diagram—the middle strike price

Calculate the value of your long position.

Add income from the sale of the two middle options.

Subtract cost of long premiums.

(98.00 – 94.00) + 2(4.15) – 6.85 – 1.85

= $3.60

Maximum loss: Maximum profit – difference between strike prices

− 3.60 – 4 = -0.40

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Butterfly Spread Using PutsButterfly spreads can be created using puts or calls

K1 K3

Profit

STK2

Short put

Long puts

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A Straddle Combination:Profit from a big move in either direction

Profit

STK

Long put

Long call

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A Strangle CombinationProfit from a big move in either direction—cheaper than a straddle

K1 K2

Profit

ST

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Strip & Strap: expected price movement in one direction more likely

Profit

K ST

Profit

K ST

Strip StrapBuy two puts, one call Buy two calls, one put

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Key Hedging StrategiesInventory hedge

0 Cost Collar

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Inventory Hedging: long soybeans, long put

AGrain inventory

Long Put

$6.55

Strike: $6.25

Put price: $0.14/bushel=$700

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Protective Put hedge: value of inventory protected

AResult

$6.55$6.55

Strike: $6.25

Effective price = 6.25 - .14 = $6.11

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0 Cost CollarHedger would like protection from a price decline.

Hedger would like to keep the cost of the hedge low, maintain some benefit if prices improve.

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0 Cost collar—SoybeansBuy one 6.25 put @ $0.14/bushel;sell one $7 call @0.14/bushel; net cost 0

$6.25 $7.00

Profit

Price

Price of inventory:$6.65/bushell =

The bold line is a combination of the two

$6.25 floor

$7.00 cap

0.14 x 5000 = $700 for each put and call

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0 Cost CollarHedging protection achieved

Cost of the hedge is 0

In exchange for the lower cost of the hedge, the hedger gives up potential higher profits if prices rise very high.

Use strategy if a price decline would have a strong negative effect on the company, and a price rise would increase profitability.

Hedger is willing to give up possibility of extra profitability if there’s a large price rise.

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Delta HedgingA delta hedge is a more “complete” hedge than simply buying one put or one call as in the previous examples.

A delta hedge can be used by a futures market maker to hedge a futures position.

An option market maker can use the delta concept to calculate the number of futures to buy/sell to hedge options positions.

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Put and Call Deltas

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Computing hedge ratio

The reciprocal of the delta

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Later…

1.The hedge ratio must be continuously monitored!!

2.Like any other hedge, it should earn the risk-free rate.

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Delta hedgingUsed by market makers to hedge their option positions using other options or futures.

The delta of a long futures = 1

The delta of a short futures = -1

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Rolling down strategy: Hedge strategy that benefits if prices continue in the same direction.Start with put option with strike price of $6.25.

If price falls, sell the 6.25 option and buy more puts at 6.00

This is called “rolling down” your option position.

The profit on the 6.25 option will allow you to buy more puts at 6.00

If the market continues down, the option position generates profits at no additional net cost.

If the market goes up, your expenses are no higher than they were before.

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The impact of option marketsDuring the 1980s and 1990s in the U.S. opton markets grew rapidly.

Some legislators and regulators and members of the press expressed concern that the large option markets might pose some unique risk.

There were even proposals to ban or limit these markets.

Many studies were done on the topic of derivatives and their impact on underlying markets.

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Results of a “study of studies” done in 1995

The growth of derivatives activity provided substantial benefits to public and private institutions using these financial tools and to the U.S. economy.

The risks of derivatives are the same types of risk that public and private institutions face in their traditional businesses and generally have not exposed them to new risks sources.

Not a single study reviewed called for banning or severely restricting the use of derivatives.

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Greenspan on derivatives

Allan Greenspan’s comment on the positive contribution of derivatives:

− "These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago."

− Alan Greenspan, Chairman of the Federal Reserve, 2003

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Greenspan on derivativesAllan Greenspan’s comment on the lower counterparty risk of futures relative to over-the-counter instruments:

− “Clearly the degree of counterparty credit risk on derivatives depends critically on the extent to which netting and margining procedures are employed to mitigate the risks. In the case of exchange-traded contracts, of course, daily variation settlements by clearing houses strictly limit, if not totally eliminate, such counterparty risks.”

− Chairman Alan Greenspan, March 19, 1999.

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Comments on by regulators & Government officials

“When one assesses this field, I think it is not hyperbole to suggest that the development and growth of financial derivatives constitute one of the most dramatic success stories in modern economic history.”

− David W. Mullins, Jr., Vice Chairman, Federal Reserve Board, in 1993.

“In the private sector truly great progress has been, and is being made, in developing the risk management, information and control systems that are so crucial for individual firms and the marketplace in general.

− E. Gerald Corrigan, Former President, Federal Reserve Bank of New York, 1994.

There are no fundamentally new or different risks in derivative products, rather … familiar kinds of risks are presentated and combined in novel ways.

− Brian Quinn, Director, Bank of England, 1993

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Academics“Derivatives serve ahighly useful risk-management role for both financial and non-financial firms.”

− Financial Economicsts Roundtable, 1994

“Financial futures are the single greatest financial innovation of the last 25 years.”

− Merton Miller, Nobel Laureate in economics (1992), during a 1995 interview.

Derivatives markets act to reduce systemic risk by spreading the impact of underlying economic shocks among a larger set of investors in a better position to absorb them.

− Ludger Hentschel and Clifford W. Smith, Jr., Professors, University of Rochester.

The reason so many holders of derivatives positions took large losses in early 1994 is in most cases exactly the same as the reason that many more investors lost money on ordinary bonds: interest rates rose very far and very fast.

− Stephen Figlewski, Professor, New York University, 1994

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AcademicsEfficient risk-sharing is what much of the futures and options revolution has been all about.

− Merton H. Miller, Nobel Laureate (1992) , University of Chicago

There is no significant evidence that spot volatilities have increased since the introduction of index futures.

− John Board, Charles Goodhart & Charles Sutcliffe, Professors, London School of Economics & University of Southhamption, 1992.

Etc.

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Impact of optionsStudies about the impact of options on the underlying market consistently find that options either reduce the volatility of the underlying market or have no impact.− Source: A. Damodaran and M. Subrahmanyam, “The Effects of

Derivative Seccurities on the Markets for Underlying Assets in the United State: A Survey,” Financial Markets, INstiuttions and Instruments, V. 1, N.5, December 1992, page 9.

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Conclusion--optionsExperience and studies have shown that the introduction of options generally leads to an increase in the volume of the related products.

Reasons:

− Users of futures have more ways to hedge their risks, and therefore are more willing to trade futures.

− Option market makers use futures to hedge their market making positions.

− Active market makers ensure that both the options and the futures markets are “fairly” priced.

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Contacts

Nick Ronalds 312 992 7094

nicholas.ronalds@abnamro.com

Michael Deaton 312 992 6910

Michael.deaton@abnamro.com

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Disclaimer

This publication is intended for informational purposes only and the opinions set forth herein should not be viewed as an offer or solicitation to buy, sell or otherwise trade futures and/or options. All opinions and information contained in this document constitute ABN AMRO Incorporated’s (“AAI”) judgment as of the date of this document and are subject to change without notice. AAI, persons connected with it, members of the ABN AMRO group of companies ("Group Companies") and their respective directors and employees may, directly or indirectly, effect or have effected a transaction for their own account in the investments referred to in the material contained herein before or after the material is published to any customer of a Group Company or may give advice to customers which may differ from or be inconsistent with the information and opinions contained herein. While the information contained herein was obtained from sources believed to be reliable, no Group Company accepts any liability whatsoever for any direct, indirect or consequential loss arising from any inaccuracy herein or from any use of this document or its contents. This document may not be reproduced, distributed or published in electronic, paper or other form for any purpose without the prior written consent of AAI. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. AAI is not a bank. Securities sold, offered or recommended by AAI and deposits made with AAI, are not insured by the Federal Deposit Insurance Corporation, are not guaranteed by or an obligation or responsibility of ABN AMRO Bank N.V., or any other affiliated bank or thrift institution and involve investment risks, including the possible loss in excess of principal.