Chapter 11Chapter 11Futures, Options, and Futures, Options, and

Swaps: Managing Swaps: Managing

RiskRisk

© 2000 South-Western College Publishing

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ForwardForward TransactionsTransactions

Transactions in which terms, including price, are completed today for transactions that will occur in the futureTwo Problems:Two Problems:•finding partners may be difficult•one party may default

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What is What is hedgedhedged??

Reduced risk

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FuturesFutures ContractsContracts

Standardized agreements in agriculture and commodity markets to trade a fixed amount of the asset on specific dates in the future at a price determined today

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Financial Futures MarketsFinancial Futures Markets

Organized markets that trade financial futures, including the Chicago Board of Trade, the Chicago Mercantile Exchange, the London International Financial Futures Exchange, and so on

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Financial FuturesFinancial Futures

Standardized contracts between two parties to trade financial assets at a future date, in which the terms including the price of the transaction are determined today

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The The pitpit is... is...The trading area on the floor of an exchange where authorized brokers gather to buy and sell for their customers

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ClearinghouseClearinghouse

The part of the exchange that takes on the responsibility of enforcing the contract, after the agreement is struck

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Performance BondPerformance Bond

A bond required by the exchange of both the buyer and seller of a futures agreement to insure that both parties abide by the agreement

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MarginMargin RequirementRequirement

The amount that brokers must collect from their customers before they make any futures purchases or sales

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Arbitrageurs are...Arbitrageurs are...

Traders who make riskless profits by buying in one market and reselling in another

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Carrying CostsCarrying Costs

Interest costs for funds used to purchase the security underlying a futures contract plus any transactions costs

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Cracking the Code on Futures PricesCracking the Code on Futures Prices

Open High Low Settle Chg Settle Chg Interest

Sept. 94.99 95.01 94.99 94.99 …. 5.01 …. 4377Dec. 95.04 95.06 95.04 95.04 …. 4.96 ….

Est vol 474; vol Wed 26; open int 4,600 + 3.

The Wall Street Journal

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ConvergenceConvergenceThe phenomenon in which the futures price is bid up or down to the spot price plus carrying costs; the futures price approaches the spot price as the expiration date draws nearer

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OptionsOptions are... are...

Standardized contracts that give the buyer the right but not the obligation to buy or sell an asset in the future at a price determined today

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Strike PriceStrike Price

The agreed-upon price in an options contract

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Options onOptions on FuturesFutures

Options that give the buyer the right but not the obligation to buy or sell a futures contract up to the expiration date on the option

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Stock Index Futures and the ‘87 CrashStock Index Futures and the ‘87 Crash

Stock Index Futures - contracts that give the buyer or seller the right and obligation to purchase or sell a multiple of the value of a stock index at some specific date in the future at a price determined todayProgram Trading - the preprogramming of computers to automatically issue buy and sell orders for stocks as stock prices changeStop Orders - orders to automatically sell if the stock falls to a certain level

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Put OptionsPut Options

Options that give the buyer of the option the right buy not the obligation to sell a standardized contract of a financial asset at a strike price determined today

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Call OptionsCall Options

Options that give the buyer of the option the right but not the obligation to buy a standardized contract of a financial asset at a strike price determined today

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OptionOption PremiumPremium

The premium paid by the buyer of the option to compensate the seller for accepting the risk of a loss with no possibility of a gain

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SwapsSwaps

Agreements in which two parties trade interest payment streams to guarantee that the inflows of payments will more closely match outflows

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Cracking the Code on OptionsCracking the Code on Options

Strike Price Calls-Settle Puts-Settle Aug Sep Dec Aug Sep Dec 122 1-21 1-52 2-38 0-01 0-32 1-36

The Wall Street Journal

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A Simple Interest Rate SwapA Simple Interest Rate Swap

Bank OneTwo-year loans earn 9% fixedDeposits cost 5% variable

Exhibit 11 - 1

This Year

Bank TwoTwo year loans earn 8% variableDeposits cost 6% fixed

Next Year Rates Go Up - No SwapBank OneLoans earn 9% fixedDeposits cost 9% variable

Bank TwoLoans earn 12% variableDeposits cost 6% fixed

Bank OneLoans earn 9% fixedDeposits cost 2% variable

Bank TwoLoans earn 5% variableDeposits cost 6% fixed

Next Year Rates Go Down - No Swap

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A Simple Interest Rate SwapA Simple Interest Rate Swap

Bank OneLoans earn 9% fixedDeposits cost 6% fixed

Exhibit 11 -1 cont.

Bank OneLoans earn 9% fixedDeposits cost 6% fixed

Bank TwoLoans earn 5% variableDeposits cost 2% variable

Bank TwoLoans earn 12% variableDeposits cost 9% fixed

The swap allows both banks to be happy all the time!

Next Year Rates Go Up - They Swap

Next Year Rates Go Down - They Swap