Chapter Ten

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill /Irwin

Chapter Ten

Derivative SecuritiesMarkets


Derivative Securities: Chapter Overview

• Derivative security– a financial security whose payoff is linked to

another previously issued security

• An agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future

• Derivative security– a financial security whose payoff is linked to

another previously issued security

• An agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future


Examples of Derivatives

• Forward and futures contracts– currency forwards and futures– interest rate futures

• Options contracts– call option – put option

• Swaps– currency swap– interest rate swap

• Forward and futures contracts– currency forwards and futures– interest rate futures

• Options contracts– call option – put option

• Swaps– currency swap– interest rate swap


Forwards and Futures

• Both are agreements to deliver (or take delivery of) a specified asset at a future date

• Prices of both are tied to the current price of the asset in the “spot” market

• Spot contract– agreement to purchase (or sell) an asset

immediately

• Both are agreements to deliver (or take delivery of) a specified asset at a future date

• Prices of both are tied to the current price of the asset in the “spot” market

• Spot contract– agreement to purchase (or sell) an asset

immediately


Forward Markets

• Forward contract– an agreement to transact involving the future

exchange of a set amount of assets at a set price– participants hedge the risk that future spot

prices on an asset will move against them

• FI’s are the major forward market participants and make a profit on the spread between the price at which they originate and sell forward contracts

• Forward contract– an agreement to transact involving the future

exchange of a set amount of assets at a set price– participants hedge the risk that future spot

prices on an asset will move against them

• FI’s are the major forward market participants and make a profit on the spread between the price at which they originate and sell forward contracts


Futures Markets

• Futures contract– an agreement to transact involving the future

exchange of a set amount of assets for a price that is settled daily - marked to market daily

• Initial margin– a deposit required on futures trades to ensure terms

of any futures contract will be met

• Maintenance margin– the margin a futures trader must maintain once a

futures position is taken.

• Futures contract– an agreement to transact involving the future

exchange of a set amount of assets for a price that is settled daily - marked to market daily

• Initial margin– a deposit required on futures trades to ensure terms

of any futures contract will be met

• Maintenance margin– the margin a futures trader must maintain once a

futures position is taken.


Futures Trading

• Occurs on organized exchanges such as CBT and CME or IMM

• Open-outcry auction - traders face each other and “cry out” their offer to buy or sell

• Floor broker - Exchange members who place trades from the pubic

• Professional traders - Exchange members who trade for their own account

• Position traders - take a position in the futures market based on their expectations of future prices

• Occurs on organized exchanges such as CBT and CME or IMM

• Open-outcry auction - traders face each other and “cry out” their offer to buy or sell

• Floor broker - Exchange members who place trades from the pubic

• Professional traders - Exchange members who trade for their own account

• Position traders - take a position in the futures market based on their expectations of future prices

(continued)


• Day traders - exchange members who take a position within a day and liquidate it before day’s end

• Scalpers - exchange members who take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading

• Long position - a purchase of a futures contract• Short position - a sale of a futures contract• Clearinghouse - the unit that oversees trading on the

exchange and guarantees all trades made by the exchange traders

• Open interest - total number of futures, put options, or call option contracts outstanding at the beginning of the day

• Day traders - exchange members who take a position within a day and liquidate it before day’s end

• Scalpers - exchange members who take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading

• Long position - a purchase of a futures contract• Short position - a sale of a futures contract• Clearinghouse - the unit that oversees trading on the

exchange and guarantees all trades made by the exchange traders

• Open interest - total number of futures, put options, or call option contracts outstanding at the beginning of the day


Futures Contracts Outstanding, 1992-1999

0

1000

2000

3000

4000

5000

6000

1992 1993 1994 1995 1996 1997 1998 1999

Financial instruments Currencies

0

1000

2000

3000

4000

5000

6000

1992 1993 1994 1995 1996 1997 1998 1999

Financial instruments Currencies


Contract Time Lines

Spot 0 1 2 3 months Price Agreed/Paid + Bonds delivered

Forward 0 1 2 3 months Price Agreed Price paid/bonds delivered

Marking to Market every day

Futures 0 1 2 3 months

Contract entered/Time 0 price EOM 3 price paid/bonds delivered

Spot 0 1 2 3 months Price Agreed/Paid + Bonds delivered

Forward 0 1 2 3 months Price Agreed Price paid/bonds delivered

Marking to Market every day

Futures 0 1 2 3 months

Contract entered/Time 0 price EOM 3 price paid/bonds delivered


Options

• A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a prespecified price for a specified price within a specified period of time

• American option - can be exercised at any time before the expiration date

• European option - can only be exercised on the expiration date

• A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a prespecified price for a specified price within a specified period of time

• American option - can be exercised at any time before the expiration date

• European option - can only be exercised on the expiration date


Definitions of a Call and a Put

• Call option– an option that gives a purchaser the right, but not

the obligation, to buy the underlying security from the writer of the option at a prespecified exercise price on a prespecified date

• Put option– an option that gives a purchaser the right, but not

the obligation, to sell the underlying security to the writer of the option at a prespecified price on a prespecified date

• Call option– an option that gives a purchaser the right, but not

the obligation, to buy the underlying security from the writer of the option at a prespecified exercise price on a prespecified date

• Put option– an option that gives a purchaser the right, but not

the obligation, to sell the underlying security to the writer of the option at a prespecified price on a prespecified date


Payoff Function for Call Options

Payoff Payoff function Gain for Buyer + C

0 Stock Price X A S at expiration

C -Payoff Payoff function Loss for writer

Payoff Payoff function Gain for Buyer + C

0 Stock Price X A S at expiration

C -Payoff Payoff function Loss for writer


Payoff Function for Put Options

PayoffGain Payoff function for Writer +P

0 Stock Price D X at expiration

-P Payoff functionPayoff for buyerLoss

PayoffGain Payoff function for Writer +P

0 Stock Price D X at expiration

-P Payoff functionPayoff for buyerLoss


Option Values

• Intrinsic value of an option– the difference between an option’s exercise

price and the underlying asset’s price

• Time value of an option– the difference between an option’s price (or

premium) and its intrinsic value

• Intrinsic value of an option– the difference between an option’s exercise

price and the underlying asset’s price

• Time value of an option– the difference between an option’s price (or

premium) and its intrinsic value


Intrinsic value vs. the Before Exercise Value of a Call Option

Value intrinsic value (option (stock price - exercise price) premium) Before exercise price$12.50 Time Value$10.00 ($2.50)

X = $50 S = $60 Stock Price

Value intrinsic value (option (stock price - exercise price) premium) Before exercise price$12.50 Time Value$10.00 ($2.50)

X = $50 S = $60 Stock Price


Option Markets

• Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded

• Stock options - the underlying asset on a stock option contract is the stock of a publicly traded company, generally 100 shares

• Stock index options - the underlying asset on a stock index option is the value of a major stock market index (e.g., the DJIA or S&P 500)

• Options give investors a way to hedge their existing stock portfolios

• Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded

• Stock options - the underlying asset on a stock option contract is the stock of a publicly traded company, generally 100 shares

• Stock index options - the underlying asset on a stock index option is the value of a major stock market index (e.g., the DJIA or S&P 500)

• Options give investors a way to hedge their existing stock portfolios


Options Market Activity, 1992-1999 (in thousands)

0100002000030000400005000060000700008000090000

1992 1993 1994 1995 1996 1997 1998 1999

Avg month-end contracts outstanding

Number of contracts traded

0100002000030000400005000060000700008000090000

1992 1993 1994 1995 1996 1997 1998 1999

Avg month-end contracts outstanding

Number of contracts traded


Regulation of Futures and Options Markets

• The Commodity Futures Trading Commission (CFTC) is the primary regulator of futures markets– protects the trading public by seeking to prevent

misrepresentation and/or market manipulation

– approves new or proposed contracts to ensure they have economic purpose, conducts economic studies, enforces rules and provides regulatory surveillance

• The Securities and Exchange Commission (SEC) is the main regulator of stock options– regulates trading of stock options and stock index options

• The Commodity Futures Trading Commission (CFTC) is the primary regulator of futures markets– protects the trading public by seeking to prevent

misrepresentation and/or market manipulation

– approves new or proposed contracts to ensure they have economic purpose, conducts economic studies, enforces rules and provides regulatory surveillance

• The Securities and Exchange Commission (SEC) is the main regulator of stock options– regulates trading of stock options and stock index options


Swaps

• An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval

• Allow firms to better manage their interest rate, foreign exchange and credit risk

• Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction

• An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval

• Allow firms to better manage their interest rate, foreign exchange and credit risk

• Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction


Swaps Definitions

• Interest rate swap - an exchange of fixed-interest payments for floating-interest payments by two counterparties

• Swap buyer - a party that makes the fixed-rate payments in an interest rate swap transaction

• Notional principal - principal amount involved in a swap

• Swap seller - a party that makes the floating-rate payments in an interest rate swap transaction

• Currency swap - used to hedge against exchange rate risk from mismatched currencies on assets and liabilities

• Interest rate swap - an exchange of fixed-interest payments for floating-interest payments by two counterparties

• Swap buyer - a party that makes the fixed-rate payments in an interest rate swap transaction

• Notional principal - principal amount involved in a swap

• Swap seller - a party that makes the floating-rate payments in an interest rate swap transaction

• Currency swap - used to hedge against exchange rate risk from mismatched currencies on assets and liabilities


Swap Transactions

Direct arrangement of swap Floating-Rate Payments Money Center Bank Thrift Fixed-Rate Payments

Swap arranged by third-party intermediary (swap agent) Floating-Rate Floating-Rate

Payment Payment

Money Center Bank Swap Agent Thrift Fixed-Rate Fixed-Rate

Payment Payment

Direct arrangement of swap Floating-Rate Payments Money Center Bank Thrift Fixed-Rate Payments

Swap arranged by third-party intermediary (swap agent) Floating-Rate Floating-Rate

Payment Payment

Money Center Bank Swap Agent Thrift Fixed-Rate Fixed-Rate

Payment Payment


Fixed-Floating Rate Swap

Money Center Bank Thrift

10% Short-Term Assets fixed Long-Term Assets (C&I indexed loans) (fixed-rate mortgages)

Long-Term Liabilities Short-Term Liabilities (5-year, 10 % notes) LIBOR + 2% (1-year CDs)

Money Center Bank Thrift

10% Short-Term Assets fixed Long-Term Assets (C&I indexed loans) (fixed-rate mortgages)

Long-Term Liabilities Short-Term Liabilities (5-year, 10 % notes) LIBOR + 2% (1-year CDs)


Caps, Floors, and Collars

• Cap– a call option on interest rates, often with multiple

exercise dates

• Floor– a put option on interest rates, often with multiple

exercise dates

• Collar– a position taken simultaneously in a cap and a

floor

• Cap– a call option on interest rates, often with multiple

exercise dates

• Floor– a put option on interest rates, often with multiple

exercise dates

• Collar– a position taken simultaneously in a cap and a

floor

Chapter Ten

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