Derivatives Markets

Chapter 9

Introduction

Futures, options, and swaps are

complicated instruments
However, they have found their way
into the risk management options of
just about every major financial
institution
DerivativesA financial
instrument/contract that derives its
value from some other underlying asset

Futures Markets

Market in standardized contracts for

future delivery of various goods.
Arose in the mid-1800s in Chicago and
institutionalized an ancient form of
contracting called forward contracting.
1842, Chicago Board of Trade
1871, Fire destroyed all records.

Futures Contracts vs. Forward

Contracts

Futures Contract

trade in an organized exchange.

standardized contract terms.
contract guaranteed by exchange (clearing
corporation)

Forward Contract

transaction in which two parties agree in advance

on the terms of a trade to be executed later.
Non standardized contract terms.
More flexibility.
Difficult to find a trading partner.

An Overview of Financial
Futures

Future Contract is a contractual agreement

that calls for delivery of a specific underlying
commodity or security at some future date at
a currently agreed-upon price
There are contracts on interest-bearing
securities (Treasury bonds, notes, etc), on
stock indices (Standard & Poors and Japans
Nikkei index), and on foreign currencies

An Overview of Financial
Futures

Trading in these contracts is conducted

on the various commodity exchanges
Financial futures were introduced about
30 years ago and volume now exceeds
the more traditional agricultural
commodities

Characteristics of Financial
Futures

Standardized agreement to buy/sell a particular asset

or commodity at a future date and a current agreedupon price
Designed to promote liquiditythe ability to buy and
sell quickly with low transactions costs
Promotes large trading volume which narrows the
bid-asked spreads
Allows many individuals to trade the identical
commodity

Characteristics of Financial
Futures

Terms specify the amount and type of

asset as well as the location and
delivery period

Financial futuresunderlying asset is

either a specific security or cash value of a
group of securities
Stock index futurescontract calls for
the delivery of the cash value of a
particular stock index

Characteristics of Financial
Futures

Precise terms of each contract are established

by the exchange that sponsors trading in the
contracts
Seller of the contract has the obligation to
deliver the securities at a specified time
In futures markets, the buyer of the contract
is called long and the seller is called short

Price of the Contract

The price is determined by bidding and

offering that occurs at the location (pit)
of the exchange sponsoring the auction
The auction process insures that all
orders are exposed to highest bid and
lowest offer, guaranteeing execution at
the best possible price

Market Structure

Open outcry

Traders call out offers to buy or sell.

Gives appearance of chaos.
Gives all traders in the pit the opportunity
to accept the offer.

Seat on the exchange

Floor Traders

Clearing Corporation

The clearing corporation associated with the

exchange acts as a middleman in the transaction

Reduce the credit risk exposure associated with future

deliveries
Longs and shorts do not have to worry that the other party
will not perform their contractual obligations
Requires the short and long to place a deposit (Margin)
which is a performance bond for both the seller and buyer
Requires that gains and losses be settled each day in the
mark-to-market operation

Settlement by Offset

To insure the obligations are met at the

delivery date, most trades in futures market
choose settlement by offset rather than
delivery

Both parties make offsetting sales/purchases to

cover the contract
Permits hedgers, speculators, and arbitrageurs to
make legitimate use of the futures market without
getting into technical details of making or taking
delivery of assets

Using Financial Futures

Contracts

Provides the opportunity to hedge legitimate

commercial activities
Allows participants to alter their risk exposure
Hedgersbuy and sell futures contracts to reduce
their exposure to the risk of future price movement
Permits dealers to cover both the short and long
position of a contract
Reduces risk since future prices move almost in
lockstep with the price of the underlying asset

Hedging Vs. Speculating

Short hedgers offset inventory risk by

selling futures while long hedgers offset
anticipated purchases of securities by buying
futures
Speculators

Purposely take on risk of price movement

Expect to make a profit on the risky transaction

Arbitrageurs

Arbitrageurs

Determine the relationship between the

price in the cash market and the price in
the futures market
During the delivery period of a futures
contract, the rights and obligations of the
contract force the price of the futures
contract and the price of the underlying
security to be identical

Arbitrageurs

If the arbitrageur senses the price

relationship between the futures contract and
the underlying asset is not correct, take
actions in the market (buy or sell) to make a
profit which forces the prices into proper
relationship
The activities of arbitrageurs cause the
prices to converge on the delivery date
or be in proper alignment during
periods prior to final delivery date

Liquidating a Position

Settlement dates
Nearby contract
Distant contract
Cash settlement contracts
Settlement by offset
Open interest

number of contracts obligated for delivery.

Each open transaction has a buyer and a seller,
but for calculation only one side of the contract is
counted.

Futures Data

Wall Street Journal

Chicago Board of Trade
Chicago Mercantile Exchange

An Overview of Options
Contracts

Options on individual stocks have been traded

in over-the-counter market since nineteenth
century
Increased visibility in 1972 when the Chicago
Board Options Exchange (CBOE) standardized
terms of contracts and introduced futurestype pit trading

Stock Options

Prior to 1973, over-the-counter market

CBOE established April 26, 1973 and begin trading

options on 16 stocks

fragmented
high transaction costs
no liquidity

creation of central market place

introduction of a clearing corporation
standardization
secondary market

June 1, 1977, SEC allowed trading in puts

Options

Contractual Obligations
Derive their value from some underlying asset

A specified number of shares of a particular stock

Stock Index OptionBasket of equities
represented by some overall stock index such as
S&P 500
In options on future contracts, the contractual
obligations call for delivery of one futures contract

Call Options

Buyer of a call option (long) has the

right (not obligation) to buy a given
quantity of the underlying asset at a
predetermined price (exercise or
strike) at any time prior to the
expiration date

Call Options

Seller of the call option (short) has the

obligation to deliver the asset at the agreed
price
Therefore, rights and obligations of option
buyers and sellers are not symmetrical
Buyer of the call option pays a price to the
seller for the rights acquired (option
premium)

Put Options

Buyer of a put option has the right (not

obligation) to sell a given quantity of the
underlying asset at a predetermined price
before the expiration date
Seller of the option (short) has the
obligation to buy the asset at the agreed
price
The buyer of the put option pays a premium
to the seller

Summary

Option buyers have rights; option

sellers have obligations
Call buyers have the right to buy the
underlying asset
Put buyers have the right to sell the
asset
In both puts and calls the option buyer
pays a premium to the option seller

Clearing Corporation

The exchange sponsoring the options trading

established rules for trading
Standardization is designed to generate interest by
potential traders, thereby contract liquidity
Clearing Corporation

Guarantees the performance of contractual obligations

Buyers and sellers do not have to be concerned with
creditworthiness of their trading partners

Only matter up for negotiation is option

premiumprice buyer pays to seller for rights

Using and Valuing Options

Investors who buy options (puts or calls)

have rights, but no obligations
Therefore, option buyers will do whatever is
in their best interest on expiration date
On expiration date, payoff on expiration of a
long call position is either zero (price below
exercise price) or stock price minus exercise
price (intrinsic value) (price above the
exercise price)

Using and Valuing Options

A long put position on expiration date

has a value of zero if price is above the
exercise price or a value equal to the
exercise price minus the stock price if
price is below the exercise price
Option PremiumThe asymmetry
payoff has the characteristic of
insurance which is why the premium is
charged on the transaction

Option Premiums - Calls

Option premiums are determined by

supply and demand
Call options are worth more (higher
premiums) the higher the price and
the greater the volatility of the
underlying asset, and the longer the
time to expiration of the option

Option Premiums - Puts

Premiums on put options will be

higher the lower the price of the
underlying asset, greater volatility of
asset and longer time to expiration
Options are an expensive way to hedge
portfolio risks if those risks are
substantial

Options Terminology

Option price (premium) (V)

Exercise price (strike price) (E)
Expiration date (maturity date) - Saturday following
the 3rd Friday of specified month.
American vs. European Options

American option - may be exercised at any time up to maturity.

European option - may be exercised only at the date of maturity.

In-the-money
Out-of-the money
At-the-money

Pricing of Options
The Pricing of Call Options at Expiration:

If VS < E, the VC=0

If VS > E, the VC= VS-E

The prices of options on stocks without cash dividends

depend upon five factors:

Stock price
Exercise Price
Time until Expiration
Volatility of the Underlying Stock
Risk-free Interest Rate

Options Investors Buy Hedges,

Then Hunker Down and Wait

NEW YORK -- Option trading was defensive but noncommittal,

mirroring investors' guarded ambivalence as they endured
updates of the Iraq standoff, terrorism alerts and a reminder
from the Federal Reserve about the precarious state of the
economy.
Here is what one investor did: John Jacobs, who runs the
Jacobs & Co. mutual fund in Charleston, W.V., this week bought
1,500 March 79 puts on the DJX, which has one-hundredth the
value of the Dow Jones Industrial Average. The puts provide
downside insurance through mid-March, particularly if the Dow
industrials remain below 7900. "We're being very defensive to
protect the stock side, where we have been writing covered
calls," he said, referring to the fund's approach of investing in
blue-chip stocks and selling call options against the stocks for
income.

To help offset the cost of buying the puts, Mr. Jacobs sold 1,000
DJX February 77 puts Tuesday, essentially betting the blue-chip
index will hold its ground in the immediate term. Mr. Jacobs
said he believes blue-chip stocks are oversold and could get a
small lift from Fed Chairman Alan Greenspan's somewhatencouraging comment that capital spending should improve
once the Iraq situation is resolved. Also, he said, any terrorist
attacks that would roil the markets are less likely to occur until
after the hajj, the climax of the Muslim pilgrimage to Mecca
later this week.
Mr. Jacobs plans to buy back the February 77 puts later this
week, possibly at a cheaper price because the short-term puts
lose their value rapidly as they approach expiration next week.
The Dow industrials fell 77 points to 7843.11. At the Chicago
Board Options Exchange, the DJX March 79 puts gained 20
cents to $3.70. The DJX February 77 puts gained 20 cents to
$1.40.

Caution remains the watchword. "In this market, you

should be more concerned about protecting profits
than giving up upside," says Elliot Spar, Ryan Beck &
Co. option strategist.
One way investors protect profits, Mr. Spar said, is
with so-called collars, where an investor sells a call to
define a target price at which he is willing to sell
stock while using the proceeds to buy a put for
downside protection. "This puts a floor under the
stock and caps the upside" at the strike price of the
call, he said.

Options Data

Wall Street Journal

Chicago Board Options Exchange

Swaps

The 1st major swap occurred in August

of 1981. The World Bank issued $290
million in eurobonds and swapped the
interest and principal on these bonds
with IBM for Swiss francs and German
marks.

An Overview of Swaps

Two broad varietiesInterest rate

swaps and currency swaps
Swaps are contractual agreement
between two parties (counterparties)
and customized to meet the
requirements of both parties

Counter parties

Fixed-rate payer

Party to a swap that makes fixed-rate

payments in exchange for floating-rate
payments.

Floating-rate payer

Party to a swap that makes floating-rate

payments in exchange for fixed-rate
payments.

Obligations of payments every six

months for the duration of the swap

Interest Rate Swap

The fixed-rate payer always pays the

same amount while payments by the
floating-rate payer varies according
to the reference rate
The dollar amount of the payments is
determined by multiplying the interest rate
by an agreed-upon principal (notional
principal amount)

What determines the rates

paid by both parties?

Shape of the yield curveexpected rates in

the future
Risk of defaultpossibility that counterparties
might default on scheduled interest payments
Financial institutions facilitate swaps

Act as the Swap Dealer

Bring the counterparties together
Impose their own credit between the
counterparties

The Swap Dealer

Commission compensates the dealer

For matching parties in the swap.

For risk of default by the counter parties.

Dealer can reduce risk by diversifying

swaps across many unrelated counter
parties.
Offers liquidity - willing to cancel
contract in exchange for an appropriate
payment.

Valuing a Swap

Contracts are traded in over-the-counter market

It is possible for one of the counterparties to sell
their obligation to another party
Changing market conditions may cause one party to
sell obligation
The third party will purchase the swap if it is to their
advantage
Therefore, swaps produce gains or losses which will
ultimate impact the value of the swap

A Simple Interest Rate Swap

This Year
Bank One

Bank Two

Two-year loans earn

9% fixed

Two-year loans earn 8%

variable

Deposits cost 5%
variable

Deposits cost 6% fixed

Next year rates go up.

Bank One

Bank Two

Loans earn 9%
fixed

Loans earn 12%

variable

Deposits cost 9%
variable

Deposits cost 6% fixed

Next Year Rates Go

Down
Bank One

Bank Two

Loans earn 9% fixed

Loans earn 5% variable

Deposits cost 2%
variable

Deposits cost 12%

variable

Next Year Rates Go Up They swap.

Bank One

Bank Two

Loans earn 9% fixed

Loans earn 12%

variable

Deposits cost 6% fixed Deposits cost 9%

variable

Next Year Rates Go

Down

They swap.

Bank One

Bank Two

Loans earn 9% fixed

Loans earn 5%
variable

Deposits cost 6% fixed Deposits cost 2%

variable

Interest Rate Swap

Currency Swaps

Two companies agree to exchange a

specific amount of one currency for a
specific amount of another at specific
dates in the future.