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©2007, The McGraw-Hill Companies, All Rights Reserved
Chapter Ten
Derivative SecuritiesMarkets
10-2 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Derivative Securities: Chapter Overview
• Derivative 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
• An agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future
10-3 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
10-4 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
10-5 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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 the future spot
price of an asset will move against them
• FI’s are the major forward market participants
• 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 the future spot
price of an asset will move against them
• FI’s are the major forward market participants
10-6 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Futures Markets
• Futures contract
• Initial margin
• Maintenance margin
• Futures contract
• Initial margin
• Maintenance margin
10-7 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Futures Trading
• Open-outcry auction • Floor broker• Professional traders• Position traders• Day traders• Scalpers• Long/Short position• Clearinghouse• Open interest
• Open-outcry auction • Floor broker• Professional traders• Position traders• Day traders• Scalpers• Long/Short position• Clearinghouse• Open interest
10-8 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Futures Contracts Outstanding, 1992-2003
0
2000
4000
6000
8000
10000
1992 1995 2000 2003
Financial instruments Currencies
0
2000
4000
6000
8000
10000
1992 1995 2000 2003
Financial instruments Currencies
10-9 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
10-10 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
10-11 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
10-12 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
10-13 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Option Values
• Intrinsic value of an option– Call Option
– Put Option
• Time value of an option– the difference between an option’s price
(or premium) and its intrinsic value
• Intrinsic value of an option– Call Option
– Put Option
• Time value of an option– the difference between an option’s price
(or premium) and its intrinsic value
10-14 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
10-15 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
• Stock index options
• Options give investors a way to hedge
• Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded
• Stock options
• Stock index options
• Options give investors a way to hedge
10-16 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Options Market Activity, 1992-2004 (in thousands)
0
50000
100000
150000
200000
1992 1995 2000 2003
Avg month-end contracts outstanding
Number of contracts traded
0
50000
100000
150000
200000
1992 1995 2000 2003
Avg month-end contracts outstanding
Number of contracts traded
10-17 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Regulation of Futures and Options Markets
• The Commodity Futures Trading Commission (CFTC)– primary regulator of futures markets
• The Securities and Exchange Commission (SEC)– main regulator of stock options– regulates trading of stock options and stock index
options
• The Commodity Futures Trading Commission (CFTC)– primary regulator of futures markets
• The Securities and Exchange Commission (SEC)– main regulator of stock options– regulates trading of stock options and stock index
options
10-18 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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, or 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, or credit risk
• Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction
10-19 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Swaps Definitions
• Interest rate swap
• Swap buyer
• Notional principal
• Swap seller
• Currency swap
• Interest rate swap
• Swap buyer
• Notional principal
• Swap seller
• Currency swap
10-20 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
10-21 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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)
10-22 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
