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Chapter Ten

Chapter Ten. Derivative Securities Markets. Derivative Securities: Chapter Overview. Derivative security a financial security whose payoff is linked to another previously issued security

brittany-wynn
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Chapter Ten

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  1. Chapter Ten Derivative Securities Markets

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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.

  7. 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 (continued)

  8. 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

  9. Futures Contracts Outstanding, 1992-1999

  10. 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

  11. 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

  12. 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

  13. Payoff Function for Call Options Payoff Payoff function Gain for Buyer + C 0Stock Price X A S at expiration C - Payoff Payoff function Loss for writer

  14. Payoff Function for Put Options Payoff Gain Payoff function for Writer +P 0Stock Price D X at expiration -P Payoff function Payoff for buyer Loss

  15. 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

  16. 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

  17. 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

  18. Options Market Activity, 1992-1999 (in thousands)

  19. 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, conductseconomic 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

  20. 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

  21. 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

  22. 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

  23. 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)

  24. 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

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