THE ROLE OF DERIVATIVE ASSETS

1. THE ROLE OFDERIVATIVE ASSETS CHAPTER SEVENTEEN Practical Investment Management Robert A. Strong

2. Outline • Background • The Rationale for Derivative Assets • Uses of Derivatives • The Options Market • Options Terminology • The Financial Page Listing • The Origin of an Option • The Role of the Options Clearing Corporation • Standardized Option Characteristics

3. Outline • The Futures Market • Futures vs. Options • Market Participants • Keeping the Promise • Categories of Futures Contracts • Financial Futures • Stock Index Futures • Interest Rate Futures • Foreign Currency Futures

4. Outline • Derivative Assets and the News • Current Events • Risk of Derivative Assets • Listed vs. Over-the-Counter Derivatives

5. Introduction • Derivative assets get their name from the fact that their value derives from some other asset. • The best-known derivative assets are futures and options contracts. • Derivatives are not all the same. Some are inherently speculative, while some are highly conservative.

6. The first organized derivatives • exchange in the United States was developed in order to bring stability to agricultural prices, by enabling farmers to eliminate or reduce their price risk. Background : The Rationale for Derivative Assets

7. Background : Uses of Derivatives • Risk management : The equity manager’s market risk or the bond manager’s interest rate risk is analogous to the farmer’s price risk. • Risk transfer : Derivatives provide a means for risk to be transferred from one person to some other market participant who, for a price, is willing to bear it. • Derivatives may provide financial leverage.

8. Background : Uses of Derivatives • Income generation : Some people use derivatives as a means of generating additional income from their investment portfolio. • Financial engineering : Derivatives can be stable or volatile depending on how they are combined with other assets. • What’s next?

9. Background : Uses of Derivatives Insert Figure 17-1 here.

10. Options Terminology • A call option gives its owner the right to buy a specified quantity of the underlying asset at a set price within a set time period. • A put option gives its owner the right to sell a specified quantity of the underlying asset at a set price within a set time period. • The set price is called the striking price or exercise price, and the last day the option is valid is called the expiration date. • The price of the option is the premium.

11. Options Terminology • Options trade in units called contracts, each of which normally covers 100 shares. • An option’s volume indicates how many option contracts changed hands over some period of time. It measures trading activity. • An option’s open interest indicates how many option contracts exist. • Open interest goes up when someone creates an option and does down when two people trade and each close out an options position.

12. Options Terminology • The owner of an option will ultimately do one of three things with it: • sell it to someone else; • let it expire; or • exercise it.

13. The Origin of an Option • Options can be created, or destroyed. The quantity of options in existence changes everyday. • The first trade someone makes in a particular option is called an opening transaction. If an investor sells an option as an opening transaction, it is called writing the option. • Options are fungible, meaning that, for a given company, all options of the same type with the same expiration and striking price are identical.

14. OCC Buyer Trading Floor Seller The Role of the Options Clearing Corporation • The Options Clearing Corporation positions itself between every buyer and seller and acts as a guarantor of all option trades.

15. Standardized Option Characteristics • Options have standardized expiration dates, striking prices, and lot size. • option premium = intrinsic value + time value • If an option has no intrinsic value, it is out-of-the-money. Otherwise, it is either in-the-money or at-the-money.

16. Standardized Option Characteristics Components of an Option Premium Time Value Option Premium Intrinsic Value + =

17. Standardized Option Characteristics • An American option can be exercised anytime prior to the expiration of the option. A European option, on the other hand, can only be exercised at expiration. • The option holder decides if and when to exercise. • Valuable options are usually sold rather than exercised.

18. Standardized Option Characteristics Fig 17-4 here

19. A futures contract is a promise. The Futures Market • The initial seller of the contract promises to deliver a quantity of a standardized commodity to a designated delivery point during a certain delivery month. • The other party to the trade promises to pay a predetermined price for the goods upon delivery. • The person who promises to buy is said to be long, while the person who promises to deliver is said to be short.

20. The Futures Market • Futures vs. options : Futures contracts do not expire unexercised. Note that the contract obligation may be satisfied by making an offsetting trade. • Market participants : • Hedgers use futures to reduce price risk. • Speculators assume risk in the hope of making a profit. • Marketmakers provide liquidity for the marketplace.

21. The Futures Market Insert Figure 17-5 here.

22. The Futures Market • Keeping the promise : Each exchange has a Clearing Corporation which ensures the integrity of the futures contract when a member is in financial distress. • Categories of futures contracts : • Agricultural e.g. wheat, cotton, cattle. • Metals and petroleum e.g. platinum, copper, natural gas, crude oil. • Financial e.g. foreign currency, stock index, interest rate. • Others e.g. electricity, catastrophe, swap.

23. Financial Futures : Stock Index Futures • A stock index future is a promise to buy or sell the standardized units of a specific index at a fixed price at a predetermined future date. • Unlike most other commodity contracts, there is no actual delivery mechanism when the contract expires. For practicality, all settlements are in cash.

24. Financial Futures : Stock Index Futures Insert Table 17-2 here.

25. Financial Futures : Interest Rate Futures • Interest rate futurescontracts are customarily grouped into short-term, intermediate-term, and long-term categories. • The two principal short-term contracts are Eurodollars and U.S. Treasury bills. • The Treasury bill futures contract calls for the delivery of $1 million par value of 90-day T-bills on the delivery date of the futures contract.

26. Financial Futures : Interest Rate Futures Insert Table 17-3 here.

27. Financial Futures : Interest Rate Futures • The contract on U.S. Treasury notes is the only intermediate-term contract, while Treasury bonds are the principal long-term contracts. • The Treasury bond futures contract calls for the delivery of $100,000 face value of U.S. Treasury bonds with a minimum of 15 years until maturity (and, if callable, with a minimum of 15 years of call protection). Bonds that meet these criteria are said to be deliverable.

28. Financial Futures : Interest Rate Futures Insert Table 17-4 here.

29. Bonds are standardized as follows: invoice price settlement price conversion factor accrued interest = [ x ] + Financial Futures : Interest Rate Futures • T-bonds are not all fungible. At any given time, several dozen bonds are usually eligible for delivery on a T-bond futures contract. Normally, only one of these bonds will be cheapest to deliver.

30. Financial Futures : Interest Rate Futures Insert Table 17-5 here.

31. Financial Futures : Foreign Currency Futures • Foreign currency futures contracts call for delivery of the foreign currency in the country of issuance to a bank of the clearing house’s choosing. • Most major corporations face at least some foreign exchange risk and quickly discovered the convenience of these futures as a hedging vehicle, while speculators saw the contracts as easy to understand and use.

32. Newspapers in recent months have • been full of reports on various businesses that have lost billions “investing in derivatives.” Derivative Assets and the News • Derivatives are neutral products. Their risk depends on what an investor does with them. • Exchange-traded derivative assets and over-the-counter derivatives are markedly different.

33. Review • Background • The Rationale for Derivative Assets • Uses of Derivatives • The Options Market • Options Terminology • The Financial Page Listing • The Origin of an Option • The Role of the Options Clearing Corporation • Standardized Option Characteristics

34. Review • The Futures Market • Futures vs. Options • Market Participants • Keeping the Promise • Categories of Futures Contracts • Financial Futures • Stock Index Futures • Interest Rate Futures • Foreign Currency Futures

35. Review • Derivative Assets and the News • Current Events • Risk of Derivative Assets • Listed vs. Over-the-Counter Derivatives

36. Appendix: Option Pricing • Fig. 17A-1

37. Appendix: Option Pricing • Black-Scholes Options Pricing Model • Insert table 17A-1

38. Appendix: Option Pricing • Insert fig. 17A2

39. Appendix: Option Pricing • Delta: the change in option premium expected from a small change in the stock price, all other things being equal