Derivative Securities Markets

8-1McGraw-Hill/IrwinChapter TenDerivative Securities Markets10-2McGraw-Hill/IrwinDerivativesA derivative security is an agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specific date in the futureDerivative securities markets are the markets in which derivative securities tradeDerivatives involve the buying and selling (i.e., the transfer of) risk, which results in a positive impact on the economic systemDerivatives are used for hedging and for speculation10-3McGraw-Hill/IrwinDerivativesThe first wave of modern derivatives were foreign currency futures introduced by the International Monetary Market (IMM) following the Smithsonian Agreements of 1971 and 1973The second wave of modern derivatives were interest rate futures introduced by the Chicago Board of Trade (CBT) after the Fed started to target nonborrowed reserves in the late 1970sThe third wave of modern derivatives occurred in the 1990s with the advent of credit derivatives10-4McGraw-Hill/IrwinForwards and FuturesA spot contract is an agreement to transact involving the immediate exchange of assets and fundsA forward contract is a nonstandardized agreement to transact involving the future exchange of a set amount of assets at a set priceA futures contract is a standardized exchange traded agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily10-5McGraw-Hill/IrwinFutures MarketsFutures contracts are usually traded on organized exchangesExchanges indemnify counterparties against credit (i.e., default) riskFutures are market to market dailymarked to market describes the prices on outstanding futures contracts that are adjusted each day to reflect current futures market conditionsThe five major U.S. exchanges are the CBOT, CME, NYFE, MACE, and KCBOTThe principal regulator of futures markets is the Commodity Futures Trading Commission (CFTC)10-6McGraw-Hill/IrwinFutures MarketsFutures contract trading occurs in trading “pits” using an open-outcry auction among exchange membersfloor brokers place trades for the publicprofessional traders trade for their own accountsposition traders take a position in the futures market based on their expectations about the future direction of the prices of the underlying assetsday traders take a position within a day and liquidate it before day’s endscalpers take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading10-7McGraw-Hill/IrwinFutures Contract TermsTrading unitDeliverable gradesTick sizePrice quoteContract monthsLast trading dayLast delivery dayDelivery methodTrading hoursTicker symbolsDaily price limit10-8McGraw-Hill/IrwinFutures ContractsA long position is the purchase of a futures contractA short position is the sale of a futures contractA clearinghouse is the unit that oversees trading on the exchange and guarantees all trades made by the exchangeOpen interest is the total number of the futures, put options, or call options outstanding at the beginning of the day10-9McGraw-Hill/IrwinFutures ContractsAn initial margin is a deposit required on futures trades to ensure that the terms of the contracts will be metThe maintenance margin is the margin a futures trader must maintain once a futures position is takenif losses occur such that margin account funds fall below the maintenance margin, the customer is required to deposit additional funds in the margin accountFutures trades are leveraged investments as traders post and maintain only a small portion of the value of their futures position and “borrow” the rest from brokers10-10McGraw-Hill/IrwinOptionsAn option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price within a specified period of timeA call option is an option that gives the purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a specified exercise price on (or up to) a specified dateA put option is an option that gives the purchaser the right, but not the obligation, to sell the underlying security to the writer of the option at a specified exercise price on (or up to) a specified date10-11McGraw-Hill/IrwinPayoff Payoff function profit for buyer C 0 Stock Price X at expiration -C Payoff Payoff function loss for writerOptionsPayoff Functions for Call Options10-12McGraw-Hill/IrwinPayoff Payoff function profit for buyer P 0 Stock Price X at expiration -P Payoff Payoff function loss for writerOptionsPayoff Functions for Put Options10-13McGraw-Hill/IrwinOptionsThe Black-Scholes option pricing model (the model most commonly used to price and value options) is a function ofthe spot price of the underlying assetthe exercise price on the optionthe option’s exercise datethe price volatility of the underlying assetthe risk-free rate of interestThe intrinsic value of an option is the difference between an option’s exercise price and the underlying asset pricethe intrinsic value of a call option = max{S – X, 0}the intrinsic value of a put option = max{X – S, 0}10-14McGraw-Hill/IrwinPlease insert Figure 10-8 here. 10-15McGraw-Hill/IrwinOption MarketsThe Chicago Board of Options Exchange (CBOE) opened in 1973 as the first exchange devoted solely to the trading of stock optionsOptions on futures contracts began trading in 1982An American option can be exercised at any time before (and on) the expiration dateA European option can be exercised only on the expiration dateThe trading process for options is similar to that for futures contracts10-16McGraw-Hill/IrwinOptionsThe underlying asset on a stock option is the stock of a publicly traded companyThe underlying asset on a stock index option is the value of a major stock market index (e.g., DJIA or S&P 500)The underlying asset on a futures option is a futures contractCredit swapsthe value of a credit spread call option increases as the default (risk) premium or yield spread on a specified benchmark bond of the borrower increases above some exercise spread a digital default option pays a stated amount in the event of a loan default10-17McGraw-Hill/IrwinOptionsThe primary regulator of futures markets is the Commodity Futures Trading Commission (CFTC)The Securities Exchange Commission (SEC) is the primary regulator of stock options and stock index optionsThe CFTC is the regulator of options on futures contracts10-18McGraw-Hill/IrwinSwapsA swap is an agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified intervalAn interest rate swap is an exchange of fixed-interest payments for floating-interest payments by two counterpartiesthe swap buyer makes the fixed-rate paymentsthe swap seller makes the floating-rate paymentsthe principal amount involved in a swap is called the notional principalA currency swap is a swap used to hedge against exchange rate risk from mismatched currencies on assets and liabilitiesCredit swaps allow financial institutions to hedge credit risk10-19McGraw-Hill/IrwinSwap MarketsSwaps are not standardized contractsSwap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselvesThe International Swaps and Derivatives Association (ISDA) is a 815 member association among 56 countries that sets codes of standards for swap documentation10-20McGraw-Hill/IrwinCaps, Floors, and CollarsFinancial institutions use options on interest rates to hedge interest rate riska cap is a call option on interest rates, often with multiple exercise datesa floor is a put option on interest rates, often with multiple exercise datesa collar is a position taken simultaneously in a cap and a floor (usually buying a cap and selling a floor)10-21McGraw-Hill/IrwinInternational Derivative MarketsThe U.S. dominates the global derivative securities marketsNorth America accounted for $57.94 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 2007The euro and European exchanges are expandingEurope accounted for $32.28 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 200710-22McGraw-Hill/IrwinBlack-Sholes Call Option Model