© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 9 Derivatives: Futures, Options, and Swaps

9-2 Derivatives: The Big Questions 1.What is a derivative? 2.How are derivatives used?

9-3 Derivatives: Roadmap Defining Derivatives Forward Contracts & Future Contracts Options: Calls and Puts Swaps

9-4 Derivatives: An Example In the winter of 1998, Bombardier offered a $1000 rebate to buyers of snowmobiles if there wasn’t enough snowfall. They bought “weather derivatives” to hedge this risk, transferring it to someone else. Without the ability to transfer the risk, Bombardier may not have been able to afford to offer the rebate and sold fewer snowmobiles.

9-5 Derivatives: Definition Derivative is a financial instrument whose value is derived from the value of an underlying asset

9-6 Derivatives: General Properties The purpose of a derivative is to allow risk to be transferred. Derivatives are all zero sum – when one side gains, the other side loses

9-7 Forward Contracts and Futures Contracts A forward contract is an agreement between a buyer and a seller to exchange a commodity or financial instrument for cash on a prearranged future date for a specified price. No money changes hands when the agreement is made.

9-8 Forward Contracts and Futures Contracts Futures contracts are forward contracts that are standardized and sold through organized exchanges. Treasury Bond contract: Specifies delivery of $100,000 face value,10-year, 6% coupon U.S. Treasury bond anytime during a given month.

9-9 Futures Contracts Contract is specific – no negotiation There are agreed upon places and times to trade them. Both sides are sure the other will perform. The clearing corporation sits between them and makes sure.

9-10 Properties of Futures Contracts Marking to Market and Margin –At then end of every day, daily gains and losses are posted to the accounts of the parties – those are the margin accounts. –If one parties account falls below an agreed upon level, the exchange will sell their position. –This guarantees performance.

9-11 Using Futures Contracts Hedgers: use futures to reduce risk –Farmers will sell futures to guarantee the price at which they will be able to sell their wheat –Bakers will buy futures to guarantee the price at which they will be able to buy flour. –You can’t always tell if someone is hedging

9-12 Using Futures Contracts Speculators –Try to profit from price movements. –Futures contracts create huge leverage: For the bond contract, the minimum investment is $2700, and a one day move could net $125, or nearly 5%!

9-13 Arbitrage Futures prices move in lock-step with the price of the underlying asset. If they don’t an arbitrageur will make it so. Imagine that the price of a bond went down, but the futures contract price didn’t. You could buy the bond, and sell a future, making a profit without taking any risk

9-14 Forwards and Futures: Who’s Who

9-15 Commodity prices are very volatile Farmers face a big risk when planting a large crop. Futures provide insurance to the farmer People in poor countries don’t have access to futures markets, so they can’t risk planting large crops.

9-16 Options: Definitions Option writer: seller Option holder: buyer Holder has a right, writer has an obligation. Call – the right to buy Put – the right to sell

9-17 Options: Definitions Strike price: predetermined price at which the option can be exercised A call is In the money : stock price > strike price At the money : stock price = strike price Out of the money: stock price < strike price

9-18 Options: Definitions American: can be exercised any time before the expiration date European: can only be exercised on the expiration date

9-19 Options: Uses Options transfer risk Both puts & calls can be used to hedge Options are closely related to insurance Can be used to speculate: Like futures they offer the ability to create substantial leverage cheaply

9-20 Using Options If you want to bet that interest rates are going to fall you can: 1.Buy a bond – that’s expensive 2.Buy a futures contract, but that risks losing money if the interest rate rises 3.Buy a call option that pays off only if the interest rate falls. (Call is the right to buy. It’s valuable if the price rises.)

9-21 A Guide to Options

9-22 Corporations work hard to appear profitable Financial statements can be misleading Never trust a statement unless it meets regulatory standards The more open a company is in its financial accounting, the more likely that it is honest.

9-23 Pricing Options The likelihood that an option will pay off depends on the volatility, or standard deviation, of the price of the underlying asset

9-24 Pricing Options Option price = Intrinsic value + Time value of the option Intrinsic value = value if exercised now Time value = what you will pay for the chance that the option will become more valuable prior to expiration Time value increases with volatility

9-25 Options: Factors Affecting the Value

9-26 If you get options instead of a higher salary, you are paying for them Are you paying too much? Try to figure out what they are likely to be worth.

9-27 Interest-Rate Swaps: Definition Agreements between two counterparties to exchange periodic interest rate payments over some future period, based on an agreed ‑ upon amount of principal – what’s called the notional principal. Transform fixed-rate into floating-rate payments, or vice versa

9-28 Interest-Rate Swaps: How They Work

9-29 Interest Rate Swaps: Who Uses Them? Banks –Deposits are short-term liabilities –Loans are long-term assets –Swaps help control risk Government debt managers: –Issue long-term debt relatively cheaply –Tax revenue matches up better with short- term interest rate.

9-30 Thinking about Derivatives They can be dangerous because they create leverage. If used prudently, they improve the efficiency of the financial system

9-31 Long Term Capital Management lost over $500 million in a single day in August 1998, and again in September Over a period of 6 weeks, they lost roughly $2½ billion. They did it trading derivatives. LTCM had over $1 trillion in interest rate swaps. The government became very concerned!

9-32 Enron borrowed a tremendous amount, but recorded it as hedging commodities trading activity Some of this entailed swaps where Enron received all the payments on its side up front. Sounds like a loan! Enron’s accounting treated it as a “risk-management asset”

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 9 End of Chapter