Copyright© 2006 John Wiley & Sons, Inc.1 Power Point Slides for: Financial Institutions, Markets, and Money, 9 th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University and Lanny R. Martindale, Texas A&M University

CHAPTER 11 DERIVATIVES MARKETS

Copyright© 2006 John Wiley & Sons, Inc.3 The Nature of Derivative Securities Derivative securities are used to minimize or eliminate an investor’s or a firm’s exposure to various types of risk that they may be exposed to. Derivatives are financial securities which are based upon or derived from existing securities. Risk to an investor or a firm can be caused by interest rate changes or foreign exchange rate changes, commodity prices or stock prices The purpose is to eliminate the price risk inherent in transactions that call for future delivery of money, a security, or a commodity.

Copyright© 2006 John Wiley & Sons, Inc.4 Spot versus Forward Market Trading for immediate or very-near-term delivery is called the spot market. Trading for future delivery - forward market.

Copyright© 2006 John Wiley & Sons, Inc.5 Forward Markets Buying/selling of a specified amount, price, and future delivery date of foreign currency. Direct relationship between buyer and seller. Foreign exchange dealers earn revenues on the spread between buying and selling. Seller delivers at the specified date called the settlement date. Buyer of the forward contract has the long position; seller of the forward contract has the short position. Banks and foreign exchange dealers are the primary counter-parties to most transactions in the forward market.

Copyright© 2006 John Wiley & Sons, Inc.6 Futures Markets Buying/selling of standardized contracts specifying the amount, price, and future delivery date of a currency, security, or commodity. Buyers/sellers deal with the futures exchange, not with each other. A specific trade (buy/sell) involves a hedger and a speculator. Delivery seldom made - buyer/seller offsets previous position before maturity. Futures contracts expire on specific dates. Margin requirements exist – varies by contract type.

Copyright© 2006 John Wiley & Sons, Inc.7 Futures Market Transaction

Copyright© 2006 John Wiley & Sons, Inc.8 Margin Requirements Initial margin - small percentage deposit required to trade a futures contract. Daily settlements - reflect gains/losses daily and cash payments. Maintenance margin - minimum deposit requirements on futures contracts.

Copyright© 2006 John Wiley & Sons, Inc.9 Futures Exchanges Competition between exchanges is keen. Contract innovation is common. Exchanges advertise and promote heavily. Exchange specifies terms of a contract. Dates. Denomination. Specific items that can be delivered. Method of delivery. Minimum daily price variance. Rules for trading.

Copyright© 2006 John Wiley & Sons, Inc.10 Futures Markets Participants Hedgers attempt to reduce or eliminate price risk. Speculators accept the price risk in turn for expected return. Traders speculate on very-short-term changes in future contract prices.

Copyright© 2006 John Wiley & Sons, Inc.11 Uses of Financial Futures Markets Reducing Systematic Risk in Stock Portfolios Stock index futures contracts trading began in Stock index futures derive their value from the value of an underlying group of selected stocks. Stock index futures permit investors to alter the market or systematic risk of their portfolio. Investors who try to protect stock gains may hedge against a decline in the market value of their stock portfolio by selling (shortening) stock index futures.

Copyright© 2006 John Wiley & Sons, Inc.12 Stock Index Program Trading Stock index program trading is done to arbitrage the price discrepancies between a stock index future and the stocks that make up the stock index. Such trading allows the program trader to earn a higher risk-free return than a T-Bill for the corresponding period. Stock index program trading involves buying or selling large number of stocks in high volume which can influence stock prices dramatically over the short-term.

Copyright© 2006 John Wiley & Sons, Inc.13 Guaranteeing Cost of Funds Futures and forward contracts can be used to hedge future borrowing costs by utilizing the inverse relationship between interest rates and security prices. If interest rates are expected to rise increasing the cost of funds, a borrower who executes a short hedge will gain in the futures market and thereby, offset all or part of the increased borrowing cost.

Copyright© 2006 John Wiley & Sons, Inc.14 Risks in the Futures Markets Basis risk - risk of an imperfect hedge because the value of item being hedged may not always keep the same price relationship to the futures contracts. Cross-hedges - using the futures market to hedge a dissimilar commodity or security. Related-contract risk - risk of failure due to a unanticipated change in the business activity being hedged, such as a loan default or prepayment.

Copyright© 2006 John Wiley & Sons, Inc.15 Risks in the Futures Markets (concluded) Manipulation risk - risk of price losses due to a person or group trading (buying or selling) to affect price. Margin risk - the liquidity risk that added maintenance margin calls will be made by the exchange.

Copyright© 2006 John Wiley & Sons, Inc.16 Options An option gives the holder the right, (but not the obligation) to buy/sell a round lot (100 shares) of the underlying security or commodity on or before a specified date at a specified price. An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date. A European option can be exercised only on its expiration date, not before. An option that would be profitable if exercised immediately is said to be in the money. The seller of the option is called the writer, and the buyer of the option, holder. The holder or buyer of the option will pay the writer of the option a premium to secure the option. With options the buyer can lose only the premium and the commission paid.

Copyright© 2006 John Wiley & Sons, Inc.17 Reading Option Quotes

Copyright© 2006 John Wiley & Sons, Inc.18 Options versus Futures Contracts The option at the strike price exists over the period of time, not at a given date. The buyer of an option pays the seller (writer) a premium which the writer keeps regardless of whether or not the option is ever exercised. The option does not have to be exercised by the buyer; it can be sold if it has a market value, before the expiration date. Gains and losses are unlimited with futures contracts; with options the buyer can lose only the premium and the commission paid.

Copyright© 2006 John Wiley & Sons, Inc.19 Calls and Puts Call option - buyer has the option to buy an item at the strike price. Put option - buyer has the option to sell an item at the strike price.

Copyright© 2006 John Wiley & Sons, Inc.20 Covered and Naked Options Covered option - writer either owns the security involved in the contract or has limited his or her risk with other contracts. Naked option - writer does not have or has not made provision to limit the extent of risk.

Copyright© 2006 John Wiley & Sons, Inc.21 The Value of Options The size of the option premium varies: directly with the price variance of the underlying commodity or security. directly with the time to its expiration. directly with the level of interest rates, and for options based on stocks, with the dividends of the underlying stocks.

Copyright© 2006 John Wiley & Sons, Inc.22 Gains and Losses in Options & Futures

Copyright© 2006 John Wiley & Sons, Inc.23 Regulation of the Futures Market The Commodity Futures Trading Commission (CFTC) The Securities Exchange Commission (SEC) regulates options markets that have equity securities as underlying assets. Exchanges impose self-regulation with rules of conduct for members.

Copyright© 2006 John Wiley & Sons, Inc.24 Swaps Compared to Forwards and Futures Swaps are like forward contracts in that they guarantee the exchange of two items in the future, but a swap only transfers the net amount. Swaps do not pre-specify the terms of trade as do forward contracts. Prices are conditional on changes in a indexed interest rate such as T-bills. Swaps are used to hedge interest rate risk as are financial futures. Credit risk differences between the parties provide the economic incentive to swap future interest flows.

Copyright© 2006 John Wiley & Sons, Inc.25 Swap Dealers Serve as Counter-parties to both Sides of Swap Transactions Dealers negotiate a deal with one party, then seek out other parties with opposite interests and write a separate contract with them. The two contracts hedge each other and the dealer earns a fee for serving both parties.

Copyright© 2006 John Wiley & Sons, Inc.26 Swaps Have Limited Regulation Bank regulators require risk-based capital support for swap-risk exposure. Other swap competitors, investment banks and life insurance companies have no regulatory capital costs. The market is self-regulated because of the lack of any organized regulator. The International Swap Dealers Association leads in this effort.

Copyright© 2006 John Wiley & Sons, Inc.27 Example of a Swap