THE ROLE OF DERIVATIVE ASSETS CHAPTER SEVENTEEN Practical Investment Management Robert A. Strong

South-Western / Thomson Learning © 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

South-Western / Thomson Learning © 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

South-Western / Thomson Learning © Outline  Derivative Assets and the News  Current Events  Risk of Derivative Assets  Listed vs. Over-the-Counter Derivatives

South-Western / Thomson Learning ©  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. Introduction

South-Western / Thomson Learning © Background : The Rationale for Derivative Assets  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.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © 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?

South-Western / Thomson Learning © Background : Uses of Derivatives Insert Figure 17-1 here.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning ©  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. Options Terminology

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © The Role of the Options Clearing Corporation OCC BuyerSellerTrading Floor  The Options Clearing Corporation positions itself between every buyer and seller and acts as a guarantor of all option trades.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © Standardized Option Characteristics Intrinsic Value Time ValueOption Premium += Components of an Option Premium

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © Standardized Option Characteristics Fig 17-4 here

South-Western / Thomson Learning ©  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. The Futures Market  A futures contract is a promise.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © The Futures Market Insert Figure 17-5 here.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © Financial Futures : Stock Index Futures Insert Table 17-2 here.

South-Western / Thomson Learning © Financial Futures : Interest Rate Futures  Interest rate futures contracts 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.

South-Western / Thomson Learning © Financial Futures : Interest Rate Futures Insert Table 17-3 here.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © Financial Futures : Interest Rate Futures Insert Table 17-4 here.

South-Western / Thomson Learning © Financial Futures : Interest Rate Futures invoice price settlement price conversion factor accrued interest = [ x ] +  Bonds are standardized as follows:  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.

South-Western / Thomson Learning © Financial Futures : Interest Rate Futures Insert Table 17-5 here.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © Derivative Assets and the News  Newspapers in recent months have been full of reports on various businesses that have lost billions “investing in derivatives.”  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.

South-Western / Thomson Learning © 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

South-Western / Thomson Learning © 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

South-Western / Thomson Learning © Review  Derivative Assets and the News  Current Events  Risk of Derivative Assets  Listed vs. Over-the-Counter Derivatives

South-Western / Thomson Learning © Appendix: Option Pricing  Fig. 17A-1

South-Western / Thomson Learning © Appendix: Option Pricing  Black-Scholes Options Pricing Model  Insert table 17A-1

South-Western / Thomson Learning © Appendix: Option Pricing  Insert fig. 17A2

South-Western / Thomson Learning © Appendix: Option Pricing  Delta: the change in option premium expected from a small change in the stock price, all other things being equal