Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 9 Demystifying Derivatives

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-2 Learning Objectives Visualize the structure of future market Describe how future contracts can be used to diversity portfolios Understand option contracts and their use in diversifying portfolios Recognize swap contracts and see their ability to limit interest rate risk

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-3 Introduction Futures, options, and swaps are complicated instruments However, they have found their way into the risk management options of just about every major financial institution Derivatives—A financial instrument/contract that derives its value from some other underlying asset

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-4 An Overview of Financial Futures Future Contract is a contractual agreement that calls for delivery of a specific underlying commodity or security at some future date at a currently agreed-upon price There are contracts on interest-bearing securities (Treasury bonds, notes, etc), on stock indices (Standard & Poors’ and Japan’s Nikkei index), and on foreign currencies

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-5 An Overview of Financial Futures (Cont.) Trading in these contracts is conducted on the various commodity exchanges Financial futures were introduced about 35 years ago and volume now exceeds the more traditional agricultural commodities

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-6 An Overview of Financial Futures (Cont.) Characteristics of Financial Futures –Standardized agreement to buy/sell a particular asset or commodity at a future date and a current agreed- upon price Designed to promote liquidity—the ability to buy and sell quickly with low transactions costs Promotes large trading volume which narrows the bid- asked spreads Allows many individuals to trade the identical commodity

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-7 An Overview of Financial Futures (Cont.) Characteristics of Financial Futures (Cont.) –Terms specify the amount and type of asset as well as the location and delivery period Financial futures—underlying asset is either a specific security or cash value of a group of securities Stock index futures—contract calls for the delivery of the cash value of a particular stock index

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-8 An Overview of Financial Futures (Cont.) Characteristics of Financial Futures (Cont.) –Precise terms of each contract are established by the exchange that sponsors trading in the contracts –Seller of the contract has the right and obligation to deliver the securities at a specified time –In futures markets, the buyer of the contract is called long and the seller is called short

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-9 An Overview of Financial Futures (Cont.) Characteristics of Financial Futures (Cont.) –The only matter left for negotiations is the price at which the securities will be delivered –This price is determined by bidding and offering that occurs at the location (pit) of the exchange sponsoring the auction –The auction process insures that all orders are exposed to highest bid and lowest offer, guaranteeing execution at the best possible price

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Financial Futures (Cont.) Characteristics of Financial Futures (Cont.) –Once the contract has been agreed upon, the clearing corporation associated with the exchange acts as a middleman in the transaction The clearing corporation satisfies the contractual agreement of the long and short They reduce the credit risk exposure associated with future deliveries Longs and shorts do not have to worry that the other party will not perform their contractual obligations

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Financial Futures (Cont.) Characteristics of Financial Futures (Cont.) –Clearing Corporation (Cont.) Requires the short and long to place a deposit (Margin) which is a performance bond for both the seller and buyer Requires that gains and losses be settled each day in the mark-to-market operation

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Financial Futures (Cont.) Characteristics of Financial Futures (Cont.) –To insure the obligations are met at the delivery date, most trades in futures market choose settlement by offset rather than delivery Both parties make offsetting sales/purchases to cover the contract Permits hedgers, speculators, and arbitrageurs to make legitimate use of the futures market without getting into technical details of making or taking delivery of assets

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Financial Futures (Cont.) Using Financial Futures Contracts –Provides the opportunity to hedge legitimate commercial activities –Hedgers—buy and sell futures contracts to reduce their exposure to the risk of future price movement –Permits dealers to cover both the short and long position of a contract –Reduces risk since future prices move almost in lockstep with the price of the underlying asset

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Financial Futures (Cont.) Using Financial Futures Contracts (Cont.) –Legitimate hedging use of the futures markets occurs with a sale of a futures contract with a subsequent offset purchase –“Short hedgers” offset inventory risk by selling futures while “long hedgers” offset anticipated purchases of securities by buying futures –Speculators Purposely take on risk of price movement Expect to make a profit on the risky transaction

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Financial Futures (Cont.) Pricing Financial Futures Contracts –Buying and selling activities of hedgers and speculators together determine the price of a futures contract –There is a definite relationship between the price of a futures contract and the price of the underlying asset

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Financial Futures (Cont.) Pricing Financial Futures Contracts (Cont.) –Arbitrageurs Determine the relationship between the price in the “cash market” and the price in the futures market During the delivery period of a futures contract, the rights and obligations of the contract force the price of the futures contract and the price of the underlying security to be identical

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Financial Futures (Cont.) Pricing Financial Futures Contracts (Cont.) –Arbitrageurs (Cont.) If the arbitrageur senses the price relationship between the futures contract and the underlying asset is not correct, take actions in the market (buy or sell) to make a profit which forces the prices into proper relationship The activities of arbitrageurs cause the prices to converge on the delivery date or be in proper alignment during periods prior to final delivery date

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts Options contracts have both a shorter and longer history in financial markets than futures contracts –Options on individual stocks have been traded in over-the-counter market since nineteenth century –Increased visibility in 1972 when the Chicago Board Options Exchange (CBOE) standardized terms of contracts and introduced futures-type pit trading –Listed on most of major future exchange markets

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) Contractual Obligations –More complicated than futures contracts –Derive their value from some underlying asset A specified number of shares of a particular stock Stock Index Option—Basket of equities represented by some overall stock index such as S&P 500 In options on future contracts, the contractual obligations call for delivery of one futures contract

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) Contractual Obligations (Cont.) –Calls Buyer of a call option has the right (not obligation) to buy a given quantity of the underlying asset at a predetermined price (exercise or strike) at any time prior to the expiration date Once order is executed, the buyer is long in the asset

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) Contractual Obligations (Cont.) –Calls (Cont.) Seller of the call option (short) has the obligation to deliver the asset at the agreed price Therefore, rights and obligations of option buyers and sellers are not symmetrical Buyer of the call option pays a price to the seller for the rights acquired (option premium)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) Contractual Obligations (Cont.) –Puts Buyer of a put option has the right (not obligation) to sell a given quantity of the underlying asset at a predetermined price before the expiration date Seller of the option (short) has the obligation to buy the asset at the agreed price The buyer of the put option pays a premium to the seller

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) Contractual Obligations (Cont.) –Summary of calls and puts Option buyers have rights; option sellers have obligations Call buyers have the right to buy the underlying asset Put buyers have the right to sell the asset In both puts and calls the option buyer pays a premium to the option seller

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) Contractual Obligations (Cont.) –The exchange sponsoring the options trading established rules for trading –Standardization is designed to generate interest by potential traders, thereby contract liquidity –Clearing Corporation Guarantees the performance of contractual obligations Buyers and sellers do not have to be concerned with creditworthiness of their trading partners –Only matter up for negotiation is option premium—price buyer pays to seller for rights

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) Using and Valuing Options –Investors who buy options (puts or calls) have rights, but no obligations –Therefore, option buyers will do whatever is in their best interest on expiration date –On expiration date, payoff on expiration of a long call position is either zero (price below exercise price) or stock price minus exercise price (intrinsic value) (price above the exercise price)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) Using and Valuing Options (Cont.) –A long put position on expiration date has a value of zero if price is above the exercise price or a value equal to the exercise price minus the stock price if price is below the exercise price –Option Premium—The asymmetry payoff has the characteristic of insurance which is why the premium is charged on the transaction

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) What Determines Option Premiums? –Both hedgers and speculators will purchase options and pay the premium –Option premiums are determined by supply and demand –Call options are worth more (higher premiums) the higher the price and the greater the volatility of the underlying asset, and the longer the time to expiration of the option

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Options Contracts (Cont.) What Determines Option Premiums? (Cont.) –Premiums on put options will be higher the lower the price of the underlying asset, greater volatility of asset and longer time to expiration –Options are an expensive way to hedge portfolio risks if those risks are substantial

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Swaps Compared to other financial instruments, Swaps are relatively new having been introduced in 1981 to help firms reduce interest rate risks Two broad varieties—Interest rate swaps and currency swaps Swaps are contractual agreement between two parties (counterparties) and customized to meet the requirements of both parties

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Swaps (Cont.) Interest rate swap (Refer to Figure 9.1) –One party (fixed-rate payer) agrees to pay the other party a fixed interest amount each specified period over the life of the contract –The other party (floating-rate payer) agrees to pay the first party, each specified period, an interest amount based on some reference rate

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 9.1 Obligations of payments every six months for the duration of the swap.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Swaps (Cont.) Interest rate swap (Cont.) –Therefore, the fixed-rate payer always pays the same amount while payments by the floating-rate payer varies according to the reference rate –The dollar amount of the payments is determined by multiplying the interest rate by an agreed-upon principal (notional principal amount)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Swaps (Cont.) What determines the rates paid by both parties –Shape of the yield curve—expected rates in the future –Risk of default—possibility that counterparties might default on scheduled interest payments Financial institutions facilitate swaps –Bring the counterparties together –Impose their own credit between the counterparties

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Swaps (Cont.) Why Swap? –Financial institution earns a fee for arranging the swap –Counterparties reduce their risk exposure –Able to undo maturity mismatches in the balance sheets of the counterparties –However, swaps can generate losses when one of the counterparties is really a speculator rather than trying to hedge to cover risk

Copyright © 2009 Pearson Addison-Wesley. All rights reserved An Overview of Swaps (Cont.) Valuing a Swap –Contracts are traded in over-the-counter market –It is possible for one of the counterparties to sell their obligation to another party –Changing market conditions may cause one party to sell obligation –The third party will purchase the swap if it is to their advantage –Therefore, swaps produce gains or losses which will ultimate impact the value of the swap