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 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.8 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.9 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.10 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.11 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.12 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.13 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.