1. Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Ten Derivative Securities Markets

2. 10-2 McGraw-Hill/Irwin Derivatives A derivative is a contract between two parties whose value is based on some underlying asset price or market condition In many derivatives, two parties agree to exchange a standard quantity of an asset at a predetermined price at a specific date in the future A derivative is a contract between two parties whose value is based on some underlying asset price or market condition In many derivatives, two parties agree to exchange a standard quantity of an asset at a predetermined price at a specific date in the future

3. 10-3 McGraw-Hill/Irwin Derivatives’ Uses Derivatives are leveraged instruments where participants put up a small amount of money and obtain the gain or loss on a much larger position Derivatives are used for speculation and for hedging Speculation Buying or selling a derivative contract in order to earn a leveraged rate of return Hedging Entering into a derivatives contract to reduce the risk associated with positions or commitments in their line of business Derivatives are leveraged instruments where participants put up a small amount of money and obtain the gain or loss on a much larger position Derivatives are used for speculation and for hedging Speculation Buying or selling a derivative contract in order to earn a leveraged rate of return Hedging Entering into a derivatives contract to reduce the risk associated with positions or commitments in their line of business

4. 10-4 McGraw-Hill/Irwin Derivatives Markets The first wave of modern derivatives were foreign currency futures introduced by the International Monetary Market (IMM) following the Smithsonian Agreements of 1971 and 1973 The second wave of modern derivatives were interest rate futures introduced by the Chicago Board of Trade (CBT) with the increase in interest rate volatility in the late 1970s The first wave of modern derivatives were foreign currency futures introduced by the International Monetary Market (IMM) following the Smithsonian Agreements of 1971 and 1973 The second wave of modern derivatives were interest rate futures introduced by the Chicago Board of Trade (CBT) with the increase in interest rate volatility in the late 1970s

5. 10-5 McGraw-Hill/Irwin Derivatives Markets The third wave of modern derivatives occurred in the 1980s with the advent of stock derivatives The fourth wave occurred in the 1990s with credit derivatives The third wave of modern derivatives occurred in the 1980s with the advent of stock derivatives The fourth wave occurred in the 1990s with credit derivatives

6. 10-6 McGraw-Hill/Irwin Selected Derivatives Markets

7. 10-7 McGraw-Hill/Irwin Forwards and Futures A spot contract is an agreement to transact involving the immediate exchange of assets and funds A forward contract is a nonstandardized agreement to buy or sell an asset in the future, with the terms of the deal set when the contract is created Forwards are: custom contracts; lack standard terms not traded, so participants must perform risky; have potential counterparty credit risk A spot contract is an agreement to transact involving the immediate exchange of assets and funds A forward contract is a nonstandardized agreement to buy or sell an asset in the future, with the terms of the deal set when the contract is created Forwards are: custom contracts; lack standard terms not traded, so participants must perform risky; have potential counterparty credit risk

8. 10-8 McGraw-Hill/Irwin Forwards and Futures A futures contract is a standardized, exchange-traded version of a forward contract Futures contracts differ from forwards in that futures are: marketable have no default risk employ margin requirements and daily marking to market margin requirement is a performance bond posted by a buyer and a seller of a futures contract A futures contract is a standardized, exchange-traded version of a forward contract Futures contracts differ from forwards in that futures are: marketable have no default risk employ margin requirements and daily marking to market margin requirement is a performance bond posted by a buyer and a seller of a futures contract

9. 10-9 McGraw-Hill/Irwin Futures Markets Futures contract trading occurs in trading “pits” using an open-outcry auction among exchange members floor brokers place trades for the public professional traders trade for their own accounts position traders take a position in the futures market based on their expectations about the future direction of the prices of the underlying assets day traders take a position within a day and liquidate it before day’s end scalpers take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading Futures contract trading occurs in trading “pits” using an open-outcry auction among exchange members floor brokers place trades for the public professional traders trade for their own accounts position traders take a position in the futures market based on their expectations about the future direction of the prices of the underlying assets day traders take a position within a day and liquidate it before day’s end scalpers take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading

10. 10-10 McGraw-Hill/Irwin Futures Markets Price volatility and trading interest determines which contracts are offered Profit pressures for derivatives exchanges to merge CME Group contains CME, CBOT, NYMEX, and COMEX Electronic trading is increasingly dominating ‘pit’ trading Intercontinental Exchange only has electronic trading Price volatility and trading interest determines which contracts are offered Profit pressures for derivatives exchanges to merge CME Group contains CME, CBOT, NYMEX, and COMEX Electronic trading is increasingly dominating ‘pit’ trading Intercontinental Exchange only has electronic trading

11. 10-11 McGraw-Hill/Irwin Futures Contract Terms Trading unit Deliverable grades Tick size Price quote Contract months Last trading day Trading unit Deliverable grades Tick size Price quote Contract months Last trading day Last delivery day Delivery method Trading hours Ticker symbols Daily price limit Last delivery day Delivery method Trading hours Ticker symbols Daily price limit

12. 10-12 McGraw-Hill/Irwin Futures Contracts A long position is the purchase of a futures contract A short position is the sale of a futures contract A clearinghouse is the unit that oversees trading on the exchange and guarantees all trades made by the exchange Open interest is the total number of the futures, put options, or call options outstanding at the beginning of the day A long position is the purchase of a futures contract A short position is the sale of a futures contract A clearinghouse is the unit that oversees trading on the exchange and guarantees all trades made by the exchange Open interest is the total number of the futures, put options, or call options outstanding at the beginning of the day

13. 10-13 McGraw-Hill/Irwin Futures Contracts An initial margin is a deposit required on futures trades to ensure that the terms of the contracts will be met The maintenance margin is the margin a futures trader must maintain once a futures position is taken if losses occur such that margin account funds fall below the maintenance margin, the customer is required to deposit additional funds in the margin account to keep the position open An initial margin is a deposit required on futures trades to ensure that the terms of the contracts will be met The maintenance margin is the margin a futures trader must maintain once a futures position is taken if losses occur such that margin account funds fall below the maintenance margin, the customer is required to deposit additional funds in the margin account to keep the position open

14. 10-14 McGraw-Hill/Irwin Futures Contracts

15. 10-15 McGraw-Hill/Irwin Example – Futures Contract Terms Contract: 30 year Treasury Bond contract Exchange: Chicago Board of Trade Delivery Months:Contract maturity months are March, June, September, December Contract Size: Contract calls for delivery of $100,000 face value Deliverable Instrument: Treasury bonds that do mature for at least 15 years from the date of delivery and mature in no more than 25 years IMR: Exchange mandated initial margin requirement to initiate a position (brokers may require a higher margin) MMR: Exchange mandated maintenance margin required to keep the account open Contract: 30 year Treasury Bond contract Exchange: Chicago Board of Trade Delivery Months:Contract maturity months are March, June, September, December Contract Size: Contract calls for delivery of $100,000 face value Deliverable Instrument: Treasury bonds that do mature for at least 15 years from the date of delivery and mature in no more than 25 years IMR: Exchange mandated initial margin requirement to initiate a position (brokers may require a higher margin) MMR: Exchange mandated maintenance margin required to keep the account open ContractExchange Delivery Months Contract Size Deliverable Instrument IMRMMR T-BondCBOTM,J,S,D$ 100,000See below*$2,530$2,300

16. 10-16 McGraw-Hill/Irwin Long and Short Positions If an investor buys or goes “long” one June contract, they are agreeing to buy $100,000 par or face value of T-Bonds at the original futures contract price when the contract expires in June. If an investor sells or goes “short” one June contract, they are agreeing to deliver $100,000 par or face value of T-Bonds and receive the original futures contract price when the contract expires in June. Each investor must put up the IMR of $2,530 when they open the contract. Each investor must maintain the MMR of $2,300 in their margin account while the position is open. If an investor buys or goes “long” one June contract, they are agreeing to buy $100,000 par or face value of T-Bonds at the original futures contract price when the contract expires in June. If an investor sells or goes “short” one June contract, they are agreeing to deliver $100,000 par or face value of T-Bonds and receive the original futures contract price when the contract expires in June. Each investor must put up the IMR of $2,530 when they open the contract. Each investor must maintain the MMR of $2,300 in their margin account while the position is open. ContractExchange Delivery Months Contract Size Deliverable Instrument IMRMMR T-BondCBOTM,J,S,D$ 100,000See below*$2,530$2,300

17. T-Bond Futures Quote Sheet 9-17 McGraw-Hill/Irwin Price quotes are in dollars and 32nds as a percent of face value ‘Open’ price for the June contract of 136’16 is $136 16/32 percent of $100,000 = $136,500 If you buy the contract at the open, what are you agreeing to do? If you sell the contract at the open, what are you agreeing to do? Price quotes are in dollars and 32nds as a percent of face value ‘Open’ price for the June contract of 136’16 is $136 16/32 percent of $100,000 = $136,500 If you buy the contract at the open, what are you agreeing to do? If you sell the contract at the open, what are you agreeing to do? Source: CBOT LastChange Prev SettleOpenHighLowVolume Jun 2014136’18-0’01136’19136’16136’30136’003,244 Sep 2014135’250 135’23136’06135’05342,159

18. Marking to Market 9-18 McGraw-Hill/Irwin Gains and losses are recognized daily IMR = $2,530, MMR = $2,300 Suppose you buy one June contract at the open of $98,500, Monday’s settle price is 98’10, and Tuesday’s close is 97’00. What is in your margin account after Tuesday’s settle? Who receives the money taken out of your margin account? Gains and losses are recognized daily IMR = $2,530, MMR = $2,300 Suppose you buy one June contract at the open of $98,500, Monday’s settle price is 98’10, and Tuesday’s close is 97’00. What is in your margin account after Tuesday’s settle? Who receives the money taken out of your margin account? Long in contract Marking to Market SettleUnderlying ValuePrice ChangeMargin Acct OPEN$98,500.00$2,530.00 Mon.98’10$98,312.50($187.50)$2,342.50 Tues.97’00$97,000.00($1,312.50)$1,030.00 MARGIN CALL (beneath $2,300) add cash =$1,500.00 $2,530.00

19. 10-19 McGraw-Hill/Irwin Options An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price within a specified period of time A call option is an option that gives the purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a specified exercise price on (or up to) a specified date A put option is an option that gives the purchaser the right, but not the obligation, to sell the underlying security to the writer of the option at a specified exercise price on (or up to) a specified date An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price within a specified period of time A call option is an option that gives the purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a specified exercise price on (or up to) a specified date A put option is an option that gives the purchaser the right, but not the obligation, to sell the underlying security to the writer of the option at a specified exercise price on (or up to) a specified date

20. 10-20 McGraw-Hill/Irwin Payoff Payoff for profit call buyer C 0 Stock price Xat expiration -C Payoff loss Payoff Payoff for profit call buyer C 0 Stock price Xat expiration -C Payoff loss Profit Diagrams for Call Options Payoff for call writer

21. 10-21 McGraw-Hill/Irwin Payoff profit P 0 Stock price Xat expiration -P Payoff loss Payoff profit P 0 Stock price Xat expiration -P Payoff loss Profit Diagrams for Put Options Payoff for put buyer Payoff for put writer

22. 10-22 McGraw-Hill/Irwin Options The Black-Scholes option pricing model (the model most commonly used to price and value options) is a function of: the spot price of the underlying asset the exercise price on the option the option’s exercise date the price volatility of the underlying asset the risk-free rate of interest The intrinsic value of an option is the difference between an option’s exercise price and the underlying asset price the intrinsic value of a call option = max{S – X, 0} the intrinsic value of a put option = max{X – S, 0} The Black-Scholes option pricing model (the model most commonly used to price and value options) is a function of: the spot price of the underlying asset the exercise price on the option the option’s exercise date the price volatility of the underlying asset the risk-free rate of interest The intrinsic value of an option is the difference between an option’s exercise price and the underlying asset price the intrinsic value of a call option = max{S – X, 0} the intrinsic value of a put option = max{X – S, 0}

23. 10-23 McGraw-Hill/Irwin Option Intrinsic Value and Time Value

24. 10-24 McGraw-Hill/Irwin Option Quotes

25. The May call is in the money (positive intrinsic value) and the call premium is $3.30 * 100 = $330 (contracts are for 100 shares) The intrinsic value of the call (S-X) is ($8.79 - $6.00) * 100 = $279 The time value of the call is $330 - $279 = $51 The May put is out of the money and the put’s intrinsic value (X-S) is 0 The put still has time value, however, equal to $0.45 * 100 = $45 The May call is in the money (positive intrinsic value) and the call premium is $3.30 * 100 = $330 (contracts are for 100 shares) The intrinsic value of the call (S-X) is ($8.79 - $6.00) * 100 = $279 The time value of the call is $330 - $279 = $51 The May put is out of the money and the put’s intrinsic value (X-S) is 0 The put still has time value, however, equal to $0.45 * 100 = $45 Option Price Quotes AMR Underlying stock price $8.79 Expiration CallPut STRIKELASTVOLUME OPEN INTERESTLASTVOLUME OPEN INTEREST May6.003.30125780.45204175 Jan7.501.3060170620.1513858909 9-25 McGraw-Hill/Irwin

26. 10-26 McGraw-Hill/Irwin Option Markets The Chicago Board of Options Exchange (CBOE) opened in 1973 as the first exchange devoted solely to the trading of stock options Options on futures contracts began trading in 1982 An American option can be exercised at any time before (and on) the expiration date A European option can be exercised only on the expiration date The trading process for options is similar to that for futures contracts The Chicago Board of Options Exchange (CBOE) opened in 1973 as the first exchange devoted solely to the trading of stock options Options on futures contracts began trading in 1982 An American option can be exercised at any time before (and on) the expiration date A European option can be exercised only on the expiration date The trading process for options is similar to that for futures contracts

27. 10-27 McGraw-Hill/Irwin Popular Options

28. 10-28 McGraw-Hill/Irwin More on Options The underlying asset on a stock option is the stock of a publicly traded company The underlying asset on a stock index option is the value of a major stock market index (e.g., DJIA or S&P 500) The underlying asset on a futures option is a futures contract Credit spread call options the value of a credit spread call option increases as the default (risk) premium or yield spread on a specified benchmark bond of the borrower increases above some exercise spread A digital default option pays a stated amount in the event of a loan default The underlying asset on a stock option is the stock of a publicly traded company The underlying asset on a stock index option is the value of a major stock market index (e.g., DJIA or S&P 500) The underlying asset on a futures option is a futures contract Credit spread call options the value of a credit spread call option increases as the default (risk) premium or yield spread on a specified benchmark bond of the borrower increases above some exercise spread A digital default option pays a stated amount in the event of a loan default

29. 10-29 McGraw-Hill/Irwin Swaps A swap is an agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval A plain vanilla interest rate swap is an exchange of fixed- interest payments for floating-interest payments by two counterparties the swap buyer makes a periodic fixed interest rate payment on a stated notional principal amount the swap seller makes a periodic floating-rate interest payments on the same stated notional principal amount no principal is exchanged A swap is an agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval A plain vanilla interest rate swap is an exchange of fixed- interest payments for floating-interest payments by two counterparties the swap buyer makes a periodic fixed interest rate payment on a stated notional principal amount the swap seller makes a periodic floating-rate interest payments on the same stated notional principal amount no principal is exchanged

30. 10-30 McGraw-Hill/Irwin Swaps A currency swap is a periodic exchange of one currency for another between the parties Usually associated with borrowing money The exchanges can be at a fixed or a variable rate of interest as negotiated in the contract, but the exchanges occur at a known currency exchange rate Used to hedge exchange rate risk from mismatched currencies of assets and liabilities A currency swap is a periodic exchange of one currency for another between the parties Usually associated with borrowing money The exchanges can be at a fixed or a variable rate of interest as negotiated in the contract, but the exchanges occur at a known currency exchange rate Used to hedge exchange rate risk from mismatched currencies of assets and liabilities

31. 10-31 McGraw-Hill/Irwin Hedging with a Swap Bank A (mill$) Assets Liabilities $150 Variable$100 Variable $150 Fixed$200 Fixed $300 Bank B (mill$) Assets Liabilities $150 Variable$200 Variable $150 Fixed$100 Fixed $300 A pays B variable rate of interest on $50 mill B pays A fixed rate of interest on $50 mill Arrows represent swap payments

32. 10-32 McGraw-Hill/Irwin Swaps Credit default swaps (CDS) allow financial institutions to hedge credit risk A CDS buyer is buying insurance on a loan or bond CDS seller receives periodic payments from the CDS buyer If the insured loan or bond defaults, the CDS seller pays the par value of the loan or bond to the CDS buyer CDS played a major role in the financial crisis, AIG and others were major sellers of CDS that insured mortgage- backed securities, but lacked capital and could not pay when the mortgage securities failed Credit default swaps (CDS) allow financial institutions to hedge credit risk A CDS buyer is buying insurance on a loan or bond CDS seller receives periodic payments from the CDS buyer If the insured loan or bond defaults, the CDS seller pays the par value of the loan or bond to the CDS buyer CDS played a major role in the financial crisis, AIG and others were major sellers of CDS that insured mortgage- backed securities, but lacked capital and could not pay when the mortgage securities failed

33. 10-33 McGraw-Hill/Irwin Swap Markets Swaps are not standardized contracts Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves The International Swaps and Derivatives Association (ISDA) is an association among 56 countries that sets codes of standards for swap documentation Swaps are not standardized contracts Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves The International Swaps and Derivatives Association (ISDA) is an association among 56 countries that sets codes of standards for swap documentation

34. 10-34 McGraw-Hill/Irwin Caps, Floors, and Collars Financial institutions use options on interest rates to hedge interest rate risk a cap is a call option on interest rates, often with multiple exercise dates a floor is a put option on interest rates, often with multiple exercise dates a collar is a position taken simultaneously in a cap and a floor (usually buying a cap and selling a floor) Financial institutions use options on interest rates to hedge interest rate risk a cap is a call option on interest rates, often with multiple exercise dates a floor is a put option on interest rates, often with multiple exercise dates a collar is a position taken simultaneously in a cap and a floor (usually buying a cap and selling a floor)

35. 10-35 McGraw-Hill/Irwin Regulators of Derivatives The primary regulator of futures markets is the Commodity Futures Trading Commission (CFTC) The Securities Exchange Commission (SEC) is the primary regulator of stock options and stock index options The CFTC is the regulator of options on futures contracts The primary regulator of futures markets is the Commodity Futures Trading Commission (CFTC) The Securities Exchange Commission (SEC) is the primary regulator of stock options and stock index options The CFTC is the regulator of options on futures contracts

36. 10-36 McGraw-Hill/Irwin Regulators of Derivatives Until the Dodd-Frank Act neither the SEC nor the CFTC directly regulated OTC derivatives such as swaps Under the new law OTC derivatives may be required to be traded on an exchange and as such would come under the purview of the SEC and CFTC Bank regulators will presumably more tightly regulate bank usage of derivatives Until the Dodd-Frank Act neither the SEC nor the CFTC directly regulated OTC derivatives such as swaps Under the new law OTC derivatives may be required to be traded on an exchange and as such would come under the purview of the SEC and CFTC Bank regulators will presumably more tightly regulate bank usage of derivatives

37. 10-37 McGraw-Hill/Irwin International Derivative Markets Securities in the U.S. markets and the euro and U.S. dollar are the most common bases for derivatives Summary of Text Table 10-11 & 10-12 Amounts of OTC Global Derivative Securities Outstanding (Bill $) ContractJun-08Dec-13% Growth Total OTC$683,814$632,579-7% Currency Contracts$62,983$67,3587% Interest Rate Contracts$458,304$489,7037% Equity Linked Contracts$10,177$6,251-39% Amounts of Exchange Traded Global Derivative Securities (Bill $) Futures Contracts$28,631.7$26,012.7-31% Option Contracts$55,655.0$33,796.2-21%

38. 10-38 McGraw-Hill/Irwin Black-Scholes Call Option Model