1. ©2007, The McGraw-Hill Companies, All Rights Reserved Chapter Ten Derivative Securities Markets

2. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-2 McGraw-Hill/Irwin Derivative Securities: Chapter Overview Derivative security An agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future Derivative security An agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-3 McGraw-Hill/Irwin Examples of Derivatives Forward and futures contracts –currency forwards and futures –interest rate futures Options contracts –call option –put option Swaps –currency swap –interest rate swap Forward and futures contracts –currency forwards and futures –interest rate futures Options contracts –call option –put option Swaps –currency swap –interest rate swap

4. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-4 McGraw-Hill/Irwin Forwards and Futures Both are agreements to deliver (or take delivery of) a specified asset at a future date Prices of both are tied to the current price of the asset in the “spot” market Spot contract –agreement to purchase (or sell) an asset immediately Both are agreements to deliver (or take delivery of) a specified asset at a future date Prices of both are tied to the current price of the asset in the “spot” market Spot contract –agreement to purchase (or sell) an asset immediately

5. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-5 McGraw-Hill/Irwin Forward Markets Forward contract –an agreement to transact, involving the future exchange of a set amount of assets at a set price –participants hedge the risk that the future spot price of an asset will move against them FI’s are the major forward market participants Forward contract –an agreement to transact, involving the future exchange of a set amount of assets at a set price –participants hedge the risk that the future spot price of an asset will move against them FI’s are the major forward market participants

6. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-6 McGraw-Hill/Irwin Futures Markets Futures contract Initial margin Maintenance margin Futures contract Initial margin Maintenance margin

7. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-7 McGraw-Hill/Irwin Futures Trading Open-outcry auction Floor broker Professional traders Position traders Day traders Scalpers Long/Short position Clearinghouse Open interest Open-outcry auction Floor broker Professional traders Position traders Day traders Scalpers Long/Short position Clearinghouse Open interest

8. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-8 McGraw-Hill/Irwin Futures Contracts Outstanding, 1992-2003

9. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-9 McGraw-Hill/Irwin Options A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a prespecified price for a specified price within a specified period of time American option - can be exercised at any time before the expiration date European option - can only be exercised on the expiration date A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a prespecified price for a specified price within a specified period of time American option - can be exercised at any time before the expiration date European option - can only be exercised on the expiration date

10. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-10 McGraw-Hill/Irwin Definitions of a Call and a Put Call option –an option that gives a purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a prespecified exercise price on a prespecified date Put option –an option that gives a purchaser the right, but not the obligation, to sell the underlying security to the writer of the option at a prespecified price on a prespecified date Call option –an option that gives a purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a prespecified exercise price on a prespecified date Put option –an option that gives a purchaser the right, but not the obligation, to sell the underlying security to the writer of the option at a prespecified price on a prespecified date

11. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-11 McGraw-Hill/Irwin Payoff Function for Call Options Payoff Payoff function Gain for Buyer +  C 0 Stock Price X A S at expiration C -  Payoff Payoff function Loss for writer Payoff Payoff function Gain for Buyer +  C 0 Stock Price X A S at expiration C -  Payoff Payoff function Loss for writer

12. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-12 McGraw-Hill/Irwin Payoff Function for Put Options Payoff Gain Payoff function for Writer +  P 0 Stock Price D X at expiration -  P Payoff function Payoff for buyer Loss Payoff Gain Payoff function for Writer +  P 0 Stock Price D X at expiration -  P Payoff function Payoff for buyer Loss

13. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-13 McGraw-Hill/Irwin Option Values Intrinsic value of an option –Call Option –Put Option Time value of an option –the difference between an option’s price (or premium) and its intrinsic value Intrinsic value of an option –Call Option –Put Option Time value of an option –the difference between an option’s price (or premium) and its intrinsic value

14. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-14 McGraw-Hill/Irwin Intrinsic value vs. the Before Exercise Value of a Call Option Value intrinsic value (option (stock price - exercise price) premium) Before exercise price $12.50 Time Value $10.00 ($2.50) X = $50 S = $60 Stock Price Value intrinsic value (option (stock price - exercise price) premium) Before exercise price $12.50 Time Value $10.00 ($2.50) X = $50 S = $60 Stock Price

15. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-15 McGraw-Hill/Irwin Option Markets Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded Stock options Stock index options Options give investors a way to hedge Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded Stock options Stock index options Options give investors a way to hedge

16. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-16 McGraw-Hill/Irwin Options Market Activity, 1992-2004 (in thousands)

17. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-17 McGraw-Hill/Irwin Regulation of Futures and Options Markets The Commodity Futures Trading Commission (CFTC) –primary regulator of futures markets The Securities and Exchange Commission (SEC) –main regulator of stock options –regulates trading of stock options and stock index options The Commodity Futures Trading Commission (CFTC) –primary regulator of futures markets The Securities and Exchange Commission (SEC) –main regulator of stock options –regulates trading of stock options and stock index options

18. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-18 McGraw-Hill/Irwin Swaps An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval Allow firms to better manage their interest rate, foreign exchange, or credit risk Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval Allow firms to better manage their interest rate, foreign exchange, or credit risk Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction

19. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-19 McGraw-Hill/Irwin Swaps Definitions Interest rate swap Swap buyer Notional principal Swap seller Currency swap Interest rate swap Swap buyer Notional principal Swap seller Currency swap

20. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-20 McGraw-Hill/Irwin Swap Transactions Direct arrangement of swap Floating-Rate Payments Money Center Bank Thrift Fixed-Rate Payments Swap arranged by third-party intermediary (swap agent) Floating-Rate Floating-Rate Payment Payment Money Center Bank Swap Agent Thrift Fixed-Rate Fixed-Rate Payment Payment Direct arrangement of swap Floating-Rate Payments Money Center Bank Thrift Fixed-Rate Payments Swap arranged by third-party intermediary (swap agent) Floating-Rate Floating-Rate Payment Payment Money Center Bank Swap Agent Thrift Fixed-Rate Fixed-Rate Payment Payment

21. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-21 McGraw-Hill/Irwin Fixed-Floating Rate Swap Money Center Bank Thrift 10% Short-Term Assets fixed Long-Term Assets (C&I indexed loans) (fixed-rate mortgages) Long-Term Liabilities Short-Term Liabilities (5-year, 10% notes) LIBOR + 2% (1-year CDs) Money Center Bank Thrift 10% Short-Term Assets fixed Long-Term Assets (C&I indexed loans) (fixed-rate mortgages) Long-Term Liabilities Short-Term Liabilities (5-year, 10% notes) LIBOR + 2% (1-year CDs)

22. ©2007, The McGraw-Hill Companies, All Rights Reserved 10-22 McGraw-Hill/Irwin Caps, Floors, and Collars Cap –a call option on interest rates, often with multiple exercise dates Floor –a put option on interest rates, often with multiple exercise dates Collar –a position taken simultaneously in a cap and a floor Cap –a call option on interest rates, often with multiple exercise dates Floor –a put option on interest rates, often with multiple exercise dates Collar –a position taken simultaneously in a cap and a floor