1. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter Ten Derivative Securities Markets Dr. Ahmed Y Dashti MBA524

2. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Derivative Securities: Chapter Overview Derivative security –a financial security whose payoff is linked to another previously issued 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 –a financial security whose payoff is linked to another previously issued 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 الدوات المالية المشتقة

3. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 العقود الاجلة و المستقبلية عقود الخيارات

4. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 future spot prices on an asset will move against them FI’s are the major forward market participants and make a profit on the spread between the price at which they originate and sell forward contracts 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 future spot prices on an asset will move against them FI’s are the major forward market participants and make a profit on the spread between the price at which they originate and sell forward contracts

6. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Futures Markets Futures contract –an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily - marked to market daily Initial margin –a deposit required on futures trades to ensure terms of any futures contract will be met Maintenance margin –the margin a futures trader must maintain once a futures position is taken. Futures contract –an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily - marked to market daily Initial margin –a deposit required on futures trades to ensure terms of any futures contract will be met Maintenance margin –the margin a futures trader must maintain once a futures position is taken. الهامش المبدئ الهامش المستمر

7. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Futures Trading Occurs on organized exchanges such as CBT and CME or IMM Open-outcry auction - traders face each other and “cry out” their offer to buy or sell Floor broker - Exchange members who place trades from the pubic Professional traders - Exchange members who trade for their own account Position traders - take a position in the futures market based on their expectations of future prices Occurs on organized exchanges such as CBT and CME or IMM Open-outcry auction - traders face each other and “cry out” their offer to buy or sell Floor broker - Exchange members who place trades from the pubic Professional traders - Exchange members who trade for their own account Position traders - take a position in the futures market based on their expectations of future prices (continued)

8. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Day traders - exchange members who take a position within a day and liquidate it before day’s end Scalpers - exchange members who take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading Long position - a purchase of a futures contract Short position - a sale of a futures contract Clearinghouse - the unit that oversees trading on the exchange and guarantees all trades made by the exchange traders Open interest - total number of futures, put options, or call option contracts outstanding at the beginning of the day Day traders - exchange members who take a position within a day and liquidate it before day’s end Scalpers - exchange members who take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading Long position - a purchase of a futures contract Short position - a sale of a futures contract Clearinghouse - the unit that oversees trading on the exchange and guarantees all trades made by the exchange traders Open interest - total number of futures, put options, or call option contracts outstanding at the beginning of the day

9. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Futures Contracts Outstanding, 1992-1999

10. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Contract Time Lines Spot 0 1 2 3 months Price Agreed/Paid + Bonds delivered Forward 0 1 2 3 months Price Agreed Price paid/bonds delivered Marking to Market every day Futures 0 1 2 3 months Contract entered/Time 0 price EOM 3 price paid/bonds delivered Spot 0 1 2 3 months Price Agreed/Paid + Bonds delivered Forward 0 1 2 3 months Price Agreed Price paid/bonds delivered Marking to Market every day Futures 0 1 2 3 months Contract entered/Time 0 price EOM 3 price paid/bonds delivered

11. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

12. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 خيار النداء خيار الإجبار

13. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

14. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

15. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Option Values Intrinsic value of an option –the difference between an option’s exercise price and the underlying asset’s price Time value of an option –the difference between an option’s price (or premium) and its intrinsic value Intrinsic value of an option –the difference between an option’s exercise price and the underlying asset’s price Time value of an option –the difference between an option’s price (or premium) and its intrinsic value القيمة الزمنية -المضارب القيمة الحقيقية

16. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

17. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 - the underlying asset on a stock option contract is the stock of a publicly traded company, generally 100 shares Stock index options - the underlying asset on a stock index option is the value of a major stock market index (e.g., the DJIA or S&P 500) Options give investors a way to hedge their existing stock portfolios Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded Stock options - the underlying asset on a stock option contract is the stock of a publicly traded company, generally 100 shares Stock index options - the underlying asset on a stock index option is the value of a major stock market index (e.g., the DJIA or S&P 500) Options give investors a way to hedge their existing stock portfolios

18. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Options Market Activity, 1992-1999 (in thousands)

19. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Regulation of Futures and Options Markets The Commodity Futures Trading Commission (CFTC) is the primary regulator of futures markets –protects the trading public by seeking to prevent misrepresentation and/or market manipulation –approves new or proposed contracts to ensure they have economic purpose, conducts economic studies, enforces rules and provides regulatory surveillance The Securities and Exchange Commission (SEC) is the main regulator of stock options –regulates trading of stock options and stock index options The Commodity Futures Trading Commission (CFTC) is the primary regulator of futures markets –protects the trading public by seeking to prevent misrepresentation and/or market manipulation –approves new or proposed contracts to ensure they have economic purpose, conducts economic studies, enforces rules and provides regulatory surveillance The Securities and Exchange Commission (SEC) is the main regulator of stock options –regulates trading of stock options and stock index options

20. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 and 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 and credit risk Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction

21. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Swaps Definitions Interest rate swap - an exchange of fixed-interest payments for floating-interest payments by two counterparties Swap buyer - a party that makes the fixed-rate payments in an interest rate swap transaction Notional principal - principal amount involved in a swap Swap seller - a party that makes the floating-rate payments in an interest rate swap transaction Currency swap - used to hedge against exchange rate risk from mismatched currencies on assets and liabilities Interest rate swap - an exchange of fixed-interest payments for floating-interest payments by two counterparties Swap buyer - a party that makes the fixed-rate payments in an interest rate swap transaction Notional principal - principal amount involved in a swap Swap seller - a party that makes the floating-rate payments in an interest rate swap transaction Currency swap - used to hedge against exchange rate risk from mismatched currencies on assets and liabilities

22. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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

23. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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)

24. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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