1. ©2009, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Ten Derivative Securities Markets

2. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-2 McGraw-Hill/Irwin Derivatives A derivative security is an agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specific date in the future Derivative securities markets are the markets in which derivative securities trade Derivatives involve the buying and selling (i.e., the transfer of) risk, which results in a positive impact on the economic system Derivatives are used for hedging and for speculation A derivative security is an agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specific date in the future Derivative securities markets are the markets in which derivative securities trade Derivatives involve the buying and selling (i.e., the transfer of) risk, which results in a positive impact on the economic system Derivatives are used for hedging and for speculation

3. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-3 McGraw-Hill/Irwin Derivatives 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) after the Fed started to target nonborrowed reserves in the late 1970s The third wave of modern derivatives occurred in the 1990s with the advent of credit derivatives 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) after the Fed started to target nonborrowed reserves in the late 1970s The third wave of modern derivatives occurred in the 1990s with the advent of credit derivatives

4. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-4 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 transact involving the future exchange of a set amount of assets at a set price A futures contract is a standardized exchange traded agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily A spot contract is an agreement to transact involving the immediate exchange of assets and funds A forward contract is a nonstandardized agreement to transact involving the future exchange of a set amount of assets at a set price A futures contract is a standardized exchange traded agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily

5. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-5 McGraw-Hill/Irwin Futures Markets Futures contracts are usually traded on organized exchanges Exchanges indemnify counterparties against credit (i.e., default) risk Futures are market to market daily –marked to market describes the prices on outstanding futures contracts that are adjusted each day to reflect current futures market conditions The five major U.S. exchanges are the CBOT, CME, NYFE, MACE, and KCBOT The principal regulator of futures markets is the Commodity Futures Trading Commission (CFTC) Futures contracts are usually traded on organized exchanges Exchanges indemnify counterparties against credit (i.e., default) risk Futures are market to market daily –marked to market describes the prices on outstanding futures contracts that are adjusted each day to reflect current futures market conditions The five major U.S. exchanges are the CBOT, CME, NYFE, MACE, and KCBOT The principal regulator of futures markets is the Commodity Futures Trading Commission (CFTC)

6. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-6 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

7. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-7 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

8. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-8 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

9. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-9 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 Futures trades are leveraged investments as traders post and maintain only a small portion of the value of their futures position and “borrow” the rest from brokers 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 Futures trades are leveraged investments as traders post and maintain only a small portion of the value of their futures position and “borrow” the rest from brokers

10. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-10 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

11. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-11 McGraw-Hill/Irwin Payoff Payoff function profitfor buyer C 0 Stock Price Xat expiration -C Payoff Payoff function lossfor writer Payoff Payoff function profitfor buyer C 0 Stock Price Xat expiration -C Payoff Payoff function lossfor writer OptionsPayoff Functions for Call Options

12. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-12 McGraw-Hill/Irwin PayoffPayoff function profitfor buyer P 0 Stock Price Xat expiration -P PayoffPayoff function lossfor writer PayoffPayoff function profitfor buyer P 0 Stock Price Xat expiration -P PayoffPayoff function lossfor writer OptionsPayoff Functions for Put Options

13. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-13 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}

14. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-14 McGraw-Hill/Irwin Please insert Figure 10-8 here.

15. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-15 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

16. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-16 McGraw-Hill/Irwin 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 swaps –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 swaps –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

17. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-17 McGraw-Hill/Irwin Options 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

18. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-18 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 An interest rate swap is an exchange of fixed-interest payments for floating-interest payments by two counterparties –the swap buyer makes the fixed-rate payments –the swap seller makes the floating-rate payments –the principal amount involved in a swap is called the notional principal A currency swap is a swap used to hedge against exchange rate risk from mismatched currencies on assets and liabilities Credit swaps allow financial institutions to hedge credit risk 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 An interest rate swap is an exchange of fixed-interest payments for floating-interest payments by two counterparties –the swap buyer makes the fixed-rate payments –the swap seller makes the floating-rate payments –the principal amount involved in a swap is called the notional principal A currency swap is a swap used to hedge against exchange rate risk from mismatched currencies on assets and liabilities Credit swaps allow financial institutions to hedge credit risk

19. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-19 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 a 815 member 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 a 815 member association among 56 countries that sets codes of standards for swap documentation

20. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-20 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)

21. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-21 McGraw-Hill/Irwin International Derivative Markets The U.S. dominates the global derivative securities markets –North America accounted for $57.94 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 2007 The euro and European exchanges are expanding –Europe accounted for $32.28 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 2007 The U.S. dominates the global derivative securities markets –North America accounted for $57.94 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 2007 The euro and European exchanges are expanding –Europe accounted for $32.28 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 2007

22. ©2009, The McGraw-Hill Companies, All Rights Reserved 10-22 McGraw-Hill/Irwin Black-Sholes Call Option Model