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Chapter 11 Futures, Options, and Swaps: Managing Risk © 2000 South-Western College Publishing
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2 Forward Transactions Transactions in which terms, including price, are completed today for transactions that will occur in the future Two Problems: finding partners may be difficult one party may default
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3 What is hedged? Reduced risk
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4 Futures Contracts Standardized agreements in agriculture and commodity markets to trade a fixed amount of the asset on specific dates in the future at a price determined today
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5 Financial Futures Markets Organized markets that trade financial futures, including the Chicago Board of Trade, the Chicago Mercantile Exchange, the London International Financial Futures Exchange, and so on
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6 Financial Futures Standardized contracts between two parties to trade financial assets at a future date, in which the terms including the price of the transaction are determined today
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7 The pit is... The trading area on the floor of an exchange where authorized brokers gather to buy and sell for their customers
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8 Clearinghouse The part of the exchange that takes on the responsibility of enforcing the contract, after the agreement is struck
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9 Performance Bond A bond required by the exchange of both the buyer and seller of a futures agreement to insure that both parties abide by the agreement
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10 Margin Requirement The amount that brokers must collect from their customers before they make any futures purchases or sales
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11 Arbitrageurs are... Traders who make riskless profits by buying in one market and reselling in another
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12 Carrying Costs Interest costs for funds used to purchase the security underlying a futures contract plus any transactions costs
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13 Cracking the Code on Futures Prices Open High Low Settle Chg Settle Chg Interest Sept.94.99 95.01 94.99 94.99 …. 5.01 …. 4377 Dec.95.04 95.06 95.04 95.04 …. 4.96 …. Est vol 474; vol Wed 26; open int 4,600 + 3. The Wall Street Journal
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14 Convergence The phenomenon in which the futures price is bid up or down to the spot price plus carrying costs; the futures price approaches the spot price as the expiration date draws nearer
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15 Options are... Standardized contracts that give the buyer the right but not the obligation to buy or sell an asset in the future at a price determined today
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16 Strike Price The agreed-upon price in an options contract
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17 Options on Futures Options that give the buyer the right but not the obligation to buy or sell a futures contract up to the expiration date on the option
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18 Stock Index Futures and the ‘87 Crash Stock Index Futures - contracts that give the buyer or seller the right and obligation to purchase or sell a multiple of the value of a stock index at some specific date in the future at a price determined today Program Trading - the preprogramming of computers to automatically issue buy and sell orders for stocks as stock prices change Stop Orders - orders to automatically sell if the stock falls to a certain level
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19 Put Options Options that give the buyer of the option the right buy not the obligation to sell a standardized contract of a financial asset at a strike price determined today
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20 Call Options Options that give the buyer of the option the right but not the obligation to buy a standardized contract of a financial asset at a strike price determined today
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21 Option Premium The premium paid by the buyer of the option to compensate the seller for accepting the risk of a loss with no possibility of a gain
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22 Swaps Agreements in which two parties trade interest payment streams to guarantee that the inflows of payments will more closely match outflows
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23 Cracking the Code on Options Strike Price Calls-Settle Puts-Settle Aug Sep Dec Aug Sep Dec 122 1-21 1-52 2-38 0-01 0-32 1-36 The Wall Street Journal
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24 A Simple Interest Rate Swap Bank One Two-year loans earn 9% fixed Deposits cost 5% variable Exhibit 11 - 1 This Year Bank Two Two year loans earn 8% variable Deposits cost 6% fixed Next Year Rates Go Up - No Swap Bank One Loans earn 9% fixed Deposits cost 9% variable Bank Two Loans earn 12% variable Deposits cost 6% fixed Bank One Loans earn 9% fixed Deposits cost 2% variable Bank Two Loans earn 5% variable Deposits cost 6% fixed Next Year Rates Go Down - No Swap
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25 A Simple Interest Rate Swap Bank One Loans earn 9% fixed Deposits cost 6% fixed Exhibit 11 -1 cont. Bank One Loans earn 9% fixed Deposits cost 6% fixed Bank Two Loans earn 5% variable Deposits cost 2% variable Bank Two Loans earn 12% variable Deposits cost 9% fixed The swap allows both banks to be happy all the time! Next Year Rates Go Up - They Swap Next Year Rates Go Down - They Swap
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