1. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 1 Chapter 2: Structure of Derivatives Markets The key to understanding derivatives is a deeper understanding of all that’s underlying. Morgan Stanley Dean Witter Advertisement in Derivatives Strategy, October 1997, p. 15 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 2 Important Concepts in Chapter 2 n Types of derivatives n Origins and development of derivatives markets n Exchange-listed derivatives trading n Over-the-counter derivatives trading n Clearing and settlement n Market participants n Transaction costs n Taxes n Regulation of derivatives markets © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 3 Types of Derivatives n Options n Forward contracts n Futures contracts n Swaps n Other types of derivatives © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 4 Options n Premium – price paid to buy an option n Call – right to buy n Put – right to sell n Exercise or strike price – fixed price to option buyer and buy (call) or sell (put) n Expiration date – options have finite lives n Moneyness – in-, at-, or out-of-the-money n European – exercise only on expiration date n American – exercise anytime before or on expiration date © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. Forward Contract n Forward contract is an obligation to engage in some transaction in the future, not a right n Forward price – analogous to exercise price n Initial forward value is typically zero n Forward price is the strike price where the call premium equals the put premium n Customizable n Counterparty default risk Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 5 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. Futures Contract n Similar to forward contract n Standardized n Transacted on organized exchange n Clearinghouse acts as intermediary n Liquidity n Futures price – price at which the underlying can be transacted at the expiration of the futures contract n Margin accounts required Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 6 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Swaps n Swap is a commitment between two parties to do a series of transactions in the future n Similar to forward contract, but involves multiple future transactions n Swaps can involve a variety of underlyings u Interest rates u Equity u Currency u Commodities Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 7 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Other Types of Derivatives n Embedded derivatives – when derivative is embedded in other assets u Callable bonds u Convertible bonds u Other instruments n Options on derivatives – option on swap, option on futures n Credit derivatives n Default option in bonds n Real options – e.g., options embedded in projects Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 8 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Origins and Development of Derivatives Markets n As old as stocks and bonds n Rice futures in Japan in 17 th century n Chicago Board of Trade (CBOT) opened in 1848 n Evolution of commodity derivatives u To arrive contracts became known as futures contracts u Commodity futures – wheat, corn, soybeans, gold n Chicago Butter and Egg Board opened in 1898 (now the CME Group) Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 9 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Evolution of Financial Derivatives n 1970 – fixed currency exchange rates ended n Foreign currency futures began trading at the CME n Financial futures popularity rose n 1973 – pivotal year u Fischer Black and Myron Scholes publish option model u Robert Merton publish rigorous foundations of model u CBOT spun off Chicago Board Options Exchange (CBOE) n Many more derivatives markets were subsequently launched Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 10 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Development of the OTC Market n Allows for customization n Over the counter (OTC) originated as investors purchased securities literally “over the counter” at broker’s offices n Regulations stemming from financial crisis of 2008-2009 are merging OTC and exchange traded products Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 11 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 12 Derivatives Exchanges n Largest derivatives exchanges (see Table 2.1) Table 2.1Table 2.1 n Derivatives exchanges span the globe n More than 20 billion contracts traded on world derivatives exchanges. Figure 2.1 shows breakdown between options (9.4 billion) and futures (12.2 billion) Figure 2.1Figure 2.1 n Exchanges are often for-profit companies n Exchange membership is often termed seats © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. Standardization of Contracts n Standardization advantages u Reduces costs u Improves efficiency n Derivatives standardization u Underlying u Expirations u Option exercise prices u Contract sizes u Unit of price quotation Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 13 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. Various Limits n Position limits – maximum number of contracts held n Exercise limits – number of options that can be exercised n Price limits u Limit up – maximum up move in underlying price u Limit down – maximum down move in underlying price n Limit move – price change that results in hitting limit n Locked limit – market where trading has stopped due to a limit move n Circuit breakers – automatic trading halts Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 14 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. Physical versus Electronic Trading n Physical trading was face-to-face in octagonal-shaped pits n Location in pit had specific meaning regarding contract maturity n Pit trading termed open outcry n Out-trade – discrepancy between traders caught by exchange process n GLOBEX at CME pioneering electronic trading system n Electronic trading reduced out-trade frequency Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 15 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. Mechanics of Trading n Types of orders u Market order u Limit order u Good-till-canceled order u Stop order u All or none order n Opening or closing orders u Opening order – order for derivative in which no position is currently held (increases open interest) u Closing order – order for derivatives that is opposite of a position previously taken (decreases open interest) Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 16 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. Expiration and Exercise Procedures n Offsetting order simply passes the derivative to someone else n With options, contracts can be exercised n At expiration, physical delivery or cash settlement via assignment n Exchange-for-physicals or against actuals – long and short agree on an alternative delivery procedure Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 17 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. OTC Derivatives Trading n Dealers – makes a market, quotes bid and ask prices n End-users – typically the one initiating the transaction n Trading platform – electronic quotation system, such as swap execution facilities n Bilateral contract – two parties agree, each promising to do something n ISDA Master Agreement – standardized OTC contract n Notional amounts and market values u Foreign Exchange/Interest Rate Forwards (Figure 2.2) Figure 2.2Figure 2.2 u Foreign Exchange/Interest Rate Swaps (Figure 2.3) Figure 2.3Figure 2.3 u Foreign Exchange/Interest Rate/Equity Options (Figure 2.4) Figure 2.4Figure 2.4 Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 18 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Orders and Procedures n OTC early termination u Offset with original party u Offset with another party F Both contracts remain F Financial risk offset F Default risk remains n Cash settlement common in OTC market Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 19 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. Clearing and Settlement n Role of clearinghouse u Futures transaction on derivatives exchange (see Figure 2.5) Figure 2.5Figure 2.5 u Options transaction on derivatives exchange (see Figure 2.6) Figure 2.6Figure 2.6 Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 20 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. Daily Settlement n Clearinghouse means of credit risk management is through margin deposit (or performance bond) n Initial margin – amount deposited on day transaction opened n Maintenance margin – amount that must be maintained every day thereafter n Settlement price – average of last few trades of day n Marked to market – gains/losses charged daily, process called daily settlement n Margin call – additional funds required n Variation margin – additional funds deposited Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 21 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. Market Participants n Market maker – quotes bid and ask prices n Scalpers – hold positions for very short period of time n Floor broker (futures commission merchant) – execute orders for non-members of exchange n Traders – execute trades for themselves or their company u Position traders – view driven u Arbitrageurs – seek profits for misalignment of prices Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 22 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

23. Transaction Costs n Floor trading and clearing fees n Commissions n Bid-Ask Spreads n Delivery Costs n Other Transaction Costs n Taxes Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 23 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

24. Regulation of Derivatives Markets n Colorful history due to alignment with gambling n SEC, created in 1934, regulates securities and options on stocks as well as currencies n In U.S., regulations originated in Department of Agriculture n Commodities Futures Trading Commission created in 1974 n Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010 u Transparency u More multilateral clearing u Disclosure u Reduce systemic risk Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 24 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

25. Summary n Types of derivatives n Origins and development of derivatives markets n Exchange-listed derivatives trading n Over-the-counter derivatives trading n Clearing and settlement n Market participants n Transaction costs n Taxes n Regulation of derivatives markets Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 25 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

26. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 26 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

27. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 27 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

28. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 28 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

29. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 29 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

30. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 30 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

31. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 31 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

32. Chance/BrooksAn Introduction to Derivatives and Risk Management, 10th ed.Ch. 2: 32 (Return to text slide) © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.