Chapter Ten Derivative Securities Markets Mc GrawHill Irwin

Chapter Ten Derivative Securities Markets Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter Outline 1. 2. 3. 4. 5. Overview Futures and Forwards Options Regulation of Futures and Options Markets Swaps

1. Derivative Securities: Overview • Derivative security – a financial security whose payoff is linked to another previously issued security • Forward and futures contracts – currency forwards and futures – interest rate futures • Options contracts – call option – put option • Swaps – currency swap – interest rate swap

Uses of Derivatives • Hedging – Reducing risk • Speculating – Increasing risk • Arbitrage – Taking advantage of pricing differences between markets • Leverage – With derivatives you can control a large amount of the underlying asset with at relatively small initial investment

2. 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

2. 1 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

2. 2 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 • Futures trading – Occurs on organized exchanges such as CBT and CME or IMM – Clearinghouse oversees trading on the exchange and guarantees all trades made by the exchange traders

Futures Trading • Open-outcry auction - traders face each other and “cry out” their offer to buy or sell • Long position - a purchase of a futures contract • Short position - a sale of a futures contract • 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. (continued) Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

3. Options • A contract that gives the holder (option buyer) the right, but not the obligation, to buy or sell an asset at a prespecified 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

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

Payoff Function for Call Options Payoff Gain Payoff function for Buyer C 0 X A S Stock Price at expiration C Payoff Loss Mc. Graw-Hill /Irwin Payoff function for writer Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Payoff Function for Put Options Payoff Gain Payoff function for Writer 0 D Payoff Loss Mc. Graw-Hill /Irwin X Stock Price at expiration Payoff function for buyer Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Options Market Activity, 1992 -2004 (in thousands) Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

4. 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 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 Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

5. Swaps • An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified price. • 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

Swaps Definitions • Swap buyer - a party that makes the fixed-rate payments in an interest rate swap transaction • Swap seller - a party that makes the floatingrate payments in an interest rate swap transaction • Notional principal - principal amount involved in a swap

Swaps Definitions • Interest rate swap - an exchange of fixedinterest payments for floating-interest payments by two counter parties • Currency swap - used to hedge against exchange rate risk from mismatched currencies on assets and liabilities

Swap Transactions Direct arrangement of swap Floating-Rate Payments Money Center Bank Fixed-Rate Payments Thrift Swap arranged by third-party intermediary (swap agent) Floating-Rate Payment Money Center Bank Floating-Rate Payment Swap Agent Fixed-Rate Payment Thrift Fixed-Rate Payment

Fixed-Floating Rate Swap Money Center Bank Short-Term Assets (C&I indexed loans) Long-Term Liabilities (5 -year, 10% notes) Mc. Graw-Hill /Irwin Thrift 10% fixed LIBOR + 2% Long-Term Assets (fixed-rate mortgages) Short-Term Liabilities (1 -year CDs) Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Pound/Dollar Currency Swap U. S. FI U. K. FI Dollar Assets Pound Assets Dollars Pound Liabilities (L 100 m, 6% coupon) Mc. Graw-Hill /Irwin Pounds Dollar Liabilities ($200 m, 6% coupon) Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.