2. Introduction
Futures, options, and swaps are complicated
instruments
However, they have found their way into the risk
management options of just about every major
financial institution
Derivatives—A financial instrument/contract that
derives its value from some other underlying asset
3. Futures Markets
Market in standardized contracts for future delivery
of various goods.
Arose in the mid-1800s in Chicago and
institutionalized an ancient form of contracting
called forward contracting.
1842, Chicago Board of Trade
1871, Fire destroyed all records.
4. Futures Contracts vs. Forward Contracts
Futures Contract
trade in an organized exchange.
standardized contract terms.
contract guaranteed by exchange (clearing corporation)
Forward Contract
transaction in which two parties agree in advance on the
terms of a trade to be executed later.
Non standardized contract terms.
More flexibility.
Difficult to find a trading partner.
5. An Overview of Financial Futures
Future Contract is a contractual agreement that calls
for delivery of a specific underlying commodity or
security at some future date at a currently agreed-
upon price
There are contracts on interest-bearing securities
(Treasury bonds, notes, etc), on stock indices
(Standard & Poors’ and Japan’s Nikkei index), and on
foreign currencies
6. An Overview of Financial Futures
Trading in these contracts is conducted on the
various commodity exchanges
Financial futures were introduced about 30 years
ago and volume now exceeds the more traditional
agricultural commodities
7. Characteristics of Financial Futures
Standardized agreement to buy/sell a particular asset or
commodity at a future date and a current agreed-upon price
Designed to promote liquidity—the ability to buy and sell
quickly with low transactions costs
Promotes large trading volume which narrows the bid-asked
spreads
Allows many individuals to trade the identical commodity
8. Characteristics of Financial Futures
Terms specify the amount and type of asset as well
as the location and delivery period
Financial futures—underlying asset is either a specific
security or cash value of a group of securities
Stock index futures—contract calls for the delivery of
the cash value of a particular stock index
9. Characteristics of Financial Futures
Precise terms of each contract are established by the
exchange that sponsors trading in the contracts
Seller of the contract has the obligation to deliver the
securities at a specified time
In futures markets, the buyer of the contract is called
long and the seller is called short
10. Price of the Contract
The price is determined by bidding and offering
that occurs at the location (pit) of the exchange
sponsoring the auction
The auction process insures that all orders are
exposed to highest bid and lowest offer,
guaranteeing execution at the best possible price
11. Market Structure
Open outcry
Traders call out offers to buy or sell.
Gives appearance of chaos.
Gives all traders in the pit the opportunity to accept
the offer.
Seat on the exchange
Floor Traders
12. Clearing Corporation
The clearing corporation associated with the exchange acts as
a middleman in the transaction
Reduce the credit risk exposure associated with future deliveries
Longs and shorts do not have to worry that the other party will not
perform their contractual obligations
Requires the short and long to place a deposit (Margin) which is a
performance bond for both the seller and buyer
Requires that gains and losses be settled each day in the mark-to-
market operation
13. Settlement by Offset
To insure the obligations are met at the delivery date,
most trades in futures market choose settlement by
offset rather than delivery
Both parties make offsetting sales/purchases to cover the
contract
Permits hedgers, speculators, and arbitrageurs to make
legitimate use of the futures market without getting into
technical details of making or taking delivery of assets
14. Using Financial Futures Contracts
Provides the opportunity to hedge legitimate commercial
activities
Allows participants to alter their risk exposure
Hedgers—buy and sell futures contracts to reduce their
exposure to the risk of future price movement
Permits dealers to cover both the short and long position of a
contract
Reduces risk since future prices move almost in lockstep with
the price of the underlying asset
15. Hedging Vs. Speculating
“Short hedgers” offset inventory risk by selling futures
while “long hedgers” offset anticipated purchases of
securities by buying futures
Speculators
Purposely take on risk of price movement
Expect to make a profit on the risky transaction
16. Arbitrageurs
Arbitrageurs
Determine the relationship between the price in the
“cash market” and the price in the futures market
During the delivery period of a futures contract, the
rights and obligations of the contract force the price of
the futures contract and the price of the underlying
security to be identical
17. Arbitrageurs
If the arbitrageur senses the price relationship
between the futures contract and the underlying asset
is not correct, take actions in the market (buy or sell)
to make a profit which forces the prices into proper
relationship
The activities of arbitrageurs cause the prices to
converge on the delivery date or be in proper
alignment during periods prior to final delivery
date
18. Liquidating a Position
Settlement dates
Nearby contract
Distant contract
Cash settlement contracts
Settlement by offset
Open interest
number of contracts obligated for delivery.
Each open transaction has a buyer and a seller, but for
calculation only one side of the contract is counted.
19. Futures Data
Wall Street Journal
Chicago Board of Trade
Chicago Mercantile Exchange
20. An Overview of Options Contracts
Options on individual stocks have been traded in
over-the-counter market since nineteenth century
Increased visibility in 1972 when the Chicago Board
Options Exchange (CBOE) standardized terms of
contracts and introduced futures-type pit trading
21. Stock Options
Prior to 1973, over-the-counter market
fragmented
high transaction costs
no liquidity
CBOE established April 26, 1973 and begin trading
options on 16 stocks
creation of central market place
introduction of a clearing corporation
standardization
secondary market
June 1, 1977, SEC allowed trading in puts
22. Options
Contractual Obligations
Derive their value from some underlying asset
A specified number of shares of a particular stock
Stock Index Option—Basket of equities represented by
some overall stock index such as S&P 500
In options on future contracts, the contractual obligations call
for delivery of one futures contract
23. Call Options
Buyer of a call option (long) has the right (not
obligation) to buy a given quantity of the
underlying asset at a predetermined price
(exercise or strike) at any time prior to the
expiration date
24. Call Options
Seller of the call option (short) has the obligation to
deliver the asset at the agreed price
Therefore, rights and obligations of option buyers
and sellers are not symmetrical
Buyer of the call option pays a price to the seller for
the rights acquired (option premium)
25. Put Options
Buyer of a put option has the right (not obligation) to
sell a given quantity of the underlying asset at a
predetermined price before the expiration date
Seller of the option (short) has the obligation to buy
the asset at the agreed price
The buyer of the put option pays a premium to the
seller
26. Summary
Option buyers have rights; option sellers have
obligations
Call buyers have the right to buy the underlying
asset
Put buyers have the right to sell the asset
In both puts and calls the option buyer pays a
premium to the option seller
27. Clearing Corporation
The exchange sponsoring the options trading established rules
for trading
Standardization is designed to generate interest by potential
traders, thereby contract liquidity
Clearing Corporation
Guarantees the performance of contractual obligations
Buyers and sellers do not have to be concerned with creditworthiness of
their trading partners
Only matter up for negotiation is option premium—price
buyer pays to seller for rights
28. Using and Valuing Options
Investors who buy options (puts or calls) have rights,
but no obligations
Therefore, option buyers will do whatever is in their
best interest on expiration date
On expiration date, payoff on expiration of a long
call position is either zero (price below exercise price)
or stock price minus exercise price (intrinsic value)
(price above the exercise price)
29. Using and Valuing Options
A long put position on expiration date has a value
of zero if price is above the exercise price or a
value equal to the exercise price minus the stock
price if price is below the exercise price
Option Premium—The asymmetry payoff has the
characteristic of insurance which is why the premium
is charged on the transaction
30. Option Premiums - Calls
Option premiums are determined by supply and
demand
Call options are worth more (higher premiums) the
higher the price and the greater the volatility of the
underlying asset, and the longer the time to
expiration of the option
31. Option Premiums - Puts
Premiums on put options will be higher the lower
the price of the underlying asset, greater volatility
of asset and longer time to expiration
Options are an expensive way to hedge portfolio
risks if those risks are substantial
32. Options Terminology
Option price (premium) (V)
Exercise price (strike price) (E)
Expiration date (maturity date) - Saturday following the 3rd
Friday of specified month.
American vs. European Options
American option - may be exercised at any time up to maturity.
European option - may be exercised only at the date of maturity.
In-the-money
Out-of-the money
At-the-money
33. Pricing of Options
The Pricing of Call Options at Expiration:
If VS < E, the VC=0
If VS > E, the VC= VS-E
The prices of options on stocks without cash dividends depend
upon five factors:
Stock price
Exercise Price
Time until Expiration
Volatility of the Underlying Stock
Risk-free Interest Rate
34. Options Investors Buy Hedges,
Then Hunker Down and Wait
NEW YORK -- Option trading was defensive but noncommittal, mirroring
investors' guarded ambivalence as they endured updates of the Iraq
standoff, terrorism alerts and a reminder from the Federal Reserve about
the precarious state of the economy.
Here is what one investor did: John Jacobs, who runs the Jacobs & Co.
mutual fund in Charleston, W.V., this week bought 1,500 March 79 puts on
the DJX, which has one-hundredth the value of the Dow Jones Industrial
Average. The puts provide downside insurance through mid-March,
particularly if the Dow industrials remain below 7900. "We're being very
defensive to protect the stock side, where we have been writing covered
calls," he said, referring to the fund's approach of investing in blue-chip
stocks and selling call options against the stocks for income.
35. To help offset the cost of buying the puts, Mr. Jacobs sold 1,000 DJX
February 77 puts Tuesday, essentially betting the blue-chip index will hold
its ground in the immediate term. Mr. Jacobs said he believes blue-chip
stocks are oversold and could get a small lift from Fed Chairman Alan
Greenspan's somewhat-encouraging comment that capital spending should
improve once the Iraq situation is resolved. Also, he said, any terrorist
attacks that would roil the markets are less likely to occur until after the
hajj, the climax of the Muslim pilgrimage to Mecca later this week.
Mr. Jacobs plans to buy back the February 77 puts later this week,
possibly at a cheaper price because the short-term puts lose their value
rapidly as they approach expiration next week.
The Dow industrials fell 77 points to 7843.11. At the Chicago Board
Options Exchange, the DJX March 79 puts gained 20 cents to $3.70. The
DJX February 77 puts gained 20 cents to $1.40.
36. Caution remains the watchword. "In this market, you should be
more concerned about protecting profits than giving up
upside," says Elliot Spar, Ryan Beck & Co. option strategist.
One way investors protect profits, Mr. Spar said, is with so-
called collars, where an investor sells a call to define a target
price at which he is willing to sell stock while using the
proceeds to buy a put for downside protection. "This puts a
floor under the stock and caps the upside" at the strike price of
the call, he said.
37. Options Data
Wall Street Journal
Chicago Board Options Exchange
38. Swaps
The 1st major swap occurred in August of 1981.
The World Bank issued $290 million in eurobonds
and swapped the interest and principal on these
bonds with IBM for Swiss francs and German marks.
39. An Overview of Swaps
Two broad varieties—Interest rate swaps and
currency swaps
Swaps are contractual agreement between two
parties (counterparties) and customized to meet the
requirements of both parties
40. Counter parties
Fixed-rate payer
Partyto a swap that makes fixed-rate payments in
exchange for floating-rate payments.
Floating-rate payer
Partyto a swap that makes floating-rate payments in
exchange for fixed-rate payments.
42. Interest Rate Swap
The fixed-rate payer always pays the same amount
while payments by the floating-rate payer varies
according to the reference rate
The dollar amount of the payments is determined by
multiplying the interest rate by an agreed-upon
principal (notional principal amount)
43. What determines the rates paid by
both parties?
Shape of the yield curve—expected rates in the
future
Risk of default—possibility that counterparties might
default on scheduled interest payments
Financial institutions facilitate swaps
Act as the Swap Dealer
Bring the counterparties together
Impose their own credit between the counterparties
44. The Swap Dealer
Commission compensates the dealer
For matching parties in the swap.
For risk of default by the counter parties.
Dealer can reduce risk by diversifying swaps across
many unrelated counter parties.
Offers liquidity - willing to cancel contract in
exchange for an appropriate payment.
45. Valuing a Swap
Contracts are traded in over-the-counter market
It is possible for one of the counterparties to sell their
obligation to another party
Changing market conditions may cause one party to sell
obligation
The third party will purchase the swap if it is to their
advantage
Therefore, swaps produce gains or losses which will ultimate
impact the value of the swap
46. A Simple Interest Rate Swap
This Year
Bank One Bank Two
Two-year loans earn Two-year loans earn 8%
9% fixed variable
Deposits cost 5% Deposits cost 6% fixed
variable
47. Next year – rates go up.
Bank One Bank Two
Loans earn 9% Loans earn 12%
fixed variable
Deposits cost 9% Deposits cost 6% fixed
variable
48. Next Year Rates Go
Down
Bank One Bank Two
Loans earn 9% fixed Loans earn 5% variable
Deposits cost 2% Deposits cost 12%
variable variable
49. Next Year Rates Go Up They swap.
Bank One Bank Two
Loans earn 9% fixed Loans earn 12%
variable
Deposits cost 6% fixed Deposits cost 9%
variable
50. Next Year Rates Go They swap.
Down
Bank One Bank Two
Loans earn 9% fixed Loans earn 5%
variable
Deposits cost 6% fixed Deposits cost 2%
variable
52. Currency Swaps
Two companies agree to exchange a specific
amount of one currency for a specific amount of
another at specific dates in the future.