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Chapter 9
Money and Capital
Markets

CHAPTER OUTLINE
I.
An Overview of Financial Futures
A. Using financial futures contracts
B. Pricing financial futures contracts
II. An Overview of Options Contracts
A. Using and valuing options
B. What determines option premiums
III. An Overview of Swaps
A. Why swap?
B. Valuing a swap

CHAPTER SUMMARY
The name derivative comes from the fact that a derivative contract derives its value from the value of an
underlying security. This chapter describes some of the basic characteristics of the main categories of
derivative contracts (futures, options, and swaps) and explains how these derivatives are priced and used.
Futures contracts are used by financial institutions to reduce the risk of price changes in the underlying
security. Long hedgers buy futures, while short hedgers sell futures. For example, a bank that wishes to
protect against the possible loss in value of its assets if interest rates rise and prices fall should short hedge
(i.e., sell futures contracts on those assets). If prices fall, these contracts will rise in value to offset the
losses on the bank’s balance sheet.
Options contracts provide the right, but not the obligation, to sell (put option) or buy (call option) the
underlying security at a stated price (strike or exercise price) on or before the contract’s expiration date.
Options are essentially an insurance policy against an adverse price movement and option writers (sellers)
charge a premium to provide this insurance. Financial institutions can use options to hedge balance sheet
risk, much as described above for futures contracts. Option prices rise when the price of the underlying
security is more volatile or when the expiration date is further in the future, because these factors increase
the risk to the seller that the option will be exercised.
Interest rate swaps are contractual agreements between two parties to exchange interest payments over a
specified time period. Financial institutions like swaps because they provide a low transactions cost
method for reducing the risk associated with a mismatch of maturities on their assets and liabilities.

TEACHING
This chapter explores the options and futures markets in detail, and a final section discusses interest-rate
swaps. Emphasize the use of these instruments in portfolio composition and risk reduction. Point out the
differences between options and futures. Material from financial news sources can readily be included in
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26  Ritter/Silber/Udell Money, Banking, and Financial Markets, Eleventh Edition
class discussions. A common sticking point for students is distinguishing between changes in the value or
premium of an option contract and the value of the underlying security. Also emphasizing the difference
between selling an option and exercising a put option is usually well worth the time. Comparing put
options to auto insurance is a useful way of making the connection between options and insurance. More
volatile drivers pay higher insurance premiums, just as more volatile stock prices cause underlie options
with higher premiums.
If pressed for time, the final section on swaps can be cut.
Useful Internet sites
1.
2.
http://www.numa.com/ — for links to lots of basic information about derivatives and their markets.
http://www.ex.ac.uk/~RDavies/arian/scandals/derivatives.html — for the cynic, a list of links to sites
concerning economic scandals including some related to derivative trading.

DISCUSSION QUESTIONS
1.
What are speculators? Do they have a destabilizing effect on the financial system?
They take open positions in derivative markets in the hope of making a profit. While they
could conceivably have a destabilizing effect, they are more likely to have a stabilizing
effect as they are likely to position themselves to profit when prices are away from long-run
equilibrium. They also add depth to the markets, which makes hedging much easier.
2.
Under what conditions would you be a long hedger in financial futures? A short hedger?
A long hedger wishes to protect against a rise in the price of the underlying asset. A short
hedger wishes to protect against a fall in the price of an asset.
3.
Would you buy stock index futures at this time based on the S&P 500?
Yes, if I were extremely confident that the S&P 500 index would rise above the price of the
futures contract.
4.
What are financial futures used for?
Hedgers use them to offset other positions so that a price movement that causes losses on
these positions will cause gains on their financial futures position. Speculators use
financial futures to “bet” on certain price movements. That is, a speculator who believe
prices on an asset will rise can take a long position in a futures contract that will payoff if
prices actually do rise. Though these same positions could be taken by buying the
underlying security, futures contracts allow the investor greater leverage.
5.
Aren’t financial futures and options markets just serving a speculative buildup of asset prices
fueled by greed?
No, it is much more like insurance against an undesirable outcome. Though it is essentially
gambling for speculators, but it actually reduces risks for hedgers. Moreover, speculators
could actually serve to reduce “speculative buildup.”

1.
ANSWERS TO QUESTIONS IN TEXT
Legitimate hedgers use the futures market do not normally make or take delivery when using futures
contracts to offset risk. The profits or losses from the contract are what is important to the hedger, and
these can be settled between the two parties without delivery of the underlying security.
2.
During the delivery period, rights and obligations force the price of the futures contract and the
price of the underlying security to be equal. If the price of the futures contract is higher, arbitragers would
sell them, then buy the securities at a lower price, pocket the difference, and deliver the securities in
satisfaction of their obligation as shorts. And vice versa, if the price is lower, arbitragers would buy them
and sell the actual security.
Chapter 9 Demystifying Derivatives  27
3.
Unlike futures contracts, the rights and obligations of options buyers and sellers are not
symmetrical. The buyer of a call has the right to buy the underlying asset at a future time and the seller has
an obligation to sell it. The buyer pays the seller an option premium for that right.
4.
The main difference between the two hedging strategies occurs when bond prices rise. Because of
the asymmetrical payoff on puts, the option buyer is protected from downside risk but retains upside
potential. Selling futures as a hedge gives downside protection but also eliminates upside potential. The
decision on which strategy is optimal depends on the option premium. Zero price movement will cause
zero profit or loss on the futures contract but loss of the premium on the options contract.
5.
The greater the volatility of a stock price, the more likely the price is to move such that the option
moves into the money. Therefore, given the current stock price, call
option buyers are willing to pay
more for a call option on a volatile stock. Large declines are not a major concern to the option buyer, due to
asymmetrical payoff to the call.
6.
Because the fixed-rate payer receives a higher variable rate on the notional principal, while
continuing to pay the same fixed rate.
7.
There would be benefits and costs associated with such laws. Most participants in these markets
are well-informed; many are institutional investors. Currently, information about options and futures is sent
to those private citizens who wish to take advantage of those instruments. The costs would be in thinner
markets; the laws might lead to larger spreads. The benefit might be the disqualification of high-pressure
operators who may be recruiting unsophisticated investors.

ESSAY QUESTIONS
1.
Distinguish between financial futures and options contracts.
Futures are standardized agreements to buy or sell a particular asset at a future date for a
currently agreed-upon price. Options are divided into two parts: buyers of puts have the
right to sell the underlying security at a fixed price, and buyers of calls have the right to buy
the underlying security at a fixed price. Options contracts do not impose an obligation on
the buyer.
How are financial futures contracts standardized? What is benefit of this?
Standardized contracts are bought and sold on the organized futures markets. Terms are
established by the exchange that sponsors the contracts. Only the price is open for
negotiation. Standardization increases liquidity and lowers transaction costs. Perhaps most
importantly, all traders pay or receive payment from the exchange rather from the other
party in the transactions. This removes the need to know with whom one is trading or their
credit rating.
What is the role of arbitragers in futures markets? What impact do they have on futures prices?
Arbitragers buy and sell futures contracts when there is a difference between the futures
price and the prices of the underlying asset. This activity tends to close that difference.
They improve market efficiency.
2.
3.
28  Ritter/Silber/Udell Money, Banking, and Financial Markets, Eleventh Edition
4.
Suppose you are advising a relatively risk-averse person. Would you recommend futures or options
to him?
Options are probably more attractive. The asymmetric payoff to puts and calls means that
unlimited gains are possible, while losses are limited to the premium paid for the option.
But my recommendation would also depend on the other assets the person had in his or her
portfolio.
5.
What are the primary determinants of the price of an option on an individual asset?
Included are the price volatility of the underlying asset and the length of time before the
option expires. Puts and calls are influenced (in opposite directions) by the price of the
underlying asset.