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Copyright© 2012 John Wiley & Sons, Inc
The Nature of Derivative Securities
Derivatives are securities whose values are based
on values of other assets.
Derivatives can be used to minimize exposure to
various types of risk
E.g., interest-rate, forex, commodity price risks
The purpose is to eliminate the price risk inherent in
transactions that call for future delivery of money, a
security, or a commodity.
Derivatives are also used to speculate.
Copyright© 2012 John Wiley & Sons, Inc
Spot versus Forward Market
Trading for immediate delivery takes place
in the spot market at spot prices (rates).
Trading for future delivery takes place in
the forward market at forward prices
Copyright© 2012 John Wiley & Sons, Inc
Forward Markets
Forward contract is an agreement to buy or sell a
specific amount of an asset at a specific future date
and price.
All terms are negotiated by counterparties.
No money changes hands at the moment forward is
Buyers = long positions; sellers = short positions.
Seller delivers at the specified date called the
settlement date.
Copyright© 2012 John Wiley & Sons, Inc
Futures Markets
Futures contract is also an agreement to buy or
sell an asset in the future.
Unlike forwards, futures are standardized in terms of
amounts, delivery dates, commodity grades.
Buyers/sellers deal with the futures exchange, not
with each other.
Delivery seldom made - buyers/sellers offset their
positions before maturity.
Standardization of futures makes them much more
liquid then forwards.
Forwards, however, can be tailored exactly to the needs
of counterparties.
Copyright© 2012 John Wiley & Sons, Inc
Futures Market Transaction
Copyright© 2012 John Wiley & Sons, Inc
Margin Requirements
Initial margin - small percentage deposit
required to start trading futures.
Daily settlements (marking-to-market)
reflect gains/losses daily and cash
Maintenance margin - minimum deposit
requirements on futures contracts.
If balance falls below maintenance margin, a
margin call takes place and funds must be
added back to the amount of initial margin.
If funds not added, position is liquidated.
Copyright© 2012 John Wiley & Sons, Inc
Futures Exchanges
Competition between exchanges is keen.
Contract innovation is common.
Exchanges advertise and promote heavily.
Exchange specifies terms of a contract.
Specific items that can be delivered.
Method of delivery.
Minimum daily price variance.
Trading rules.
Copyright© 2012 John Wiley & Sons, Inc
Futures Markets Participants
Hedgers attempt to reduce or eliminate
price risk.
Speculators consciously accept price risk
hoping for high return.
Traders speculate on very-short-term
changes in futures contract prices.
Copyright© 2012 John Wiley & Sons, Inc
Uses of Financial Futures Markets
Reducing Systematic Risk in Stock Portfolios
Stock-index futures contracts trading began in
Stock-index futures derive their value from the
value of an underlying group of selected stocks.
Stock-index futures permit investors to alter the
market or systematic risk of their portfolio.
Investors who want to protect stock portfolio
gains may hedge by selling (shorting) stockindex futures.
Copyright© 2012 John Wiley & Sons, Inc
Stock-Index Program Trading
Done to arbitrage price discrepancies
between stock-index futures and the stocks
that make up the index.
Allows the program trader to earn a higher
risk-free return than a T-Bill for the
corresponding period.
Involves buying or selling large number of
stocks in high volume, which can influence
stock prices dramatically over the shortterm.
Copyright© 2012 John Wiley & Sons, Inc
Guaranteeing Cost of Funds
Futures and forwards can be used to hedge
future borrowing costs.
If interest rates are expected to rise:
a borrower can sell T-bill or T-bond futures
(executes a short hedge);
the borrower will gain in the futures market and
offset the increased borrowing cost.
Copyright© 2012 John Wiley & Sons, Inc
Risks in the Futures Markets
Basis risk - risk of an imperfect hedge because the
value of item being hedged may not always keep
the same price relationship to the futures contracts.
Cross-hedging - using the futures market to hedge a
dissimilar commodity or security.
E.g., hedging a portfolio of common stocks different
from those in the S&P 500 index with S&P 500 index
Related-contract risk - risk of failure due to
unanticipated changes in the business activity
being hedged, such as loan defaults or
Copyright© 2012 John Wiley & Sons, Inc
Risks in the Futures Markets (continued)
Manipulation risk - risk of price losses due
to a person or group trading to affect price.
Margin risk - the risk of losing a hedge if
margin calls cannot be satisfied and position
is liquidated.
Copyright© 2012 John Wiley & Sons, Inc
An option is a right to buy or sell an
underlying asset on or before a specified
date at a strike (exercise) price.
Call option = the right to buy
Put option = the right to sell
American option can be exercised on or
before the expiration date.
European option can be exercised only on
its expiration date.
Copyright© 2012 John Wiley & Sons, Inc
Options (cont.)
An option that would be profitable if
exercised immediately is said to be in the
Otherwise, it is at the money or out of the
Seller of the option = writer, buyer =
Buyer pays writer a premium for the option.
Buyer can lose only the premium and
commissions paid.
If buyer exercises the option, writer must
honor this request.
Copyright© 2012 John Wiley & Sons, Inc
Covered and Naked Options
Covered option - writer either owns the
security involved in the contract or has
limited his or her risk with other contracts.
Naked option - writer does not have or has
not made provision to limit the extent of
Copyright© 2012 John Wiley & Sons, Inc
Reading Option Quotes
Copyright© 2012 John Wiley & Sons, Inc
Options versus Futures Contracts
The option at the strike price exists over the period
of time, not at a given date.
The buyer of an option pays the seller (writer) a
premium which the writer keeps regardless of
whether or not the option is ever exercised.
The option does not have to be exercised; it is a
right, not an obligation.
Gains and losses are unlimited with futures
contracts; with options the buyer can lose only the
premium and the commissions paid.
Copyright© 2012 John Wiley & Sons, Inc
The Value of Options
The size of the option premium varies:
directly with the price volatility of the
underlying asset;
directly with the time to its expiration;
directly with the level of interest rates.
Copyright© 2012 John Wiley & Sons, Inc
Gains and Losses in Options & Futures
Copyright© 2012 John Wiley & Sons, Inc
Regulation of the Futures Market
The Commodity Futures Trading Commission
The Securities Exchange Commission (SEC)
regulates options that have equity securities as
underlying assets.
Exchanges impose self-regulation with rules of
conduct for members.
Copyright© 2012 John Wiley & Sons, Inc
Swaps Compared to Forwards and Futures
Swaps are agreements to exchange series of
payment obligations.
E.g., Fixed-rate vs. variable-rate payments, both based
on the notional principal.
Only net amount is transferred.
Amounts are conditional on changes in an interest
rate such as LIBOR.
Swaps are used to hedge interest rate risk.
Credit risk differences between parties provide
incentive to swap future interest flows.
A swap can be viewed as a series of forwards.
Copyright© 2012 John Wiley & Sons, Inc
Swap Dealers
Serve as counterparties to both sides of
swap transactions.
Dealers negotiate a deal with one party,
then seek out parties with opposite interests
and write a separate contract with them.
The two contracts hedge each other and the
dealer earns a fee for serving both parties.
Copyright© 2012 John Wiley & Sons, Inc
Swaps Had Limited Regulation
Bank regulators required risk-based capital
support for swap-risk exposure.
Other swap competitors, investment banks
and life insurance companies had no
regulatory capital costs.
The market was self-regulated because of
lack of any organized regulator. The
International Swap Dealers Association
leaded in this effort.
Copyright© 2012 John Wiley & Sons, Inc
Example of a Swap
Copyright© 2012 John Wiley & Sons, Inc
Credit Default Swaps
Investors pay the counterparty a premium
for the counterparty’s guarantee that in the
event of a credit event (bankruptcy or
restructuring), the investors would receive
payment from the counterparty.
Credit default swaps are similar to
insurance but they were not regulated, had
no capital requirements, and the investors
do not have to own the underlying asset.
Copyright© 2012 John Wiley & Sons, Inc
Dodd-Frank Act (2010)
Reshaped the regulation of swaps market to
increase transparency and reduce systemic risk.
Five major changes for the swaps market:
1) A central clearinghouse;
2) Execution through exchange versus OTC;
3) Dealers have to post margin;
4) Capital requirements;
5) Register with the CFTC and/or the SEC.
Copyright© 2012 John Wiley & Sons, Inc