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Chapter Ten
Derivative
Securities Markets
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Derivatives

A derivative is a contract between two parties whose value is
based on some underlying asset price or condition

In a derivative, two parties agree to exchange a standard
quantity of an asset at a predetermined price at a specific
date in the future
10-2
Derivatives’ Uses


Derivatives are leveraged instruments where participants
put up a small amount of money and obtain the gain or loss
on a much larger position
Derivatives are used for speculation and for hedging
 Speculation
Buying or selling a derivative contract in order to earn a
leveraged rate of return
 Hedging
Entering into a derivatives contract to reduce the risk
associated with positions or commitments in their line of
business
10-3
Derivatives Markets

The first wave of modern derivatives were foreign currency
futures introduced by the International Monetary Market
(IMM) following the Smithsonian Agreements of 1971 and
1973

The second wave of modern derivatives were interest rate
futures introduced by the Chicago Board of Trade (CBT)
with the increase in interest rate volatility in the late 1970s
10-4
Derivatives Markets

The third wave of modern derivatives occurred in the 1980s
with the advent of stock derivatives

The fourth wave occurred in the 1990s with credit
derivatives
10-5
Forwards and Futures

A spot contract is an agreement to transact involving the
immediate exchange of assets and funds

A forward contract is a nonstandardized agreement to buy
or sell an asset in the future, with the terms of the deal set
when the contract is created

Forwards are:
 custom contracts; lack standard terms
 not traded, so participants must perform
 risky; have potential counterparty credit risk
10-6
Forwards and Futures


A futures contract is a standardized, exchange-traded
version of a forward contract
Futures contracts differ from forwards in that futures are:
 marketable
 have no default risk
 employ margin requirements and daily marking to market

margin requirement is a performance bond posted by a buyer
and a seller of a futures contract
10-7
Futures Markets

Futures contract trading occurs in trading “pits” using an
open-outcry auction among exchange members
 floor brokers place trades for the public
 professional traders trade for their own accounts
 position traders take a position in the futures market
based on their expectations about the future direction of
the prices of the underlying assets
 day traders take a position within a day and liquidate it
before day’s end
 scalpers take positions for very short periods of time,
sometimes only minutes, in an attempt to profit from active
trading
10-8
Futures Markets

Price volatility and trading interest determines which
contracts are offered

Profit pressures for derivatives exchanges to merge
• CME Group contains CME, CBOT, NYMEX, and COMEX

Electronic trading is increasingly dominating ‘pit’ trading
• Intercontinental Exchange only has electronic trading
10-9
Futures Contract Terms






Trading unit
Deliverable grades
Tick size
Price quote
Contract months
Last trading day





Last delivery day
Delivery method
Trading hours
Ticker symbols
Daily price limit
10-10
Futures Contracts




A long position is the purchase of a futures
contract
A short position is the sale of a futures contract
A clearinghouse is the unit that oversees trading
on the exchange and guarantees all trades made
by the exchange
Open interest is the total number of the futures, put
options, or call options outstanding at the beginning
of the day
10-11
Futures Contracts

An initial margin is a deposit required on futures trades to
ensure that the terms of the contracts will be met

The maintenance margin is the margin a futures trader must
maintain once a futures position is taken

if losses occur such that margin account funds fall below the
maintenance margin, the customer is required to deposit
additional funds in the margin account to keep the position open
10-12
Example -- Futures Contract
Terms
Contract
T-Bond
Exchange
CBOT
Delivery
Months
M,J,S,D
Contract
Size
$ 100,000
Deliverable
Instrument
See below*
IMR
$3,713
MMR
$2,750
Contract: 30 year Treasury Bond contract
Exchange: Chicago Board of Trade
Delivery Months: Contract maturity months are March, June,
September, December
Contract Size: Contract calls for delivery of $100,000 face value
Deliverable Instrument: Treasury bonds that do mature for at least 15
years from the date of delivery and mature in no more than 25
years
IMR: Exchange mandated initial margin requirement of $3,713
(brokers may require a higher margin)
MMR: Exchange mandated maintenance margin required to keep the
account open
10-13
Long and Short Positions
Contract
T-Bond
Exchange
CBOT
Delivery
Months
M,J,S,D
Contract
Size
$ 100,000
Deliverable
Instrument
See below*
IMR
$3,713
MMR
$2,750
If an investor buys or goes “long” one June contract, they are agreeing to
buy $100,000 par or face value of T-Bonds at the original futures contract
price when the contract expires in June.
If an investor sells or goes “short” one June contract, they are agreeing
to deliver $100,000 par or face value of T-Bonds and receive the original
futures contract price when the contract expires in June.
Each investor must put up the IMR of $3,713 when they open the
contract.
Each investor must maintain the MMR of $2,750 in their margin account
while the position is open.
10-14
T-Bond Futures Quote Sheet
Jun
Sep




Last
124’26
123’20
Change
-0’01
+0’02
Prev
Settle
124’27
123’18
Open
124’28
123’20
High
124’28
123’20
Low
124’16
123’20
Close
124’26
123’20
Source:
CBOT
Price quotes are in dollars and 32nds as a percent of face value
‘Open’ price for the June contract of 124’28 is $124 28/32 percent
of $100,000 = $124,875
If you buy the contract at the open, what are you agreeing to do?
If you sell the contract at the open, what are you agreeing to do?
10-15
Marking to Market


Gains and losses are recognized daily
IMR = $3,713, MMR = $2,750
Suppose you buy one June contract at the open of $124,875,
Monday’s close is 124’26, and Tuesday’s close is 122’29. What is
in your margin account after Tuesday’s settle?
Underlying Price
Settle
Value
Change
OPEN
124’28
$124,875.00
Mon.
124’26
$124,812.50 -$ 62.50
Tues.
122’29
$122,906.25 -$1,906.25
MARGIN CALL (beneath $2,750) add cash =

Margin
Acct
$3,713.00
$3,650.50
$1,744.25
$1,968.75
$3,713.00
Who receives the money taken out of your margin account?
10-16
Options


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An option is a contract that gives the holder the right, but not
the obligation, to buy or sell the underlying asset at a
specified price within a specified period of time
A call option is an option that gives the purchaser the right,
but not the obligation, to buy the underlying security from the
writer of the option at a specified exercise price on (or up to)
a specified date
A put option is an option that gives the purchaser the right,
but not the obligation, to sell the underlying security to the
writer of the option at a specified exercise price on (or up to)
a specified date
10-17
Profit Diagrams for Call Options
Payoff
profit
Payoff for
call buyer
C
0
X
Stock Price
at expiration
-C
Payoff
loss
Payoff for call
writer
10-18
Profit Diagrams for Put Options
Payoff
profit
Payoff for put
writer
P
0
X
-P
Payoff
loss
Stock Price
at expiration
Payoff for put
buyer
10-19
Options


The Black-Scholes option pricing model (the model most
commonly used to price and value options) is a function of:
 the spot price of the underlying asset
 the exercise price on the option
 the option’s exercise date
 the price volatility of the underlying asset
 the risk-free rate of interest
The intrinsic value of an option is the difference between an
option’s exercise price and the underlying asset price
 the intrinsic value of a call option = max{S – X, 0}
 the intrinsic value of a put option = max{X – S, 0}
10-20
Option Intrinsic Value and Time
Value
10-21
Option Price Quotes
AMR
Call
Expiration
May
Jan
STRIKE
6.00
7.50
LAST
3.30
1.30
VOLUME
12
60
OPEN
INTEREST
578
17062
LAST
0.45
0.15
Underlying stock price $8.79
Put
OPEN
INTEREST
VOLUME
20
138
4175
58909
• The May call is in the money (positive intrinsic value) and the call
premium is $3.30 * 100 = $330 (contracts are for 100 shares)
• The intrinsic value of the call (S-X) is ($8.79 - $6.00) * 100 = $279
• The time value of the call is $330 - $279 = $51
• The May put is out of the money and the put’s intrinsic value (X-S) is
0
• The put still has time value, however, equal to $0.45 * 100 = $45
10-22
Option Markets

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The Chicago Board of Options Exchange (CBOE) opened
in 1973 as the first exchange devoted solely to the trading of
stock options
Options on futures contracts began trading in 1982
An American option can be exercised at any time before
(and on) the expiration date
A European option can be exercised only on the expiration
date
The trading process for options is similar to that for futures
contracts
10-23
More on Options

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The underlying asset on a stock option is the stock of a publicly
traded company
The underlying asset on a stock index option is the value of a
major stock market index (e.g., DJIA or S&P 500)
The underlying asset on a futures option is a futures contract
Credit spread call options
 the value of a credit spread call option increases as the
default (risk) premium or yield spread on a specified benchmark
bond of the borrower increases above some exercise spread
A digital default option pays a stated amount in the event of
a loan default
10-24
Swaps


A swap is an agreement between two parties to exchange
assets or a series of cash flows for a specific period of time at a
specified interval
A plain vanilla interest rate swap is an exchange of fixedinterest payments for floating-interest payments by two
counterparties



the swap buyer makes a periodic fixed interest rate payment on a
stated notional principal amount
the swap seller makes a periodic floating-rate interest payments on
the same stated notional principal amount
no principal is exchanged
10-25
Swaps

A currency swap is a periodic exchange of one currency for
another between the parties
 Usually associated with borrowing money
 The exchanges can be at a fixed or a variable rate of interest as
negotiated in the contract, but the exchanges occur at a known
currency exchange rate
 Used to hedge exchange rate risk from mismatched currencies
of assets and liabilities
10-26
Swaps

Credit default swaps (CDS) allow financial institutions to
hedge credit risk
 A CDS buyer is buying insurance on a loan or bond
 CDS seller receives periodic payments from the CDS
buyer
If the insured loan or bond defaults, the CDS seller pays
the par value of the loan or bond to the CDS buyer
CDS played a major role in the financial crisis, AIG and
others were major sellers of CDS that insured mortgagebacked securities, but lacked capital and could not pay
when the mortgage securities failed


10-27
Swap Markets

Swaps are not standardized contracts

Swap dealers (usually financial institutions) keep markets
liquid by matching counterparties or by taking positions
themselves

The International Swaps and Derivatives Association
(ISDA) is an association among 56 countries that sets codes
of standards for swap documentation
10-28
Caps, Floors, and Collars

Financial institutions use options on interest rates to
hedge interest rate risk

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a cap is a call option on interest rates, often with multiple
exercise dates
a floor is a put option on interest rates, often with multiple
exercise dates
a collar is a position taken simultaneously in a cap and a
floor (usually buying a cap and selling a floor)
10-29
Regulators of Derivatives

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The primary regulator of futures markets is the
Commodity Futures Trading Commission
(CFTC)
The Securities Exchange Commission (SEC) is
the primary regulator of stock options and stock
index options
The CFTC is the regulator of options on futures
contracts
10-30
Regulators of Derivatives

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Until the Dodd-Frank Act neither the SEC nor the
CFTC directly regulated OTC derivatives such as
swaps
Under the new law OTC derivatives may be
required to be traded on an exchange and as such
would come under the purview of the SEC and
CFTC
Bank regulators will presumably more tightly
regulate bank usage of derivatives
10-31
International Derivative Markets
Summary of Text Table 1011 & 10-12
Contract
Total OTC
Currency Contracts
Interest Rate Contracts
Equity Linked Contracts
Futures Contracts
Option Contracts
Amounts of OTC Global Derivative Securities
Outstanding (Bill $)
2007
2009
% Growth
$339,651
$614,674
81%
$ 40,179
$ 49,196
22%
$291,987
$449,793
54%
$ 7,485
$ 6,591
-12%
Amounts of Exchange Traded Global Derivative
Securities Outstanding (Bill $)
$31,682.3
$21,757.2
-31%
$64,983.9
$51,382.8
-21%
Securities in the U.S. markets and the euro and U.S. dollar
are the most common bases for derivatives
10-32
Black-Sholes Call Option Model
C  N (d1 ) S  E (e  rT ) N (d 2 )
ln( S / E )  (r   2 / 2)T
d1 
 T
d 2  d1  T
10-33