Download Ch10

Chapter Ten
Derivative Securities
Markets
©2007, The McGraw-Hill Companies, All Rights Reserved
Derivative Securities: Chapter
Overview
• Derivative security
• An agreement between two parties to exchange a
standard quantity of an asset at a predetermined
price at a specified date in the future
• Derivatives are contracts whose value is linked to
and derived from something else.
• The ‘something else’ is usually a security, a
portfolio or an index.
McGraw-Hill/Irwin
10-2
©2007, The McGraw-Hill Companies, All Rights Reserved
Derivatives are financial contracts or
financial instruments
• whose values are derived from the value of
something else (known as the underlying). The
underlying on which a derivative is based can be
an asset (e.g., commodities, equities (stocks),
residential mortgages, commercial real estate,
loans, bonds), an index (e.g., interest rates,
exchange rates, stock market indices, consumer
price index, or other items (e.g., weather
conditions, or other derivatives). Credit
derivatives are based on loans, bonds or other
forms of credit
McGraw-Hill/Irwin
10-3
©2007, The McGraw-Hill Companies, All Rights Reserved
Derivatives may be used for different
purposes
• For instance, mortgage backed derivatives are
often created to improve the marketability of
existing loans, thereby improving a FI’s liquidity.
• The primary purpose of most derivative markets is
however to reallocate risk from parties who do not
wish to bear some or all of the risk arising from
their underlying lines of business (hedgers) to
other parties who are willing to bear the risk
(speculators).
McGraw-Hill/Irwin
10-4
©2007, The McGraw-Hill Companies, All Rights Reserved
Derivatives uses
• Derivatives can be used to mitigate the risk
of economic loss arising from changes in
the value of the underlying. This activity is
known as hedging. Alternatively,
derivatives can be used by investors to
increase the profit arising if the value of the
underlying moves in the direction they
expect. This activity is known as
speculation
McGraw-Hill/Irwin
10-5
©2007, The McGraw-Hill Companies, All Rights Reserved
Hedging
• Derivatives allow risk about the value of the underlying
asset to be transferred from one party to another. For
example, a wheat farmer and a miller could sign a futures
contract to exchange a specified amount of cash for a
specified amount of wheat in the future. Both parties have
reduced a future risk: for the wheat farmer, the uncertainty
of the price, and for the miller, the availability of wheat.
However, there is still the risk that no wheat will be
available due to causes unspecified by the contract, like the
weather, or that one party will renege on the contract.
(Although a third party, called a clearing house, insures a
futures contract, not all derivatives are insured against
counterparty risk.)
McGraw-Hill/Irwin
10-6
©2007, The McGraw-Hill Companies, All Rights Reserved
Speculation and arbitrage
• Derivatives can be used to acquire risk, rather than
to insure or hedge against risk.
• Speculative trading in derivatives gained a great
deal of notoriety in 1995 when Nick Leeson, a
trader at Barings Bank, made poor and
unauthorized investments in futures contracts.
Through a combination of poor judgment, lack of
oversight by the bank's management and by
regulators, and unfortunate events like the Kobe
earthquake, Leeson incurred a $1.3 billion loss
that bankrupted the centuries-old institution.
McGraw-Hill/Irwin
10-7
©2007, The McGraw-Hill Companies, All Rights Reserved
Types of derivatives; OTC and exchangetraded
• Over-the-counter (OTC) derivatives are
contracts that are traded (and privately
negotiated) directly between two parties,
without going through an exchange or other
intermediary. Products such as swaps,
forward rate agreements, and exotic options
are almost always traded in this way
McGraw-Hill/Irwin
10-8
©2007, The McGraw-Hill Companies, All Rights Reserved
OTC2
• The OTC derivative market is the largest market
for derivatives, and is unregulated. According to
the Bank for International Settlements, the total
outstanding notional amount is $596 trillion (as of
December 2007). Of this total notional amount,
66% are interest rate contracts, 10% are credit
default swaps (CDS), 9% are foreign exchange
contracts, 2% are commodity contracts, 1% are
equity contracts, and 12% are other.
McGraw-Hill/Irwin
10-9
©2007, The McGraw-Hill Companies, All Rights Reserved
OTC3
• OTC derivatives are largely subject to
counterparty risk, as the validity of a
contract depends on the counterparty's
solvency and ability to honor its obligations.
McGraw-Hill/Irwin
10-10
©2007, The McGraw-Hill Companies, All Rights Reserved
Exchange-traded derivatives
• (ETD) are those derivatives products that
are traded via specialized derivatives
exchanges or other exchanges. A
derivatives exchange acts as an
intermediary to all related transactions, and
takes Initial margin from both sides of the
trade to act as a guarantee
McGraw-Hill/Irwin
10-11
©2007, The McGraw-Hill Companies, All Rights Reserved
Derivatives traders at the Chicago Board of
Trade
McGraw-Hill/Irwin
10-12
©2007, The McGraw-Hill Companies, All Rights Reserved
Examples of Derivatives
• Forward and futures contracts
– currency forwards and futures
– interest rate futures
• Options contracts
– call option
– put option
• Swaps
– currency swap
– interest rate swap
McGraw-Hill/Irwin
10-13
©2007, The McGraw-Hill Companies, All Rights Reserved
History
• Although commodity futures have a long history
in the U.S., options were not widely traded until
the development of the Black-Scholes Option
Pricing Model in the early 1970s.
• In modern times derivatives have developed as
the need to manage the risk of a given commodity
or exposure grew.
•
McGraw-Hill/Irwin
10-14
©2007, The McGraw-Hill Companies, All Rights Reserved
• For instance, currency futures were introduced by
the International Monetary Market (IMM), a
subsidiary of the Chicago Mercantile Exchange
(CME) as the collapse of the Bretton Woods
Agreement led to higher currency volatility .
• Interest rate derivatives were created after
the Fed stopped targeting interest rates in
1979
McGraw-Hill/Irwin
10-15
©2007, The McGraw-Hill Companies, All Rights Reserved
As stock trading grew, stock index derivatives were
introduced in the early 1980s
• With the extreme increases in short term interest
rates in the early 1980s, institutions became
interested in swaps to manage interest rate risk.
• In the 1990s, credit risk derivatives were created
that pay the holder if the credit risk on an
underlying asset increases.
• Enron was a major trader in credit risk
derivatives. Trading gains from these derivatives
were used to help mask losses on other business
lines at Enron
McGraw-Hill/Irwin
10-16
©2007, The McGraw-Hill Companies, All Rights Reserved
• Banks are major players in derivative
markets, particularly in certain OTC
derivatives and in mortgage backed
securities. Derivatives usage among banks
however is limited to the largest 600 or so
banks and 95% of derivatives held by banks
are written by just 5 banks.
McGraw-Hill/Irwin
10-17
©2007, The McGraw-Hill Companies, All Rights Reserved
in some contracts the volume of electronic
trading is now exceeding the volume of
traditional exchange trading
• Derivatives are now being traded on electronic
exchanges.
• Eurex (a European exchange) launched a fully
electronic exchange in Chicago offering futures
and options on U.S. T-notes and T-bonds as well
as contracts on Euro interest rates.
• The CME’s Globex system is growing as well.
Electronic trading is gaining ground on traditional
pit trading;.
McGraw-Hill/Irwin
10-18
©2007, The McGraw-Hill Companies, All Rights Reserved
Forwards and Futures
–
•
Spot Markets
A spot contract is a contract for
immediate payment and delivery.
Settlement is usually within two to three
business days.
McGraw-Hill/Irwin
10-19
©2007, The McGraw-Hill Companies, All Rights Reserved
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
McGraw-Hill/Irwin
10-20
©2007, The McGraw-Hill Companies, All Rights Reserved
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 the future spot price of
an asset will move against them
• FI’s are the major forward market participants
• FIs agree to take the opposite side of the contract
as the customer for a fee and to earn the bid-ask
spread
McGraw-Hill/Irwin
10-21
©2007, The McGraw-Hill Companies, All Rights Reserved
forward rate agreement
• Forward contracts can specify interest rates
on future borrowings as well as prices on
specified assets.
• A forward rate agreement (FRA) is a
forward contract for loans that fixes the
interest rate today on a loan that will be
originated in the future
McGraw-Hill/Irwin
10-22
©2007, The McGraw-Hill Companies, All Rights Reserved
• Forward contracts are custom arrangements
negotiated by the buyer and seller.
• Both parties are at risk if the counterparty
fails to perform as promised; hence, both
parties should evaluate the creditworthiness
of the counterparty.
• If the counterparty is not known to the
bank, collateral may be required.
McGraw-Hill/Irwin
10-23
©2007, The McGraw-Hill Companies, All Rights Reserved
Futures Markets
• Futures contract
• Initial margin
• Maintenance margin
McGraw-Hill/Irwin
10-24
©2007, The McGraw-Hill Companies, All Rights Reserved
Futures Trading
•
•
•
•
•
•
•
•
•
Open-outcry auction
Floor broker
Professional traders
Position traders
Day traders
Scalpers
Long/Short position
Clearinghouse
Open interest
McGraw-Hill/Irwin
10-25
©2007, The McGraw-Hill Companies, All Rights Reserved
• A buyer of a futures contract (long
position) incurs the obligation to pay the
extant futures price at the time the contract
is purchased.
• Payment is made at contract maturity in
exchange for receipt of the underlying
commodity.
McGraw-Hill/Irwin
10-26
©2007, The McGraw-Hill Companies, All Rights Reserved
• A seller of a futures contract (short
position) incurs the obligation to deliver the
underlying commodity at contract maturity
in exchange for receiving the futures price
that was outstanding at the time the contract
was enacted.
McGraw-Hill/Irwin
10-27
©2007, The McGraw-Hill Companies, All Rights Reserved
initial margin requirement
• On a forward contract, no cash is paid or received
until contract maturity. Buyers and sellers of
futures contracts however must post an initial
margin requirement (IMR) to enter into a futures
deal. The IMR is usually set at about 3%-5% of
the face value of the contract, depending on the
volatility of the underlying commodity and
whether there are daily price limits on the futures
contracts.
McGraw-Hill/Irwin
10-28
©2007, The McGraw-Hill Companies, All Rights Reserved
maintenance margin requirement
• Participants must also maintain minimum margin
requirements called the maintenance margin
requirement (usually about 75% of the IMR).
Futures contracts are marked to market daily,
which means that gains or losses on the contracts
are realized daily. This may require additional
cash outlays if the customer’s margin falls below
the minimum required.
McGraw-Hill/Irwin
10-29
©2007, The McGraw-Hill Companies, All Rights Reserved
Gambling?
• Most futures contracts do not result in delivery;
indeed some contracts do not even allow delivery.
• The long position is eliminated by selling the
same contract.
• The clearinghouse nets the position (1 long and 1
short) to zero. Likewise, the short seller simply
purchases the same contract and the clearinghouse
nets their position to zero
McGraw-Hill/Irwin
10-30
©2007, The McGraw-Hill Companies, All Rights Reserved
It is just a gambling
• Because of the lack of delivery, futures contracts
are really bets on the way the price of the
underlying commodity will move.
• The purchaser (seller) of a futures contract agrees
to receive (pay) any increase in the value of the
underlying commodity and agrees to pay (receive)
any decrease in value between contract origination
and termination.
McGraw-Hill/Irwin
10-31
©2007, The McGraw-Hill Companies, All Rights Reserved
Why delivery is not an issue on futures
contracts
• I go long and default the pound futures contract F = futures
price, S = spot price at time = 0 (today) or time = T at
expiration.
• Suppose F0=$110,000 but at contract expiration ST =
$108,000 and I renege and refuse to pay $110,000 to
receive £62,500 (contract size) when I could buy them in
the spot for $108,000.
• The seller of the pounds could sell the pound spot and
receive $108,000 and the seller has ALREADY gained
$2,000 from the daily marking to market. The net
proceeds to the seller are $110,000, the same as if no
default occurred.
McGraw-Hill/Irwin
10-32
©2007, The McGraw-Hill Companies, All Rights Reserved
• I go short and default the Pound futures contract:
• F0= $110,000 but ST = $112,000 and I renege and
refuse to deliver £62,500 in order to receive
$110,000 when I could receive $112,000 in the
spot.
• The buyer of the pounds could buy the pound spot
and pay $112,000 and (s)he (buyer) has
ALREADY gained $2,000 from the daily marking
to market. Net cost to buyer $110,000.
McGraw-Hill/Irwin
10-33
©2007, The McGraw-Hill Companies, All Rights Reserved
Settlement
• Settlement is the act of consummating the contract, and
can be done in one of two ways, as specified per type of
futures contract:
• Physical delivery - Physical delivery is common with
commodities and bonds. In practice, it occurs only on a
minority of contracts. Most are cancelled out by
purchasing a covering position (Use of an option in a trading
strategy in the underlying asset which is already owned) . The
Nymex crude futures contract uses this method of
settlement upon expiration.
• Cash settlement
McGraw-Hill/Irwin
10-34
©2007, The McGraw-Hill Companies, All Rights Reserved
open interest
• The amount of open interest on a contract
is the amount of long (short) positions that
have not executed offsetting trades.
• Open interest is useful as a measure of
liquidity on the contract
McGraw-Hill/Irwin
10-35
©2007, The McGraw-Hill Companies, All Rights Reserved
clearinghouses
• An agency associated with an exchange, which settles trades and
regulates delivery
• Clearing corporations, or clearinghouses, provide
operational support for securities and commodities
exchanges. They also help ensure the integrity of listed
securities and derivatives transactions in the United States
and other open markets.
• For example, when an order to buy or sell a futures or
options contract is executed, the clearinghouse compares
the details of the trade. Then it delivers the product to the
buyer and ensures that payment is made to settle the
transaction
McGraw-Hill/Irwin
10-36
©2007, The McGraw-Hill Companies, All Rights Reserved
open outcry auction
• Futures trading uses an open outcry
auction where traders communicate with
each other via oral communications (usually
shouted) and a variety of hand signals
McGraw-Hill/Irwin
10-37
©2007, The McGraw-Hill Companies, All Rights Reserved
• An observer would think the trading process rather
chaotic but it seems to work.
• Trading is very stressful, with hundreds or
thousands of dollars quickly changing hands and
emotions can run high, indeed fisticuffs are not
unheard of on the exchange.
• The NYSE, while it can be extremely busy, is
typically much more quiet than trading in the
futures and options pits.
• The Chicago markets still hearken back to the
style and zest of Chicago’s earlier days
McGraw-Hill/Irwin
10-38
©2007, The McGraw-Hill Companies, All Rights Reserved
Professional traders
• Position traders that maintain positions in a
contract for longer than a day,
• Day traders that liquidate their positions by the
end of the day,
• Scalpers who hold positions only a matter of
minutes and attempt to profit from either very
small price changes or the bid-ask spread.
Scalpers who hold their positions for more than 3
minutes typically lose.
McGraw-Hill/Irwin
10-39
©2007, The McGraw-Hill Companies, All Rights Reserved
• Day traders and position traders often use
proprietary models to estimate which way
they believe prices will move. They
normally will not disclose what their trading
models.
McGraw-Hill/Irwin
10-40
©2007, The McGraw-Hill Companies, All Rights Reserved
floor brokers
• Similar to the NYSE, floor brokers process
public orders to buy and sell.
McGraw-Hill/Irwin
10-41
©2007, The McGraw-Hill Companies, All Rights Reserved
Today, there are more than 75 futures and
futures options exchanges worldwide
trading to include:
• Chicago Mercantile Exchange(CME)
• London International Financial Futures Exchange in 1982
(now Euronext.liffe),
• Deutsche Terminbörse (now Eurex)
• Tokyo Commodity Exchange (TOCOM).
• CME Group (formerly CBOT and CME) -- Currencies,
Various Interest Rate derivatives (including US Bonds);
Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork,
Cattle, Butter, Milk); Index (Dow Jones Industrial
Average); Metals (Gold, Silver), Index (NASDAQ, S&P,
etc)
McGraw-Hill/Irwin
10-42
©2007, The McGraw-Hill Companies, All Rights Reserved
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
ICE Futures - the International Petroleum Exchange trades energy including crude
oil, heating oil, natural gas and unleaded gas and merged with
IntercontinentalExchange(ICE)to form ICE Futures.
Liffe
South African Futures Exchange - SAFEX
Sydney Futures Exchange
London Commodity Exchange - softs: grains and meats. Inactive market in Baltic
Exchange shipping.
Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures)
Tokyo Commodity Exchange TOCOM
Tokyo Financial Exchange TFX (Euroyen Futures, OverNight CallRate Futures,
SpotNext RepoRate Futures)
Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures)
London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel ,tin and
steel
New York Board of Trade - softs: cocoa, coffee, cotton, orange juice, sugar
New York Mercantile Exchange - energy and metals: crude oil, gasoline, heating
oil, natural gas, coal, propane, gold, silver, platinum, copper, aluminum and
palladium
Dubai Mercantile Exchange
Singapore International Monetary Exchange (SIMEX)
Futures on many Single-stock futures
McGraw-Hill/Irwin
10-43
©2007, The McGraw-Hill Companies, All Rights Reserved
Futures Contracts Outstanding, 1992-2003
10000
8000
6000
4000
2000
0
1992
1995
Financial instruments
McGraw-Hill/Irwin
10-44
2000
2003
Currencies
©2007, The McGraw-Hill Companies, All Rights Reserved
Who trades futures?
• Futures traders are traditionally placed in
one of two groups: hedgers, who have an
interest in the underlying commodity and
are seeking to hedge out the risk of price
changes; and speculators, who seek to make
a profit by predicting market moves and
buying a commodity "on paper" for which
they have no practical use.
McGraw-Hill/Irwin
10-45
©2007, The McGraw-Hill Companies, All Rights Reserved
Hedgers typically include producers and
consumers of a commodity
• For example, in traditional commodity
markets, farmers often sell futures contracts
for the crops and livestock they produce to
guarantee a certain price, making it easier
for them to plan. Similarly, livestock
producers often purchase futures to cover
their feed costs, so that they can plan on a
fixed cost for feed.
McGraw-Hill/Irwin
10-46
©2007, The McGraw-Hill Companies, All Rights Reserved
The social utility
• The social utility of futures markets is
considered to be mainly in the transfer of
risk, and increase liquidity between traders
with different risk and time preferences,
from a hedger to a speculator for example.
McGraw-Hill/Irwin
10-47
©2007, The McGraw-Hill Companies, All Rights Reserved
Options
• A contract that gives the holder the right, but
not the obligation, to buy or sell an asset at a
prespecified price for a specified 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
McGraw-Hill/Irwin
10-48
©2007, The McGraw-Hill Companies, All Rights Reserved
Definitions of a Call
• 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.
– The call buyer must pay the option premium (C)
to the call writer. The option buyer may exercise
the option and purchase the underlying spot
commodity by paying the exercise or strike
price (X).
McGraw-Hill/Irwin
10-49
©2007, The McGraw-Hill Companies, All Rights Reserved
• The option has intrinsic value if the
underlying spot price (S) is greater than X.
In this case the option is said to be ‘in the
money.’ If at expiration S > X, the option
will be exercised, if not the option expires
worthless. In either case, the initial call
price C is a sunk cost.
McGraw-Hill/Irwin
10-50
©2007, The McGraw-Hill Companies, All Rights Reserved
• Call options will not normally be exercised prior to
maturity unless the underlying commodity pays a large
enough cash flow prior to maturity, even if they are in the
money. This is so because the option is worth more
“alive” (unexercised) than “dead” (exercised); the option
has both time value and intrinsic value. The time value is
forfeited if the option is exercised. An option holder
wishing to terminate their option position could simply sell
the option instead of exercising it. Mathematically, this is
equivalent to stating that C > Max (0, S-X) for a call prior
to maturity
McGraw-Hill/Irwin
10-51
©2007, The McGraw-Hill Companies, All Rights Reserved
• Purchasing a call option is a bullish strategy
that makes money if the underlying
commodity price rises. Writing a call is a
neutral or bearish strategy. Buying a call is
a limited loss strategy with a potentially
unlimited gain, writing a call is the
opposite.
McGraw-Hill/Irwin
10-52
©2007, The McGraw-Hill Companies, All Rights Reserved
• Options are wasting assets, their time value
erodes as expiration approaches. Option
prices are also directly related to the level of
underlying spot price volatility.
McGraw-Hill/Irwin
10-53
©2007, The McGraw-Hill Companies, All Rights Reserved
• Suppose an at the money American style Swiss franc (Sfr)
call option has the following terms:
• Exercise price 1Sfr = $0.655 Option Premium = 2¢/Sfr
• Contract size = 62,500 Sfr
Expiration = 90 days
• This option gives the buyer the right to purchase 62,500
Sfr at any time within the next 90 days at an exercise (or
strike) price of 62,500 Sfr  $0.655/Sfr = $40,937.50.
• The price the option buyer must pay to obtain this right
(the premium) is 62,500 Sfr  $.02/Sfr = $1,250.
McGraw-Hill/Irwin
10-54
©2007, The McGraw-Hill Companies, All Rights Reserved
Payoff Function for Call Options
Payoff
Gain
+
C
Payoff function
for Buyer
0
X
A
C
-
Payoff
Loss
McGraw-Hill/Irwin
S
Stock Price
at expiration
Payoff function
for writer
10-55
©2007, The McGraw-Hill Companies, All Rights Reserved
Tip
• A majority of options expire worthless and
many institutions write calls to generate
additional income to improve their current
period rate of return.
McGraw-Hill/Irwin
10-56
©2007, The McGraw-Hill Companies, All Rights Reserved
Definitions of a Put
• 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
– The put buyer must pay the option premium (P) to the
put writer. The option buyer may exercise the option
and sell the underlying spot commodity by delivering
the commodity in exchange for the exercise or strike
price (X).
McGraw-Hill/Irwin
10-57
©2007, The McGraw-Hill Companies, All Rights Reserved
• The option has intrinsic value if the
underlying spot price (S) is less than X. If
at expiration S < X the option will be
exercised, if not the option expires
worthless.
• Similar to calls, put options will not
normally be exercised prior to maturity
unless the option is deep in the money
McGraw-Hill/Irwin
10-58
©2007, The McGraw-Hill Companies, All Rights Reserved
• Purchasing a put option is a bearish strategy
that makes money if the underlying
commodity price falls. Writing a put is a
neutral or bullish strategy. Buying a put is a
limited loss strategy with a potentially large
gain, writing a put is the opposite.
McGraw-Hill/Irwin
10-59
©2007, The McGraw-Hill Companies, All Rights Reserved
Payoff Function for Put Options
Payoff
Gain
Payoff function
for Writer
+P
0
market D =10
X =14
Stock Price
at expiration
-P
Payoff function
for buyer
Payoff
Loss
McGraw-Hill/Irwin
10-60
©2007, The McGraw-Hill Companies, All Rights Reserved
Option Values
• Intrinsic value of an option
– Call Option
– Put Option
• Time value of an option
– the difference between an option’s price
(or premium) and its intrinsic value
McGraw-Hill/Irwin
10-61
©2007, The McGraw-Hill Companies, All Rights Reserved
• The intrinsic value of a call option is the
maximum of zero or S-X.
• The intrinsic value of a put option is the
maximum of zero or X-S.
McGraw-Hill/Irwin
10-62
©2007, The McGraw-Hill Companies, All Rights Reserved
time value
• An option also has time value because the
option’s returns are asymmetric. An out of the
money option that has not yet expired may yet
wind up in the money, an in the money option
may wind up further in the money. If not, the
option is simply not used. As a result, normally an
option is worth more than its intrinsic value. The
option’s time value is calculated as the option
premium minus the intrinsic value.
McGraw-Hill/Irwin
10-63
©2007, The McGraw-Hill Companies, All Rights Reserved
time value1
• The time value is representative of the right to
purchase the security or not, depending upon
whether it is profitable to do so. It literally
represents the probability that the commodity
price will increase and move the option further in
the money. Time value is greatest for an at the
money option. For deep out of the money options,
the time to expiration provides little likelihood
that an option will be exercised; for deep in the
money options, the ability to not exercise the
option has little value.
McGraw-Hill/Irwin
10-64
©2007, The McGraw-Hill Companies, All Rights Reserved
Intrinsic value vs. the Before Exercise
Value of a Call Option
Value
(option
premium)
$12.50
$10.00
intrinsic value
(stock price - exercise price)
Before exercise
price
Time Value
($2.50)
X = $50
McGraw-Hill/Irwin
10-65
S = $60
Stock Price
©2007, The McGraw-Hill Companies, All Rights Reserved
Options on individual common stocks and
stock indexes
• Options on individual common stocks and stock
indexes are popular today for both hedgers and
speculators. Hedgers may use long put options or
written call options on individual stocks or
indexes to hedge a long stock position. Stock
index options are cash settled and the major
S&P500 contract is a European option. Index
options allow the investor to hedge systematic risk
and partial hedges can be used to adjust a
portfolio’s beta up or down.
McGraw-Hill/Irwin
10-66
©2007, The McGraw-Hill Companies, All Rights Reserved
Options exist on futures
• Options exist on futures contracts as well. The
buyer of a call (put) option on a futures contract
has the right, but not the obligation, to purchase
(sell) a futures contract at the exercise price.
Options on futures are popular because it is often
cheaper to deliver the futures contract rather than
the underlying commodity. The futures contract is
typically more liquid than the underlying spot and
more information about supply and demand for
futures may be available than can be easily found
for the underlying commodity or security.
McGraw-Hill/Irwin
10-67
©2007, The McGraw-Hill Companies, All Rights Reserved
Option Markets
• Options traded on the floor of Chicago
Board Options Exchange (CBOE) by floor
brokers, professional traders or a market
maker for the particular option being
traded
• Stock options
• Stock index options
• Options give investors a way to hedge
McGraw-Hill/Irwin
10-68
©2007, The McGraw-Hill Companies, All Rights Reserved
Options Market Activity, 1992-2004
(in thousands)
200000
150000
100000
50000
0
1992
1995
2000
2003
Avg month-end contracts outstanding
Number of contracts traded
McGraw-Hill/Irwin
10-69
©2007, The McGraw-Hill Companies, All Rights Reserved
Regulation of Futures and Options
Markets
• The Commodity Futures Trade Commission
(CFTC) is the main regulator of futures
contracts and options on futures contracts. The
CFTC seeks to eliminate trading abuses and
prevent market manipulation.
• The Securities Exchange Commission (SEC)
regulates options on stocks and stock indexes.
• Neither party directly regulates OTC
derivatives
McGraw-Hill/Irwin
10-70
©2007, The McGraw-Hill Companies, All Rights Reserved
Swaps
• A swap is an agreement whereby two parties
agree to pay each other specified cash flows
for a set period of time. They are custom
designed contracts primarily used to hedge
currency and/or interest rate risk
McGraw-Hill/Irwin
10-71
©2007, The McGraw-Hill Companies, All Rights Reserved
the major types
•
•
•
•
Interest rate swaps,
currency swaps,
credit risk swaps,
commodity swaps (a producer wishes to fix his income and would
agree to pay the market price to a financial institution, in return for receiving
fixed payments for the commodity, The vast majority of commodity swaps
involve oil)
•
equity swaps (An equity swap is a swap where a set of future
cash flows are exchanged between two counterparties. The two cash
flows are usually referred to as "legs". One of these cash flow streams
can be pegged to floating rate of interest or pay a fixed rate (named
"floating leg"). The other will be based on the performance of a share
of stock or stock market index (named "equity leg").
McGraw-Hill/Irwin
10-72
©2007, The McGraw-Hill Companies, All Rights Reserved
Interest rate swaps
• As of 2004 the notional principal of interest
rate swap contracts outstanding was
$164.49 trillion.
• Interest rate swaps are by far the largest
single component of the OTC derivatives
market
McGraw-Hill/Irwin
10-73
©2007, The McGraw-Hill Companies, All Rights Reserved
plain vanilla interest rate swap
• In a plain vanilla interest rate swap one
party agrees to pay a fixed interest rate on a
given notional principle to the counterparty,
and the counterparty agrees to pay a
variable rate of interest on the same notional
principle. Swap maturities range from a
few months to many years
McGraw-Hill/Irwin
10-74
©2007, The McGraw-Hill Companies, All Rights Reserved
Interest rate swap Definitions
• Swap buyer The party making a fixed interest
payment .
• Swap seller the party making a variable payment.
• Notional principal since Principal is not normally
exchanged this term designates only the amount used
to calculate the dollars of interest paid Only net
payments are actually transferred
McGraw-Hill/Irwin
10-75
©2007, The McGraw-Hill Companies, All Rights Reserved
Example
• An institution that has too many rate sensitive liabilities
relative to its holdings of rate sensitive assets is at risk from
an interest rate increase (the typical position of a mortgage
lender that is funding the mortgages with deposits). This FI
may seek a swap where the FI agrees to pay a fixed rate of
interest in exchange for receiving a variable rate of interest.
If their own liability costs rise with rising interest rates, the
swap payments received will also rise but their swap
outflows are fixed. Large money center banks are often
willing to serve as a counterparty to a bank or thrift in need of
a swap. The intermediary banks may also act as brokers by
finding a suitable counterparty.
McGraw-Hill/Irwin
10-76
©2007, The McGraw-Hill Companies, All Rights Reserved
Credit risk exposure
• Credit risk exposure on a swap is less than
on a loan since no principal is involved and
only net interest payments are at risk but
credit risk is still present. The agent bank
may guarantee swap payments for a fee.
McGraw-Hill/Irwin
10-77
©2007, The McGraw-Hill Companies, All Rights Reserved
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
Swap Agent
Fixed-Rate
Payment
McGraw-Hill/Irwin
Floating-Rate
Payment
10-78
Thrift
Fixed-Rate
Payment
©2007, The McGraw-Hill Companies, All Rights Reserved
Fixed-Floating Rate Swap
Money Center Bank
Short-Term Assets
(C&I indexed loans)
Long-Term Liabilities
(5-year, 10% notes)
McGraw-Hill/Irwin
Thrift
10%
fixed
Long-Term Assets
(fixed-rate mortgages)
LIBOR + 2%
10-79
Short-Term Liabilities
(1-year CDs)
©2007, The McGraw-Hill Companies, All Rights Reserved
Currency Swaps
• Currency swaps may be used to hedge
mismatches in the currency of a FI’s assets
and liabilities or other commitments.
• As of 2004 the notional principal of
currency swap contracts outstanding
(adjusted for double counting) was $26,997
billion.
McGraw-Hill/Irwin
10-80
©2007, The McGraw-Hill Companies, All Rights Reserved
• Fixed for fixed currency swaps involve a
swap of principle and interest between two
parties at a fixed rate of exchange.
• Fixed for floating currency swaps can be
used to hedge both currency and interest
rate exposure simultaneously.
McGraw-Hill/Irwin
10-81
©2007, The McGraw-Hill Companies, All Rights Reserved
• Swap dealers greatly facilitate the market
for swaps. Large commercial banks and
investment banks are the primary swap
dealers. Swap dealers usually guarantee
payments on both sides of the swap (for a
fee)..
McGraw-Hill/Irwin
10-82
©2007, The McGraw-Hill Companies, All Rights Reserved
Regulation
• Regulators have worried that the swap
market is largely unregulated and some of
the specific terms of swap agreements may
not be publicly available. Since the swap
market involves U.S. banks, swap market
activities are indirectly regulated through
the normal bank regulatory process.
McGraw-Hill/Irwin
10-83
©2007, The McGraw-Hill Companies, All Rights Reserved
Caps, Floors, and Collars
• Cap
– a call option on interest rates, often with multiple
exercise dates
• Floor
– a put option on interest rates, often with multiple
exercise dates
• Collar
– a position taken simultaneously in a cap and a
floor
McGraw-Hill/Irwin
10-84
©2007, The McGraw-Hill Companies, All Rights Reserved
• Caps, floors and collars are options on
interest rates. The majority of these
contracts have between 1 and 5 years,
although some have longer expirations.
McGraw-Hill/Irwin
10-85
©2007, The McGraw-Hill Companies, All Rights Reserved
Cap
• A cap is an OTC call option on interest rates.
Conceptually, it may also be thought of as a put
option on bond prices. If interest rates rise above
a specified minimum (the strike “price” or “cap
rate”), the seller of the cap pays the buyer the
difference between the market interest rate and
the strike interest rate times the notional value.
Settlement (payment) dates may be at the end of
contract, annually, or at other times negotiated by
the parties.
McGraw-Hill/Irwin
10-86
©2007, The McGraw-Hill Companies, All Rights Reserved
Floor
• A floor is an OTC put option on interest
rates. Conceptually, it may also be thought
of as a call option on bond prices. If
interest rates fall below a specified
minimum (the strike “price” or “floor rate”),
the seller of the floor pays the buyer the
difference between the strike and the market
interest rate times the notional value.
McGraw-Hill/Irwin
10-87
©2007, The McGraw-Hill Companies, All Rights Reserved
Collar
• Collar: A collar is a simultaneous position
in a cap and a floor. If a FI is at risk from
rising (falling) interest rates they may wish
to buy a cap (floor). To offset some of the
cost of purchasing the cap (floor) the FI
may simultaneously sell a floor (cap).
McGraw-Hill/Irwin
10-88
©2007, The McGraw-Hill Companies, All Rights Reserved
McGraw-Hill/Irwin
10-89
©2007, The McGraw-Hill Companies, All Rights Reserved