Transcript - ShareStudies.com

Derivative Securities Markets
Chapter Outline
 Derivative Securities: Chapter Overview
 Forwards and Futures
 Options
 Regulation of Futures and Options Markets
 Swaps
 Caps, Floors and Collars
 International Aspects of Derivative Securities
Markets
Derivative Securities
 a financial security whose payoff is linked to another,
previously issued security
 Value changes with the change of the underlying
 derivatives have developed as the need to manage the risk
of a given commodity or exposure grew
Derivative Securities Markets
 Derivative securities markets exist to trade derivatives,
newest market
 First wave
 Second wave
 Third wave
 options
 stock index derivatives
 swaps
 Banks are major players in derivative markets,
particularly in certain OTC derivatives and in
mortgage backed securities
 In addition to CME and CBT: open outcry, derivatives
are now being traded on electronic exchanges
Forwards and Futures
 Spot Markets:
 A spot contract
 Forward Markets: A forward contract is a contract for future
payment and delivery (beyond two or three days)
 Hedgers
 A forward rate agreement (FRA), ex….
 custom arrangements
 Commercial banks, Investment banks, brokers-dealers, major
players, making returns on spread for buy/sell underlying asset
 Becoming more standardized, computerized, OTC sec market
 Futures Markets: Futures contracts are exchange traded (CME and
the New York Futures Exchange).
 Difference with forwards…
 A buyer of a futures contract (long position) incurs the obligation
to pay the extant futures price at the time the contract is purchased.
 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.
 Most futures contracts do not result in delivery; some do not even
allow delivery, EFP: exchange for physical
 Types:
commodity,
 currency, interest earning assets,
 index
 Purpose of the market:
 Price discovery
 Speculation hedging

 The clearinghouse
 Clearing member
 Open interest on a contract
 no cash is paid or received until contract maturity.
 initial margin requirement (IMR) . The IMR is usually
set at about 3%-5% of the face value
 maintenance margin requirement (usually about
75% of the IMR)
 marked to market daily
Suppose an investor purchases the June CBOT 30 year T-bond contract when
it is priced at 98-16. The investor is technically agreeing to purchase $100,000
face value T-bonds (the contract size) at contract maturity in June and is
agreeing to pay 98 16/32% of $100,000 or $98,500. As of June 2005 the initial
margin requirement was $1,553 and the maintenance margin requirement was
$1,150
Settle
OPEN
Underlying Value
$98,500.00
Price Change
Margin Acct
$1,553
Mon.
98-10
$98,312.50
-$187.50
$1,365.50
Tues.
97-00
$97,000.00
-$1,312.50
$53.00
MARGIN CALL ADD CASH:
$1,500
$1,553
 The exchange (clearing corporation) guarantees
payment for both parties in a futures contract
 Margin requirements, price limits, position limits and
daily marking to market limit the risk to the exchange.
 If the underlying spot volatility increases, exchanges are
quick to impose stricter requirements
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.
 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.
 standardized
 Interest rate contracts with the highest amount of open
interest include the Eurodollar, Eurolibor, Short
Sterling, T-note and T-bond contracts.
 The euro, yen and the S&P500 contracts are among the
highest in open interest for currency and stocks
respectively.
 Futures trading uses an open outcry auction
Types of traders include
 Professional traders: similar to specialists, trade for their
acct
 Position traders
 Day traders
 Scalpers




floor brokers
Either market or limit orders
Long or short positions
Clearinghouse clears the trade
Example: futures quote
LIFETIME
OPEN
INT
Mar
OPEN
112-09
HIGH
112-15
LOW
112-00
SETTLE
112-11
CHG
8
HIGH
114-02
LOW
100-25
612,141
Sep
109-31
109-31
109-31
110-26
8
111-02
109-31
195
March is the near term contract.
The contract size is for $100,000 face value T-bonds and the price quotes (Open,
High, Low and Settle) are percentages of face value where the price quotes are in
32nds.
For example 112-09 is 112 9/32% of $100,000.
The change (CHG) is the change in 32nds from the prior settle. Notice the large
difference in open interest in the two contracts. Only the near term contracts in
most futures are active
Futures Contracts Outstanding, 1992-2003
10000
8000
6000
4000
2000
0
1992
1995
Financial instruments
2000
2003
Currencies
 Profit or loss
Long Position
Futures price falls
Short Position
Futures price rises
Payoff
gain
Futures price falls
Payoff
gain
Futures
Price
Payoff
loss
Futures price rises
Futures
Price
Payoff
loss
Options
 Unlike futures and forwards, options give the holder the right, but not
the obligation, to either buy or sell the underlying commodity at a fixed
price called the exercise or strike price, for a specified period
 American style options
 European options
 Cheaper and more volatile than security (gain)
 Option clearing corporation: matches/clears trades , takes margin
payment on option
Options
 Use:



Change risk of portfolio
Tax purposes
Enhance return
 Participants:





Market maker
Floor broker: represent brokerage firm
Order book official: employee, facilitate trade, not trade for his
own
Scalpers: position trader
Exchange official
Some exchanges employ specialists instead of order book officials
 Call options:
 provide the right to buy the underlying commodity,
option premium (C) , exercise or strike price (X).
 ‘in the money
 time value and intrinsic value
 C > Max (0, S-X) for a call prior to maturity
 Purchasing a call option… , writing a call …
 Buying a call …, writing a call is …
 not normally exercised prior to maturity unless the
option is deep in the money
 Covered call/naked call
Comparing a call option with a spot position
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. Assuming the
buyer holds the option to just before expiration for simplicity,
the investor’s profit diagram looks this:
Profit
Spot
ST
$0.655
-$1,250
Call
$0.675
This option position does not appear very risky due to the limited loss feature
of the option, but it is actually riskier than a spot position. Why?
To compare to the option to a spot position you would have to consider an
equivalent dollar amount invested ($40,937.50) or buying 32.75 option
contracts ($40,937.50/$1,250). In the option position, you have only a few
months for the currency to move or you stand to lose 100% of $40,937.50.
An investor can purchase at the money, in the money, or out of the money
calls. In the money calls will have a larger potential dollar loss but a lower
breakeven than out of the money calls. Out of the money calls are more likely
to result in a loss, but may yield high percentage rates of return if the
commodity price increases significantly
Buying a call on margin
Stock price $105
Exercise $100
Call price $6
Call is in the money:
You would sell the call and receive $600
Margin is 100% + 20% of stock price = $105+100*02+600=$2700
For out of the money call options:
Margin is: sale proceeds + 20% of (stock price – amount option is
out of the money) if negative then
Margin is 100% of option proceeds + 10% of stock price
 Put options:
 A put option provides the right to sell the underlying
commodity.
 option premium (P)
 strike price (X)
 intrinsic value
 Purchasing a put option …
 Writing a put …
 Buying a put …
 not normally exercised prior to maturity unless the
option is deep in the money
Long Put
Profit
X
St
BUYING A PUT
Profit Table
ST < E
ST > E
-P0
-P0
-P0
+PT
E- ST
0
= Profit
E – ST - P0
-P0
Breakeven
ST = E - P0
Writing a put
Profit
X
St
WRITING A PUT0
Profit Table
ST < E
ST > E
+P0
+P0
+P0
-PT
-(E- ST)
0
= Profit
ST – E + P0
+P0
Breakeven
ST = E - P0
 Option Values:
 The intrinsic value of a call option…
 The intrinsic value of a put option …
 time value
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
S = $60
Stock Price
 Other variables include:




Risk free rate (Rf
Time to expiration
 Option Markets:
 From modest beginnings in 1973 with the Chicago Board
Options Exchange (CBOE), the world’s first market dedicated
to options, option trading has grown worldwide.
 In the U.S. open outcry auctions, 2000, the CBOE introduced
hand held computers
 Who can transact on the floor, how?
 Options on individual common stocks and stock indexes are
popular today for both hedgers and speculators (multiplier)
Example January AMR options quote
AMR
Underlying stock price $8.79
Call
Expiration
May
Jan
Put
STRIKE
6.00
LAST
3.30
VOLUME
12
OPEN
INTEREST
578
7.50
1.30
60
17062
LAST
0.45
VOLUME
20
OPEN
INTEREST
4175
0.15
138
58909
The May call is in the money and the call premium is $3.30 * 100 = $330. 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. An investor would not exercise this call because that
would be throwing away the $51 time value.
The May put is out of the money and the put’s intrinsic value (X-S) is 0. Note
that the put still has time value however equal to $0.45 * 100 = $45. Notice that
the closer to the money option has much higher open interest
Example: Stock Index to hedge stock portfolio
Portfolio: $2.15 million
S&P500 currently 1,075.0
Expects a decline
Long put option on index
Multiplier 500
Option price: 1,075 * 500 = $537,000
Buy: 2.15/0.537 = 4 put options
S&P dropped 15% to 913.75, portfolio now $1,827,500, loss $322,500
Offset loss through option: intrinsic value (1,075913.75)*500*4=$322,500
 Options exist on futures contracts as well.


Options on futures are popular
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.
 The Philadelphia Options Exchange offers several
popular currency options contracts. Options are
available for the Euro, British pound, Japanese yen,
Australian dollar, Canadian dollar and the Swiss franc.
Options Market Activity, 1992-2004 (in
thousands)
200000
150000
100000
50000
0
1992
1995
2000
Avg month-end contracts outstanding
Number of contracts traded
2003
Option combinations
 Covered call: buy security and sell call option
 Protective put: buy security and buy put option
 Bull call spread: buy call with low X and sell call with high X
 Bear call spread: sell call with low X and buy call with high X
 Butterfly spread with calls: buy one call with low X and another
with high X, and sell two calls with X in between (could be done
with puts)
 Straddle: buy call and put on same asset with same X and
expiration
 Collar: covered call and protective put (put strike less than call
strike)
Regulation of Futures and Options Markets
 The Commodity Futures Trade Commission (CFTC)
 The Securities Exchange Commission (SEC)
 Neither party directly regulates OTC derivatives.
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.
 Provide privacy
 Interest rate swaps, currency swaps, credit risk swaps,
commodity swaps and equity swaps comprise the major types
 Futures are only liquid upon expiration, for longer term
strategies use Swap
 Interest Rate Swaps:
 plain vanilla interest rate swap
 Swap maturities
 swap buyer,
 swap seller.
 notional principal
 An institution that has too many rate sensitive liabilities
relative to its holdings of rate sensitive assets ...
 Credit risk exposure on a swap
Direct arrangement
Fixed rate payment
Money center
bank
Thrift
Floating rate payment
Third party arrangement
Fixed rate
payment
less fees
Money center
bank
Fixed rate
payment
SWAP
agent
Floating
rate
payment
Thrift
Floating
rate
payment
Less fees
 Currency Swaps: Currency swaps may be used to
hedge mismatches in the currency of a FI’s assets and
liabilities or other commitments
 Fixed for fixed currency swaps
 Fixed for floating currency swaps
Example
U.S. firm might have a British subsidiary that is earning pounds.
Suppose the subsidiary is not well known and cannot procure
pound financing at an acceptable cost, so the parent arranges
variable rate dollar loans.
The U.S. parent is now at risk if the pound declines because a
depreciating pound will make repaying the dollar loans more
expensive. Moreover, the loans are variable rate and cannot be fully
hedged with forward contracts because of the changing outflow
amounts.
The parent may arrange a swap with a counterparty where the
British subsidiary agrees to pay a fixed rate of interest (and
principle when due) in pound sterling in exchange for receiving a
dollar denominated variable rate of interest (and principle).
 Swap Markets:
 Swap dealers greatly facilitate the market for swaps.
 Swap dealers usually guarantee payments on both sides of the
swap (for a fee), min cost of finding counterparty
 Dealers book their own swaps and keep a ‘swap book’ to
facilitate management of their net payment obligations.
 Swap brokers
 Swap Markets:
 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.
 The Basle accord also specifies capital requirements to offset the
risks associated with swaps
 ISDA: codes and standards, spokesgroup for regulatory issues,
promotes dev of risk mgmt practices for SWAP dealers
Caps, Floors and Collars
 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.
 Cap: A cap is an OTC call option on interest rates.
 Floor: A floor is an OTC put option on interest rates.
 Collar: A collar is a simultaneous position in a cap and a
floor.
International Aspects of Derivative Securities
Markets
 The global OTC derivatives market is huge, and dwarfs the size
of exchange traded contracts. At year-end 2004 there was $220
trillion worth of OTC contracts outstanding compared to $49
trillion in exchange traded contracts. Interest rate contracts are
the predominate type. Securities in the U.S. markets and the
euro and U.S. dollar are the most common bases for derivatives.
Summary of Table 10-11
Amounts of OTC Global Derivative Securities Outstanding
(Bill $)
Contract
2004
Total
$220,058
Currency Contracts
$ 26,997
Interest Rate Contracts
$164,626
Equity Linked Contracts
$
4,520