Transcript Derivatives
Chapter 9 Derivatives: Futures, Options, and Swaps McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. The Basics: Defining Derivatives • A derivative is a financial instrument whose value depends on – is derived from – the value of some other financial instrument, called the underlying asset. • The purpose of derivatives is to transfer risk from one person or firm to another. 9-2 Forwards and Futures • A forward, or forward contract, is an agreement between a buyer and a seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date. • Because they are customized, they are very difficult to resell to someone else 9-3 Forwards and Futures • a future, or a futures contract, is a forward contract that has been standardized and sold through an organized exchange 9-4 Forwards and Futures • A futures contract specifies that the seller – called the short position – will deliver some quantity of a commodity or financial instrument to the buyer – called the long position – on a specific date called the settlement or delivery date, for a predetermined price. • No payments are made initially when the contract is agreed to. The seller/short position benefits from declines in the price of the underlying asset, while the buyer/long position benefits from increases 9-5 Forwards and Futures • Instead of making a bilateral arrangement, the two parties to a futures contract each make an agreement with a clearing corporation • A clearing corporation reduces the risk buyers and sellers face. 9-6 Forwards and Futures • Margin Accounts and Marking to Market • the clearing corporation requires both parties to a futures contract are required to place a deposit with the corporation itself. • This practice is called posting margin in a margin account. • The margin deposits serve as a guarantee that when the contract comes due, the parties will be able to meet their obligations 9-7 Forwards and Futures • Hedging and Speculating with Futures • insure against declines in the value of an asset. • Futures contracts are popular tools for speculation because they are cheap. The fact is, an investor needs only a relatively small amount of investment – the margin – to purchase a futures contract that is worth a great deal 9-8 Forwards and Futures • Arbitrage and the Determinants of Futures Prices • The practice of simultaneously buying and selling financial instruments in order to benefit from temporary price differences is called arbitrage, and the people who engage in it are called arbitrageurs. • the futures price must move in lock step with the market price of the bond. 9-9 Forwards and Futures 9-10 Options • Options are agreements between two parties. • There is a seller, called an option writer, and a buyer, called an option holder. • option writers incur obligations • option holders obtain rights. • Two basic options, puts and calls. 9-11 Options • A call option is the right to buy – “call away” – a given quantity of an underlying asset at a predetermined price, called the strike price, on or before a specific date. • A put option gives the holder the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date. 9-12 9-13 Options • The likelihood that an option will pay off depends on the volatility, or standard deviation, of the price of the underlying asset 9-14 Options 9-15 Swaps • Interest rate swaps are agreements between two counterparties to exchange periodic interest rate payments over some future period, based on an agreed-upon amount of principal – what’s called the notional principal. • The effect of this agreement is to transform fixed-rate payments into floating-rate payments, and vice versa. 9-16 Swaps • Users of interest-rate swaps • government debt managers who find longterm fixed-rate bonds cheaper to issue, but prefer short-term variable-rate obligations for matching revenues with expenses • The second group uses interest rate swaps to reduce the risk generated by commercial activities 9-17