Chapter Ten

Derivative Securities
Markets

McGraw-Hill/Irwin 8-1 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Derivatives

•• AAderivative
derivativesecurity
securityisisan
anagreement
agreementbetween
betweentwo two
parties
partiesto
toexchange
exchangeaastandard
standardquantity
quantityof ofan
anasset
assetatataa
predetermined
predeterminedprice
priceatataaspecific
specificdate
dateininthe
thefuture
future
•• Derivative
Derivativesecurities
securitiesmarkets
marketsare arethe
themarkets
marketsin inwhich
which
derivative
derivativesecurities
securitiestrade
trade
•• Derivatives
Derivativesinvolve
involvethe
thebuying
buyingandandselling
selling(i.e.,
(i.e.,the
the
transfer
transferof)
of)risk,
risk,which
whichresults
resultsin
inaapositive
positiveimpact
impacton onthe
the
economic
economicsystem
system
•• Derivatives
Derivativesare
areused
usedfor
forhedging
hedgingandandfor
forspeculation
speculation

McGraw-Hill/Irwin 10-2 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Derivatives

•• The
Thefirst
firstwave
waveof ofmodern
modernderivatives
derivativeswere
wereforeign
foreign
currency
currencyfutures
futuresintroduced
introducedby bythe
theInternational
International
Monetary
MonetaryMarket
Market(IMM)(IMM)following
followingthe
theSmithsonian
Smithsonian
Agreements
Agreementsof of1971
1971andand1973
1973
•• The
Thesecond
secondwavewaveofofmodern
modernderivatives
derivativeswere
wereinterest
interest
rate
ratefutures
futuresintroduced
introducedby bythe
theChicago
ChicagoBoard
BoardofofTrade
Trade
(CBT)
(CBT)after
afterthe
theFed
Fedstarted
startedto
totarget
targetnonborrowed
nonborrowed
reserves
reservesininthe
thelate
late1970s
1970s
•• The
Thethird
thirdwave
waveof ofmodern
modernderivatives
derivativesoccurred
occurredin
inthe
the
1990s
1990swith
withthe
theadvent
adventof ofcredit
creditderivatives
derivatives

McGraw-Hill/Irwin 10-3 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Forwards and Futures

•• AA spot
spot contract
contract isis anan agreement
agreement to to transact
transact
involving
involving the the immediate
immediate exchange
exchange of of assets
assets and
and
funds
funds
•• AA forward
forward contract
contract isis aa nonstandardized
nonstandardized
agreement
agreement to totransact
transactinvolving
involving the
the future
future
exchange
exchange of of aa set
set amount
amount of of assets
assetsat
at aaset
set price
price
•• AA futures
futures contract
contract isis aa standardized
standardized exchange
exchange
traded
traded agreement
agreement to to transact
transact involving
involving the
the future
future
exchange
exchange of of aa set
set amount
amount of of assets
assetsfor
for aaprice
pricethat
that
isis settled
settled daily
daily
McGraw-Hill/Irwin 10-4 ©2009, The McGraw-Hill Companies, All Rights Reserved
 Futures Markets
•• Futures
Futurescontracts
contractsare
areusually
usuallytraded
tradedon
onorganized
organized
exchanges
exchanges
•• Exchanges
Exchangesindemnify
indemnifycounterparties
counterpartiesagainst
againstcredit
credit(i.e.,
(i.e.,
default)
default)risk
risk
•• Futures
Futuresare
aremarket
markettotomarket
marketdaily
daily
–– marked
markedtotomarket
marketdescribes
describesthe
theprices
pricesononoutstanding
outstandingfutures
futures
contracts that are adjusted each day to reflect current futures
contracts that are adjusted each day to reflect current futures
market
marketconditions
conditions
•• The
Thefive
fivemajor
majorU.S.
U.S.exchanges
exchangesare
arethe
theCBOT,
CBOT,CME,CME,
NYFE,
NYFE,MACE,
MACE,and andKCBOT
KCBOT
•• The
Theprincipal
principalregulator
regulatorof
offutures
futuresmarkets
marketsisisthe
the
Commodity
CommodityFutures
FuturesTrading
TradingCommission
Commission(CFTC)
(CFTC)

McGraw-Hill/Irwin 10-5 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Futures Markets
•• Futures
Futurescontract
contracttrading
tradingoccurs
occursin
intrading
trading“pits”
“pits”using
using
an
anopen-outcry
open-outcryauction
auction among
amongexchange
exchangemembers
members
–– floor
floorbrokers
brokersplace
placetrades
tradesfor
forthe
thepublic
public
–– professional
professionaltraders
traderstrade
tradefor
fortheir
theirown
ownaccounts
accounts
–– position
positiontraders
traderstake
takeaaposition
positionininthe
thefutures
futuresmarket
marketbased
based
on
ontheir
theirexpectations
expectationsabout
aboutthethefuture
futuredirection
directionofofthe
theprices
prices
of the underlying assets
of the underlying assets
–– day
daytraders
traderstake
takeaaposition
positionwithin
withinaaday
dayand
andliquidate
liquidateitit
before
beforeday’s
day’send
end
–– scalpers
scalperstake
takepositions
positionsfor
forvery
veryshort
shortperiods
periodsofoftime,
time,
sometimes
sometimesonlyonlyminutes,
minutes,ininananattempt
attempttotoprofit
profitfrom
fromactive
active
trading
trading

McGraw-Hill/Irwin 10-6 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Futures Contract Terms

•• Trading
Trading unit
unit •• Last
Last delivery
delivery day
day
•• Deliverable
Deliverable grades
grades •• Delivery
Delivery method
method
•• Tick
Tick size
size •• Trading
Trading hours
hours
•• Price
Price quote
quote •• Ticker
Ticker symbols
symbols
•• Contract
Contract months
months •• Daily
Daily price
price limit
limit
•• Last
Last trading
trading day
day

McGraw-Hill/Irwin 10-7 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Futures Contracts

•• A
A long
long position
position isis the
the purchase
purchase of of aa futures
futures
contract
contract
•• A
A short
short position
position isis the
the sale
sale of
of aa futures
futures contract
contract
•• A
A clearinghouse
clearinghouse isis the the unit
unit that
that oversees
oversees trading
trading
on
on the
the exchange
exchange and and guarantees
guarantees all all trades
trades made
made
by
by the
the exchange
exchange
•• Open
Open interest
interest isis the
the total
total number
number of of the
the futures,
futures,
put
put options,
options, or
or call
call options
options outstanding
outstanding at at the
the
beginning
beginning of of the
the day
day

McGraw-Hill/Irwin 10-8 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Futures Contracts

•• An
Aninitial
initialmargin
marginisisaadeposit
depositrequired
requiredononfutures
futurestrades
trades
to
toensure
ensurethat
thatthe
theterms
termsof
ofthe
thecontracts
contractswill
willbebemet
met
•• The
Themaintenance
maintenancemargin
marginisisthe
themargin
marginaafutures
futurestrader
trader
must
mustmaintain
maintainonce
onceaafutures
futuresposition
positionisistaken
taken
–– ififlosses
lossesoccur
occursuch
suchthat
thatmargin
marginaccount
accountfunds
fundsfall
fallbelow
belowthe
the
maintenance
maintenancemargin,
margin,the thecustomer
customerisisrequired
requiredtotodeposit
deposit
additional
additionalfunds
fundsininthe
themargin
marginaccount
account
•• Futures
Futurestrades
tradesare
areleveraged
leveragedinvestments
investmentsas astraders
traderspost
post
and
andmaintain
maintainonly
onlyaasmall
smallportion
portionof
ofthe
thevalue
valueofoftheir
their
futures
futuresposition
positionand
and“borrow”
“borrow”the
therest
restfrom
frombrokers
brokers

McGraw-Hill/Irwin 10-9 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Options
•• An
Anoption
optionisisaacontract
contractthat
thatgives
givesthetheholder
holderthe
theright,
right,but
but
not
notthe
theobligation,
obligation,totobuy
buyor orsell
sellthe
theunderlying
underlyingasset
assetatataa
specified
specifiedprice
pricewithin
withinaaspecified
specifiedperiod
periodofoftime
time
•• AAcall
calloption
optionisisananoption
optionthat
thatgives
givesthethepurchaser
purchaserthethe
right,
right,but
butnot
notthe
theobligation,
obligation,to tobuy
buythetheunderlying
underlying
security
securityfrom
fromthethewriter
writerofofthe
theoption
optionatataaspecified
specified
exercise
exerciseprice
priceon on(or
(orup
upto)
to)aaspecified
specifieddate
date
•• AAput
putoption
optionisisananoption
optionthat
thatgives
givesthethepurchaser
purchaserthethe
right,
right,but
butnot
notthe
theobligation,
obligation,to tosell
sellthe
theunderlying
underlyingsecurity
security
to
tothe
thewriter
writerofofthe
theoption
optionatataaspecified
specifiedexercise
exerciseprice
priceon
on
(or
(orup
upto)
to)aaspecified
specifieddate
date

McGraw-Hill/Irwin 10-10 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Payoff Functions
Options
for Call Options

Payoff
Payoff Payoff
Payofffunction
function
profit
profit for
forbuyer
buyer

CC

00 Stock
StockPrice
Price
XX atatexpiration
expiration
-C
-C

Payoff
Payoff Payoff
Payofffunction
function
loss
loss for
forwriter
writer
McGraw-Hill/Irwin 10-11 ©2009, The McGraw-Hill Companies, All Rights Reserved
 Payoff Functions
Options
for Put Options

Payoff
Payoff Payoff
Payofffunction
function
profit
profit for
forbuyer
buyer

PP

00 Stock
StockPrice
Price
XX atatexpiration
expiration
-P
-P

Payoff
Payoff Payoff
Payofffunction
function
loss
loss for
forwriter
writer
McGraw-Hill/Irwin 10-12 ©2009, The McGraw-Hill Companies, All Rights Reserved
 Options

•• The
TheBlack-Scholes
Black-Scholesoption
optionpricing
pricingmodel
model(the
(themodel
modelmost
most
commonly
commonlyused
usedto
toprice
priceand
andvalue
valueoptions)
options)isisaafunction
functionof
of
–– the
thespot
spotprice
priceof
ofthe
theunderlying
underlyingasset
asset
–– the
theexercise
exerciseprice
priceon
onthe
theoption
option
–– the
theoption’s
option’sexercise
exercisedate
date
–– the
theprice
pricevolatility
volatilityof
ofthe
theunderlying
underlyingasset
asset
–– the
therisk-free
risk-freerate
rateof
ofinterest
interest
•• The
Theintrinsic
intrinsicvalue
valueofofan
anoption
optionisisthe
thedifference
differencebetween
betweenan
an
option’s
option’sexercise
exerciseprice
priceand
andthe
theunderlying
underlyingasset
assetprice
price
–– the
theintrinsic
intrinsicvalue
valueof
ofaacall
calloption
option==max{S
max{S––X,
X,0}
0}
–– the
theintrinsic
intrinsicvalue
valueof
ofaaput
putoption
option==max{X
max{X––S,
S,0}
0}

McGraw-Hill/Irwin 10-13 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Please insert Figure 10-8 here.

McGraw-Hill/Irwin 10-14 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Option Markets

•• The
TheChicago
ChicagoBoard
Boardof ofOptions
OptionsExchange
Exchange(CBOE)
(CBOE)
opened
openedin in1973
1973as
asthe
thefirst
firstexchange
exchangedevoted
devotedsolely
solelyto
tothe
the
trading
tradingof
ofstock
stockoptions
options
•• Options
Optionson onfutures
futurescontracts
contractsbegan
begantrading
tradinginin1982
1982
•• An
AnAmerican
Americanoption
optioncan
canbebeexercised
exercisedatatany
anytime
timebefore
before
(and
(andon)
on)the
theexpiration
expirationdate
date
•• AAEuropean
Europeanoption
optioncan
canbe
beexercised
exercisedonly
onlyononthe
the
expiration
expirationdate
date
•• The
Thetrading
tradingprocess
processfor
foroptions
optionsisissimilar
similarto
tothat
thatfor
for
futures
futurescontracts
contracts

McGraw-Hill/Irwin 10-15 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Options

•• The
Theunderlying
underlyingasset
asseton
onaastock
stockoption
optionisisthe
thestock
stockof
ofaa
publicly
publiclytraded
tradedcompany
company
•• The
Theunderlying
underlyingasset
asseton
onaastock
stockindex
indexoption
optionisisthe
thevalue
valueof
ofaa
major
majorstock
stockmarket
marketindex
index(e.g.,
(e.g.,DJIA
DJIAororS&P
S&P500)
500)
•• The
Theunderlying
underlyingasset
asseton
onaafutures
futuresoption
optionisisaafutures
futurescontract
contract
•• Credit
Creditswaps
swaps
–– the
thevalue
valueof
ofaacredit
creditspread
spreadcall
calloption
optionincreases
increasesas
asthe
thedefault
default
(risk)
(risk)premium
premiumororyield
yieldspread
spreadon
onaaspecified
specifiedbenchmark
benchmarkbond
bondof of
the
theborrower
borrowerincreases
increasesabove
abovesome
someexercise
exercisespread
spread
–– aadigital
digitaldefault
defaultoption
optionpays
paysaastated
statedamount
amountininthe
theevent
eventof
ofaa
loan
loandefault
default

McGraw-Hill/Irwin 10-16 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Options

•• The
The primary
primary regulator
regulator ofof futures
futures markets
markets isis the
the
Commodity
Commodity Futures
Futures Trading
Trading Commission
Commission
(CFTC)
(CFTC)
•• The
The Securities
Securities Exchange
Exchange Commission
Commission (SEC)
(SEC) isis
the
the primary
primary regulator
regulator ofof stock
stock options
options and
and stock
stock
index
index options
options
•• The
The CFTC
CFTC isis the
the regulator
regulator of
of options
options on
on futures
futures
contracts
contracts

McGraw-Hill/Irwin 10-17 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Swaps
•• AAswap
swapisisananagreement
agreementbetween
betweentwo
twoparties
partiestotoexchange
exchangeassets
assets
or
oraaseries
seriesofofcash
cashflows
flowsfor
foraaspecific
specificperiod
periodofoftime
timeatataa
specified
specifiedinterval
interval
•• An
Aninterest
interestrate
rateswap
swapisisan
anexchange
exchangeof offixed-interest
fixed-interest
payments
paymentsfor forfloating-interest
floating-interestpayments
paymentsby bytwo
twocounterparties
counterparties
–– the
theswap
swapbuyer
buyermakes
makesthe
thefixed-rate
fixed-ratepayments
payments
–– the
theswap
swapseller
sellermakes
makesthe
thefloating-rate
floating-ratepayments
payments
–– the
theprincipal
principalamount
amountinvolved
involvedininaaswap
swapisiscalled
calledthe
thenotional
notional
principal
principal
•• AAcurrency
currencyswap
swapisisaaswap
swapused
usedtotohedge
hedgeagainst
againstexchange
exchange
rate
raterisk
riskfrom
frommismatched
mismatchedcurrencies
currencieson onassets
assetsand
andliabilities
liabilities
•• Credit
Creditswaps
swapsallow
allowfinancial
financialinstitutions
institutionsto
tohedge
hedgecredit
creditrisk
risk

McGraw-Hill/Irwin 10-18 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Swap Markets

•• Swaps
Swaps are
are not
not standardized
standardized contracts
contracts
•• Swap
Swap dealers
dealers (usually
(usually financial
financial institutions)
institutions) keep
keep
markets
markets liquid
liquid by
by matching
matching counterparties
counterparties oror by
by
taking
taking positions
positions themselves
themselves
•• The
The International
International Swaps
Swaps andand Derivatives
Derivatives
Association
Association (ISDA)
(ISDA) isis aa 815
815 member
member association
association
among
among 56 56 countries
countries that
that sets
sets codes
codes of
of standards
standards
for
for swap
swap documentation
documentation

McGraw-Hill/Irwin 10-19 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Caps, Floors, and Collars

•• Financial
Financial institutions
institutions use
use options
options on
on interest
interest rates
rates
to
to hedge
hedge interest
interest rate
rate risk
risk
–– aacap
capisisaacall
calloption
optionon
oninterest
interestrates,
rates,often
oftenwith
with
multiple
multipleexercise
exercisedates
dates
–– aafloor
floorisisaaput
putoption
optionon
oninterest
interestrates,
rates,often
oftenwith
with
multiple
multipleexercise
exercisedates
dates
–– aacollar
collarisisaaposition
positiontaken
takensimultaneously
simultaneouslyin inaacap
capand
and
aafloor
floor(usually
(usuallybuying
buyingaacap
capand
andselling
sellingaafloor)
floor)

McGraw-Hill/Irwin 10-20 ©2009, The McGraw-Hill Companies, All Rights Reserved

 International Derivative Markets

•• The
The U.S.
U.S. dominates
dominates the
the global
global derivative
derivative
securities
securities markets
markets
–– North
NorthAmerica
Americaaccounted
accountedfor
for$57.94
$57.94trillion
trillionof
ofthe
the
$96.67
$96.67trillion
trillioncontracts
contractsoutstanding
outstandingon
onorganized
organized
exchanges
exchangesin in2007
2007
•• The
The euro
euro and
and European
European exchanges
exchanges are
are expanding
expanding
–– Europe
Europeaccounted
accountedfor
for$32.28
$32.28trillion
trillionof
ofthe
the$96.67
$96.67
trillion
trillioncontracts
contractsoutstanding
outstandingon
onorganized
organizedexchanges
exchanges
in
in2007
2007

McGraw-Hill/Irwin 10-21 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Black-Sholes Call Option Model

 rT
C  N (d1 ) S  E (e ) N (d 2 )

ln(S / E )  (r   2 / 2)T
d1 
 T
d 2  d1  T

McGraw-Hill/Irwin 10-22 ©2009, The McGraw-Hill Companies, All Rights Reserved