FIN2001 - FINANCIAL MARKETS

AND INSTITUTIONS

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 Chapter 5
DERIVATIVES MARKETS

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 Content

§ Background on Derivatives Markets

§ Forwards Markets
§ Futures Markets
§ Option Markets
§ Swap Markets

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 Readings

n Chapter 13, 14, 15, 16; Financial Markets and Institutions,

10th Edition; Jeff Madura; South-Western Cengage
Learning (2017).
n Chapter 24; Financial Markets and Institutions; Federic S.
Mishkin, Stanley G. Eakins; Pearson (2017).

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 5.1. Derivatives Markets
5.1.1. Background on Derivatives Markets

q A derivative security is a financial contract whose value

depends on, or is derived from, the value of underlying assets.
q Some underlying assets:
- Commodity: metal, agricultural products, wood, copper,
gold, silver...
- Energy: oil, gas, electricity…
- Financial instrument: stocks, bonds, currencies, interest
rates, stock indices...

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 5.1. Derivatives Markets
5.1.1. Background on Derivatives Markets

q Common types of derivative contracts:

o Forwards
o Futures
o Options
o Swaps

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 5.1. Derivatives Markets
5.1.1. Background on Derivatives Markets

q Derivatives can be used for hedging or speculating:

• Hedgers take position in derivatives markets to reduce their
exposure to future price movements of the underlying asset.
• Speculators are willing to take risks in the derivatives
markets in order to profit from their expectations of future
price movements of the underlying asset.

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 5.1. Derivatives Markets
5.1.2. Some models of derivatives markets
q Derivatives exchange
v A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the
exchange.
v Example:
• The Chicago Board Options Exchange (CBOE)
• Chicago Board of Trade (CBT)
• Chicago Mercantile Exchange (CME)

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 5.1. Derivatives Markets
5.1.2. Some models of derivatives markets

q Over-the-counter markets
v A telephone- and computer-linked network of dealers
v Trades are done over the phone and are usually between
two financial institutions or between a financial
intermediaries and one of its clients.
v The terms of a contract can be tailored to each party's
needs.
v There is a small risk that the contract will not be honored.

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 5.2. Forward Markets
q A forward contract involves two parties agreeing today on
a price, called the forward price, at which the purchaser
will buy a specified amount of underlying asset from the
seller at a fixed date sometime in the future.
q The buyer of a forward contract is said to have a long
position and is obligated to pay the forward price for the
asset.
q The seller of a forward contract is said to have a short
position and is obligated to sell the asset to the buyer for the
forward price.
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 5.2. Forward Markets
q The future date on which the buyers pays the sellers is the
settlement date.
q The person on the other side of the contract is the
counterparty.
q Ordinarily, both parties are bound by the contract and are
not released from that obligations early unless they
renegotiate the contract prior to its fulfillment.

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 5.2. Forward Markets
Figure 1. Potential Gains and Losses on a Forward Contract

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 5.3. Futures Markets
q Like forward contracts, futures contracts involve two
parties agreeing today on a price, called the future price, at
which the purchaser will buy a given amount of underlying
assets from the seller at a fixed date sometime in the future.
q Futures and forwards serve many of the same economic
functions, but the markets for them are sufficiently
different.

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 5.3. Futures Markets
5.3.1. The differences between forwards and futures contracts
Forward contracts
Unstandardized
Direct contract between two
parties
High credit risk
A specified delivery date
Settlement at the termination
of the contract
Actual delivery of specified
items on the specified date
Futures contracts
Standardized
Formal contract between each
party and the futures exchange
Low credit risk
Specific delivery dates
Daily cash settlement of all
contracts
Almost all contracts are offset
prior to delivery 14
 5.3. Futures Markets
5.3.2. Futures market instruments
q Futures markets can be started for any type of securities,
foreign currency, or commodity.
q Initially, several exchanges may issue similar contracts, or
one exchange may issue several closely related contracts.
q However, over time one contract tends to gain popularity at
the expense of other closely related contracts, and trading
tends to be concentrated in that single contract.

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5.3. Futures Markets

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 5.3. Futures Markets
Figure 2. Potential Gains and Losses on a Futures Contract

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 5.4. Option Markets
q An option contract allows people to enter into a contract to
buy or sell underlying asset at a predetermined price, called
the strike price or exercise price, until some future time.
q Unlike futures contracts, an option buyer has the right to
buy or sell assets, but not the obligation to buy or sell
assets.
q The option buyer pays an amount, called option premium,
for the option seller (the writer).

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 5.4. Option Markets

q There are two types of option contracts:

• American option – can be exercised at any time up to
the expiration date of the contract.
• European option – can be exercised only on the
expiration date.

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 5.4. Options Markets
5.4.1. Types of options

q Call options give the buyer the right (but not obligation) to
buy the underlying asset at the strike price. The writer of a
call agrees to sell the underlying asset at the strike price if
the buyer exercises the option.
q Put options give the buyer the right (but not obligation) to
sell the underlying asset at the strike price. The writer of a
put agrees to buy the underlying asset at the strike price if
the buyer exercises the option.

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 5.4. Options Markets
5.4.2. Gains and Losses

Potential gains and losses are different for buyers and

writers of puts and calls.

Figure 3. Potential Gains and Losses on an Option Contract 21

 5.4. Options Markets
Figure 4. Potential Gains and Losses on a Call Option

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 5.4. Options Markets
Figure 5. Potential Gains and Losses on a Put Option

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 5.4. Options Markets
5.4.3. Determinants of option premiums

5.4.3.1. Determinants of call option premiums

q Market Price - The higher the existing market price of the
underlying asset relative to the exercise price, the higher the call
option premium, other things being equal.
q Stock’s Volatility - The greater the volatility of the underlying
asset, the higher the call option premium, other things being equal.
q Time to Maturity - The longer the call option’s time to maturity,
the higher the call option premium, other things being equal.

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 5.4. Options Markets
5.4.3. Determinants of option premiums

5.4.3.2. Determinants of put option premiums

q Market Price - The higher the existing market price of the
underlying asset relative to the exercise price, the lower the put
option premium, other things being equal.
q Stock’s Volatility - The greater the volatility of the underlying
asset, the higher the put option premium, other things being equal.
q Time to Maturity - The longer the time to maturity, the higher the
put option premium, other things being equal.

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 5.5. Swap Markets
q A swap is an agreement between two parties to make
periodic payments or to exchange cash flows in
predetermined time in the future.
q Common types of swaps:
§ Interest rate swap
§ Currency swap

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 5.5. Swap Markets
5.5.1. Interest rate swap
q An interest rate swap is an arrangement whereby a party
exchanges one set of interest payments for another.
q The provisions of an interest rate swap include:
§ The notional principal value
§ The fixed interest rate
§ The floating rate
§ The frequency of payments
§ The lifetime of the swap

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 5.5. Swap Markets
5.5.1. Interest rate swap

q Example:
A and B enter into an interest rate swap with a nominal
principal of $1 million and the lifetime of the swap is 5 years.
A owes B at a fixed interest rate of 4% on nominal principal. B
owes A at a floating rate (2% + T-bills rate) on the same
nominal principal. A and B agree to pay interest annually.

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 5.5. Swap Markets
5.5.1. Interest rate swap
§ The exact terms of trade are usually not pre-specified, but rather
they typically vary with interest rates.
§ Swap is usually arranged for only a net transfer of funds.
o Ex: If the T-bill rate in the first year is 1%, A and B will exchange
$10,000 as the interest difference due on the nominal principal of
$1 million .
n The nominal principal is never actually transferred between
counterparties; it serves only as the basis for calculating the
swapped interest payments.

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 5.5. Swap Markets
5.5.1. Interest rate swap
q Use of Swaps for Hedging
Example: Financial institutions in the U.S. with more interest
rate sensitive liabilities than assets were adversely affected by
increasing interest rates.
Financial institutions in Europe had more access to long-term
fixed rate funding and used the funds for floating-rate loans and
were adversely affected by declining interest rates.
Interest rate swaps allowed both types of financial institutions
to reduce exposure to interest rate risk.

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 5.5. Swap Markets
5.5.1. Interest rate swap
q Use of Swaps for Hedging

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 5.5. Swap Markets
5.5.1. Interest rate swap
q Use of Swaps for Speculating
§ Interest rate swap are sometimes used by financial
institutions and other firms for speculative purposes.
§ Example: An institution may engage in a swap to benefit
from its expectations that interest rate will rise, even if its
other operations are not exposed to interest rate movements.
When the swap is used for speculating rather than for
hedging, any loss on the swap positions will not be offset by
gains from other operations

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 5.5. Swap Markets
5.5.2. Currency swap

q A currency swap is an arrangement whereby currencies

are exchanged at specified exchange rates and at specified
intervals.

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 5.5. Swap Markets
5.5.2. Currency swap
q Example: A U.S. firm expects to receive £2 million in each of the
next 4 years. It may therefore want to lock in the exchange rate
at which it can sell British pounds over the next 4 years. A
currency swap will specify the exchange rate at which the £2
million can be exchanged in each year.
Assume the exchange rate specified by a swap is £1= $1.70, so
that firm will receive $3.4 million in each of the 4 years. If the
firm does not engage in a currency swap, the dollar amount
received will depend on the spot exchange rate at the time the
pounds are converted to dollars.

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 5.5. Swap Markets
5.5.2. Currency swap
q Impact of currency swaps

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