Dfol Txt-Vol1-2019 12 en V01

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© CANADIAN SECURITIES INSTITUTE (2019)

DERIVATIVES FUNDAMENTALS AND
OPTIONS LICENSING COURSE
VOLUME 1
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ISBN: 978-1-77176-341-7
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Revised and reprinted: 2000, 2001, 2002, 2003, 2004, 2007, 2008, 2010, 2011, 2012, 2013, 2014, 2015, 2016,
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Copyright © 2019 by Canadian Securities Institute

Preface
WELCOME TO THE DERIVATIVES FUNDAMENTALS AND OPTIONS
LICENSING COURSE
The Derivatives Fundamentals and Options Licensing Course (DFOL) is a one-step solution towards meeting
both the regulatory and educational requirements to advise clients in options, and the base requirement for CSI’s
Certificate in Derivatives Market Strategies.
ONE ENROLMENT, ONE LEARNING PLATFORM AND ONE EXAM

This one-step solution includes, in DFOL Volume 1, selected Chapters from the Derivatives Fundamentals Course
(DFC), and, in DFOL Volume 2, all of the Chapters from the Options Licensing Course (OLC).

ii DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | VOLUME 1
CSI’S DERIVATIVES EDUCATION MISSION

The goal of both the one-step and the standard two-step (enrolling first in the DFC and then in the OLC) licensing
programs is to help increase knowledge and competency levels in the field of derivatives amongst professionals
serving derivatives markets and the general public. By having potential options-licensed representatives go through
these programs, the following benefits will accrue to the industry, the public and the markets:
• The investment industry’s high level of professionalism will be supported, which will help reduce regulatory
problems and client complaints.
• Potential registrants who will be in the position of giving advice will be able to provide increasingly higher
levels of service to their clients, who in turn will become more knowledgeable about the benefits and risks of
derivatives.
• Liquidity in Canadian derivatives markets will improve. Greater liquidity will attract more users, which will in
turn improve the efficiency of the marketplace.
STRUCTURE OF VOLUME 1 AND VOLUME 2 OF THE DFOL

Each volume is divided into two major components: Part I, the Textbook, and Part II, the Workbook.
Part I, the Textbook, contains all the examinable content, divided in Chapters and Topic Sections.
Part II, the Workbook, presents multiple review activities that integrate the material learned in Part I. The Workbook
includes chapter summaries and review questions, case studies and all solutions.
DFOL ONLINE MODULES

Your registration as a student in the DFOL includes access to online modules that guide your progress through the
course materials. The modules are designed as additional study guides that help reinforce the textbook content and
assess your knowledge. We suggest you log in to the online course and use the modules along with your text.
COURSE OBJECTIVES
By the end of this course, you should be able to:
1. Describe generally what derivatives are, the commonalities and differences between the various types and
how they are used.
2. Demonstrate the effect of leverage inherent in derivatives.
3. Recognize the conditions that facilitate arbitrage.
4. Calculate the cost of carry on a futures contract given financing, storage and insurance costs.
5. Demonstrate how corporations use swaps to mitigate the various types of risks that they are exposed to.
6. Demonstrate how investment funds and structured products use derivatives.
7. Recommend suitable speculative or hedging strategies to an approved client given the client’s profile, need
and market view.
8. Calculate the risk and reward parameters of both buying and writing put and call options.
9. Demonstrate the impact volatility has on the time value of an option.
10. Know the proper procedures and documentation required for opening and maintaining option accounts.

PREFACE iii
11. Calculate margin requirements and margin calls.

12. Evaluate the tax implications of options trading.
13. Understand the various roles both clearing corporations and exchanges play in listed options trading.
14. Know the rules of trading options on the Bourse de Montréal and the structure and systems of the U.S. options
exchanges.
15. Understand how market makers hedge their price risk.
16. Understand how dividends, rights issues and stock splits affect options.
17. Know the unique aspects and risks of non-equity options.

DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE
Content Overview
Volume 1
Part 1 | Textbook
1 An Overview of Derivatives
2 Basic Features of Forward Agreements and Futures Contracts
3 Pricing of Futures Contracts
4 Hedging with Futures Contracts
5 Speculating with Futures Contracts
6 Basic Features of Options
7 Pricing of Options
8 Over-the-Counter Options
9 Introduction to Swaps
10 Interest Rate Swaps
11 Currency Swaps
12 Credit Swaps
13 Other Types of Swaps
14 Mutual Funds
15 Hedge Funds
16 Principal Protected Notes (PPNs)
17 Derivative-Based Exchange-Traded Funds
G Glossary
Part 2 | Workbook
SECTION 1 Chapter Summaries and Review Questions
SECTION 2 Answers to Questions

vi DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | VOLUME 1
Volume 2
Part 1 | Textbook
1 Bullish Option Strategies
2 Bearish Option Strategies
3 Option Volatility Strategies
4 Conduct and Practices
5 Opening and Maintaining Retail Option Accounts
6 Client Margin Requirements
7 Entering Listed Option Orders
8 Canadian Tax Aspects of Listed Options Trading
9 Opening and Maintaining Institutional Option Accounts
10 The Role of Clearing Corporations in Listed Options Trading
11 The Role of Exchanges in Listed Options Trading
12 Listed Options Trading
13 A Day in the Life of a Market Maker
14 The Impact of Stock Splits, Dividends and Rights Issues on Option Contracts
15 Stock Index Options
16 Currency Options
Part 2 | Workbook
SECTION 1 Chapter Summaries and Review Questions
SECTION 2 Multiple Choice Review Questions
SECTION 3 Case Studies
SECTION 4 Solutions

DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE vii
Table of Contents | Volume 1 | Part 1

SECTION 1 | AN OVERVIEW OF DERIVATIVES
1•3 INTRODUCTION
1•3 WHAT IS A DERIVATIVE?
1•3 COMMON FEATURES OF ALL DERIVATIVE INSTRUMENTS
1•4 TYPES OF DERIVATIVE INSTRUMENTS

1•4 Option-Based Derivatives
1•5 Forward-Based Derivatives
1•6 KEY DIFFERENCES BETWEEN OPTION-BASED AND FORWARDBASED DERIVATIVES
1•7 EXCHANGE-TRADED AND OVER-THE-COUNTER DERIVATIVES

1•7 Exchange-Traded Derivatives
1•8 Over-the-Counter Derivatives
1•9 KEY DIFFERENCES BETWEEN EXCHANGE-TRADED AND OVER-THE-COUNTER
DERIVATIVES
1 • 10 TYPES OF UNDERLYING INTERESTS

1 • 11 Commodities
1 • 12 Financials
1 • 13 WHY ARE DERIVATIVES USEFUL?
1 • 14 Risk Reduction Through Hedging
1 • 17 Cost Reduction
1 • 18 Market Entry and Exit
1 • 18 Yield Enhancement
1 • 19 Speculation
1 • 21 Arbitrage
1 • 21 Structuring Products
1 • 21 OPERATIONAL CONSIDERATIONS
1 • 22 WHO USES DERIVATIVES AND TO WHAT EXTENT ARE THEY USED?
1 • 24 SUMMARY

viii DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | VOLUME 1
SECTION 2 | FUTURES CONTRACTS

2•3 A BRIEF OVERVIEW OF FORWARD-BASED DERIVATIVES
2•3 A HISTORY OF FORWARDS
2•4 WHAT IS A FORWARD AGREEMENT?
2•6 WHAT IS A FUTURES CONTRACT?
2•7 ORGANIZED FUTURES MARKETS
2•9 BUYING AND SELLING A FUTURES CONTRACT
2 • 11 CASH SETTLEMENT
2 • 11 MARGIN REQUIREMENTS AND MARKING-TO-MARKET
2 • 12 FUTURES TRADING AND LEVERAGE
2 • 12 READING A FUTURES QUOTATION PAGE
2 • 13 CONTRACT SIZE AND THE VALUE OF THE UNDERLYING INTEREST

3•3 A BRIEF OVERVIEW OF FUTURES PRICING
3•3 FUTURES MARKET VERSUS CASH MARKET
3•3 COST OF CARRY
3•5 BASIS
3•5 Normal Market
3•6 CASH AND CARRY ARBITRAGE
3•7 REVERSE CASH AND CARRY ARBITRAGE
3•8 CONDITIONS THAT FACILITATE ARBITRAGE
3•8 INVERTED MARKETS
3•9 CONVERGENCE

TABLE OF CONTENTS ix

4•3 HEDGING
4•3 TYPES OF HEDGES

4•3 Short Hedge
4•4 Long Hedge
4•6 IMPERFECT HEDGES
4•8 OPTIMAL HEDGE RATIO

5•3 WHAT ATTRACTS SPECULATORS?
5•3 Ease of Entry and Exit
5•3 Variety of Opportunities
5•3 Leverage
5•4 Excitement
5•4 TYPES OF SPECULATORS
5•4 Locals
5•4 Day Traders
5•4 Position Traders
5•5 SPREAD TRADERS
5•5 Intramarket Spread
5•5 Intercommodity Spread
5•6 Intermarket Spread
5•6 Commodity Product Spread
5•6 Managed Futures Investors
5•7 Managed Accounts
5•7 Managed Futures Funds
5•7 Hedge Funds
5•7 Commodity Pools
5•8 PRICE FORECASTING TECHNIQUES
5•8 Fundamental Analysis
5 • 10 Technical Analysis

x DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | VOLUME 1
SECTION 3 | EXCHANGE-TRADED OPTIONS

6•5 THE HISTORY OF OPTIONS
6•5 KEY OPTION TERMINOLOGY AND DEFINITIONS
6•7 APPLICATION OF KEY TERMS AND DEFINITIONS
6•9 WHY INVESTORS BUY OPTIONS

6 • 10 Leverage
6 • 11 The Lesson Learned from Leverage
6 • 11 Limited Risk
6 • 15 WHY INVESTORS WRITE OPTIONS
6 • 19 A Lesson to Be Learned: The Danger of Uncovered or Naked Option Writing
6 • 19 OTHER RELATED BENEFITS OF OPTIONS
6 • 20 ADVANTAGES OF EXCHANGE-TRADED OPTIONS VERSUS OVER-THE-COUNTER

OPTIONS
6 • 20 Third-Party Guarantor
6 • 20 Increased Liquidity
6 • 20 More Comprehensive Disclosure and Surveillance Rules
6 • 21 Price Transparency
6 • 21 READING OPTION QUOTATIONS
6 • 22 COMMON QUESTIONS PERTAINING TO THE OPTIONS MARKET
7•3 PRICING OF OPTIONS
7•3 MAJOR FACTORS THAT AFFECT THE PRICE OF AN OPTION
7•4 INTRINSIC VALUE

7•4 Difference Between Strike Price and Market Price
7•4 European-Style and American-Style Options
7•5 TIME VALUE
7•5 Time Remaining to Expiration

TABLE OF CONTENTS xi
7•6 Difference Between Strike Price and Current Price of the Underlying Interest
7•7 Volatility of the Underlying Instrument
7•9 Implied Volatility Indices
7•9 Cost of Carrying the Underlying Investment
7 • 10 DELTA
7 • 11 A Practical Use of the Delta
8•3 OVER-THE-COUNTER INTEREST RATE OPTIONS
8•3 INTEREST RATE CAPS

8•3 Definition of an Interest Rate Cap
8•4 Characteristics of an Interest Rate Cap
8•5 INTEREST RATE FLOORS
8•5 The Characteristics of an Interest Rate Floor
8•6 INTEREST RATE COLLARS
8•7 Exotic Options
8•7 Compound Options
8•8 Asian Options
8•8 Barrier Options
8•8 Multi-Asset Options
8•9 Shout Options
8•9 CONCLUSION
8 • 11 APPENDIX 8A
SECTION 4 | SWAPS
9•3 OVERVIEW OF THE SWAP MARKET
9•3 WHAT IS A SWAP?
9•4 ROLE OF THE SWAP DEALER
9•5 HISTORY OF SWAPS

xii DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | VOLUME 1
9•5 OTC DERIVATIVES MARKET REFORM

9•7 Canadian Implementation of OTC Derivatives Trade Reporting

10 • 3 PLAIN VANILLA INTEREST RATE SWAP
10 • 3 A NOTE ON RATE AND DAY COUNT CONVENTIONS
10 • 3 THE STRUCTURE OF AN INTEREST RATE SWAP
10 • 6 PRICING AN INTEREST RATE SWAP
10 • 7 INDICATION PRICING SCHEDULE
10 • 8 CREDIT RISK
10 • 9 TERMINATING AN INTEREST RATE SWAP
10 • 9 WHY ARE INTEREST RATE SWAPS USED?
10 • 10 DELIVERABLE INTEREST RATE SWAP FUTURES AND CENTRALLY CLEARED SWAPS
10 • 10 OTHER TYPES OF INTEREST RATE SWAPS
10 • 11 SWAPTIONS
11 Currency Swaps
11 • 3 THE STRUCTURE OF A CURRENCY SWAP
11 • 5 CURRENCY SWAPS AS A PORTFOLIO OF EITHER FIXED-OR FLOATING-RATE BONDS OR

BOTH
11 • 5 PRICING OF CURRENCY SWAPS
11 • 6 REASONS FOR CURRENCY SWAPS
12 Credit Swaps
12 • 3 CREDIT DERIVATIVES
12 • 3 THE ROLE OF CREDIT DERIVATIVES
12 • 4 THE STRUCTURE OF CREDIT DEFAULT SWAPS

TABLE OF CONTENTS xiii
12 • 6 INDEX CREDIT DEFAULT SWAPS

12 • 6 How are Index CDSs Structured?
12 • 7 How do Index CDSs Trade?
12 • 9 USES FOR CREDIT DEFAULT SWAPS

13 • 3 EQUITY SWAPS
13 • 4 COMMODITY SWAPS
SECTION 5 | HOW INVESTMENT FUNDS AND STRUCTURED PRODUCTS USE DERIVATIVES
14 Mutual Funds
14 • 3 DERIVATIVES USE BY INVESTMENT FUNDS AND STRUCTURED PRODUCTS
14 • 3 REGULATORY RESTRICTIONS ON DERIVATIVES USE BY MUTUAL FUNDS

14 • 3 National Instrument 81-102
14 • 3 MUTUAL FUND USE OF DERIVATIVES
14 • 4 NI 81-102 Definition of Hedging
14 • 6 DERIVATIVES FOR NON-HEDGING PURPOSES
14 • 6 Additional Non-Hedging Information
14 • 7 Derivatives Use and Disclosure
14 • 7 RISKS OF DERIVATIVES USE BY MUTUAL FUNDS
15 Hedge Funds
15 • 3 WHAT IS A HEDGE FUND?
15 • 3 Hedge Fund Product Structures
15 • 4 HEDGE FUND AND COMMODITY POOL REGULATION
15 • 4 Distributions
15 • 5 HOW HEDGE FUNDS USE DERIVATIVES
15 • 6 RISKS OF DERIVATIVES

xiv DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | VOLUME 1
15 • 6 ADVANTAGES OF DERIVATIVES
15 • 7 DISADVANTAGES OF DERIVATIVES

16 • 3 WHAT ARE PRINCIPAL-PROTECTED NOTES?
16 • 3 Issuers of PPNs
16 • 3 Regulation of PPNs
16 • 3 RELATIONSHIP TO MARKET-LINKED GIC s
16 • 3 STRUCTURES OF PRINCIPAL-PROTECTED NOTES AND THEIR USE OF DERIVATIVES
16 • 4 Zero-Coupon Bond Plus Call Option
16 • 6 Constant Proportion Portfolio Insurance
16 • 8 KEY DIFFERENCES BETWEEN THE TWO PPN STRUCTURES
16 • 8 Risks Inherent in PPNs

17 • 3 INTRODUCTION
17 • 3 COMMODITY EXCHANGE-TRADED FUNDS

17 • 3 Physical Ownership
17 • 3 Synthetic Replication
17 • 3 The Futures Curve
17 • 5 The Roll Window
17 • 5 SWAP-BASED ETFs AND THE SYNTHETIC REPLICATION OF INDEXES
17 • 5 Unfunded swap ETF structure
17 • 6 Funded swap ETF structure
17 • 6 Counterparty Risk and the Collateral Basket
17 • 7 LEVERAGED AND INVERSE ETFs
17 • 8 Daily reset to maintain constant leverage
17 • 9 Rebalancing in the same direction of the market

TABLE OF CONTENTS xv
Table of Contents | Volume 1 | Part 2

SECTION 1 | CHAPTER SUMMARIES AND REVIEW QUESTIONS
1•1 CHAPTER 1 – AN OVERVIEW OF DERIVATIVES
1• 7 CHAPTER 2 – BASIC FEATURES OF FORWARD AGREEMENTS AND FUTURES CONTRACTS
1• 15 CHAPTER 3 – PRICING OF FUTURES CONTRACTS
1• 21 CHAPTER 4 – HEDGING WITH FUTURES CONTRACTS
1• 27 CHAPTER 5 – SPECULATING WITH FUTURES CONTRACTS
1• 31 CHAPTER 6 – BASIC FEATURES OF OPTIONS
1• 37 CHAPTER 7 – PRICING OF OPTIONS
1• 41 CHAPTER 8 – OVER-THE-COUNTER OPTIONS
1• 47 CHAPTER 9 – INTRODUCTION TO SWAPS
1• 51 CHAPTER 10 – INTEREST RATE SWAPS
1• 59 CHAPTER 11 – CURRENCY SWAPS
1• 63 CHAPTER 12 – CREDIT SWAPS
1• 67 CHAPTER 13 – OTHER TYPES OF SWAPS
1• 69 CHAPTER 14 – MUTUAL FUNDS
1• 73 CHAPTER 15 – HEDGE FUNDS
1• 77 CHAPTER 16 – PRINCIPAL PROTECTED NOTES (PPNS)
1• 79 CHAPTER 17 – DERIVATIVE-BASED EXCHANGE-TRADED FUNDS
SECTION 2 | ANSWERS TO QUESTIONS
G Glossary

SECTION 1
AN OVERVIEW OF DERIVATIVES

An Overview of Derivatives 1
CONTENT AREAS
What Is a Derivative?
Common Features of All Derivative Instruments
Types of Derivative Instruments
Key Differences Between Option-Based and Forward-Based Derivatives
Exchange-Traded and Over-the-Counter Derivatives
Key Differences Between Exchange-Traded and Over-the-Counter Derivatives
Types of Underlying Interests
Commodities
Financials
Why Are Derivatives Useful?
Operational Considerations
Who Uses Derivatives and to What Extent Are They Used?

1•2 DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | TEXTBOOK | SECTION 1 | VOLUME 1
LEARNING OBJECTIVES
1 | Describe generally what derivatives are, the commonalities and differences between the various
types and how they are used.
2 | Describe the features that are common to all derivatives.
3 | Differentiate between option-based and forward-based derivatives.
4 | Differentiate between exchange-traded and over-the-counter derivatives.
5 | Identify the various financial needs clients may have that derivatives can address.
6 | Identify the operational considerations firms that use derivatives must consider.
KEY TERMS
Key terms are defined in the Glossary and appear in bold text in the chapter.
arbitrage over-the-counter
call option performance bond
comparative advantage premium
counterparties put option
exchange-traded swap
forward contract time to expiration
hedging underlying interest
leverage zero-sum game
option

CHAPTER 1 | AN OVERVIEW OF DERIVATIVES 1•3
INTRODUCTION
In this chapter, we provide an overview of derivatives, which is a class of security whose value is derived from an
underlying asset. First, we describe the different types of derivative products and explain their key differences. We
also provide a brief outline of the types of assets that underlie derivative instruments and from which they derive
their value. You will then learn how derivatives can be used to hedge risk, along with a number of other ways they
can be put to use in a portfolio. Next, you will learn the risks and operational considerations inherent in the use of
derivatives, in particular, the risks involved with excess use of the leverage opportunities they provide. Finally, we
provide some statistics on the use of derivatives that should shed light on who is using them and to what extent
they are being used.
WHAT IS A DERIVATIVE?
Derivatives are financial instruments whose value is derived solely from an underlying interest, such as stocks,
commodities, currencies, bonds, indices, or loans. Their value can also be tied to a specific event, such as a weather
occurrence or a change in interest rates. Derivatives are not asset classes unto themselves. They were created to
allow market participants to easily trade and manage the asset upon which these instruments are based.
The International Accounting Standard Board (IASB) states in its definition of a derivative1 that a derivative
instrument must have all three of the following characteristics:
1. Its value must change in response to the change in a specified interest rate, security price, commodity price,
foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable.
2. Excluding margin, it must require little or no initial net investment relative to other types of contracts with a
similar response to changes in market conditions.
3. It must be settled at a future date.
Examples of common derivative instruments with these characteristics are shown in Table 1.1.
Table 1.1 | Examples of Common Derivative Instruments
Derivative Underlying Initial Investment Future Settlement
A futures contract to buy 1,000 barrels of Crude oil $0 Yes – 3 months

crude oil at US$65 in 3 months
A forward contract to buy US$10,000 for US$/C$ $0 Yes – 1 year

C$10,800 in 1 year exchange rate
An option to buy 100 ABC common shares at ABC common shares $200 Yes – 1 month
$35 in 1 month. The option costs $2 per share
COMMON FEATURES OF ALL DERIVATIVE INSTRUMENTS

The financial vehicles that users create to trade and manage underlying assets are contractual agreements between
two parties, a buyer and a seller, known as counterparties. The agreements spell out the precise rights and
obligations of each party.
1
International Accounting Standard (IAS) 39.9.

Almost all derivative contracts have a specific time to expiration. (The lone exception is a contract for differences,
as discussed later in this chapter.) Depending on the type of derivative, the contract imposes obligations on both
parties, or it grants a right to one party and imposes an obligation on the other. Both parties must honour any
obligations and, if they so choose, exercise any rights of the contract (i.e., to buy or sell a specified underlying
interest) on or before expiration. The contract automatically terminates upon expiration.
With all derivative contracts, a price or a formula for exchanging payments is set up initially, which takes effect at
some point during the life of the contract. With some derivatives, the buyer makes an upfront payment to the seller
in exchange for the right to buy or sell the underlying interest at a pre-set price during the life of the contract. With
other contracts, no up-front payment is involved. Instead, one party makes a good-faith deposit upon entry in the
form of a performance bond, which provides strong assurance for the other side of the transaction that the terms
of the contract will eventually be honoured.
All derivative contracts facilitate the use of leverage – that is, the ability to control large dollar amounts of an
underlying interest with a comparatively small amount of capital. Because leverage can greatly magnify the effect
of price changes in the underlying interest, its aggressive use can result in tremendous gains for its user, but it can
also pose a serious risk. For many derivative instruments, the ratio of underlying interest to capital needed can be as
high as 30- or 40-to-1. By comparison, for many qualified equities, the ratio is only about 3-to-1.
Although derivative instruments facilitate the generous use of leverage, they do no impose it; it is the
counterparties who determine how much of the available leverage to use. Leverage can be used very aggressively or
very conservatively. Some derivative users may choose not to use leverage at all, even though it is available. Instead,
they deposit enough capital to cover the full value of the contract. When leverage is used in aggressively, the
contract must be monitored closely. Many recent high-profile losses involving derivative instruments have had less
to do with the inherent risks associated with derivatives than with the reckless use, or outright misuse, of leverage.
Another difference between derivatives and financial assets such as stocks and bonds is that derivatives are a zero-
sum game. In other words, commission fees and bid-ask spreads aside, the gain from a derivative contract by one
party is exactly offset by the loss to the counterparty. The huge financial losses incurred by some well-known users
of derivatives were actually large wealth transfers. Two such examples are Long-Term Capital Management and
Amaranth Advisors. Every dollar lost by these parties represented a dollar gained by the counterparties on the other
side of the transactions.
TYPES OF DERIVATIVE INSTRUMENTS

All derivative instruments, no matter how complex their structure, fall into one of two basic types: option-based
contracts and forward-based contracts. Both forward and option products can trade either on or off an organized
exchange, as explained later in this section.
Although the two derivative types differ significantly in fundamental respects, it is important to understand that
they are both ultimately used to achieve similar financial goals. Just as one can choose between different modes
of transportation to reach the same destination, investors can choose between option-based and forward-based
products to fulfill the same objective.
OPTION-BASED DERIVATIVES
Whenever you are offered an option, you have the right, but not the obligation, to exercise it. For example, when
you order a salad at a restaurant, you are often offered a choice of dressings. You can choose from among the
options, or you can choose no salad dressing at all. This course deals with a very specific type of option – an option
created through a financial contract.
An option contract, as the name implies, gives the holder the option to buy or sell an underlying interest at a
specified price, known as the exercise price, or strike price, within a specified period. Depending on whether they

want to buy or sell, market participants use either of two types of option contracts to lock in the price of an
underlying asset at some point in the future:
• A call option gives the purchaser the right to buy the underlying asset at a locked-in purchase price. In other
words, the call buyer has the right to call away (i.e., buy) the underlying asset from the call seller.
• A put option gives the purchaser the right to sell the underlying asset at a locked-in a sale price. In other words,
the put buyer has the right to put (i.e., sell) the underlying asset to the put seller.
Example 1.1 illustrates a call option in the context of a real estate deal.
EXAMPLE 1.1 | CALL OPTIONS

Let’s assume that you plan to buy a house priced at $345,000 in six months. You are concerned that house prices
may rise in the meantime, but you do not want to commit to buying the house right now.
Faced with this situation, you approach the house seller and come to an agreement. The seller gives you the
option to buy the house at an exercise price of $350,000 at any time during the next six months. In return, you
pay the seller a fee of $5,000, which is referred to as the option premium. Because the option gives you the right
to buy, rather than sell, it is referred to as a call option.
If, at any time during the six-month life of the contract, you decide to exercise your option (i.e., buy the house),
the exercise price will be $350,000. Your total cost will be $355,000 because it will also include the $5,000
premium you paid for the option contract.
As the call option holder (i.e., the buyer in the contract), the most you risk losing is $5,000. For example, if the
market price of the house falls to $330,000, you would choose to walk away rather than exercise your option
to pay $350,000. Your loss would therefore be limited to the $5,000 you paid for the contract. If, on the other
hand, the market price rises above $355,000, the contract could turn out to be a valuable purchase. For example,
if the house price rises to $375,000, and you opt to buy at the $350,000 exercise price, you will have saved
$20,000 ($25,000 less the $5,000 premium) on the house purchase.
For the call option writer (i.e., the seller in the contract), the risk of loss is much greater. In fact, there is
theoretically no limit to the potential size of a call writer’s loss because, unlike the call holder, the call writer has
an obligation under the contract. If, for example, the price of the house rises to $400,000, and you choose to
exercise your right to buy it, the call writer is obligated to sell the home at the exercise price of $350,000. The
seller will have suffered an opportunity loss of $50,000, minus the $5,000 premium you paid initially.
In effect, purchase of a call option is akin to buying insurance. The buyer is protected against an adverse
development (i.e., a rise in the price of the underlying asset). If that development does not take place, the buyer
does not lose anything more than the insurance premium. Because option holders will not exercise when it is
unprofitable to do so, the loss is always limited to the premium paid. In such contracts, the call writer is willing to
take on the risk that the price of the underlying asset will rise in return for the premium. The writer, of course, does
not believe that prices will rise enough to cause a loss.
FORWARD-BASED DERIVATIVES
Whereas option contracts give holders the right to buy or sell, with no obligation, a forward contract is one that
obligates one party to buy and another party to sell a defined amount of an underlying interest at an agreed-upon
price on a specific date (unless both parties agree to cancel the obligation). The buyer does not pay the agreed-upon
price right away, nor does the seller deliver the underlying interest. Payment and delivery take place at a specified
date in the future, known as the delivery date. The agreed-upon price, known as the delivery price, is defined when
the parties enter into the contract.

One has to look no further than the real estate market for an example of a forward-based transaction. When buying
or selling a home, the terms of the transaction, including the price, are agreed upon when the deal is made. The
closing of the deal, including payment and possession, typically takes place some months later.
Example 1.2 illustrates a forward contract, again in the context of a real estate deal.
EXAMPLE 1.2 | FORWARD CONTRACTS

Again, suppose you want to buy a house in six months’ time. Rather than buying a call option, which gives you
the right to buy within six months at the exercise price of $350,000, you commit to buying the home, and the
seller commits to selling the home, at $345,000. The closing of the deal, including payment and delivery (i.e.,
possession), will be in six months’ time.
If the market price of the home falls to, say, $300,000 between the time of the sale and the possession date,
you are still contractually obligated to take possession of the home at the agreed-upon price of $345,000 even
though its value has declined in the interim.
Unlike the option buyer, neither you nor the seller can walk away from the contract if its terms will result in a loss
due to adverse market changes. The advantage of the forward contract, however, is that no up-front premium
has to be paid.
KEY DIFFERENCES BETWEEN OPTION-BASED AND FORWARDBASED

DERIVATIVES
The primary distinction between the two basic derivative types is that option-based instruments give holders the
right to buy or sell an underlying interest up to some point in the future, whereas forwards represent an obligation
to buy or sell.
A second key difference is that, at expiration, options only have value if the price of the underlying asset is above
(in the case of calls) or below (in the case of puts) a trigger point known as the exercise price. This value is referred
to as intrinsic value. For example, the call option on the house described above, with an exercise price of $350,000,
only has value at its expiration if the price is above $350,000. If the price rose to $348,000 at expiration, the option
would have no value, despite the fact that the market price of the house at that time was higher than the price
when the counterparties entered into the option contract.
Forwards, on the other hand, have value to one or the other of the counterparties as soon as a price changes. In
our real estate example, if the actual house price falls to $300,000, the forward contract will have positive value
of $45,000 to the seller, which is the amount by which the seller is able to sell the house over the current market
price. At the same time, the contract has negative value of $45,000 to the buyer.
In this respect, it can be said that an option has a non-linear relationship with its underlying asset because the price
or value of the option does not typically change dollar-for-dollar with the underlying asset’s price or value. Forward
contracts, by comparison, have a linear relationship with their underlying asset because their prices typically track
the prices of their underlying assets very closely.
A third difference between option-based and forward-based derivatives is that there is a cost to entering an option
contract, which is the premium the buyer pays to the seller. The size of the premium takes into account the option’s
current intrinsic value plus the counterparties’ expectations regarding the intrinsic value of the option by expiration.
Forwards, by comparison, have no value to either party on entry; the agreed-upon price is the same as the forward
price. As shown in the real estate example, the contract develops value (positive or negative) to the counterparties
only as the market price starts to deviate from the agreed-upon price. Because forwards have no value to either
party upon entry, there is no cost to enter a forward contract.

EXCHANGE-TRADED AND OVER-THE-COUNTER DERIVATIVES

As mentioned, forward and option products can trade either on or off an organized exchange. On an exchange, they
are referred to as exchange-traded derivatives. Off an exchange, they are referred to as over-the-counter (OTC)
derivatives. If measured by the notional amounts outstanding, the OTC market is estimated to be about seven times
as large as the exchange-traded market, as shown in Table 1.2.
Table 1.2 | Global Derivatives Market, 2001-2017

(Notional Amounts Outstanding, US$ Billions, End of Year)
Year Exchange-Traded Over-the-Counter (OTC) Total

2001 23,760 111,178 134,938
2002 23,769 141,665 165,434
2003 36,553 197,167 233,720
2004 46,304 258,628 304,932
2005 57,029 299,261 356,290
2006 69,151 418,131 487,282
2007 78,864 585,932 664,796
2008 57,761 598,148 655,909
2009 73,152 603,900 677,052
2010 67,972 601,046 669,018
2011 58,320 647,811 706,131
2012 54,109 635,685 689,794
2013 64,098 710,633 774,731
2014 64,858 630,150 695,008
2015 63,462 492,707 556,169
2016 67,245 482,422 549,667
2017 80,984 531,912 612,896
Source: Bank for International Settlements.
EXCHANGE-TRADED DERIVATIVES
An exchange is a legal corporate entity organized for the trading of securities, futures, and options. It provides the
facilities for trading, which can be either a trading floor or an electronic trading system or, in some cases, both. To
maintain fairness, order, and transparency in the marketplace, the exchange also stipulates rules and regulations
governing the transactions in the instruments traded on it. In the derivatives markets, organized exchanges evolved
in response to the lack of standardization and liquidity in the OTC markets.
When forward-based instruments are traded on organized exchanges, they are referred to as futures contracts. The
Chicago Board of Trade (CBOT) introduced futures trading in 1848, with early contracts based solely on agricultural
commodities. Now, about 80 percent of overall futures volumes are in interest rate, currency, and stock index
contracts. There are currently more than 80 futures exchanges around the world. Futures are discussed in detail in
Section II.

Options have been traded on organized exchanges for a much shorter period than futures. In 1973, trading in
exchange-traded options began on the newly created Chicago Board Options Exchange (Cboe), where options
on individual common stocks were listed. The early success of these options led to the development of organized
option trading on other underlying interests, such as foreign exchange, debt instruments, commodities, futures
contracts, and stock indexes. Options are discussed in detail in Section III.
OVER-THE-COUNTER DERIVATIVES
The OTC market is an active and vibrant market with no trading floor and no regular trading hours. It generally
consists of a loosely connected network of brokers and dealers who negotiate transactions directly with one
another, primarily over telephone lines and computer terminals. This market is dominated by financial institutions,
such as banks and brokerage houses, who trade with corporate clients and other financial institutions. Traders
do not meet in person to negotiate transactions, and the market stays open 24 hours a day. At nights and during
weekends and holidays, some traders and support staff are still working at their trading desks.
When a forward-based derivative trades OTC, it is generally referred to as a forward agreement. The two most
popular types of forward agreements are those that are based on foreign exchange rates (known as foreign exchange
agreements) and those that are based on interest rates (known as forward rate agreements).
One attractive feature of OTC derivative products is that they can be custom designed by the buyer and seller. As a
result, these products tend to be somewhat more complex, as special features are added to the basic properties of
options and forwards.
An example of a forward-based derivative that has had special features added to it is a swap agreement. Swaps are
private, contractual agreements between two counterparties, which are used to exchange (swap) periodic payments
in the future based on an agreed-on formula. The most common form is the interest rate swap, in which the
swapped cash flows are determined by two different interest rates. A typical interest rate swap consists of one party
swapping fixed-rate payments in exchange for another party’s floating-rate payments.
Swap contracts differ from most regular forward contracts in two very general ways. First, rather than one party
delivering an underlying security and the other party paying for it, the two parties exchange the difference between
their respective obligations. The net payer in the deal is the party who is obligated to make a larger payment than
what he or she receives as a result of an adverse change in the price of the underlying interest. The loss equals the
net difference between the two payment amounts. This concept is illustrated in Example 1.3.
EXAMPLE 1.3 | SWAP CONTRACTS

As a result of changes in the price of an underlying interest, Party A must pay $100,000 to Party B, and Party B
must pay $80,000 to Party A. As a result, only the net payment of $20,000 from A to B actually occurs.
The second difference between swap contracts and other forward contracts is that swap contracts are essentially
equivalent to a series of forward contracts packaged together. There is not one delivery and one payment, as there
would be with a regular forward contract. Rather, there occurs a series of exchanges of cash flows at future intervals,
with the dates set out in the contract. Swaps are discussed in detail in Section IV.
Options that trade OTC also often carry special features. A knock out option, for example, is one where the option
ceases to exist if the underlying interest falls to or below the exercise price prior to expiry. Other examples of OTC
options are covered in detail in Section III, including interest rate caps and floors, barriers, and compound options.

KEY DIFFERENCES BETWEEN EXCHANGE-TRADED AND

OVER-THE-COUNTER DERIVATIVES
How do organized exchanges and OTC markets successfully co-exist, one might ask, when the interests that
underlie derivative instruments in both markets are basically the same? Over time, it would seem that one of the
two markets would prevail.
The co-existence has proven successful and long-lasting because the two markets differ in significant ways, each
market offering advantages to users with particular needs.
One of the most important differences between the two markets is flexibility. In the OTC market, the terms and
conditions of the derivative contracts can be tailored to the specific needs of their users. The users may choose the
most appropriate underlying interest, maturity, contract size, and other specifications. In contrast, with exchange-
traded derivatives, the exchange selects the underlying interests and standardizes contract size, maturity, and other
specifications. The terms and conditions may or may not meet the needs of most derivatives users.
Another important difference is the private nature of OTC derivatives. In an OTC derivatives transaction, the general
public and even competitors are not informed of the transaction. On exchanges, all transactions are recorded and
known to the general public.
An OTC contract’s private nature and custom design are features that many users find attractive, but such contracts
also have a downside. Because of these very features, OTC derivatives cannot easily be terminated or transferred to
other investors through secondary markets before expiration. In many cases, these contracts can only be terminated
through negotiations between the two counterparties. The sale of a house, as described earlier, is a simple example
of an OTC forward contract in that it cannot be terminated by one counterparty without the other agreeing.
By contrast, the standardized and public nature of exchange-traded derivatives means that they can be terminated
easily by taking an offsetting position in the contract. Because a user’s needs may change in line with changing
economic and business conditions, it is sometimes advantageous to be able to terminate a derivative position
before its expiry.
Another downside to the private nature of OTC derivatives is the major concern of default risk (also called credit
risk), which is the risk that one counterparty will default on the terms of the contract. Given this risk in the OTC
market, many derivatives dealers exclude customers who are unable to establish their creditworthiness. In addition,
the size of the transactions in the OTC market may be greater than many investors can manage.
By contrast, default risk is not a significant concern with exchange-traded derivatives. Clearinghouses are set up
by exchanges to ensure that markets operate efficiently, thereby guaranteeing the financial obligations of every
contract. Market participants need not be concerned with the honesty or reliability of other trading parties; the
integrity of the clearinghouse is the only concern. However, in the history of U.S. and Canadian futures and options
exchanges, a clearinghouse has never failed to meet its obligations, so that concern is minimal.
The main reasons why no clearinghouse has ever defaulted is that clearinghouses use a system of performance
bonds, along with a daily accounting method called marking-to-market. Those who enter into futures contracts or
write exchange-traded calls and puts must put up a performance bond (known as margin) to provide assurance
to the clearinghouse that the obligations of the contracts will be met. And each day, as prices of the derivative
instrument change, gains are credited and losses debited to the derivative user’s account.
A final difference between OTC and exchange-traded derivatives arises out of the fact that OTC contracts are
private, and exchange-traded contracts are public. Derivative transactions on exchanges are extensively regulated
by the exchanges themselves and by government agencies, but OTC derivative transactions have historically had
much less regulation. On one hand, a less regulated environment in the OTC markets permits unrestricted and
explosive growth in financial innovation and engineering. Generally, no government approval is needed to offer
new types of derivatives. They are simply created by parties that see mutual gain in doing business with each other,

1 • 10 DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | TEXTBOOK | SECTION 1 | VOLUME 1
without costly constraints or bureaucratic red tape. On the other hand, the regulated environment of exchange-
traded derivatives brings about fairness, transparency, and an efficient secondary market.
Following the financial crisis of 2007–2008, regulators and market observers from around the world unanimously
agreed that segments of the OTC derivatives market (including swaps) played a role in the rapid and widespread
and rise of counterparty and liquidity risks during the crisis. The crisis impelled finance ministers and central bank
governors of the Group of Twenty countries to propose reforms to the OTC derivatives market. The reforms were
aimed at increasing transparency, mitigating systemic risk, and protecting against market abuse.
Table 1.3 lists ten major differences between exchange-traded and OTC derivatives. However, as the international
reforms continue to take hold, the lines between exchange-traded and OTC derivatives have become somewhat
blurred. The crossover is particularly evident with reference to central clearing, transparency, and performance
bonds. For example, standardized OTC trades are increasingly being cleared and guaranteed by central
counterparties who require margin deposits from the counterparties to a trade, just as in an exchange-traded
market. As well, the reforms have called for mandatory reporting of trades to trade repositories, and many
jurisdictions have already implemented this aspect of the reform package.2
Table 1.3 | Differences Between Exchange-Traded and Over-The-Counter Derivatives
Exchange OTC
Exchange-traded derivatives are traded on an OTC derivatives are traded largely through computers
exchange. and phone lines.
Contracts are standardized. Terms of the contract are agreed to between buyer and
seller.
Trades are transparent (public). Trades are private.
Contracts are easy to terminate before they expire. Early termination is more difficult.
A clearinghouse acts as third-party guarantor ensuring No third-party guarantor

the contract’s performance to both trading partners.
A performance bond is required. No performance bond is required in most cases.
Gains and losses accrue daily through a system of Contracts are generally not marked-to-market;
marking-to-market. gains and losses normally settled at the end of
the contract.
Trading is heavily regulated. Trading is much less regulated.
Delivery rarely takes place. Delivery or final cash settlement usually takes place.
The commission is visible. The fee is usually built into the price.
TYPES OF UNDERLYING INTERESTS

There are generally two major categories of underlying interests for derivative instruments – commodities and
financial assets. In all cases, the need for effective risk management tools fuels the development of an efficient
market for these derivative instruments. In the OTC marketplace for derivatives, the underlying interest is limited
2
The Financial Stability Board regularly publishes reports on the progress jurisdictions have made in implementing reforms.
http://www.fsb.org/2017/06/otc-derivatives-market-reforms-twelfth-progress-report-on-implementation/

CHAPTER 1 | AN OVERVIEW OF DERIVATIVES 1 • 11
only by the imagination and risk management needs of market participants. A brief outline of the interests that
underlie derivative instruments traded on organized exchanges in the United States and Canada follows.
COMMODITIES
Commodity futures and options are commonly used by producers, merchandisers, and processors of commodities
to protect themselves against changing cash prices. Some commodities are used mainly for consumption purposes,
whereas others are used primarily for investment purposes. Types of commodities that underlie derivative
instruments on North American exchanges are noted below. Commodity contracts are less common in the
OTC market.
AGRICULTURAL PRODUCTS
Most agricultural commodities are grown for human or animal consumption, but some, such as lumber and cotton,
have industrial applications. In the derivatives market, agricultural products fall into three categories: grains and
oilseeds; livestock and meat; and forest, fiber, and food, as follows:
Grains and The grain and oilseed category includes such products as wheat, corn, soybeans, and canola. It is
oilseeds the oldest category of futures contracts, and for many years, these contracts were the ones most
actively traded in the market. However, in recent years, their volume has been surpassed by the
contracts on financial assets.
The primary trading interest in this category comes from speculative and hedging activities by
farmers, food processors, grain storage firms, exporters, and an increasing number of foreign
countries that import grain. These contracts are heavily influenced by agricultural production,
weather, government farm policies and international trade, among other factors. In the United
States, the CBOT is the major exchange where futures and futures option trading in these contracts
takes place.
Livestock The livestock and meat category includes such agricultural products as pork bellies, hogs, live
and meat cattle and feeder cattle. Prices of livestock and meat contracts are affected by the domestic and
worldwide demand for meat. They are also influenced by indirect factors, such as prices of grains
used as feed, government policies, demographic trends, and international trade. Traders in this
category include farmers, slaughterhouses, meat packers, and major users of beef and pork, such
as fast-food restaurant chains. This category of futures and options on futures is traded on the
Chicago Mercantile Exchange (CME).
Forest, fibre, Forest, fibre, and food contracts are a diverse category of commodities that includes lumber,
and food cotton, orange juice, sugar, cocoa, and coffee. Prices are influenced by the demand for and supply
contracts of these products. Because most of these commodities are imported or exported, international
economic and political conditions are also key factors. As its name implies, the Coffee, Sugar and
Cocoa Exchange (a subsidiary of the New York Board of Trade) is where trading in these so-called
”breakfast commodities” takes place. The CME trades lumber, while trading in cotton and orange
juice takes place at the New York Cotton Exchange (also a subsidiary of the New York Board of
Trade). Options on futures are available on most of these contracts.
PRECIOUS AND INDUSTRIAL METALS

The precious and industrial metals category includes metals used in jewellery and industrial applications, such as
gold, silver, platinum, copper, and aluminum. Each of these commodities is considered a non-renewable natural

resource. Much of the production is located overseas and often in politically unstable countries. Worldwide demand
and supply are much more important than domestic demand and supply. As a consequence, international economic
and political factors play a crucial role. In North America, trading in precious and industrial metal futures and
futures options takes place largely on the New York Mercantile Exchange (NYMEX), the largest physical commodity
futures exchange in the world. Outside of North America, the key metal exchange is the London Metal Exchange,
where the bulk of trading takes place in industrial metals such as copper, lead, and nickel.
ENERGY PRODUCTS
Energy products include crude oil, heating oil, gasoline, natural gas, and propane. These commodities provide energy
sources for automobile, manufacturing, telecommunications, agricultural, and other industries. Prices depend
on worldwide production and demand which, in turn, are influenced by the international economic and political
environment. In North America, energy futures and options on futures are traded on the New York Mercantile
Exchange. In London, the International Petroleum Exchange trades futures on energy products.
FINANCIALS
In the last two decades, we have witnessed an explosive growth in derivatives, especially in financial derivatives. This
growth has been fuelled by the following factors:
• Increasingly volatile interest rates, currency exchange rates, and commodity prices
• Financial deregulation and intensified competition among financial institutions
• Globalization of trade
• Advances in information technology
• Theoretical breakthroughs in financial engineering
The commonly used financial derivatives are summarized as follows:
Equity Equity is the underlying interest of a large category of financial derivatives. The predominant
equity derivatives are equity options – that is, options on individual stocks. These derivatives are
traded mainly on organized exchanges such as the CBOE, the Philadelphia Stock Exchange, and
the International Securities Exchange in the United States; and the Bourse de Montréal in Canada.
All major trading nations have equity derivatives listed and traded on their home exchanges. Each
exchange selects a group of individual stocks to have options listed on them. These stocks are
usually traded actively and have large numbers of shares outstanding.
Interest rate With increased volatility in interest rates, the need for interest rate derivative instruments is
instruments apparent. Financial and non-financial companies alike employ various types of such instruments
for risk management purposes.
Exchange-traded interest rate derivatives are generally based on interest rate-sensitive securities,
rather than on interest rates directly. In the United States, the underlying interests for exchange-
traded interest rate derivatives include Treasury bills and Eurodollars, which are traded at the
CME, as well as Treasury notes and bonds, which are traded at the CBOT. Futures options are
available on these contracts. In Canada, the underlying interests include bankers’ acceptances
and Government of Canada bonds. All interest rate futures trading in Canada takes place at the
Bourse de Montréal. Futures options are available on three-month bankers’ acceptances and ten-
year Government of Canada bond futures. As is the case with equity derivatives, all major trading
nations list and trade interest rate derivatives. Eurex and Euronext.liffe are among the largest
financial futures exchanges outside of the United States.

In the OTC markets, interest rate derivatives are generally based on well-defined floating interest
rates, which are not easily manipulated by market participants. Examples of such underlying
interests include the London Interbank Offered Rate (LIBOR), which is the interest earned on
Eurodollar deposits in London, and the yields on Treasury bills and Treasury bonds.
Foreign The most commonly used underlying interests in currency derivatives are the U.S. dollar, British
currencies pound, Japanese yen, Swiss franc, and euro. The types of contracts traded include currency futures
and options on organized exchanges, and currency forwards and currency swaps in the OTC market.
Foreign currency futures were introduced in 1972 by the CME. The International Monetary Market
was established specifically for the trading of futures contracts in foreign currencies. Foreign
currency options first began trading on the Philadelphia Stock Exchange in 1982. In 2005, options
on the U.S. dollar began trading on the Montreal Exchange.
Stock The stock index derivatives markets have been one of the most spectacular success stories of the
indexes financial markets in recent history. These contracts are based on widely used indices of common
stocks, such as the S&P 500 index in the United States and the S&P/TSX 60 Index in Canada. Futures,
options, and options on futures are the three most commonly traded derivatives on stock indexes.
The settlement of stock index contracts is not based on the sale or purchase of the underlying
index. Gains or losses are settled in cash. This system is designed to eliminate the potential
difficulty and costs of trading a basket of the underlying stocks. Investors of many types use these
contracts to hedge positions in stock, speculate on the direction of the stock market in general,
adjust portfolios, and arbitrage the contracts against comparable combinations of stocks.
WHY ARE DERIVATIVES USEFUL?

Corporations operate in an increasingly risky and volatile financial environment. The breakdown in the early 1970s
of the Bretton Woods Accord and the freeing of the U.S. dollar from the gold standard by the Nixon administration
led to dramatic increases in the volatility of interest rates, foreign exchange rates, commodity prices, and stock
indexes.3 This increased volatility has caused corporate profitability to swing widely in response to large movements
in exchange rates, interest rates, and commodity prices. With increasing financial deregulation and globalization,
the effect of that volatility becomes more apparent and dramatic.
The use of any financial instrument usually arises from necessity, and this is certainly true for derivatives. Volatile
market conditions created the need for new and innovative financial tools to help manage risk. Supported by the
tremendous advances in information and technology, the global derivatives market has experienced explosive
growth and innovation.
In addition to helping manage risk, derivative products have many other effective and useful applications for a broad
range of end users. The most common applications other than risk management are cost reduction, market entry
and exit, arbitrage, speculation, and yield enhancement. Users of derivatives for these various purposes include
financial institutions, manufacturers, mining and natural resource companies, farmers, retailers, and governments.
For each one of these applications, there are typically several different derivative instruments available. For example,
an equity portfolio manager looking to facilitate entry into a foreign equity market could use index options or index
futures, or even an equity swap. If an index option is chosen, the manager must decide which exercise price to use
3
The Bretton Woods Accord helped maintain the stability of world interest rates and currency exchange rates from the end of World War II
to the early 1970s.

and which option strategy is most appropriate, such as outright call options or a combination of options. A manager
who decides to use index options or forwards must consider whether to use an exchange-traded or OTC instrument.
The differences between the basic derivative types and OTC and exchange-traded products were discussed earlier.
A description of each derivative application, with a practical example demonstrating that application, follows below.
Where applicable, the differences between derivative types are highlighted.
Equity swaps are discussed in Section IV, and the various option strategies are discussed in Section III.
RISK REDUCTION THROUGH HEDGING

Hedging to reduce risk is probably the most common use of derivatives. Research indicates that minimizing
fluctuations in cash flows is the primary risk management objective for derivatives. Given the ease and speed of
trading derivatives, along with other capital and accounting advantages, derivatives give risk managers valuable
tools for managing or adjusting specific risks.
Hedging is the attempt to eliminate or reduce the risk of either holding an asset for future sale or anticipating
a future purchase of an asset. Hedging with derivatives involves taking an opposite position of equal size in the
derivative instrument of the asset to be hedged (or one that is very close to it). If a hedger owns an asset and is
concerned that the price of the asset could fall in the future, a short position in the asset’s derivative instrument
would counter the risk. A price decline would result in a loss on the asset being held, but the loss would be offset by
a gain in the derivative position. If a hedger anticipates owning an asset in the future and is concerned that the price
could rise by the time the purchase is made, a long position in the asset’s derivative instrument would counter the
risk. A price increase would result in a higher price being paid by the hedger, but the cost would be offset by a gain
on the derivative position.
As illustrated in Example 1.4, a hedger starts with a pre-existing risk position that is generated from the normal
course of business.
EXAMPLE 1.4 | HEDGING

A farmer growing wheat has a pre-existing risk that the price of wheat will decline by the time it is harvested
and ready to be sold. In the same way, an oil refiner that holds storage tanks of crude oil waiting to be refined
has a pre-existing risk that the price of the refined product may decline in the interim. To reduce or eliminate
this price risk, both the farmer and refiner could take short positions in their respective commodities derivative
instruments. Any losses in the underlying commodities would be offset by gains in the derivative instruments
(though, equally, any commodity gains would be offset by derivative losses).
It is neither the farmer’s nor the refiner’s normal course of business to speculate on where the prices of their
respective commodities will be when ready for sale. The goal in both of their businesses is to sell products at a
profit. By not attempting to hedge, both the farmer and refiner become, in effect, speculators.
TO HEDGE OR NOT TO HEDGE?

Although it may seem like a simple exercise, the decision whether or not to hedge can often be complex.
First, it is important to understand that hedging does not always result in the complete elimination of all risks.
For one thing, the price of the derivative instrument may not correlate perfectly with the price of the asset to be
hedged. One reason for poor correlation could be that the derivative instrument represents a different grade. For
example, if a farmer uses wheat futures to hedge, the wheat underlying the futures contract may represent #2 Soft
Red Winter Wheat, rather than the #1 Soft Red Winter Wheat that the farmer actually grows. The prices of the two
types of wheat will likely correlate well with one another, but the correlation will not be perfect.
In other cases, hedgers may decide to use a derivative contract with an underlying interest that is similar to, but
not the same as, the asset to be hedged. For example, a Canadian real estate developer who is at risk if the prime
rate rises may use a derivative instrument such as a bankers’ acceptance futures contract because no such contract

exists on the prime rate. Although the two rates may correlate strongly with one another, there could be significant
differences between them.
By using a derivative instrument that does not precisely match up with the asset to be hedged, the hedger, is effect,
substituting one kind of risk for another. The real estate developer has eliminated general interest rate risk, but has
introduced the risk of differences between movements of the prime rate and the bankers’ acceptance rate. This
type of risk, known as basis risk, is explained in detail in Section II. Before implementing a hedge, basis risk must be
carefully considered.
In addition to basis risk, hedgers must consider that risk and return go hand in hand. The elimination of all risks is
necessarily accompanied by low expected returns. The farmer, refiner, or real estate developer may want to take
on risk to help generate higher returns. For example, a farmer who feels very strongly that wheat prices will rise by
harvest may be willing to take on the risk of a price decline in the hope of increasing profits.
In reality, the proper use of derivatives involves first understanding the derivative instruments that can be used for
a particular hedge, and then deciding on an appropriate balance between risk and return that is consistent with the
hedger’s overall strategy.
The issue of whether or not to use hedging is discussed in Exhibit 1.1.
Exhibit 1.1 | Hedging or not hedging: A legal matter?
Corporate boardrooms are not the only place where the decision whether to hedge or not is debated and answered.
This question is increasingly decided in courtrooms.
An example is provided by the case of Farmers Cooperative (FC), a grain elevator co-op in Indiana that engaged in
the business of buying, storing, and selling grain. In the late 1970s, FC’s profits had declined steadily. Acting on the
advice of its accountant, FC’s board of directors authorized FC’s manager to begin hedging using futures contracts.
The co-op continued to experience substantial operating losses because less than one percent of grain sales was
actually hedged. Shareholders figured that a proper hedge would have saved them large amounts of money and
consequently sued the board.
The plaintiffs argued that the board breached its duty by using an inexperienced manager and by failing to supervise
the manager. The plaintiffs also argued that the board members failed to learn enough about hedging to protect the
shareholders’ interests. The plaintiffs won the lawsuit, and the directors were ordered to pay more than $400,000
to the plaintiffs.
A lesson to be learned? Directors must fully understand how the futures market works and must inform themselves
about the advantages and disadvantages of hedging. They must also supervise management to ensure that a
hedging program is executed properly. Ignorance cannot be used as a legal defence.
SELECTING APPROPRIATE HEDGING INSTRUMENTS

When a company decides to hedge, the next step is to determine the appropriate instruments and their proper use
for hedging purposes.
Earlier in this chapter, you learned that both options and forwards are used to achieve similar goals, but their
methods of achieving those goals differ. As shown in Example 1.1, forward-based derivatives allow users to lock in a
price. Once the forward is established, the counterparties are obligated to fulfill the terms of the contract, even if it
is not in one party’s best interest because of adverse market price changes.
Option-based contracts, on the other hand, allow holders to set a maximum purchase price or minimum selling
price while still providing the opportunity to participate in favourable underlying price movements. Remember that
an option contract represents the right, not the obligation, to buy or sell an underlying interest. If it is unprofitable
to exercise that right, option holders can simply let the contract expire. However, option holders pay a premium for

this flexibility. Hedgers using options, in effect, are buying insurance against adverse price swings. If the price swings
do not materialize, the option may be worthless at expiry, but the hedger can still benefit from any favourable price
movement. In a hedge, this favourable price movement results in a so-called windfall gain.
Example 1.5 shows why hedging is used, how it works, and the difference between the use of forwards and options.
EXAMPLE 1.5 | HEDGING CURRENCY RISK

A Canadian firm is expecting to receive payment of US$1 million for goods that it has shipped to a customer in
the United States. The payment is to be received in one month, and the firm is concerned that the U.S. dollar may
depreciate in value relative to the Canadian dollar in the meantime. If that happens, the US$1 million payment
will be worth less in terms of Canadian dollars. Based on the exchange rate of C$1.20 per U.S. dollar, the firm will
receive C$1.2 million. If the U.S. dollar weakens against the Canadian dollar to C$1.10, for example, the US$1 million
will convert to only C$1.1 million. The firm will, in effect, suffer a loss of C$100,000 due to currency fluctuations.
The firm may hedge its U.S. dollar exposure by entering into a forward contract with a bank to sell the expected
US$1 million payment in one month at the current forward rate of C$1.20.* When the firm receives the
US$1 million payment from its customer, it will deliver the payment to the bank to satisfy the terms of the
forward contract and will receive C$1.2 million from the bank regardless of the exchange rate at that time. In
other words, the forward contract enables the firm to lock in the U.S. exchange rate at C$1.20 and ensures that
there will be no loss due to currency fluctuations.
Instead of using a forward contract to hedge its currency exposure, the firm can buy a U.S. dollar put option
from the bank. The option will give the firm the right to sell U.S. dollars (in exchange for Canadian dollars) in one
month’s time at a fixed exchange rate. If the firm decides on an exercise price (i.e., exchange rate) of C$1.20, it
will have the right to sell US$1 million to the bank in exchange for C$1.2 million. Of course, this option is not free;
the firm will have to pay the bank a price in the form of the premium.
If, in one month’s time, the U.S. dollar does fall in value, the firm will exercise its right to sell U.S. dollars at the
exercise price of C$1.20. The firm will give the US$1 million it received from its U.S. customer to the bank, and in
return, the bank will give the firm C$1.2 million.
The purchase of the put option ensures that the firm will not suffer from a decline of the U.S. dollar below
C$1.20. The firm is guaranteed that it will get at least C$1.2 million, regardless of how low the U.S. dollar falls.
Up to this point, it appears that the forward contract has an advantage over the option contract. Both
instruments protect the firm from a falling U.S. dollar by guaranteeing a minimum exchange rate. However,
unlike the option contract, the entry into a forward contract does not entail an upfront cost.
The benefit of options, however, comes into play if, instead of falling, the U.S. dollar rises in value. Remember that
options represent rights, not obligations. If the U.S. dollar were to rise in value, the firm would not exercise its right
to sell the US$1 million at the exercise price of C$1.20. (Why would it sell U.S. dollars at C$1.20 when they could
be sold for more in the spot market?) The firm would merely walk away from the option and let it expire. If, for
example, the U.S. dollar were to rise to C$1.30 when the US$1 million is due from its U.S. customer, the firm could
take this amount to a bank and exchange it for C$1.3 million, thus earning a windfall gain of C$100,000. If the firm
uses the forward contract and the U.S. dollar rises, the firm will still be locked into the forward rate agreed to when
the hedge was initially placed. (Remember that forwards represent obligations, not rights.) In other words, the
option hedge allows the firm to benefit from a rise in the U.S. dollar, but the forward hedge does not.
* For illustrative purposes, the forward rate and spot rate were the same in this example. In reality, as will be explained in Chapter 3
of Section II, these two prices will normally differ.
When deciding between options and forwards, investors must weigh the advantages and disadvantages of each.
Put options lock in a minimum price while still permitting windfall gains. However, there is the cost of the premium
attached to them. Forwards, meanwhile, lock in a price with no upfront payment, but they do not allow for windfall
gains.

In addition to deciding between using an option-based or forward-based derivative, investors must decide between
using an OTC or exchange-traded product. The attraction of an OTC derivative is that it can be custom designed
to meet a firm’s needs. The downside is that the contract cannot be terminated as easily as an exchange-traded
product. Early termination may be desired if the hedge is no longer needed. To illustrate, the firm in the preceding
example may have had a very strong view that the U.S. dollar was going to get stronger in comparison to the
Canadian dollar and, therefore, may have seen little reason to hedge.
COST REDUCTION
Derivatives are often used to reduce the cost of new or existing debt. In most of these cases, interest rate swaps
or currency swaps are used to reduce an issuer’s financing cost. Such cost savings are possible because of what is
known as comparative advantage. Specifically, two companies with complementary comparative advantages may
come together and design a swap to reduce the financing costs of both companies.
Figure 1.1 illustrates a currency swap. In this illustration, Company A enjoys a comparative advantage in borrowing
Canadian dollars. It can borrow dollars at 6%, whereas Company B can only borrow Canadian dollars at 7%. On the
other hand, Company B enjoys a comparative advantage in borrowing British pounds. It can borrow pounds at 8%,
whereas Company A must pay 9%.
Figure 1.1 | A Currency Swap is Used to Reduce Borrowing Costs
At onset forwards C$s to B.

On interest payment dates, pays 8% on £ to B*
Company A Company B
At onset forwards £ to A.
Borrows C$s On interest payment dates, pays 6% on C$s to A* Borrows £
and pays 6% and pays 8%
Third party Third party

lender lender
* Co. A pays net 8% (pays 6%, receives 6% and pays 8%). Co. B pays net 6% (pays 8%, receives 8% and pays 6%).
At maturity of the swap A and B return each other’s principal.
In Figure 1.1, each company’s comparative advantage raises the possibility of a swap, whereby each firm exploits
the other’s advantage. Company A borrows Canadian dollars at 6% and forwards the dollars to Company B, which
requires Canadian dollars. In exchange, Company B borrows British pounds at 8% and forwards the pounds to
Company A, which needs British pounds. In effect, the two parties have made independent borrowings and then
exchanged the proceeds. The net effect is that both firms are able to borrow foreign currency at lower rates than
they could have independently. Company A is borrowing pounds at 8%, which is 1% lower than what it could have
borrowed at on its own. And Company B is borrowing Canadian dollars at 6%, which is 1% lower than what it could
have borrowed on its own.
Such comparative advantages also exist in the domestic loan markets. One company may have a comparative
advantage over another company in the fixed-rate or floating-rate loan market.
In addition to corporations and financial institutions, sovereign governments and state agencies have been able
to reduce their funding costs using interest rate and currency swaps, as well as other similar products. In its
capacity as fiscal agent for the federal government, the Bank of Canada has carried out swap agreements since fiscal
year 1984–85.

MARKET ENTRY AND EXIT

Entering and exiting a market in the conventional way can be inefficient and costlier than one might imagine.
The costs associated with trading include commission fees, bid-ask spreads, and other administrative fees. These
transaction costs can be quite high in some cases, and may influence the decision to enter or exit a market. In
addition, buying or selling a large quantity of an asset may produce adverse price pressures on the market, which
represents a hidden transactional cost. A large buy order may bid up the price to the point where it costs more than
the current available price to complete the transaction. Conversely, a large sell order may push the price down so
that less money will be received from selling the assets. This adverse price effect could be especially severe in thinly
traded equity or bond markets.
Derivatives can be used to facilitate entry into and exit from a specific market. In today’s ever-changing financial
environment, portfolio managers may need to shift funds constantly from one market segment to another,
from one type of market to another, and from one country to another. If the switch is permanent, it is usually
accomplished by liquidating positions in the unfavourable market and transferring the funds into the favourable
market. Quite frequently, however, the switch from market to market is only temporary. When market conditions
subsequently change, a reverse switch and other shifts of funds are quite possible. In these cases, it is more efficient
and cost-effective to carry out the switch temporarily using derivatives, rather than trading in the underlying assets
directly.
Example 1.6 illustrates how call options facilitate an equity purchase.
EXAMPLE 1.6 | USING CALL OPTIONS TO FACILITATE AN EQUITY PURCHASE

Suppose you want to purchase 1,000 shares of Bank of Montreal common stock because you anticipate a
significant increase in its stock price in the coming weeks. At the current price of $60 per share, you need to
invest $60,000 plus transaction costs. Right now, you have only $5,000 in cash at your disposal. (Assume in this
example that your broker does not accept margin accounts.)
You expect to receive $57,000 within a month, so you will have sufficient funds to purchase the stock at that
time. However, you do not want to wait another month to purchase the stock, because its price might rise by
then. In this case, a trading strategy involving call options can facilitate the acquisition of the stock.
Assume that call options on the stock with an exercise price of $60 and a maturity of one month are currently
traded at $0.85. You decide to purchase 10 call option contracts, with each contract consisting of 100 shares.
The contracts, which cost only $850, will give you the right to purchase 1,000 shares at $60 per share within
the next month. In other words, with only $850 down today, you gain control over 1,000 shares that currently
cost $60,000.
The leverage provided by the call options is tremendous. Once you receive the $57,000, together with the $5,000
cash you currently have, you may exercise the option to purchase the shares at $60 per share, even though the
actual stock price may turn out to be $65. When you exercise, you will buy 1,000 shares at $60 per share from a
seller of the call option.
Thus, the call option provides the leverage you need to gain control over common shares you cannot afford
to buy right away. If your bullish forecast on the stock turns out to be incorrect, and the stock price drops
substantially, to $55, for example, you would opt not to buy the stock. By walking away, you would lose only the
$850 you paid to purchase the call options. If you had bought the shares directly, you would have been obliged to
buy them at the fixed price of $60, thereby losing $5,000 ($5 loss per share on 1,000 shares).
YIELD ENHANCEMENT
Yield enhancement is an investment strategy generally used to boost returns on an underlying investment portfolio
by taking a speculative position based on expectations of future market movements. A yield enhancement strategy

does not need to be a high-risk strategy. The most popular method of enhancing an investment’s yield is by selling
options against the position. An example of a yield enhancement strategy is depicted in Example 1.7.
EXAMPLE 1.7 | SELLING OPTIONS TO ENHANCE PORTFOLIO RETURN

Suppose you are the manager of a $10 million stock portfolio. The stock market has been in an upward swing for
the past several months, and most of your stocks have gained handsomely during this time. You feel strongly that
the market has now peaked, and you expect no further upward movements in the near future. In this scenario,
you decide to enhance the returns on your portfolio by selling call options on stocks within your portfolio. You
receive payments from the buyers, who are willing to pay a price for the options because they hold a contrary
view that the market still has room to go up.
If you are correct that the market has indeed peaked, and stock prices stay fairly flat in the near future, the call
options you sold will be worthless. In this case, the proceeds from selling the call options become extra returns
earned on your portfolio.
To illustrate further, assume that your portfolio holds 1,000 shares of stock that is currently trading at $50 per
share, and you strongly believe that the price has peaked. Each option contract represents 100 shares, so you sell
10 call options. You choose an exercise price of $50 (because you do not believe the stock will rise over this level)
and an expiry date three months into the future. The call option is currently trading at $2.50, and, because you
sold 10 options, you receive $2,500 from the buyer. If your prediction is correct and the stock price indeed stays
at $50 or less for the next three months, the call options will be worthless at expiry because the holder will not
have a chance to exercise them.
If the stock rises over $50, the holder of the call option will exercise the right to buy the stock. You will have to
sell the stock to the option holder at $50 regardless of the market price. In other words, in exchange for earning
a premium, you have given up the right to profit from any increase in the stock over $50. Because you felt the
stock would not rise over $50, the trade-off makes sense.*
* In reality, the portfolio manager can still profit, albeit in a reduced amount, if the price rises over $50 up to $52.50 ($50 exercise plus
the $2.50 premium).
SPECULATION
In general, speculation is inconsistent with the objective of risk management because it increases risk instead of
reducing it. Specifically, speculation involves a future focus, the formulation of expectations, and the willingness to
take positions in order to profit. In other words, speculators bet on the direction of the market and take positions
accordingly in an attempt to profit from a predicted movement of the market.
Speculators use commodities, currencies, stocks, bonds, and other financial securities in their transactions, as
well as derivatives. Quite often, derivatives make speculating easier because derivatives transactions are relatively
fast and inexpensive. In addition, derivatives may provide the necessary leverage for some investors to carry
out a speculative position, given that small (and sometimes zero) initial investments are generally required in a
derivatives transaction.
A couple of simple examples illustrate how derivatives may be used to speculate on certain market movements.
The first, Example 1.8, illustrates how options may be used to profit from an anticipated market decline. The second,
Example 1.9, illustrates how futures can be used to speculate.

EXAMPLE 1.8 | SPECULATING USING OPTIONS

Suppose you have a strong belief that the price of the shares of PQR Corporation are going to decline
significantly over the next few months due to the entrance of a major U.S. telecommunications company into the
Canadian market. You can establish a speculative position to take advantage of your belief by buying put options
on PQR shares.
To illustrate, suppose that PQR shares are currently trading at $60 and that you expect them to drop to $55
within two months. To speculate on the expected price decline, you buy one PQR put option with an exercise
price of $60 and an expiration date two months in the future. The put option gives you the right to sell 100
shares at the exercise price of $60 at any time between now and the expiration date, regardless of what the
actual share price is. This option is currently trading at $2 per share, so it costs you $200 (plus brokerage
commissions) to establish the position.
If in two months the price of PQR shares declines to $55 as you expect, you can realize a profit in either of two
ways:
• You can buy 100 shares of PQR at $55 and then sell them at $60 by exercising the put option. You will make
a gross profit of $5 per share, or $500 in total. After factoring in the cost of buying the put option, your net
profit will be $300 ($500 minus $200).
• You can sell the option. With PQR stock trading at $55, the option will be worth at least $5. Selling the
option at this price results in a similar profit of $300.
Because the purchase of a put option gives you the right, but not the obligation, to sell PQR shares, you cannot
lose more than what you paid for the option. In other words, if in two months PQR shares are trading at $65, for
example, you would not exercise your right to sell the stock at $60 because you would lose money by doing so.
You may not be able to sell the put option either, because nobody would be willing to pay for this option. You
would simply let it expire worthless.
EXAMPLE 1.9 | SPECULATING USING FUTURES

Suppose you strongly believe that the Canadian dollar is going to appreciate against the U.S. dollar because of
an unexpectedly robust performance of the Canadian economy in the last quarter of the year. You may speculate
by taking a long position in (i.e., purchasing) Canadian dollar futures (traded on the CME). One contract allows
you to buy $100,000 Canadian dollars at the agreed-upon exchange rate during a period in the future. If the
Canadian dollar does, indeed, appreciate against the U.S. dollar, your futures position will be quite profitable. If
you hold the position through to the delivery period, you will receive delivery of Canadian dollars at the agreed-
upon exchange rate. You will then be able to sell the dollars in the open market at the price to which they have
appreciated.
To illustrate further, suppose that the current exchange rate is US$0.9196 per Canadian dollar. The Canadian
dollar futures contract with a one-month expiration is trading at US$0.9210. If the Canadian dollar turns out
to be worth US$0.9235 one month later, your futures position gains US$0.0025 per Canadian dollar. If you
purchase C$1 million in Canadian dollar futures (10 contracts each worth $100,000 per contract), your profit will
be US$2,500 or C$2,707.09 (converted at the spot exchange rate of US$0.9235 per Canadian dollar).
As a risk strategy, speculating with futures may lead to huge losses if it is taken to extremes and the market does
not move as expected. For example, if the Canadian dollar depreciated instead of increasing in value in the above
example, you would have experienced a large loss. Keep in mind that futures represent contractual obligations.
Unlike options, you cannot walk away from the contract in the case of adverse price movements. You would have to
either take delivery or offset the contract prior to delivery. Either way, you would have suffered a loss.

It is well accepted, however, that risk and return go hand in hand. Higher expected returns have to be generated by
taking on more risk. Sometimes, investors and companies are willing to take on more risk because they can afford it
and they want to generate higher returns.
ARBITRAGE
Arbitrage activities using derivatives are generally the domain of derivatives dealers and traders, not end users. Only
large and sophisticated end users may engage in active arbitrage activities.
An arbitrage opportunity refers to a scenario where the same asset or commodity is traded at different prices
in two separate markets. By purchasing low in one market and selling high in the other market simultaneously,
investors lock in a fixed amount of profit at no risk. In other words, they buy low and sell high. More sophisticated
arbitrage activities may involve simultaneous transactions in more than two markets.
These activities are known as academic arbitrage or pure arbitrage activities. The terms refer to profitable trading
activities that involve no investment and no risk. In the real world, however, arbitrage generally cannot be
effectively conducted without some, at least temporary, investment, and it is rarely completely risk free. For
example, suppose an arbitrageur spots an exploitable market mispricing and attempts to profit by buying in
the cheap market and selling in the rich market. If the two transactions are effected simultaneously, then there
is no investment or risk involved in the arbitrage. In practice, however, the transactions are usually only nearly
simultaneous. In other words, a very short period (seconds or minutes) goes by between the buying and selling
transactions. It is possible that, after the first transaction, the bid price or offer price or both are withdrawn by the
opposing parties in the second transaction. In such cases, the arbitrage opportunity disappears, and the arbitrageur
winds up with a completed single transaction that may represent a risky investment position. Given this reality,
real-world arbitrage may be better defined as trading activities undertaken to earn a low-risk profit on little
investment by exploiting a pricing discrepancy between two or more markets.
STRUCTURING PRODUCTS
The use of derivatives allows product engineers to provide investors with highly focused investments that are
targeted to their risk profile, return requirements, and market expectations. A good example is an equity index-
based or commodity-based note, either of which typically combines the use of a risk-free bond with a derivative
instrument based on an underlying equity index or commodity. This combination provides principal protection with
the possibility of attractive returns based on the performance of the underlying equity index or commodity.
OPERATIONAL CONSIDERATIONS
So far, we have discussed the various ways derivatives are used to achieve certain financial goals. As with any other
financial instrument, however, their use should be clearly understood. The real danger of derivatives is not the
complexity of the instruments, but rather the leverage inherent in them. It is not hard to create highly leveraged
positions, and sometimes the leverage builds inadvertently. Companies are potentially vulnerable to abusers of
leverage, especially when derivatives are used to speculate rather than to hedge.
It must be emphasized again that derivatives are a zero-sum game, meaning that each winner in derivatives, there
is a loser on the other side. The gain enjoyed by one counterparty is always exactly equal to the loss suffered by
the other counterparty. This is precisely the reason why a risk management program cannot be operated as a profit
centre. To expect end users to generate profits consistently through derivative activities is unrealistic. One would
have to believe in good luck or that users on the other side of the transaction are not as smart.

To limit the potential danger of derivatives, a company must accomplish at least two things:
• First, the use of derivatives must be integrated into the overall risk management program. The board of directors
and senior management must oversee and be actively involved in the entire derivatives operation. They must
strive to make sure that everyone involved in the risk management program understands the objective and
works hard towards achieving it.
• Second, the organization must establish strong internal control and monitoring of its derivatives operation. The
principle of clear separation of duties must be an integral part of the internal control and monitoring system.
In particular, those individuals responsible for front-office trading activities should not have authority for the
back-office activities of processing, recording, verifying, valuing, or approving those transactions. Otherwise,
rogue traders such as Nicholas Leeson, the futures trader responsible for the collapse of Barings Bank in 1995,
would be able to assume excessive risks without restraint. Further, compensation for front-office personnel
must be independent of compensation for back-office personnel. Segregation of compensation is as important in
providing checks and balances in the risk management program as the separation of duties. Similarly, individuals
who are responsible for monitoring and controlling derivatives must not receive any form of bonus or other
reward from the profits generated by traders. Proper limits to the maximum acceptable risk levels and to the
types of acceptable derivative products are also important. Guidelines must be established for each derivative
instrument regarding the maximum total position permitted and the maximum position that each trader
is allowed to take. A good reporting system must also be put in place so that any potential problem can be
detected quickly and dealt with effectively.
WHO USES DERIVATIVES AND TO WHAT EXTENT ARE THEY USED?

The use of derivatives has increased dramatically in the past twenty-five years. From 2001 to 2017 alone, the
global derivatives market has more than quadrupled in size, as measured by the notional principal amount or
underlying amount in all global derivative contracts.4 A recent survey of financial institutions conducted by the
Bank for International Settlements (BIS) found that the notional value of OTC derivatives outstanding worldwide
in December 2017 was US$531.9 trillion. The gross market value of these contracts is US$10.9 trillion, which is a
measure of the potential exposure if all contracts default.
Given the explosive growth in the worldwide derivatives market, one might be curious about who uses derivatives
and to what extent they are used. Some extensive surveys of derivative end users have shed some light on this
important aspect of derivatives. One survey in particular was based on a large sample of non-financial companies
and sought to document the usage of foreign exchange, interest rate, and commodity price derivatives.5 The
50 countries in the study represented 99.3% of global market capitalization at that time. The 7,319 firms
represented 62.5% of overall global market capitalization and 82.2% of global market capitalization of non-
financial firms.
Across all countries, more than half of the sample firms (60.3%) used some type of derivative. More precisely,
45.2% of the firms used foreign exchange derivatives, 33.1% used interest rate derivatives, and 10.0% used
commodity price derivatives. Strong evidence showed that the purpose of derivative use was, in fact, hedging,
rather than simply speculation. Specifically, firms that used foreign exchange derivatives had higher proportions of
foreign assets, sales, and income, and firms that used interest rate derivatives had higher leverage.
The type of derivative contracts used varied across the different classes of financial risk. For example, 37.4% of
firms used either forwards or futures (or both) to hedge foreign exchange risk, and 11.2% used swaps. Usage rates
4
The notional principal reflects only the volume of the derivative business, not the size of the associated exposure or risks, which are also
affected by the amount of leverage involved.
5
Bartram, Söhnke M., Brown, Gregory W. and Fehle, Frank Rudoff, “International Evidence on Financial Derivative Usage” (October 2006).
AFA San Diego Meetings. Available at http://ssrn.com/abstract=471245.

were reversed for interest rate derivatives, where swaps were the most popular risk management instrument (used
by 29.0% of firms), and forwards were used by only 1.1% of firms. The use of derivatives with non-linear payoffs
varied less across types of risk: 9.7% of firms used foreign exchange options, and 7.4% used some type of non-linear
interest rate derivative, such as an option, cap, floor, or option on swap.
(Note that, because of their non-linear payoffs, options are said to be non-linear derivatives. As mentioned, the
gains for option buyers are potentially unlimited, but losses are limited to the premium paid. The converse holds
true for the option sellers – their losses are potentially unlimited, but gains are limited to the premium received.)
In contrast to foreign exchange and interest rate derivatives, commodity price hedgers did not appear to have a
preferred type of contract, with forwards, futures, swaps, and options all used in roughly the same proportion.
Examining derivative usage by type of financial risk and industry also revealed distinct patterns. As one would
expect, the use of commodity price derivatives was concentrated in a few industries, such as utilities, oil, mining,
steel, and chemicals. However, the use of interest rate derivatives varied substantially across industries, with utilities
having the highest usage rates (61.7%) and mining the lowest (20.3%). Foreign exchange derivative usage was more
uniform between industries.
An additional objective of the survey was to examine the use of derivatives at the country level and establish which
country-specific factors, if any, were important determinants. Overall, these factors were usually less important
than firm-specific factors, such as the maturity and financial sophistication of the firm. One country-specific
factor consistently relevant was the size of the local-currency derivative market, which suggests that supply-side
constraints were an important determinant of derivative usage.

SUMMARY
Despite negative media attention and widespread confusion about derivative instruments, many corporations
and other institutions are continuing the practice of using derivatives primarily to manage risk and less frequently
to lower costs, enhance returns, facilitate market entry and exit, and engage in arbitrage activities. These users
recognize that the benefits of using derivatives outweigh the potential risks by a wide margin.
There are two basic types of derivatives – options and forwards – and two ways that they can be traded – on an
exchange and over the counter.
Option-based products give holders an opportunity to lock in a maximum purchase price or minimum selling price,
while still allowing for windfall gains. The benefits, however, are not free, given that holders must pay a premium,
the size of which must be taken into consideration when deciding on an appropriate derivative strategy.
Forward-based products also allow users to lock in a future sale or purchase price. However, because forwards
represent obligations, there is no avenue for windfall gains. The user is locked into a price regardless of which
way the market price moves. Unlike options, however, users of forward-based contracts do not have to pay an
up-front fee.
Although there are significant differences between different derivative products, they are all used to achieve the
same financial goals.
Some users prefer the features of option-based products, while others prefer forwards. Some prefer OTC products,
while others would rather take advantage of the features that exchange-traded products offer.
It must be reiterated that derivative products do not create risk. They simply transform it or transfer it between
counterparties. They may transform one type of risk, such as market risk, into a more manageable type of risk,
such as basis risk; or they may transfer an unwanted risk to more efficient managers, so that corporations can
concentrate on their core business operations.
If used correctly and sensibly, derivatives are an essential risk management tool. They are flexible and versatile
and, in most situations, they are the best hedging instrument available in the marketplace. In volatile economic
and business conditions, derivatives may help to reduce a firm’s exposure to market risks such as interest rate risk,
foreign exchange risk, and stock market volatility. They may help stabilize earnings through the reduction of these
risks. They are cost-efficient and provide liquidity to the markets. Effective use of derivatives may lower funding
costs for users by exploiting comparative advantages between counterparties due to market inefficiencies or credit
risk differences. Derivatives such as currency swaps also help companies gain access to otherwise unattainable
markets.
However, although derivatives help market participants achieve financial goals, they must be used with caution. The
real danger of derivatives does not lie in their complexity, but rather in their capacity for leverage.
To limit the potential danger of derivatives, a company must approach a risk management program with a clear
objective and with strong internal control and monitoring procedures in place.
In summary, many corporations, financial institutions, and government agencies have used and are continuing
to use derivative instruments as risk management tools. While the recent negative media coverage involving
derivatives reminds us of potential dangers, the benefits of derivatives are clear to users. Derivatives will continue to
be an integral part of business strategy for years to come.

SECTION 2
FUTURES CONTRACTS


Basic Features of Forward
Agreements and Futures 2
Contracts
CONTENT AREAS
A Brief Overview of Forward-Based Derivatives
A History of Forwards
What Is a Forward Agreement?
What Is a Futures Contract?
Organized Futures Markets
Buying and Selling a Futures Contract
Cash Settlement
Margin Requirements and Marking-to-Market
Futures Trading and Leverage
Reading a Futures Quotation Page
Contract Size and the Value of the Underlying Interest

LEARNING OBJECTIVES
1 | Calculate the value of a forward agreement at any point in time.
2 | Differentiate between forward agreements and futures contracts.
3 | Calculate the possible daily trading range for a futures contract that has a given daily trading limit.
4 | Calculate the profit or loss from offsetting a futures contract.
5 | Describe the steps in the futures delivery process.
6 | Demonstrate the effect of leverage on the percentage gain or loss from the entry and offset of
a futures contract.
7 | Interpret each of the items on a futures quotation page.
KEY TERMS
cash settlement margin
daily price limit marking-to-market
delivery notice offsetting transaction
delivery price original margin
first notice day settlement price
long position short position
maintenance margin warehouse receipt

CHAPTER 2 | BASIC FEATURES OF FORWARD AGREEMENTS AND FUTURES CONTRACTS 2•3
A BRIEF OVERVIEW OF FORWARD-BASED DERIVATIVES

Forward-based derivatives have been around for centuries. Initially, they were largely based on agricultural products,
but in the 1970s, volatility in the financial markets led to the development of forwards based on financial products
such as stocks, bonds, and currencies.
In 1968, approximately 15 million futures contracts were traded worldwide, predominantly based on agricultural
commodities on U.S. exchanges. In 2014, more than 12 billion contracts were traded on 60 exchanges in more than
25 different countries.1 The vast majority of those contracts were based on financial products (either interest rates
or equity prices).
The over-the-counter (OTC) forward market has experienced even greater growth. For example, by the end of 2014,
the global foreign exchange and interest rate forward market had US$581 trillion in notional principal outstanding.
Interest rate and currency swaps made up nearly 70% of this figure, which is remarkable considering that the swaps
market barely existed prior to the early 1980s.
The almost exponential growth in forward markets since the late 1960s has been the direct result of the application
by financial markets of the same concepts that made forward contracts popular in agricultural markets more than a
century before.
In this chapter, we explore the origins of forward markets and discuss the difference between forward agreements
and futures contracts. Organized futures trading is illustrated by an example that takes the reader through the
process of buying and eventually either offsetting the contract or taking delivery of the underlying asset. We also
discuss the margin process, marking-to-market, and the concept of trading limits. An example of a typical futures
quotation found in the financial press provides further clarity.
A HISTORY OF FORWARDS
Producers and consumers in the agricultural industry were largely responsible for the development of forward
trading as participants such as wheat growers and millers sought to minimize price uncertainty.
Agricultural prices fluctuate with supply and demand, just as the prices of most other products do. However,
seasonality and weather conditions tend to make agricultural price fluctuations more severe and unpredictable.
For example, an unusually large harvest can overwhelm markets with excess supply, causing prices to fall. Similarly,
as supplies are drawn down after harvest, shortages can result in escalating prices. The concept of forward buying
and selling was developed to help producers and consumers protect themselves against these seasonal price
fluctuations.
The Japanese were the first people to introduce forward trading in the 1600s with rice forwards. In North America,
the grain industry was the first to embrace forward-based contracts. Initially, contracts were developed in which a
buyer and seller agreed privately, in advance, to the terms of a sale that would be consummated when the goods
arrived. These agreements, known as to-arrive contracts, had their origin in the Liverpool cotton trade in the late
1700s. In the beginning, buyers and sellers met in the street to conduct business, but as volumes grew, a more
permanent marketplace was sought.
The to-arrive contracts helped smooth out seasonal boom and bust cycles, but they were not a perfect solution.
Disputes often arose at delivery over the terms of the contracts, and the threat of default was always present.
Furthermore, the private nature of the contracts meant that pricing information was limited. The buyer and seller
in a particular deal were generally unaware of prices from other contracts and therefore would have difficulty
determining the current market price. Another problem concerned contract resale. Early contracts were not
1
The Futures Industry Association (FIA) compiles and makes available on its website detailed monthly reports on volume and open interest for
futures contracts traded on exchanges worldwide. https://fia.org/categories/exchange-volume

transferable, and even when they became transferable, it was difficult for a buyer or seller to find a third party
willing to accept the risk.
Many of the problems with what were essentially OTC forwards were resolved with the introduction of exchange-
traded forwards, which became known as futures contracts. The Chicago Board of Trade became North America’s
first organized futures market in 1848, when buyers and sellers moved off the street and into the exchange.
However, it was not until the 1860s that the innovative concept of standardized contract terms was introduced.
Listed futures contracts were standardized in terms of size, quality, grade, and time and place of delivery.
Standardization facilitated accurate and immediate price dissemination, as did the requirement that all trading take
place in a single location through the open outcry system. Soon, a margin system was developed to guarantee the
financial integrity of each contract.
The development of futures trading for merchants involved in the grain trade also attracted individuals who were
interested in the market only for its profit possibilities. The influx of these speculators greatly improved liquidity,
which helped enhance market efficiency. Liquid futures markets helped eliminate the risk of being unable to resell
and also helped to minimize wide price fluctuations.
The success of exchange-traded grain contracts led to tremendous growth in new futures contracts and new
exchanges. Cotton, lumber, livestock, coffee, and orange juice futures were eventually followed by contracts based
on industrial and precious metals. In the early 1970s, the first foreign currency contracts were developed, followed
by contracts on debt instruments starting with the Government National Mortgage Association futures (GNMA or
Ginnie Mae). In the early 1980s, the next generation of futures complexes, stock index futures, was initiated with
the introduction of the Value Line and S&P 500 index contracts. Energy-based futures began trading in the
mid-1980s.
Since their birth in the early 1970s, financial futures (i.e., interest rate, currency, and stock index contracts)
have grown to account for approximately 80 percent of all futures trading. These contracts have been primarily
responsible for the almost exponential growth in overall futures volumes.
It is evident that futures contracts were developed to solve some of the problems associated with OTC forward
agreements. Their growth was so rapid that, not too long after their inception, futures markets became the
predominant market for transacting forward-based contracts. This predominance became even more pronounced
with the inception of precious metal and, later, financial futures contracts.
The demand for forward-based derivatives, which fuelled the growth of futures markets, led to renewed interest
in informal markets where individual parties could negotiate customized agreements. In effect, the evolution of
forward markets had come full circle. An OTC market emerged that consisted of a network of brokers and dealers
negotiating transactions primarily over telephone lines. Prior to the 1980s, the primary OTC forward market was
the foreign exchange market. Since then, a host of new instruments have been introduced, including forward rate
agreements, interest rate and currency swaps, and, more recently, weather-related and credit-related derivatives.
WHAT IS A FORWARD AGREEMENT?

A forward agreement is a contract between counterparties to buy or sell an underlying asset at some predetermined
future date at an agreed-upon forward price, known as the delivery price. Once the contract is initiated, the
delivery price is locked in until the contract expires. This type of contract is traded, not on an exchange, but in
the OTC market. It represents an agreement tailor-made to suit the needs of the two parties involved. The party
that agrees to buy the asset is said to have the long position in the contract, and the party that agrees to sell the
underlying asset assumes the short position.
The value of a forward contract to both buyer and seller is calculated as the difference between the forward price
on entry into the contract (i.e., the delivery price) and the current forward price. The value of the contract at onset

is zero to both parties, given that the delivery price at that point is the same as the forward price. For that reason, it
costs nothing to enter a forward contract in either the long or short position.
The delivery price of a forward contract remains the same throughout the life of the contract, but the forward price
fluctuates either up or down over time. The contract develops value to the parties only as the forward price changes.
If the forward price increases, the value of the contract becomes positive for the party holding the long position
in the contract (the buyer) and negative for the party holding the short position (the seller). If the forward priced
decreases, the reverse is true. At maturity of the contract, the party with the short position delivers the underlying
asset, and the holder of the long position pays the predetermined delivery price. The forward market is a zero-sum
game in that one party’s loss in the contract is precisely the other party’s gain.
At maturity, the payoff from a long position in a forward contract on one unit of the underlying asset is calculated
as follows:
PT – D
Where:
PT = the price of the underlying asset at the maturity of the contract
D = the price agreed to at entry of the contract (i.e., the delivery price).
The payoff from the short position in the contract is the exact opposite, or:
D – PT
The payoffs can be positive or negative depending on the relationship between the delivery price and the spot price
of the underlying asset at maturity. Example 2.1 provides an illustration of a forward-based agreement.
EXAMPLE 2.1 | HEDGING PRICE RISK USING A FORWARD AGREEMENT

Consider two companies: Company A manufactures jewellery, and Company B mines silver. Company A knows
it needs 18,000 ounces of silver for its manufacturing operation in six months. Its risk is that the price of silver,
which is currently at US$19.00 per ounce, will rise significantly in the interim. A price increase could severely
reduce its profit margin when it manufactures and then sells the finished product. Company A knows that, given
the current economy, it would be very difficult to pass a price increase along to its customers.
Company B also has risk. With silver prices at US$19.00 an ounce and over, the mining operation is currently
profitable, but if prices fall much below the US$19.00 mark, it could become unprofitable. The company also
knows that it has approximately 18,000 ounces of silver that will be ready for sale in six months.
The two parties enter into a forward agreement. Company A agrees to buy 18,000 ounces of silver from
Company B in six months at an agreed-upon delivery price of US$19.40 per ounce. At the onset of the
agreement, the delivery price and the forward price are the same (US$19.40), so it costs nothing for either party
to enter into the contract.
At the end of six months, the price of silver has increased to US$22.00.
Company A takes delivery of 18,000 ounces of silver at the agreed-upon price of US$19.40. Its payoff is a profit
of US$2.60 per ounce, calculated as follows:
PT – D = payoff
US$22.00 – US$19.40 = US$2.60 per ounce

EXAMPLE 2.1 | HEDGING PRICE RISK USING A FORWARD AGREEMENT

Company B delivers the 18,000 ounces of silver at the agreed-upon delivery price of US$19.40. Its payoff is –
US$2.60 per ounce, calculated as follows:
D – PT = payoff
US$19.40 – US$22.00 = –US$2.60 per ounce
The payoff is not in cash. For Company A, the payoff is the amount that was saved by locking in a purchase price
which is now lower than the current market price. For Company B, the payoff is the foregone opportunity to sell
silver at the higher market price of US$22.00. Because the forward market is a zero-sum game, Company A’s gain
will be equal to Company B’s loss which is US$2.60 per ounce or US$46,800 (US$2.60 x 18,000 ounces).
For illustration purposes, this example was simplified in the sense that most forward agreements are not transacted
directly between two commercial parties. Typically, a dealer such as an investment bank either will act as an agent
between the two parties or will actually be a counterparty itself. As a counterparty, the dealer would sell the
forward agreement to Company A in one transaction and buy it from Company B in another transaction.
Note several significant facts about this example:
1. The terms of the contract were tailored to the specific needs of both parties.
2. The payoff took place only at the end of the contract.
3. If Company B, after seeing prices starting to rise, had wanted to liquidate the agreement, it would have had
difficulty doing so. Company A (or a dealer) may not have agreed to liquidation, or, if it did agree, it would
have demanded adequate compensation. As well, the terms of the agreement were tailored to the unique
needs of the counterparties, so Company B would have had difficulty finding a third party to whom the
agreement could be transferred.
As we will discuss, the terms of futures contracts are standardized for all users, and payoffs take place every day
throughout the life of the contract. Further, because futures contracts are standardized, they are easily offset prior
to expiration.
WHAT IS A FUTURES CONTRACT?

Similar to a forward agreement, a futures contract is an agreement between two parties to buy or sell an asset at
some future point in time at a predetermined price. Unlike forward agreements, however, which are traded over
the counter, futures contracts are traded on an exchange. Therefore, they are standardized with respect to delivery
time and place, and the quantity and the quality of the underlying asset. Furthermore, they are guaranteed by the
particular exchange where they are traded.
As with a forward agreement, the initial value of a futures contract to both buyer and seller is zero; the contract
only gains value as the futures price changes. The payoff from a position in a futures contract is the same as the
payoff from a forward agreement. However, the timing of the cash flows is different because of the daily settlement
feature of a futures contract, which is known as marking-to-market.
A second difference is that the delivery date of the silver futures contract may not have coincided exactly with the
timing needs of either or both companies.
A third difference is that futures contracts are marked to market daily. In other words, payoffs are received
in daily amounts representing the daily settlement of gains and losses. They do not occur in one lump sum
at the settlement date, as they do with forward agreements. The size of the daily amount is based on the
difference between the previous day’s settlement price and the current day’s settlement price. If the position

was initiated during the current day, gains or losses are realized from the initial entry price. If the current
day’s settlement price for the futures contract is higher, an amount equal to the contract’s change in price is
transferred from the short to the long party. If the current day’s settlement price is lower, the money flows the
other way. The total payoff is the same when compared with a forward agreement, but the timing of the cash
flows is different.
In Example 2.1, if, at the end of the day that the contract was initiated, the silver futures price rose from US$19.40
to US$19.60, Company B, which was short, would be in a losing position. It would have to make a payment through
the clearinghouse to Company A in the amount of the open loss. If four contracts were sold (representing 20,000
ounces of silver), the loss and payment would be US$4,000 (US$0.20 × 20,000 ounces).
Another difference between futures contracts and forward agreements is that Company A or Company B could
have easily terminated their respective futures contracts at any time following onset up to contract expiration.
The cancellation process is referred to as an offsetting transaction. Company A could have independently sold,
and Company B independently bought, the contract in the secondary market, which would have had the effect of
liquidating their respective positions. The payoff for both the long and the short would have been determined by
taking the difference between the initial entry price and the offsetting futures price.
A final difference is that futures contracts are guaranteed by the particular exchange where they are traded. If
Company A or B defaulted on its obligations, the exchange would assume the obligations of the defaulted party.
Over-the-counter forward agreements do not have a third-party guarantor.
ORGANIZED FUTURES MARKETS

Compared with the OTC forward market, futures markets are highly organized and structured. Contract terms are
standardized. and procedures are in place for marking-to-market, settlement, and delivery.
Before a futures contract can be listed for trading, it must be approved by regulatory authorities. In Canada, the
provincial securities commission of the province where the contract will be listed for trade is generally the approver.
In the United States, all new contracts must be approved by the Commodity Futures Trading Commission.
As mentioned earlier, all futures contracts are standardized in terms of their size, grade, and time and place of
delivery. Other standardized features of futures contracts include their trading hours, minimum price fluctuations,
and, for contracts that have them, maximum daily price limits. (Daily price limits are the maximum amount that
prices are allowed to rise or fall in one day)
Exhibit 2.1 is an example of the standard specifications of canola futures, a typical futures contract that trades on
ICE Futures U.S..
Exhibit 2.1 | Contract Specifications of Canola Futures
Feature Terms
Trading Unit 20 metric tonnes
Minimum Tick Size $0.10 per metric tonne ($2 per contract)
Daily Price Limit $30 per metric tonne
Delivery Months January, March, May, July and November
Trading Hours 9:30 a.m. to 1:15 p.m. (Central Time)
The trading unit describes the number of units that underlie the futures contract. This is the amount per contract
that must be delivered or accepted for delivery if the contract is held to the delivery month. If the current canola

price were $400 per tonne, the dollar value of the contract would be $8,000 ($400 × 20 tonnes). At delivery, the
seller would deliver $8,000 worth of canola which the buyer would have to pay cash for.
The minimum tick size represents the smallest price increment the futures contract can move up or down. In the
case of canola, the tick size is 10 cents per tonne. If the current price of an October canola futures contract is $400
per tonne, the next trade could take place at a price of either $400, $400.10 or greater, or $399.90 or less. The
10-cent-per-tonne increment translates to $2.00 per contract (20 tonnes × 10 cents).
Exchanges set limits on the amount by which most futures can move, either up or down, during one day’s trading
session. If the price moves down by an amount equal to the daily limit, the contract is said to be limit down. If it
reaches the upper limit, then it is said to be limit up.
The limits are designed to calm market panic, and to give market participants time to absorb new information that
may have been disseminated. This concept is illustrated in Example 2.2.
EXAMPLE 2.2 | DAILY TRADING LIMITS

A severe drought on the Canadian prairies results in volatile trading in the canola futures contract. After a
settlement price of $450 per metric tonne on the previous trading day, July canola futures move up the daily
limit of $30 to $480. The $30 limit prohibits any trading from taking place at more than$30 above or less than
$30 below the previous day’s settlement price of $450. In this particular case, no trades may take place above
$480 or below $420.
If canola futures finished the day limit up at $480, the following session’s permitted trading range would be reset
in exactly the same manner, with a limit down price level at $450 and a limit up price level at $510.
If there were still a lack of sellers willing to trade within the latest price limits, canola futures could then close
limit up for a second day in a row. Traders who are on the wrong side of the market in these so-called lock-limit
situations are exposed to considerable market risk.
When a futures price moves its daily limit, there still may be some trading at the limit price. Most often,
however, trading comes to a complete halt as bids or offers dry up when the market moves limit down or limit up
respectively. (Note that a bid is the highest price at which someone is willing to buy, and an offer is the lowest
price at which someone is willing to sell.) This kind of situation can be dangerous for traders holding losing long
or short positions because they are unable to liquidate. If the limit situation lasts for several days, huge losses can
result.
Partially in recognition of this risk, most exchanges have adopted procedures to deal with limit moves. One
procedure expands price limits after a few days of limit moves. Expanded limits may, for example, widen out to
150 percent of regular limits, which gives traders holding losing long or short positions a greater chance to liquidate.
Another procedure removes limits entirely for futures contracts trading in their delivery month. Finally, some
exchanges have abolished limits on some contracts altogether.
The exchanges also set the delivery months, as well as the specific deadline days for when trading in a contract
ceases and for when the delivery period begins and ends. In the case of canola futures, the last trading day for a
particular delivery month is always the business day preceding the fifteenth calendar day of the delivery month. The
first delivery day is always the first business day of the delivery month.
The exchange also sets the deliverable grade (i.e., the quality of an asset that will be accepted for delivery in terms
of grade, weight, or other characteristics) and identifies alternative grades that are acceptable for delivery.

BUYING AND SELLING A FUTURES CONTRACT

Examples 2.3, 2.4, and 2.5 illustrate a futures trade from onset to delivery.
EXAMPLE 2.3 | BUYING A FUTURES CONTRACT

Trader A places an order with a futures representative to buy 1 November canola futures contract on ICE Futures
Canada. The order is relayed to the exchange’s electronic trading system where it is filled at a price of $420 per
tonne. The speculator is now long, and if the contract is held to the expiration in November, the speculator is
obligated to accept delivery of 20 tonnes of canola from the short based on the terms of the contract, at an
effective price of $420 per tonne.
Note: As explained in Example 2.5, the actual delivery price for a futures contract is the settlement price at delivery. The effective price,
however, is the initial entry price as the futures profit or loss is netted from the settlement price.
Although a futures contract represents an obligation to deliver or accept delivery of an underlying asset, in
most futures trades that obligation is terminated prior to the delivery period through what is known as an
offsetting transaction. Settlement by offset is accomplished by the holder of a long position independently
selling the contract, or the holder of a short position independently buying back the contract. The payoff from
settling the contract prior to delivery is calculated as the difference between the offsetting and original entry
prices.
Many people unfamiliar with the workings of the futures market visualize receiving physical delivery of the
underlying asset. Needless to say, the thought of having 20 tonnes of canola, for example, dumped on one’s
doorstep is enough to steer someone well clear of the futures markets.
In fact, nothing could be further from the truth. The delivery period only begins with the first notice day, which is
typically near the end of the month prior to the delivery month. As long as a contract is offset before this important
date (and as mentioned, most contracts are offset), there is no actual delivery.
Even if a person decides to take delivery, what is received or delivered, in the case of most physical commodities, is a
warehouse receipt that the seller endorses over to the buyer. The receipt is issued by a storage point authorized by
the exchange, which confirms the presence and ownership of the underlying asset.
EXAMPLE 2.4 | SETTLEMENT BY AN OFFSETTING TRANSACTION

Before the start of the delivery month, Trader A, who is long one November canola futures contract, places
an order with the same futures representative to sell one contract of November canola futures. The order is
relayed to the floor of the exchange, where it is filled at a price of $430 per tonne. By selling November canola,
the trader has, in effect, cancelled out, or offset, the earlier long position. Because the offsetting price is higher
than the original delivery price, Trader A has earned a profit of $10 per tonne, which is based on the difference
between the buying and selling prices. And because one contract represents 20 tonnes, the trader’s profit
is $200.
Contracts that have not been offset prior to the delivery period are subject to physical delivery (with the exception
of cash-settled futures, discussed later in this chapter). There are several considerations to keep in mind with regard
to delivery.
First, it is the short that controls the delivery process. Within what is allowed by the terms of the futures contract,
the short determines the time and location of delivery, as well as the quality or grade of the underlying asset to be
delivered. Most contracts allow for multiple delivery points and for the delivery of grades that may be slightly better
or worse than what par delivery specifications demand. The allowance of premium or discount grades is designed
to increase the amount of a commodity available and to help prevent one group from cornering (i.e., controlling)
the market.

A second consideration is that the delivery process begins with what is known as first notice day. The exact day
depends on the particular futures contract, but it typically occurs near the end of the month preceding the delivery
month. If a long futures holder such as Trader A does not offset a position before this day, the trader risks receiving a
delivery notice. The risk grows higher the further into the delivery month the contract is held. If the contract is held
to the end of last trading day, delivery is guaranteed.
Anytime on or after first notice day, shorts will notify the exchange’s clearinghouse of their intention to deliver,
the location of delivery, and the deliverable grade. Upon this notification, the clearinghouse then allocates delivery
notices among clearing members who have long positions on or after first notice day. One method of allocation
used by clearinghouses is the first-in, first-out method, whereby the oldest long positions are given notices first.
Actual delivery typically takes place a few days after the party with the long position in the contract receives notice.
On the delivery day, the long position issues payment by certified cheque to the short position and takes delivery in
exchange.
Rather than receiving the actual physical commodity at that time, the long receives a warehouse receipt that
represents the amount and grade of the commodity that is stored at one of the acceptable delivery points. If the
underlying asset to be delivered is a financial product such as a currency or bond, in exchange for the certified
cheque, the long position receives documentation verifying ownership of the asset at an exchange-approved bank.
Some futures contracts call for settlement by cash and not by physical delivery. Stock index futures are the most
common type of cash-settled futures contract.
EXAMPLE 2.5 | SETTLEMENT BY DELIVERY

Instead of offsetting the long position in November canola futures, Trader A decides to carry the position past
first notice day. In early November, the trader receives a delivery notice that was delivered to the clearing
corporation the previous day by someone holding a short position. The notice calls for Trader A to accept delivery
of a warehouse receipt that represents 20 tonnes of canola at an exchange-approved warehouse at a price of
$440 in two days’ time. On the delivery day, he accepts delivery of the warehouse receipt in exchange for a
certified cheque in the amount of $8,800.
Anyone who is short this particular contract at any price can initiate the delivery process; it does not have to
be the original seller to Trader A’s purchase. In fact, there may not be any shorts still holding the contract who
entered at a price of $420. For that reason, the actual delivery price is the settlement price at delivery, or $440
in this example. Although Trader A pays $8,800 ($440 per tonne), he has made a $400 profit on the futures
position, thereby lowering his effective price to $8,400 ($420 per tonne, or his initial entry price).
Note in Example 2.5 that the delivery process was initiated by the short who delivered a notice of intention to
deliver to the clearing corporation in early November. In reality, the notice would be delivered by the short’s broker
on instructions from the short. The notice includes details as to the timing of delivery, the grade of canola to be
delivered, and the location where the canola is stored. It does not specify to whom delivery is to be made. The
clearing corporation allocates delivery notices to the various member firms who are showing long positions, and the
member firms, in turn, allocate them to their long clients.
It is important to note that the delivery price, rather than being Trader A’s entry price of $420, was actually $440
which represented the settlement price on the day the short position issued the delivery notice. Based on a price of
$440, Trader A issued a cheque for $8,800 to the short ($440.00 × 20 tonnes).
Although a cheque was issued for $8,800, the net cost of the canola to Trader A was only $8,400. A profit of $400
would have been earned on the long futures position, which would have been automatically closed out the day
the delivery notice was issued. The profit would be the difference between the settlement price on this day ($440)
and the entry price ($420). The effective net price Trader A would have paid would have been $420 per tonne
($8,400/20 tonnes), which was the initial entry price.

CHAPTER 2 | BASIC FEATURES OF FORWARD AGREEMENTS AND FUTURES CONTRACTS 2 • 11
As already mentioned, most market participants have no desire to accept or deliver an underlying asset. The best
way to avoid making delivery is to offset the position before first notice day. If market participants still wish to
maintain the same exposure to a particular futures contract, they can “roll over” into a more distant contract by
offsetting the old contract, while simultaneously entering into a new contract. In Example 2.2, if Trader A did not
wish to take delivery but wanted to maintain a long exposure, he could have sold the November contract before
first notice day and bought a deferred canola contract, such as a March contract, at the same time.
Member firms have procedures for notifying their clients that first notice day is approaching. Typically, clients are
notified several days prior and advised to either liquidate the position or roll over to a more distant month. To
encourage their clients to offset or roll over their positions, margin requirements are typically raised significantly on
and after first notice day.
Occasionally, however, a long client who had no intention of taking delivery accidentally holds on to the position
through first notice day and receives a delivery notice. Most exchanges have a mechanism that allows those clients
to offset their obligation by selling an equivalent number of futures contracts and then passing along the delivery
notice to the clearing corporation, which, in turn, allocates it to another long position. This procedure, however, can
be costly to the client. It entails extra commission costs as well as the possibility of the carrying costs of the physical
commodity if the delivery notice cannot be passed on right away.
CASH SETTLEMENT
Not all futures contracts involve delivery of a physical asset in exchange for payment. A certain type of futures
contract dictates that delivery be conducted with an exchange of cash or a cash settlement. This type of contract is
typically referred to as a cash-settled futures contract.
An example of a futures contract that is cash-settled is a stock index futures contract. Those who are long on a stock
index futures contract are not obliged to accept delivery of the stocks that make up the index, nor are the shorts
obliged to make delivery. Instead, if the position is held to expiration, the long and short must either pay or receive
the difference between the initial entry price and the expiration price. If the futures price increases, then the holder
of the long position receives a payment from the short for an amount equal to the difference. If the futures price
decreases, the holder of the short position receives a payment from the long for an amount equal to the difference.
As with all other futures contracts, positions can be liquidated prior to expiration through an offsetting transaction.
MARGIN REQUIREMENTS AND MARKING-TO-MARKET

Futures transactions are typically margin transactions. However, the margins are not the same as margins on
securities, which are counterpart to the maximum loan value that a dealer may extend to its customer to purchase
a security. Futures margins are amounts of money that a customer must deposit with a broker to provide some
assurance that the financial obligations of the futures contract will be met. In effect, a futures margin represents a
good faith deposit or a performance bond.
The minimum margin rate for a client who wishes to establish a position in a futures market is set by the exchange
or clearinghouse. A member firm may impose higher margin rates on its clients, but it may not charge the client less
than the exchange’s minimum requirements.
Two levels of margin are used in futures trading: original margin (also called initial margin) and maintenance
margin. Original margin is the deposit required when a trader enters into a futures contract. Maintenance margin is
the minimum balance of margin that must be maintained during the life of the contract.
Remember that one of the characteristics of a futures contract is its daily settlement, or what is referred to as
marking-to-market. As mentioned earlier, at the end of each trading day, the party in the long position makes a

payment to the short position, or vice versa, depending on the relationship between the current futures price and
the initial entry price.
In reality, the process is a bit more complicated. First, the payment is not made directly between the long and
short but takes place between the counterparties’ respective investment dealers (member firms) through the
clearinghouse. Second, although the long’s and short’s respective accounts are debited or credited each day by the
amount of loss or gain, the party in the losing position must deposit additional margin only when his or her account
balance falls below the maintenance margin level.
FUTURES TRADING AND LEVERAGE

Because futures prices only reflect the prices of their underlying interests, one might ask why futures trading is
considered riskier than trading the underlying interests themselves. The main reason is leverage. Leverage describes
the amount of capital that must be put up in order to buy or sell an asset. In mathematical terms, it is simply the
ratio of the investment relative to the amount of capital needed to purchase it. If, for example, a $300,000 house
is purchased with a $75,000 down payment and a $225,000 loan, the purchaser has a 4:1 leverage ratio. Because
futures trading requires smaller margins than equity trading, more leverage is available.2
Investors can buy or sell equities with margin deposits ranging from 30% to 80%. For example, a $10,000 long
position in a security eligible for reduced margin can be arranged with only a $3,000 deposit. However, futures
margin requirements are typically only 3% to 10% of a contract’s value, so that same $3,000 deposit could secure
a futures position with a value of $100,000. If the equity investor sees the value of the stock rise by 10%, the sale of
the stock would yield a 33% return on margin. If the futures price increases by the same 10%, the return on margin
would be 333%. Of course, leverage would magnify losses if prices moved in the wrong direction.
Leverage is often associated with futures trading, but it is not inherent in a futures contract. A futures trader
could decide to deposit a contract’s full value as margin rather than the minimum margin required. For example,
a trader who goes long in a gold futures contract could deposit the contract’s value of US$59,000 (100 troy
ounces at an assumed price of $590 per ounce) as margin. In such a case, the trader would not be leveraged at all.
In practice, however, most traders take advantage of the leverage offered. It is one of the attractions of trading
futures. Nevertheless, leverage should be thought of as separate from a futures contract. It is a feature that most
participants will exploit, but some may choose not to use. For example, pension funds in Canada are regulated in a
way that prevents them from taking leveraged positions in futures contracts.
READING A FUTURES QUOTATION PAGE

Real-time or delayed intraday quotations are available on most exchanges’ websites. Table 2.1 duplicates an intraday
quotation on light sweet crude oil (WTI) from the New York Mercantile Exchange’s website. This is the world’s
largest-volume futures contract trading on a physical commodity, and because of its excellent liquidity and price
transparency, the contract is used as a principal international pricing benchmark. The numbers in parentheses
indicate that these items are explained in the notes that follow the table.
2
Futures margins are set at only a small percentage of a contract’s underlying value to give market participants, particularly hedgers,
reasonable access to a market.

CHAPTER 2 | BASIC FEATURES OF FORWARD AGREEMENTS AND FUTURES CONTRACTS 2 • 13
Table 2.1 | Light Sweet Crude (1)
Open
Month Last Change Open High Low Volume Interest
(2) (3) (4) (5) (6) (7) (8) (9)
Oct 2019 55.79 -1.11 56.83 57.55 55.31 582,353 359,238

Nov 2019 55.48 -1.03 56.38 57.05 55.06 85,083 209,540
Dec 2019 55.11 -0.97 56.02 56.58 54.65 81,937 269,811
Jan 2020 54.77 -0.93 54.40 56.06 54.31 25,720 142,089
Feb 2020 54.49 -0.90 55.45 55.63 54.04 12,147 69,940
Notes
(1) The asset underlying the futures contract – in this case, crude oil.
(2) The delivery month of the contract.
(3) The last price at which the contract traded.
(4) The change in the price of the contract from the previous trading session’s settlement price.
(5) The current trading session’s first trade price for the contract.
(6) The highest price at which the contract traded during the current trading session.
(7) The lowest price at which the contract traded during the current trading session.
(8) The estimated number of contracts that have traded during the current trading session.
(9) The total number of contracts outstanding (i.e., contracts that have not been closed out or offset by
delivery) at the close of the previous trading session. At any point, the total number of contracts held
long, must, by definition, equal the total number of contracts held short in the same futures for the same
expiration month. To calculate the open interest, only one side, either the long or short side, is
counted.
CONTRACT SIZE AND THE VALUE OF THE UNDERLYING INTEREST

Calculating the value of the underlying interest represented by one futures contract is a relatively simple task; it
is simply a matter of multiplying the contract size by the latest price. Most of the financial press includes contract
sizes within their end-of-day quotations. The exchanges tend to post this information separately from their
quotations.
For example, in the case of crude oil futures, the standard size of one contract is 1,000 barrels. With the October
2019 contract trading at a price of US$55.79 per barrel, the value of the underlying interest per contract is
US$55,790 (US$55.79 × 1,000 barrels).

Pricing of Futures Contracts 3
CONTENT AREAS
A Brief Overview of Futures Pricing
Futures Market versus Cash Market
Cost of Carry
Basis
Cash and Carry Arbitrage
Reverse Cash and Carry Arbitrage
Conditions that Facilitate Arbitrage
Inverted Markets
Convergence
LEARNING OBJECTIVES
1 | Calculate cost of carry on a futures contract given financing, storage and insurance costs.
2 | Recognize the conditions that facilitate arbitrage.
3 | Demonstrate how, when the conditions for arbitrage are in place, arbitrage keeps futures prices
within their general cost of carry range throughout the life of the contract.
4 | Recognize the market conditions where arbitrage may not apply and thus may lead to
backwardization.

KEY TERMS
arbitrage cost of carry
backwardation fair value
basis inverted market
cash and carry arbitrage normal market
contango reverse cash and carry arbitrage
convenience yield spot price
convergence

CHAPTER 3 | PRICING OF FUTURES CONTRACTS 3•3
A BRIEF OVERVIEW OF FUTURES PRICING

Many people who are not familiar with futures markets have a misconception about futures pricing. They think that
a futures price merely reflects the expectations of market participants about where current prices will be in the
future. In other words, if the current gold price is at $800 per ounce, and the six-month futures price is $810 per
ounce, many observers feel that $810 per ounce represents the price that market participants anticipate will be the
current price in six months’ time.
Although expectations do play a significant role in futures pricing in some markets, in many others, that role is very
limited. The gold market is one of those markets. In all likelihood, the six-month futures price would have been at
or near $810 regardless of whether the market had a bullish or bearish view on gold one year out. In these markets,
futures pricing is determined by a concept known as cost of carry.
In this chapter, we explain how futures prices relate to the spot price of the underlying asset. We introduce the basic
cost-of-carry model, and we explain the concept of basis. Next, we discuss normal and inverted markets, and we
describe the arbitrage process. We conclude the chapter with a discussion of convergence.
We use the futures market to illustrate the pricing concepts of forward-based contracts. For purposes of this text,
we assume that the relationship between a forward agreement price and a spot price is the same as that between
a futures contract price and a spot price. In practice, however, there can be some minor differences in the way they
are priced, primarily because futures are settled daily, whereas forward agreements are settled at expiration.
FUTURES MARKET VERSUS CASH MARKET

Investors can buy and sell assets in a cash market or a futures market. The cash market typically is not conducted in
a central, physical trading location; rather, it is a network of buyers and sellers who conduct their business at various
locations by telephone or on computer terminals. The price at which an asset is bought and sold in a cash market
is known as the spot price, or cash price, which will vary on a particular asset depending on the grade and location.
Cash market participants usually assume the risk of counterparty default.
A futures market is found at a central location that brings together buyers and sellers. Futures contracts are
standardized in terms of the grade and location of the underlying asset. Rather than buyers and sellers assuming
counterparty risk, a clearing corporation assumes this risk.
Because a futures contract represents an obligation to buy or sell an underlying asset, futures and cash prices are
very similar. The only difference results from the fact that transactions in the cash market are for immediate delivery
and payment, whereas those in the futures market are for future delivery and payment.
COST OF CARRY
The price of a futures contract represents the current price of the underlying asset adjusted for the opportunity cost
that arises from delayed settlement.
Consider the case of someone who plans to buy an automobile in six months but is concerned that prices will
increase in the interim. She could buy the car now, but she does not have the funds or the storage space available.

Rather than wait six months and risk a possible rise in car prices, the person enters into a forward agreement with
the car dealership. The dealership agrees to sell the car at an agreed-upon price and accept payment in exchange for
delivery of the car in six months.
By entering into this agreement, the dealer incurs the carrying costs associated with holding the car for six months,
including the costs of financing, storage, and insurance.
The forward price agreed upon between the buyer and the seller should therefore compensate the car dealer for
incurring these costs. If the current price of the car is $20,000, and carrying costs are $200 per month, the six-
month forward price should be $21,200 - that is, six months’ worth of carrying costs ($1,200) plus the current price
of $20,000.
If the price were higher than $21,200, the buyer would probably be wiser to finance the purchase and pay for
storage. If the price were lower, the dealer would not be adequately compensated and should probably not enter
into the agreement. Example 3.1 takes this same principle and applies it to the futures market.
EXAMPLE 3.1 | COST OF CARRY

An investor feels that gold prices are about to move higher, and in response he has decided to buy 100 ounces of
physical gold bullion in the cash market. The spot price for gold bullion is $800 per ounce. The investor calculates
that the costs involved in carrying the physical bullion for six months will be $10 per ounce. The costs, which
include storage, financing, and insurance, increase the cost of buying and carrying the gold for six months to
$810 per ounce. This price is, in effect, the six-month futures price for gold.*
* Note that this example, and others in this chapter, ignore the impact that continuously compounded interest and present value have on
carrying charges.
In a normal cost-of-carry market, known as a contango market, the price of gold futures for delivery in one year will
be equal to the cash price plus carrying costs. In Example 3.1, the fair value of a six-month gold futures contract is
$810 per ounce. Because the asset is the same, the futures should be priced so that investors would be indifferent
about whether to buy gold futures or the physical gold (and pay the carrying costs associated with holding for six
months). If there were a discrepancy between the two prices, market forces would eventually serve to move them
back in line with one another.
For example, if the futures were underpriced at $790 per ounce, buyers would have an incentive to buy the “cheap”
futures contract, and sellers would have an incentive to sell gold at the “expensive” cash price of $800. Such a
mispricing would also attract market participants who want to lock in a risk-free profit by simultaneously buying
the futures and selling short the physical gold. They then would hold this strategy until the expiration of the futures,
when the two prices become the same. This strategy would earn the investor not only the $10 difference by virtue
of buying low and selling high, but also the interest on the proceeds of the gold sale.
This type of strategy, whereby the same or a related asset is bought and sold on two different markets to take
advantage of a price discrepancy, is known as arbitrage. We discuss arbitrage in greater detail later in this chapter.
Over time, these collective buy-and sell-pressures would force futures and cash prices to shift so that they better
reflect carrying charges. A contract’s delivery obligation ensures that cash and futures prices become one at
expiration. However, it is important to understand that it is the collective actions of market participants attempting
to “buy low and sell high” that helps keep cash and futures prices in line with one another during the life of a
contract.

BASIS
The numerical difference between a spot price and a futures price is known as the basis. If the gold futures price is
at $810 per ounce, and the spot price is at $800 per ounce, the basis is said to be $10 per ounce.1 When commodity
futures prices are trading higher than cash prices, the market is said to be a normal market. In such a market, the
basis widens when futures prices increase at a faster rate or fall at a slower rate than spot prices. The basis narrows
when futures prices rise slower or fall faster than cash prices.
When commodity future prices are lower than cash prices, the market is said to be an inverted market or in
backwardation. In an inverted market, the basis widens when futures prices rise slower or fall faster than spot
prices. The basis narrows when futures prices rise faster or fall slower than spot prices.
NORMAL MARKET
A normal commodity futures market is characterized by adequate supplies of the underlying asset through all
delivery months. Because supplies are sufficient, there is no undue price pressure on any of the deliverable contract
months. Futures prices will therefore trade at a premium to spot prices, reflecting all, or at least some, of the
carrying charges.
Table 3.1 shows a summary of basis movements in commodity futures markets.
Table 3.1 | Summary of Basis Movements in Commodity Futures Markets
Futures price movement relative to cash price movements Normal Market Inverted Market
Futures price rises faster than the cash price, or falls more slowly Basis widening Basis narrowing
Futures price falls faster than the cash price, or rises more slowly Basis narrowing Basis widening
Figure 3.1, below, illustrates hypothetical gold futures prices in a normal, full-cost-of-carry market. Notice that the
futures contract with three months to delivery is trading at a $5 premium to the cash price, and each successive
futures contract is trading at a $5 premium to the previous delivery month’s price. In this example, $5 represents
the cost of carrying the physical gold for three months. Carrying the gold for six months would entail a cost of $10.
In a normal market, futures prices reflect the full cost of carrying the physical asset. In this case, the six-month
futures should trade at a $10 premium to the cash price. As a result, the theoretical value or fair value of the six-
month futures is $810.
As time passes, the cost of carrying an underlying asset to delivery decreases. If it costs $10 to carry gold for
six months, it will cost only $5 for three months. By expiration of the futures contract, carrying costs will have been
reduced to zero, and the futures price will equal the cash price.
1
In traditional practice, the basis in this example would be referred to as being $10 under, which is calculated by subtracting the futures
price from the spot price. This method, however, can be confusing because it produces a negative number in a normal market. Many texts
(including this one) calculate the basis by subtracting the spot price from the futures price, which, in a normal market, produces a positive
number.

Figure 3.1 | Hypothetical Pricing Structure of Gold Futures in a Normal Full Cost of Carry Market
825
12-Month Futures
820
9-Month Futures
815
Price ($/ounce)
6-Month Futures
810
3-Month Futures
805
Cash
800
Time
CASH AND CARRY ARBITRAGE

As mentioned, arbitrage is the act of simultaneously buying and selling the same or a related asset in two
different markets in an attempt to profit from price discrepancies. Arbitrage plays a major role in most futures
markets because it is the mechanism by which futures prices remain aligned with spot prices during the life of the
futures contract. Whenever futures prices move away from spot prices in a way not reflected by the cost of carry,
arbitrageurs will either buy or sell futures against the underlying spot asset, depending on whether the futures price
is trading cheap or expensive relative to that asset. Without the possibility of arbitrage, futures prices are free to
drift from their fair value.
The easier and cheaper it is to implement arbitrage, the closer futures prices will trade to fair value. Gold and silver
futures are two contracts in which arbitrage is relatively easy to implement. As a result, they typically trade close to
fair value.
EXAMPLE 3.2
Arbitrage
In late December, an arbitrageur noticed that the price of June silver futures was US$12.00 per ounce, while the
spot price of silver was at US$11.00 per ounce. The arbitrageur estimated that, when the monthly cost of carry
(US$0.10) was taken into consideration, the theoretical futures price for the June contract was US$11.60. In other
words, June silver futures were overpriced. Recognizing an opportunity, the arbitrageur sold the “expensive” June
silver futures contract at US$12.00 and bought the “cheap” physical silver at US$11.00. In June, at expiration,
the arbitrageur delivered the physical silver at US$12.00 per ounce, US$1.00 higher than its purchase price.
After incurring costs of carrying the silver (US$0.60), the arbitrageur earned a profit of US$0.40 per ounce, or
US$2,000 per silver futures contract (contract size being 5,000 ounces).
In Example 3.2, the $0.40 per ounce profit represents a return for the arbitrageur of 3.6% over six months, or 7.3%
annualized. This return is risk-free and above and beyond all carrying costs. For all practical purposes, it is a windfall
gain. Naturally, this kind of opportunity does not appear very often, or last very long. The collective action of

arbitrageurs buying physical silver and selling silver futures ensure that such opportunities are short-lived. Buy-and-
sell arbitrage pressures quickly closes price gaps, thus forcing futures prices back to around fair value.
An arbitrage position does not need to be held until delivery, and, indeed, most are not. In Example 3.2, if the basis
narrowed to a point where the arbitrageur was satisfied with the return, the physical silver could have been sold and
the short futures position offset.
Example 3.2 illustrates what is commonly referred to as cash-and-carry arbitrage. The arbitrageur takes advantage
of a situation where futures are overpriced relative to the physical asset by buying the asset and carrying it against
the sale of the futures. Cash and carry arbitrage helps reinforce a futures’ fair market or theoretical value.
In reality, arbitrageurs will exploit only those discrepancies that cover at least the transaction costs (e.g.,
commissions and bid-ask spreads) associated with the arbitrage itself (beyond storage, insurance, and financing
costs). Because large institutional traders have the lowest transaction costs, arbitrage opportunities are rarely, if
ever, available to retail traders.
Cash-and-carry arbitrage is almost always possible. It is usually not difficult or expensive for a professional
arbitrageur to sell a futures contract while buying and holding the underlying asset. The only situation where it does
become difficult, if not impossible, is when the underlying asset does not store well and therefore cannot be carried
for long. It is for this reason that most futures contracts are based on underlying assets that store reasonably well.
REVERSE CASH AND CARRY ARBITRAGE

If silver futures are underpriced relative to fair market value, the arbitrageur could implement a reverse cash-and-
carry arbitrage strategy. To do so, the arbitrageur would sell short the underlying asset in the cash market and
enter a long position in the futures contract.
A reverse cash-and carry-arbitrage strategy is slightly more complicated than a straight cash-and-carry arbitrage
because it involves different carrying costs. In the previous example, if silver futures were underpriced relative to fair
value, the arbitrageur would have sold the physical silver short when he bought the undervalued futures. To be able
to sell the silver short, the arbitrageur would have had to borrow it. There would be no responsibility for storage or
insurance costs, but there would be a cost associated with borrowing the silver, which is often referred to as a lease
cost.
Although the arbitrageur would earn interest on the proceeds of the sale of the borrowed silver, in all likelihood,
some of those proceeds would have to remain with the lender as collateral, and thus would not be available for
reinvestment. The inability to reinvest the entire proceeds of the sale is, in effect, another cost of doing a reverse-
cash and-carry arbitrage.
Because cash-and-carry arbitrage is typically cheaper and easier to implement than reverse cash-and-carry
arbitrage, there is usually an asymmetry in the size of price deviations above or below fair value. After all, it is
cheaper for arbitrageurs to keep futures prices from rising too far above fair value, but more expensive to prevent
futures prices from falling below fair value. In other words, as a general rule, futures prices are more easily
underpriced relative to fair value than overpriced.

CONDITIONS THAT FACILITATE ARBITRAGE

Many futures contracts have the following characteristics that facilitate easy arbitrage and thus dictate that prices
will trade at or near to fair value:
Ease of short selling If short selling of the underlying interest is not possible, futures prices could
trade under the fair value because reverse cash-and-carry arbitrage would not
be possible.
A large supply of the A large supply makes it easier for cash and carry arbitrageurs to buy and store the
underlying interest underlying interest against the sale of a futures contract. It also makes it easier for
reverse cash-and-carry arbitrageurs to borrow the asset.
High storability If an underlying interest cannot be stored, cash and carry arbitrage is not possible.
Non-seasonal production Temporary imbalances in supply and demand can make arbitrage very difficult.
or consumption
Financial futures meet all of the conditions that facilitate arbitrage. Short selling is typically not a problem, and
there is usually a large supply of the underlying asset. Furthermore, storability is not an issue, nor is seasonal
production or consumption. Arbitrage therefore is generally easy to implement with financial futures, so their prices
trade relatively close to fair value. Gold and silver are examples of futures contracts that meet the above conditions
for the most part.
Grains and oilseeds are examples of commodities that do not meet the above criteria. Production is seasonal, and
shortages can very often result. When shortages occur, short selling may be difficult. The same can be said of a
commodity such as crude oil, for which consumption is seasonal, and which is subject to shortages.
In these cases, when arbitrage becomes difficult, futures prices will not trade on a strict cost-of-carry basis.
Expectation will then play a new, significant role. When shortages occur, market participants place a high value on
the benefits of owning the physical commodity. This value is referred to as a convenience yield.2 The value of these
benefits can be high if the probability of future shortages in the underlying commodity is high. If the probability
of shortages is low, then the convenience yield tends to be low. In other words, the size of the convenience yield
is based on market expectations regarding the length and severity of the shortage.
When a commodity has a convenience yield, the cash price can rise well above the futures price. When this occurs,
the market is said to be inverted or in backwardation.
INVERTED MARKETS
An inverted commodity futures market typically results from a shortage of the underlying asset in the cash
market. The lack of available supply fuels aggressive buying by those who have an immediate need for the asset.
Consequently, spot prices are driven up to exceed futures prices. As the asset becomes scarcer, demand moves out
to the nearest delivery futures contract, pushing up its price to a large premium over the prices of deferred delivery
futures contracts (i.e., those contracts with a longer time until expiration). Often, deferred-month prices will barely
move, despite significant increases in cash and nearby prices. In these situations, market participants do not expect
the near-term rise in prices to persist for very long. In fact, the rise in nearby prices may even be considered bearish
for deferred prices because of the possibility that current high prices will attract new supplies into the market in the
future.
2
The convenience yield is often quantified and incorporated into the basic cost of carry model.

Inversions do not occur only in situations where unusual market conditions exist. Normal seasonal influences
can often have the impact of forcing a market into inversion. Grain markets typically can go into inversion as
supplies from the previous harvest become exhausted in late winter or spring. In response to the short supply, the
marketplace will put a premium on cash grain relative to future grain. This premium could be extreme if the previous
harvest was unusually small or demand unusually high.
As a result of the shortage, the asset becomes very difficult or even impossible to borrow. And because of the value
placed on owning the asset, those holding it will reluctant to lend it out.
If the asset cannot be borrowed, reverse cash-and-carry arbitrage is not possible. As a result, there is theoretically
no limit on how far futures prices can trade under fair value, or even under the underlying cash price. The history
of futures trading is filled with examples of cash prices moving to extreme premiums relative to futures prices. For
example, during the first Gulf War in 1990, concern about the availability of crude oil supplies drove cash prices to
almost US$40 a barrel. At the same time, deferred futures prices remained in the low- to mid-US$20 range due to
market expectations that the crisis would not last long.
Figure 3.2 illustrates hypothetical corn futures prices with the market in inversion. Notice that the inversion
between contract months is not even. Cash is at only a slight premium to the three- and six-month futures, but it is
at a very large premium to the nine- and 12-month futures. In this example, cash and the nearby futures represent
the old crop, whereas the deferred futures represent the new crop. New crop prices are considerably lower than
cash prices because market participants typically expect farmers to increase their output due to the attractive
cash prices.
Figure 3.2 | Pricing Structure of Corn Futures in an Inverted Market
3.6
Cash
3-Month Futures
3.4
6-Month Futures
Price ($/bushel)
3.2
3.0
9-Month Futures
12-Month Futures
2.8
Time
CONVERGENCE
Convergence is the term used to describe the process whereby the basis narrows as a futures contract approaches
its expiration. Convergence reflects the gradual decline in the cost of carry. It dictates that, in normal commodity
futures markets, when cash prices are rising, the rise in futures prices will be lower as contract expiration nears. If
spot prices are falling, the futures price decline would have to be greater. Figure 3.3 shows the relationship between
a commodity futures price and spot price as the delivery month approaches. Part (A) of the figure illustrates the
convergence of spot and commodity futures prices in a rising market. Part (B) illustrates the convergence of spot
and commodity futures prices in a falling market.

Figure 3.3 | Relationship Between a December Commodity Futures Price and Spot Price as the Delivery
Month Approaches
Figure 3.3(A) | Convergence in a Rising Market
640
Legend:
620 Futures
Cash
600
580
560
540
Jan. June Oct. Dec.
Figure 3.3(B) | Convergence in a Falling Market
640
Legend:
630 Futures
Cash
620
610
600
590
580
Jan. June Oct. Dec.

Hedging with
Futures Contracts 4
CONTENT AREAS
Hedging
Types of Hedges
Imperfect Hedges
Optimal Hedge Ratio
LEARNING OBJECTIVES
1 | Demonstrate how futures contracts can be used to hedge price risk.
2 | Differentiate between perfect and imperfect hedges.
3 | Recommend a futures hedging strategy to a client, including determination of the number of

contracts required.

KEY TERMS
basis risk long hedge
cross-hedge optimal hedge ratio
hedging perfect hedge
imperfect hedge short hedge

CHAPTER 4 | HEDGING WITH FUTURES CONTRACTS 4•3
HEDGING
The primary function of a futures market is to allow risk-averse participants to reduce or eliminate risk by shifting it
to others who are willing to assume it in return for the possibility of earning a profit. A market participant may need
to reduce either the risk of holding a particular asset for future sale or the risk involved in anticipating the purchase
of a particular asset. This act of attempting to reduce or eliminate risk is referred to as hedging, which is the subject
of this chapter. The act of assuming risk is referred to as speculating, which we discuss in Chapter 5.
In this chapter, we explain short and long hedges and the concepts of perfect and imperfect hedges. We also explain
basis risk and describe the types of futures contracts that are most prone to this type of risk. Finally, we introduce
the concept of an optimal hedge ratio as a way of dealing with basis risk.
TYPES OF HEDGES
There are two basic types of hedges, a selling hedge (called a short hedge) and a buying hedge (called a long hedge).
As much as possible, hedgers try to fix future sale prices by short hedging and future purchase prices by long hedging.
SHORT HEDGE
A short hedge is executed by someone who owns or, in the case of a farmer or miner, anticipates owning an asset in
the cash market that will be sold at some point in the future. To protect against a decline in price between now and
the time when the asset will be ready for sale, the hedger can take a short position in a futures contract on the same
underlying asset that matures at approximately the time of the anticipated sale. By taking this action in the futures
market, the hedger will be able to receive an amount equal to the agreed-upon price in the contract, even if the spot
price of the asset at the time of the sale is considerably different.
Example 4.1 illustrates a short hedge.
EXAMPLE 4.1 | SHORT HEDGE

On August 15, a farmer sells 1,000 tonnes of canola to a commercial grain elevator at a price of $420 per
tonne. The elevator now has an inventory of 1,000 tonnes of canola, which it expects to sell in November at
whatever price is prevailing at that time. To protect this inventory against a decline in prices over the next three
months, the elevator sells 50 contracts of November canola futures at $430 per tonne. Each contract represents
20 tonnes.
Three months later, at the expiration of the futures contract, the price of canola has fallen to $400 per tonne,
and the elevator sells 1,000 tonnes at this price. At the same time, when it sells the physical canola, the elevator
offsets the short futures position at $400 per tonne. The cash and futures market gain and loss are illustrated
in Table 4.1.
Table 4.1 | Short Hedge Gain and Loss
Time Cash Market Futures

August 15 Buys 1,000 metric tonnes of canola Shorts 50 November canola futures contracts
at $420 per tonne. at $430 per tonne.
November 15 Sells 1,000 tonnes of canola at $400 Offsets the 50 canola futures contracts at $400
per tonne, losing $20 per tonne. per tonne, making a profit of $30 per tonne.
Net Result The $30 per tonne futures profit more than offsets the $20 per tonne cash sale loss. The
elevator earns a $10 per tonne gross profit. Assuming that the futures are priced at fair value,
carrying costs are also $10. Therefore, on a net profit basis, the elevator breaks even.

In Example 4.1, the grain elevator locked in its selling price before selling the actual canola. By hedging, the elevator
eliminated the risk that prices would fall before the physical canola was sold, thereby reducing its profits. Because
the hedge was lifted when the futures contracts expired, the prices of the physical canola and the canola futures
were the same.
While the elevator lost $20 per tonne on the purchase and sale of the physical canola, the short futures contract
resulted in a $30 profit. The effective net sale price was $430 per tonne. After taking into consideration the
$10-per-tonne cost of carrying the canola for three months, the elevator’s net profit was zero.
By hedging, the elevator actually locked in a $10 per tonne gross profit (i.e., not including the cost of carry),
regardless of what happened to prices between October 1 and December 1, as long as the canola was not sold and
the futures contract was not offset before December.
If, instead of falling, canola prices rose, the net sale price still would have been $430 per tonne. If canola rose to
$450 per tonne, for example, the elevator would have gained $30 per tonne on the physical canola sale, but would
have lost $20 per tonne on the short futures position. The $10 gross profit and break-even net profit is locked in
regardless of whether prices rise or fall. This example illustrates a perfect hedge – in this case, a perfect short hedge.
Note that, in this hedge, the futures contract was offset (on the last trading day). The elevator did not deliver
canola; it merely used the futures market to lock in a price by taking an opposite position to the canola inventory.
This example is typical of most hedges. Hedgers use futures contracts not as a delivery mechanism, but rather as a
vehicle to offset adverse changes to the price of assets they carry in their normal course of business.
LONG HEDGE
A long hedge is executed by someone who anticipates buying the underlying asset at some point in the future.
To protect against rising prices between now and the time when the asset is needed, the hedger can take a long
position in a futures contract on the underlying asset that matures approximately at the time of the anticipated
purchase of the asset. In doing so, the hedger has fixed the purchase price, even though delivery does not need to be
accepted until some point in the future.
Example 4.2 illustrates a long hedge.
EXAMPLE 4.2 | LONG HEDGE

In January, a dental supply company estimates that it will need 10,000 troy ounces of silver in April. The firm is
concerned that prices will increase in the interim and would like to lock in a price. The current spot silver price is
$11.00 per ounce.
The company has considered locking in the price by buying the physical silver immediately and holding it until it
is needed. To do so, however, would tie up considerable working capital.
An alternative is to hope that silver prices will fall in the interim; however, the risk that prices will increase rather
than fall is too great. The company decides that it is not in the speculation business and chooses instead to hedge
the price risk through the futures market.
On January 25, the company buys two April silver futures (5,000 troy ounces per contract) that trade on the
New York Mercantile Exchange (NYMEX) at $11.20 per troy ounce.
Three months later, when the futures contract expires, the dental supply company buys the physical silver
at $11.40 and offsets the long futures position at $11.40 per ounce.* The cash and futures gain and loss are
illustrated in Table 4.2.
* In reality, a delivery notice probably would have been issued to the dental supply company earlier in the month with respect to the long
futures positions. For illustrative purposes, we show the long futures position being carried right to expiration day.

Table 4.2 | Long Hedge Gain and Loss
Time Cash Position Futures Position

January 25 Anticipates the need for 10,000 ounces of Buys two April silver futures at $11.20
silver in April, with current spot price at $11.00 per ounce.
per ounce.
Three months later Silver prices rise to $11.40, and the company Offsets the futures contracts at $11.40
buys 10,000 ounces at this price. for a profit of $0.20 per ounce.
Net result Pays $0.40 more for the silver than expected. Makes a $0.20 profit on the rise in silver
futures from $11.20 to $11.40. The effective purchase price is $11.20 ($11.40 – $0.20).
Example 4.2 illustrates a long hedge, where a dental supply company locked in its purchase price before it bought
the physical silver. By hedging, the company eliminated the risk of its net purchase price rising between January and
April, when it planned to purchase the silver. It locked in a net purchase price of $11.20 regardless of what happened
to prices between January and April, as long as the silver was not bought or the futures contract offset before April.
Because the hedge was lifted when the futures contract expired, the price of the physical silver and the silver futures
were the same.
In this example, the $0.40 rise in the price of silver was at least partially offset by the $0.20 profit on the futures
contracts. If, instead of rising, silver prices had fallen, then the net purchase price would still have been $11.20.
If silver had fallen to $10.80, for example, the company would have paid $0.20 less per ounce than the January
price, but it would have experienced a $0.40 loss in the futures contract, which would have been offset at $10.80.
The net result would have been the same. By implementing the hedge, the company would have locked in a net
purchase price of $11.20.
As with Example 4.1, Example 4.2 illustrates a perfect hedge – in this case, a perfect long hedge. The hedge was
perfect because the futures price behaved exactly as expected relative to the cash price. In other words, the basis
narrowed to the point where futures prices and cash prices were the same at expiration.
Prior to onset, a hedger will know with certainty that a hedge will be perfect if both of two conditions are met:
Maturity match The hedger’s holding period must match the expiration date of the futures contract.
Asset match The asset being hedged must match the asset underlying the futures contract.
If both conditions are met, the hedger will know with certainty how the futures contract price will behave relative
to the price of the asset being hedged: on expiration, the spot and futures prices will be the same. The hedger will
therefore have eliminated the risk associated with a future market commitment. In Example 4.1, the elevator knows
that it has locked in a sale price on canola of $430, regardless of what the market price does through the life of the
hedge. In Example 4.2, the dental supply company knows that it has locked in a purchase price on silver of $11.20.
If, at the outset of a hedge, at least one of the two conditions described above were not met, the hedger would be
exposed to what is known as basis risk, which is the risk of unexpected movements in the basis. This risk does not
necessarily mean that a hedge will not be perfect, only that the chances of an imperfect hedge are significant.
In fact, a hedge may turn out to be perfect even if the two conditions described above are not met. For this to
happen, either one of two events must occur:
• The asset being hedged matches the asset underlying the futures contract, and the hedge is lifted early (i.e., the
futures contract is offset prior to its expiration), but the basis behaves as expected by the hedger at the onset of
the hedge; or,
• The asset being hedged does not match the asset underlying the futures contract, but the basis behaves in a
way that was expected by the hedger at the onset of the hedge.

To illustrate, consider Example 4.1. The three-month canola futures basis was $10 per tonne, or $3.30 (rounded) per
tonne per month. If the hedge was lifted with one month left to futures expiration, and if the basis was at $3.30 at
that time (as it was expected to be), the hedge would still be considered perfect because it behaved exactly as was
expected when it was first implemented. If the canola was sold at $410 at that time, and if the futures contract was
lifted at $413.30, the elevator would still break even on a net profit basis. It would lose $10 in the cash market, earn
$16.70 on the futures contract, and pay $6.70 (rounded) by carrying the canola for two months.
If the basis were to behave in an unexpected way, however, the hedge would be considered imperfect.
IMPERFECT HEDGES
Earlier in the discussion of futures prices, the basis for a particular contract was defined as the difference between
the spot and futures prices. If, at the end of a hedge’s life (not necessarily coinciding with a contract’s expiration),
the basis was where the hedger reasonably expected it to be when the hedge was first implemented, the result
would be a perfect hedge. This was demonstrated in Examples 4.1 and 4.2 (although it is not necessary for the basis
to move to zero, as it did in these two examples, for a hedge to be perfect). If a hedge is lifted before the contract
expires, it would still be considered perfect as long as the basis narrowed in line with the carrying charges that were
evident when the hedge was first put on (i.e., as long as it behaved as expected).
However, if the basis moves unexpectedly, the hedge will likely be an imperfect hedge.
The implementation of a hedge can be justified only when it can reasonably be assumed that basis risk will be less severe
than market risk, which is the risk of being unhedged.1
If, in Example 4.1, the hedge was lifted early but the basis behaved unexpectedly, it would not be a perfect hedge.
If the basis, with one month left to expiration, was at $10, but was expected to be at $3.30, and if, as a result, the
futures price was at $420 (the cash price at that time being $410), the elevator would have experienced a net loss
of $6.70. To be clear, it would have lost $10 in the cash market and gained $10 in the futures market, but it would
not have broken even because it would have lost $6.70 by carrying the canola for two months.
When the basis moves in an unexpected manner, it may be due to changes in the supply-demand equilibrium of a
particular asset, which results in futures prices diverging from cash prices, at least temporarily.
Example 4.3 illustrates an imperfect hedge.
EXAMPLE 4.3 | IMPERFECT HEDGE

A manufacturing company anticipated the need for copper in one year’s time. To protect against a possible
increase in the price of copper, the company bought one-year copper futures at $2.70 per pound, when the cash
price was at $2.60 per pound. Six months after implementing the hedge, the company realized that it needed
the copper earlier than expected. Unfortunately, due to unexpected strong world demand and strikes at various
mines in South America, the copper market had gone into backwardation. Cash copper prices had risen sharply to
$3.00 per pound, while the futures contract used for the hedge rose only to $2.80, reflecting market sentiment
that the current short squeeze would not last much longer. The company was forced to buy spot copper at $3.00,
$0.40 higher than the price was at the start of the hedge, and sell the futures contracts at $2.80, $0.10 higher
than at the entry point. The cash and futures market gain and loss are illustrated in Table 4.3.
1 As explained later in this chapter, it is possible in certain circumstances to reduce basis risk to an acceptable level by adjusting the number of
contracts used in the hedge.

EXAMPLE 4.3 | IMPERFECT HEDGE
Table 4.3 | Imperfect Hedge Gain and Loss
Time Cash Position Futures Position

Present Anticipates the need for copper in one year, Buys one-year copper futures at US$2.70
with current cash price at US$2.60 per pound. per pound.
Six Months Later Buys the cash copper at US$3.00. Settles the contract position at US$2.80.
Net Result Rather than buying the cash copper at US$2.60, the company was forced to buy at
US$3.00, or US$0.40 higher. The futures profit of US$0.10 only partially offset this increase.
Six months into the hedge, the copper market went into backwardation and the cash price moved higher
than the futures price. From an initial value of US$0.10. the basis changed to negative US$0.20. By the time
the hedge was lifted at the six-month mark, the cash price had risen to US$0.30 more than the futures price.
Because the company needed the physical copper earlier than expected, it was forced to pay the market price
of US$3.00. The profit on the long futures position of US$0.10 only partially offset the increased cost of buying
the cash copper.
This hedge was imperfect because the hedger was forced to lift the hedge prematurely when there was an
unexpected change in the basis.
Basis risk may also be introduced to a hedge if there is a difference between the asset being hedged and the futures
contract’s underlying asset. When there are no contracts available on the asset being hedged, a hedger may use a
futures contract with a different underlying asset, but that is highly correlated with the asset to be hedged. This kind
of hedge is referred to as a cross-hedge.
Cross-hedges are quite common in financial markets. An example is a situation where a Canadian corporate
treasurer needs to hedge against prime rate increases. Because there are no futures contracts based on the prime
rate, the treasurer may be forced to use a contract that is based on a different interest rate, such as a Bankers’
Acceptance futures contract that trades on the Bourse de Montréal. Although the two rates would most likely be
highly correlated with each other, it is very difficult to predict with any certainty what their precise movements will
be relative to each other during the course of a hedge. Almost certainly, there will be unexpected changes in the
basis, which would make a hedge like this imperfect.
Cross-hedges are also used when a hedger has exposure to changes to the price of a processed product, but futures
contracts exist only on the unprocessed commodity. An example of this kind of cross-hedge occurs when a baker
uses wheat futures to hedge against increases in the price of flour. Wheat futures are used because flour futures do
not exist. This kind of hedge is probably feasible because wheat is the predominant component of flour. The baker
must realize, however, that the basis between wheat futures prices and flour prices may deviate in some unexpected
way during the course of the hedge. Nevertheless, because the deviation will not likely be significant, this kind of
hedge would still probably be a better alternative than going completely unhedged. In other words, basis risk in this
case is probably of less concern than market risk.
An example of a poor cross-hedge is that of a footwear retailer using cattle futures to hedge against possible
increases in the price of leather shoes the company expects to buy at some point in the future. While leather
from cowhide is a major component of boots and many types of shoes, it is by no means the only component.
Fluctuations in the price of footwear typically reflect not only the price of leather, but also factors such as
competitive market conditions and labour, marketing, and transportation costs. In this case, basis risk would likely
be greater than market risk.
Another kind of cross-hedge is one that takes place in situations where the grade or quality of the asset being
hedged is different from the grade specified in a futures contract. Film manufacturers, for example, are significant

users of silver. The silver used, however, is considerably less pure than the silver that underlies the futures contracts
trading on the New York Mercantile Exchange. As a result, using a silver futures contract to hedge the purchase of
industrial silver introduces the risk of unexpected changes in the basis. In all likelihood, this basis risk will be less
than the market risk, but hedgers must understand in advance the risks associated with hedging using a vehicle that
does not precisely match the asset in question.
OPTIMAL HEDGE RATIO

In Chapter 3, we listed a number of conditions that make arbitrage easy to implement, thus ensuring that futures
prices will trade in a predictable manner (i.e., on the basis of cost of carry) relative to spot prices. When these
conditions are in place, it can reasonably be assumed, for hedges where there is an asset match, that basis risk will
not typically be greater than market risk. As a result, lifting a hedge before a contract expires should not damage the
results of the hedge significantly. As a reminder, these conditions are as follows:
• A large supply of the underlying asset
• Storability of the underlying asset
• Non-seasonal production and consumption of the underlying asset
• Ease with which the underlying asset can be sold short
Financial assets, as well as gold and silver, generally meet all of these criteria, so basis risk is usually very small with
these assets. As the futures contract approaches maturity, the basis usually narrows in a predictable manner, and
basis risk arises only as a result of interest rate risk (i.e., a possible change in the cost of financing).
Many commodities, including agriculture- and energy-based assets, do not meet some or all of these criteria.
Consequently, using these contracts entails higher basis risk because futures prices can trade erratically at times
relative to spot prices. If a hedge is lifted prior to contract expiration, there is a risk that the futures price may have
deviated significantly from the spot price.
This does not mean that hedgers should never use these contracts. However, their use should be accompanied by
an understanding of both the risks involved and the measures that can be taken to minimize those risks. One such
measure is the use of an optimal hedge ratio.
For hedges where there is both an asset match and a maturity match, the optimal hedge ratio should approximate
the ratio of the value of the futures contracts to the value of the underlying asset. In Example 4.2, the dental
supply company anticipated buying 10,000 ounces of silver. Because the size of each silver futures contract was
5,000 ounces, the company bought two contracts representing 10,000 ounces. And because there is presumably a
one-to-one relationship between silver prices and silver futures prices, the hedge ratio in that case was 1/1.
For hedges where there is a maturity or asset mismatch, the hedge ratio can be adjusted to reflect the historical or
expected price relationship between the futures contract and the asset being hedged.
EXAMPLE 4.4 | ADJUSTING THE HEDGE RATIO

A farmer entering a hedge that has a mismatch can adjust the number of contracts used in the hedge to reflect
his expectations of how futures prices will perform relative to cash prices. If he feels that cash prices may rise in
relation to futures prices (on the basis of either historical precedence or a market outlook), he can increase the
number of contracts used in the hedge to compensate.
For example, if, after analyzing the historical relationship between a spot price and a different but related futures
price (cross-hedge), the farmer decides that basis risk may be significant, he can adjust the number of contracts
used in the hedge to reflect this expectation. If he finds, for example, that futures prices have historically been
more volatile relative to the price of the cash instrument being hedged, he will use fewer futures contracts.

The optimal hedge ratio is calculated as follows:

H = CorrPF (SDP / SDF)
Where:
SDP = Standard deviation of changes in the spot price, P, of the asset to be hedged during a period of time
equal to the duration of the hedge
SDF = Standard deviation of changes in the futures price, F, of the asset underlying the contract during a
period equal to the duration of the hedge
CorrPF = Coefficient of correlation between changes in P and F
Example 4.5 illustrates an optimal hedge ratio.
EXAMPLE 4.5 | OPTIMAL HEDGE RATIO

A company, anticipating the need for 2 million gallons of jet fuel in three months, wants to hedge the risk that jet
fuel prices will increase in the near future. Because there are no jet fuel futures contracts, the company hedges by
buying three-month futures contracts on heating oil. The standard deviation of changes in the jet fuel spot price
per gallon over a three-month period is 0.054, and the standard deviation of changes in heating oil futures prices
over a three-month period is 0.06. The correlation between changes in the prices of heating oil and jet fuel over a
three-month period is 0.76.
The optimal hedge ratio in this scenario is calculated as follows:
0.76 x (0.054 / 0.06) = 0.684
Because each contract is for 42,000 gallons of heating oil, the company has to enter a long position in
approximately 33 contracts, as follows:
0.684 x (2,000,000 / 42,000) = 32.57 contracts
If the company does not consider relative volatility or the correlation between the two assets, it will need to use
47.61 or 48 contracts (2,000,000/42,000). This will leave the company considerably over-hedged.

Speculating with
Futures Contracts 5
CONTENT AREAS
What Attracts Speculators?
Types of Speculators
Price Forecasting Techniques
Fundamental Analysis
Technical Analysis
LEARNING OBJECTIVES
1 | Identify the various ways that individuals can gain financial exposure to futures contracts.
2 | Differentiate between the four categories of futures spreads.
3 | Recommend a futures spread given a client’s market view on a particular underlying asset or between
different-but-related underlying assets.
4 | Calculate the profit or loss from a futures spreads.
5 | Contrast fundamental and technical analysis.

KEY TERMS
commodity pools managed futures accounts
commodity product spread managed futures funds
day traders mini contracts
fundamental analysis position traders
intercommodity spread spread strategy
intermarket spread spread traders
intramarket spread technical analysis
locals (scalpers) whipsaw

CHAPTER 5 | SPECULATING WITH FUTURES CONTRACTS 5•3
WHAT ATTRACTS SPECULATORS?

Speculators are market participants who, in the pursuit of profit, are willing to assume the risk that hedgers seek to
avoid. The futures market is particularly attractive to speculators for the following reasons:
• Ease of entry and exit
• Variety of opportunities
• Leverage
• Excitement
EASE OF ENTRY AND EXIT

Once an account is set up, the speculator simply calls an investment advisor (at a full-service firm) or an investment
representative (at a discount broker), who can set up a long or short position in a particular futures contract within
minutes.
VARIETY OF OPPORTUNITIES
The futures market allows smaller speculators to trade assets that they could not trade anywhere else. For example,
the only realistic way for a small speculator to trade most grain and oilseed commodities is through outright futures
or futures options in the futures market. The futures market also opens up to speculators the opportunity to trade
different relationships through a so-called spread strategy. Different types of spread strategies are discussed later
in this chapter.
Another opportunity particularly useful to smaller speculators or investors is the mini contract. Mini contracts
are derivative contracts representing a fraction (typically one-fifth or one-tenth) of a standard futures or options
contract. They are designed to fully reflect the larger “full” contracts, and trade on the same exchanges with the
same expiration schedules. Minis are available for a wide range of underlying interests, including indices (S&P
500, Nasdaq 100, and Dow Jones Industrial Average), currencies (euro and yen), and commodities (crude oil,
gold, wheat, corn, and soybeans). Minis are highly liquid and affordable and can be used to either speculate or
hedge.
LEVERAGE
Speculators are attracted to futures contracts for their ability to control a large dollar amount of a particular asset
with very little money down. Often, speculators have to put up a margin deposit of only 3% to 10% of the value of
a contract. Percentage gains and losses can be enormous over relatively short periods.
Although leverage is one of the attractions of speculating in futures, it is not inherent to the nature of a futures
contract; rather, it is a feature that speculators can choose to use. Market participants can choose to deposit the
full value of a particular contract as margin and thereby be completely unleveraged. For example, a participant who
takes a position in gold futures could choose to deposit the full value of the contract, approximately US$55,000 (at
a price of $550 per ounce), rather than depositing only the margin required of about US$2,000.
Futures contracts in effect facilitate the use of leverage, and indeed almost all speculators take advantage of
leverage when trading in futures. It is important to understand, however, that leverage and futures are not the same
thing.
Canadian pension, insurance, and trust companies, for example, use futures contracts primarily to reduce a
portfolio’s risk. They can legally use futures (and other derivatives) to increase risk as long as the increase in risk is
the same as or similar to what it would have been if the same investment had been made directly in the underlying

security. Futures (and indeed all derivatives) cannot be used to leverage risk. These institutions use futures (and
other derivatives) not for their leverage, but to manage risk and provide a cost-effective, quick, and efficient way of
entering into or exiting from a particular investment.
EXCITEMENT
In addition to the ability to make (or lose) a lot of money, futures are alluring because they let speculators pit their
ability to analyze markets against the ability of everyone else. And they receive almost immediate feedback on their
success or failure. Speculators are apt to say that they receive a report card at the end of each day.
TYPES OF SPECULATORS
The speculator types are distinguished from each other by a number of factors, including the length of time they
plan to hold a particular futures position, the amount of profit per position they anticipate, and the amount of
money they are willing to risk. The various types of speculators are described below.
LOCALS
Locals, also referred to as scalpers, operate from the floor of the exchange and have the shortest time horizon of
all. Taking advantage of the knowledge and instincts gained from their proximity to the trading action, the local
attempts to profit from small price changes that take place over very short periods. The time horizon for a local
can often be measured in minutes, rather than hours or days. Because the local is only looking to profit from very
small price changes, the amount that is typically at risk on any given trade is small. Consequently, locals depend on
relatively large volumes to make a successful living.
DAY TRADERS
As the name suggests, day traders are speculators whose time horizon is a single day. Positions taken during a
trading day are liquidated by the end of that day; they are not carried overnight. Day traders may trade on or off the
floor.
Day traders look to profit from larger price moves than locals and are willing to take greater risks. However, as
is evidenced by their desire not to hold any positions overnight, there is a limit to the amount of risk they will
tolerate. Overnight trading can entail considerable risk, particularly in futures contracts whose underlying assets
trade 24 hours a day. Foreign currencies, for example, often see their greatest price moves in European or Asian
trading. While a speculator sleeps, the value of a particular foreign exchange futures contract could change
significantly. By the time North American trading is set to open, the speculator could be greeted with a significant
open loss.
Another risk that day traders tend to avoid is the risk of holding positions when a major report is pending that could
affect the price of a particular futures contract. Day traders involved with grain and oilseed futures, for example,
typically go into major supply/demand reports (which are released regularly by the United States Department of
Agriculture) without any positions. These reports are normally released just before a market opening or just after a
market close. Price movements in response to a report can be significant, particularly if the data released is different
from market expectations.
POSITION TRADERS
Position traders attempt to profit from longer-term price trends and have a time horizon that can be
measured in terms of weeks or even months. Timing is not as important for a position trader as it is for a
local or day trader. The position trader is typically well financed and is therefore in a better position to avoid

being whipsawed out of the market. This expression refers to a common occurrence in futures trading where
speculators are forced to close out a position after an adverse price movement, only to see the price quickly
rebound back in the favoured direction. Position traders are willing and able to withstand adverse short-term
price changes to a larger extent than locals or day traders, in order to maintain a position consistent with their
long-term view of the market.
SPREAD TRADERS
Spreading involves the purchase of one futures contract against the sale of another that is related in some way.
Spread traders attempt to identify market situations where the price relationship between two related assets has
deviated from its historical norm. When such a situation is identified, the trader will take a spread position designed
to profit from a move back towards a level or range that is more in line with historical performance. The trader does
this by simultaneously buying the “underpriced” asset and selling the “overpriced” asset.
Spreads can be divided into four broad categories, as follows:
• Intramarket
• Intercommodity
• Intermarket spread
• Commodity product spread
INTRAMARKET SPREAD
The intramarket spread (also known as calendar or time spread) is a spread involving the purchase and sale of
futures contracts that have the same underlying asset, but different delivery months.
EXAMPLE 5.1 | INTRAMARKET SPREAD – HEATING OIL

After reading the Farmers Almanac prediction of a very cold winter, a spread trader implemented a spread
strategy in November using heating oil futures. The trader felt that strong demand for heating oil during the
winter months would force prices of contracts with winter delivery to rise relative to the prices of contracts with
spring or summer delivery. The trader bought the February contract at US$1.59 per gallon and sold the May
contract at US$1.57 per gallon. The spread was lifted in January. The February contract was settled at US$1.63
and the May contract settled at US$1.58. The trader earned a profit of 3 cents as the spread widened from 2
cents premium February to 5 cents premium February. A heating oil contract is 42,000 gallon, so each cent move
represents US$420; therefore, the spread trader’s profit was US$1,260.
Intramarket spreads are also very popular with agricultural futures, where traders speculate on the relative changes
in old and new crop prices.
INTERCOMMODITY SPREAD
An intercommodity spread occurs between two different-but-related futures contracts that may trade on the
same exchange or on different exchanges. Traders implement an intercommodity spread when they feel that the
price of one asset has become undervalued or overvalued relative to the price of another asset with a similar use.
For example, both corn and oats, which trade on the Chicago Board of Trade, are used for animal feed. Historically,
corn trades at between a 50-cent and 200-cent premium to oats. If that spread rose, for example, to 250 cents, a
trader might see an opportunity to buy the “cheap” oats and sell the “expensive” corn, hoping the spread will move
back down to its historical norm.

A popular financial futures intercommodity spread, known as the notes over bonds (NOB) spread, involves the
purchase or sale of 10-year Treasury note futures (N) against the opposite position in 30-year Treasury bond
futures (B). A trader buys the NOB spread by going long N and short B, and shorts the NOB spread by going short
N and long B. Generally, traders use the NOB spread to take advantage of an expected shift in the U.S. Treasury
yield curve.
When the U.S. Treasury yield curve is normal, 30-year yields are higher than 10-year yields. A trader who expects
the yield curve to flatten (so that 30-year rates decline relative to 10-year rates) can profit by selling the NOB
spread. A trader who expects the yield curve to steepen can profit by buying the NOB spread. If the yield curve is
inverted (in which case 30-year yields are lower than 10-year yields), the trader takes the opposite position for the
same expected shift in the yield curve. In other words, if the inverted yield curve is expected to flatten, the trader
can profit by buying the NOB spread, and if it is expected to steepen, the trader can profit by selling the NOB
spread.
Because the price of Treasury bond futures is more sensitive to a given change in yield than Treasury note futures,
traders can also use an NOB spread to profit from an expected parallel shift in the yield curve. If the yield curve is
expected to move up in a parallel fashion, a trader will buy the NOB spread because the expected drop in the price
of B will be greater than the expected drop in the price of N. Conversely, selling the NOB spread will be profitable if
the yield curve is expected to decline in a parallel fashion.
The FIT spread (involving 5- and 10-year Treasury note futures) and the FOB spread (involving 5-year Treasury note
futures and 30-year Treasury bond futures) are two other popular yield curve trades that use contracts listed at the
Chicago Board of Trade.
INTERMARKET SPREAD
An intermarket spread involves the purchase and sale of futures contracts that trade on different exchanges,
but which have the same underlying asset. Opportunities arise for various reasons. For example, in the case of
wheat futures, which trade on the Chicago Board of Trade, Kansas City Board of Trade, and the Minneapolis Grain
Exchange, a spread opportunity may occur because of relative changes in supply and demand conditions of different
deliverable grades trading in each respective market.
COMMODITY PRODUCT SPREAD

A commodity product spread involves the purchase or sale of a commodity against the opposite position in the
products of that commodity. The most common example of a commodity product spread is the crush spread, which
involves taking a long position in, for example, soybeans against a short position in soybean products. The objective
of the spread is to take advantage of any unusual price differences between soybeans, which are not often used in
their natural state, and the products they are crushed into – soybean meal, which is used primarily for animal feed,
and soybean oil, which is used as a vegetable oil.
MANAGED FUTURES INVESTORS

Investors looking to diversify their equity and bond portfolios are increasingly turning to managed futures products,
of which there are essentially two types:
• Managed accounts
• Managed funds
The Managed Funds Association estimates that, as of 2014, assets of about US$337 billion are invested in the U.S.
alone in managed futures products.

Individuals and institutions invest in managed futures products primarily to gain exposure to an asset class that is
distinct from traditional stocks, bonds, and cash. Research into managed futures has found that managed futures
accounts are a distinct asset class because of their low correlation with other asset classes. As a result, the addition
of futures to a portfolio of other asset classes can provide diversification benefits.
MANAGED ACCOUNTS
An investor who wants some exposure to the futures market, but who lacks the trading expertise or the time to
trade, may give trading authority over to a trading advisor. Such an advisor is known in Canada as a commodity
trading manager (CTM) and in the U.S. as a commodity trading advisor (CTA).The extent of the authority vested to
the CTM or CTA is agreed on prior to the arrangement. Managed futures accounts are used primarily by high-net-
worth investors and increasingly by institutions.
MANAGED FUTURES FUNDS

Managed futures funds are investment funds that employ strategies using specified derivatives, physical
commodities, and leverage. In Canada, they are structured either as hedge funds or commodity pools.
Regardless of how they are structured, managed futures funds generally focus on a wide variety of market sectors
using trading styles based on fundamental or technical analysis (or a combination of both). Fund managers may
base their trading decisions on fully automated computer programs or on some degree of personal judgement or
both. Fund managers also may trade on the basis of trends, anticipated trend reversals, or arbitrage. Unlike equity
mutual funds, whose performance may be highly dependent on the direction of the overall stock market, the
performance of managed futures is much more dependent on the skills of the manager.
HEDGE FUNDS
In many ways, hedge funds are similar to mutual funds. Both are professionally managed pools of money that may
charge investors front-end or back-end sales commissions. Both charge management fees and can be bought and
sold through an investment dealer at a price equal to the funds’ net asset value per share.
However, unlike mutual funds, hedge funds are structured as limited partnerships that allow the managers to use
a wide variety of alternative strategies and investments. In contrast, mutual funds are generally limited to buying
securities or holding cash. A hedge fund’s strategies and investments may include derivatives, short selling, leverage,
arbitrage, currency trading, and more.
While most hedge fund managers have the mandate to speculate using futures, one type of hedge fund, the
managed futures hedge fund, is dedicated to the use of futures.
Because hedge funds are private offerings, regulations do not compel their managers to provide the same level of
information to investors as mutual funds provide. for that reason, hedge funds are suitable only for very experienced
investors, and it is essential that those investors do their due diligence before investing in the fund. In fact, the
regulations require that buyers of hedge funds be accredited or sophisticated investors.1
COMMODITY POOLS
Commodity pools are essentially managed futures funds that are structured and sold as mutual funds. The
regulatory regime for commodity pools in Canada underwent a significant change on November 1, 2002, when
the provincial securities administrators, under the auspices of the Canadian Securities Administrators, adopted
Multilateral Instrument 81-104.
1
To be considered accredited or sophisticated, an investor must meet certain minimum financial requirements, which vary by province.

In essence, this new rule allows mutual fund companies to create funds that use at least some of the strategies2 that
had been previously available only to hedge funds. These managed funds are sold as mutual funds (through public
offerings) to general investors.
Managed funds are discussed in detail in Section V.
PRICE FORECASTING TECHNIQUES

Speculators typically use one or both of two basic techniques to help forecast price movements: fundamental
analysis and technical analysis.
Fundamental analysis is generally helpful in forecasting long-term price movements, and is favoured by position
traders. Technical analysis is helpful in forecasting an underlying asset’s short-term price movements, and is
favoured by locals and day traders.
This discussion is not intended to cover these two methods in depth. What follows is a brief explanation of how
these techniques are used.
FUNDAMENTAL ANALYSIS
Fundamental analysis is the study of an asset’s supply and demand factors to help forecast future price movements.
A fundamental analyst attempts to project what supply and demand will be during or at the end of a particular
time horizon, and at what price equilibrium will take place. If projections show that the supply of a particular asset
will be limited in the future, but that demand will remain strong, prices will most likely have to rise. If demand is
expected to be weak and supply plentiful, the analyst will forecast weaker prices in the future. As one can expect,
accurate identification and analysis of factors affecting the demand and supply of a particular underlying asset is of
the utmost importance.
EXAMPLE OF FUNDAMENTAL ANALYSIS: CORN MARKET

Table 5.1 shows the supply and demand factors that analysts following the corn futures market would usually
consider when developing a price forecast.
Table 5.1 | Supply and Demand Factors
Supply Demand
Existing inventory (carryover) Domestic
Expected size of new crop Exports
Imports
Existing inventory, referred to as carryover, is basically the previous year’s unused production. If carryover is small,
the new crop may have to be relatively large to meet demand. If there is any threat to the new crop, such as drought
or floods, the potential for sharp price increases is evident.
In forecasting the size of a new crop, analysts consider many factors, including acreage, yield, and weather patterns.
In North America, imports do not typically play a big role in most grain and oilseed commodities; however, they do
in commodities such as sugar, coffee, and cocoa.
2
The new rule allows mutual funds to encroach into the hedge fund world by giving them greater flexibility with respect to derivatives and
leverage. However, it does not allow the funds to sell common shares short. Short selling is a significant component of many different types
of hedge funds (long/short funds, convertible arbitrage funds, and dedicated short selling funds), but mutual funds are still largely excluded
from this world.

Fundamental analysts receive information on farm production from private services and from government sources
such as the United States Department of Agriculture (USDA) and Statistics Canada. These reports are released
regularly and are widely anticipated by market participants.
On the demand side of the equation, analysts watch a different set of indicators. For example, because feed for
livestock comprises roughly 50 percent of corn usage, market participants on the demand side monitor the size
of livestock herds. And because a growing share of North American corn production is used for export, analysts
pay close attention to crop developments in foreign countries, as well as economic and political activity in those
countries. A country with a rising standard of living may be likely to increase imports of corn and other commodities
to meet the growing needs of the populace.
Another factor in fundamental analysis is the foreign exchange trend. A rising U.S. dollar, for example, will make U.S.
exports more expensive and could dampen demand overseas.
FUNDAMENTAL ANALYSIS AND FUTURES TRADING

While fundamental analysis is a necessary tool in the development of a long-term price forecast, it has its
limitations, both generally and as it relates to futures markets in particular. The limitations can be summarized as
follows:
• Although fundamental analysis is useful in helping to determine long-term price trends, it cannot predict
precise commodity price levels. Analysis of the corn market may lead us to believe that prices will be heading
higher, but how much higher? Will corn increase to $4.00 per bushel or to $4.50 per bushel? In the highly
leveraged world of futures trading, a $0.50 difference per bushel is significant.
• In comparison to commodities, fundamental analysis of equity and debt securities lends itself to more precise
price forecasts. Analysts have several quantitative methods available to help them set a specific price forecast.
• As well as forecasting imprecise price levels, fundamental analysis is also imprecise about timing. Gold prices
may be forecasted to rise, but will they rise over the next three months, or over the next year?
• There are so many factors that could impact prices that it is difficult for fundamental analysis to capture them
all. In analyzing a particular currency’s exchange rate, for example, analysts must consider economic and
political factors affecting the two countries whose respective currencies define the exchange rate, as well as
other global factors that could come into play. Often, a fundamental analyst will feel that all current factors
have been accounted for just when some unforeseen new factor enters into the market equation.
• Markets tend to be very efficient at quickly discounting known fundamentals. As a result, an analyst may
be correct in interpreting fundamentals, but this information may already be reflected in prices. A market
participant who takes a position on the basis of fundamental analysis may find that the market has already
priced in this analysis and is already looking beyond it. A good example of this phenomenon can be found in
the Treasury bond market. Bond prices may rally in anticipation of an easing by the Federal Reserve Board, but
when the easing finally does take place, the market will already have priced it in. Often in response to a much
anticipated event finally taking place, the markets will do the exact opposite of what was expected. “Buying the
rumour and then selling the news” is common in futures trading.
• Because a considerable amount of leverage can be used in the futures markets, fundamental analysis does
not lend itself as well to futures trading as it may to long-term equity or debt security investing. Fundamental
analysis may help in determining the long-term trend of a futures market, but is not very useful with respect
to timing and picking entry and exit points. The more leveraged an investment is, the more important timing
becomes. Experienced futures participants have all seen situations where a long-term market forecast was
correct, but money was still lost due to poor timing in entering or exiting the market.

TECHNICAL ANALYSIS
Rather than using fundamental analysis to understand the supply and demand factors that cause price movements,
technical analysis focuses on the price movements themselves. Technical analysts believe that all known market
influences are fully reflected in market prices and that there is no advantage to be gained by doing further
fundamental analysis. All that is required is to study the price action itself.
In effect, the technical analyst lets the market “do the talking”. Technical analysts use several methods to interpret
market action, letting the market indicate the direction and the extent of its next price move. The term market
action encompasses the three primary sources of information available to a technical analyst – price, open interest,
and volume.
One of the key premises on which technical analysis is based is that prices move in trends and that trends tend to
persist for relatively long periods. Given this premise, the primary task of a technical analyst is to identify trends,
preferably in their early stages, and carry positions in that direction until the trend has been proven to have reversed
itself.
Another important premise is that human nature tends to remain constant, and that individuals tend to react to
similar situations in very consistent ways. On this basis, technical analysts believe that past market behaviour will
be repeated again and again in the future.
The methods used by technical analysts can be divided into two broad categories – chart analysis and statistical
analysis. Both methods attempt to judge and measure trends and human nature.
Chart analysis is the older and more common method used by technical analysts. A chartist plots daily, weekly, and
monthly price movements to help identify trends and familiar patterns of market behaviour that may give insight
into future price direction. Charts are useful in helping traders identify points of entry and exit.
Statistical analysis is a relatively new form of technical analysis that has been greatly enhanced by the growing
sophistication of computers. Whereas interpreting charts can be a relatively subjective endeavour (more art than
science), statistical analysis attempts to reduce or even eliminate emotion through the use of quantitative tools
that produce buy and sell signals. Some of the tools used include moving averages, oscillators, and stochastics.
As with fundamental analysis, technical analysis, whether in the form of chart or statistical analysis, has its flaws.
Market participants must realize that markets can be irrational at times (some would say most of the time) and that
unexpected news can suddenly change market sentiment. Furthermore, chart formations can be misread, and even
if the formation is read correctly, it may still give a false signal.
Rather than relying solely on fundamental or technical analysis, most futures participants use elements of both
methods. A trader may use fundamental analysis to derive a long-term forecast, and then use technical analysis
to determine price entry and exit points. Though it may seem a contradiction to use both methods, traders
nevertheless develop their own style based on what has been successful in the past. For many traders, that style
involves a hybrid of both types of analysis.
Whatever method of analysis a market participant uses, proper money management is essential. Successful
speculators probably have more losing trades than winning ones. The key to their success is that they know when to
cut their losses on losing trades and how to eke out as much profit as possible on winning trades (a concept called
letting the profits run).

SECTION 3
EXCHANGE-TRADED OPTIONS


Basic Features of Options 6
CONTENT AREAS
The History of Options
Key Option Terminology and Definitions
Application of Key Terms and Definitions
Why Options Are Bought
Why Options Are Written
Other Related Benefits of Options
Advantages of Exchange-Traded Options Versus Over-the-Counter Options
Reading Option Quotations
Common Questions Pertaining to the Options Market
LEARNING OBJECTIVES
1 | Identify the rights and obligations of buyers and writers of call and put options.
2 | Calculate the in-the-money and out-of-the-money portions of an option given a particular strike
price and market price.
3 | Calculate the profit or loss from the sale and/or exercise of an option contract.
4 | Demonstrate the effect of leverage on the percentage gain or loss from the entry and offset of an
option contract.
5 | Calculate the risk and reward parameters of both buying and writing put and call options.
6 | Interpret each of the items on an option’s quotation page.

KEY TERMS
American-style intrinsic value
assigned out-of-the-money
at-the-money time value
covered trading unit
European-style uncovered
in-the-money

CHAPTER 6 | BASIC FEATURES OF OPTIONS 6•5
THE HISTORY OF OPTIONS

Options have been traded on organized exchanges for a shorter time than futures, but they have been traded over-
the-counter (OTC) since the early 1900s. At that time, a group of firms called the Put and Call Brokers and Dealers
Association organized with the goal of bringing together buyers and sellers of options. Traders at that time did not
meet physically on the floor of an exchange. If someone wanted to buy an option, a member of the group would
find an option writer willing to sell. If the member could not find a writer, it would write the option itself. In this
way, the first OTC market was created. However, the market suffered from a number of deficiencies. First, options in
this market were supposed to be held until maturity, without the possibility of sale prior to expiration. Second, if the
seller of an option did not fulfill his or her part of the agreement or went bankrupt when the option was exercised,
the buyer had to resort to costly legal remedies.
In 1973, the Chicago Board of Trade organized an exchange for trading call options on individual stocks. The Chicago
Board Options Exchange (Cboe) opened its doors on April 26, 1973. The Cboe remedied the problems faced by the
earlier over-the-counter market. First, it added liquidity by standardizing the terms and conditions of an options
contract. More importantly, it added a clearinghouse that acted as a third-party guarantor to both buyers and
writers of options. These changes made options more attractive to the general public. In 1977, put option trading
was introduced in the U.S.
In 1975, the Bourse de Montréal (the Bourse) began trading call options on the stocks of several large Canadian
companies. Early in 1976, the Toronto Stock Exchange (TSX) also began trading call options. In 1977, the two
option markets amalgamated their options-clearing corporations into a single organization called Trans Canada
Options Inc. (TCO). (The name has since been changed to the Canadian Derivatives Clearing Corporation.) In 1979,
put options started being listed in Canada.
In early 1999, the TSX and the Bourse entered into a ten-year agreement whereby the TSX agreed to transfer its
options-trading business to the Bourse, making the Bourse the sole exchange for options trading in Canada. In
return, the Bourse agreed to transfer the majority of its listed stock trading to the TSX. In 2008 the two exchanges
agreed to merge to form the TMX Group.
Over the last 30 years, the options market has experienced rapid growth, with the creation of several new
exchanges and many different kinds of new option contracts. There are currently more than 60 exchanges around
the world that list options. These exchanges trade options on assets ranging from individual stocks and bonds to
foreign currencies, stock indexes, ETFs, and options on futures contracts.
KEY OPTION TERMINOLOGY AND DEFINITIONS

An option contract gives the holder the right to buy or sell an asset at a specified price, known as the exercise price
or strike price, within a specified period that ends on the expiration date. The option with the right to buy is a call
option, and the option with the right to sell is a put option. The asset being bought or sold is typically referred to
as the underlying interest or asset. In this chapter, we deal specifically with equity options (or stock options), where
stocks are the underlying interest.
Options are contracts between the buyer and seller only; the company whose stock underlies the option is not
involved in the transaction. The opening buyer of an option is said to be long the contract, and the opening writer
(i.e., the seller) is said to be short the contract. It is the option buyer who is given the right to buy the stock (in the
case of calls) or sell (in the case of puts). If this right is exercised, the option writer is then obligated to honour the
terms of the contract.
The price an option buyer pays to the option writer for the right to buy or sell the underlying stock is called the
premium. The size of the premium is determined in a competitive marketplace. The premium takes into account a
number of different factors, the most important of which are the time left to expiration and the relationship between
the exercise price and the market price of the underlying stock. (Option pricing is discussed in detail in Chapter 7.)

Holders of stock options do not have the same rights afforded to stockholders. Dividends are not paid, nor are
voting rights extended. Options are merely vehicles that allow holders to participate in any potential upside
(in the case of calls) or downside (in the case of puts) movement in the price of the stock.
An option’s trading unit represents the standardized number of shares underlying the option. All stock options
have a trading unit of 100 shares or one board lot. A holder of one call option has the right to buy 100 shares of the
underlying stock, and the holder of one put option has the right to sell 100 shares.
American-style options are options that can be exercised at any time up to the expiration date. European-style
options can be exercised only at the expiration date.1
Following an opening transaction (i.e., either the initial purchase or the writing of an option) and up to expiration,
any of three events may take place:
The option may be If the option is liquidated prior to expiration, in effect, it cancels the position. In other
liquidated before it words, the option holder may sell the option or the option writer may buy the option at the
expires. prevailing option price in what is referred to as a closing transaction.
The option may be For call option holders, the act of exercising involves buying the underlying stock at the
exercised. exercise price from the call option writer in exchange for payment. For put option holders,
exercising involves selling the underlying stock at the exercise price to the put option writer
in exchange for payment.
Exercise takes place only if it is in the option holder’s best financial interest, which can only
occur when an option is in-the-money. A call option is considered in-the-money when the
market price of the stock is higher than the exercise price. In such a case, the call option
holder can exercise the right to buy the stock at the exercise price and then turn around and
sell the stock at the higher market price. A put option is considered in-the-money when
the market price of the stock is lower than the exercise price. In such a case, the holder can
exercise the right to sell the stock at the higher exercise price.
When an option holder exercises, the option writer is said to be assigned. A call writer is
assigned to deliver the stock to the call buyer, and a put writer is assigned to accept delivery
of the stock from the put buyer.
The in-the-money portion of a call or put option is referred to as the option’s intrinsic
value. When an option’s premium is worth more than just its intrinsic value, it is said to
have time value. Time value is equal to the option’s premium minus its intrinsic value. Time
value is discussed in detail in Chapter 7 of this section.
The option may Option holders are extended rights, not obligations, and if it is not in their financial best
expire worthless. interest to exercise, they will not do so. Option holders will not exercise if the option is out-
of-the-money or at-the-money. A call option is considered out-of-the-money when the
market price of the stock is lower than the exercise price. In such a case, it does not make
sense to buy at the exercise price when the call option holder could buy the stock at the
lower market price. A put option is considered out-of-the-money when the market price is
higher than the exercise price. Likewise, it does not make sense to sell at the exercise price
when the put option holder could sell the stock at the higher market price.
An option is considered at-the-money if the market price is equal to the exercise price.
There is no advantage to exercising an at-the-money option, particularly given the
commission costs of buying or selling the stock at expiration. Instead, the option holder will
let the option expire worthless.
1
All equity options in North America are American-style options.

Most options are either liquidated before expiration or allowed to expire. This somewhat parallels the futures
market, where only a very small percentage of futures positions result in delivery of the underlying asset.
Table 6.1 details the rights and obligations of an options contract.
Table 6.1 | An Option Contract’s Rights and Obligations
Call Option Put Option
Holder (Buyer) Owns the right to buy the underlying security Owns the right to sell the underlying security
Writer (Seller) May have to sell the security if called upon May have to buy the security if called upon
to do so to do so
APPLICATION OF KEY TERMS AND DEFINITIONS

In this section, we discuss many of the terms and definitions described previously by using examples of each type
of option position. To keep things simple, commissions, margin requirements, and dividends are ignored in all
examples in this chapter.
EXAMPLE 6.1 | CALL OPTION BUYER

In this example, the investor has bought five HSV Energy call options from the option writer. The strike price
is $75, and the expiry date is in January. The premium paid for the options is $1,500 ($3.00 x 5 contracts x
100 shares per contract). Given that the market price of HSV is $76, the premium of the option consists of $1
of intrinsic value and $2 of time value. The option is considered in-the-money by $1. (See the table below for
details.)
Buy/Sell # Call/Put Underlying Expiry Month Exercise Price Premium HSV Price
Buy 5 Call 100 HSV Jan. $75 $3 $76
The options give the investor (i.e., the call buyer) the right to buy 500 shares of HSV from the option writer at
the exercise price of $75 per share any time up to the expiration day in January. From the time of purchase to
expiry, one of three outcomes will take place: the option holder will either exercise the options, sell the options,
or let them expire.
The desired outcome is that the price of HSV will rise above the strike price by more than the premium paid prior
to expiration. If it does, the investor can exercise the options or sell them at a profit.
If, for example, HSV rose to a price of $80 during the life of the option, the investor could exercise his option
to buy 500 shares of HSV at $75. Once purchased, he can either hold the shares or sell them immediately at
the market price of $80. If he sells at $80, he earns a profit of $1,000. The $3 per share premium cost would be
deducted from the $5 per share profit for a net profit of $2 per share on 500 shares.
The investor could also sell the call options in the market. With HSV at $80, the call option would be worth at
least $5, and perhaps more if it still retained some time value. If the investor sells the options for $5, he will earn
a net profit of $2 per share on 500 shares, for a total of $1,000, the same as the profit on exercise. If the option
had time value left, the investor would earn an even larger profit, and, as a result, would be inclined to sell the
option rather than exercise it.
Finally, if the option is out-of-the-money or at-the-money at expiration, the investor could let it expire. If, for
example, HSV closed at $70 at expiry, the investor would obviously not exercise his option to buy at $75 when he
could buy at $70. He could not sell the option because it would have no value at expiry. In this case, the option
holder would simply walk away from the option and accept a loss of $1,500, which was the initial purchase cost.

EXAMPLE 6.2 | CALL OPTION WRITER
In this example, an investor writes five KGP Gold Corporation call options. The strike price is $35 and the expiry is
in February. The premium received for the options is $1,000 ($2 × 5 contracts × 100 shares per contract). Because
the market price is lower than the strike price, the option has no intrinsic value; the $2 premium is entirely time
value. The option is out-of-the-money. (See the table below for details.)
Buy/Sell # Call/Put Underlying Expiry Month Exercise Price Premium KGP Price
Sell 5 Call 100 KGP Feb. $35 $2 $34
If called upon to do so, the investor (i.e., the option writer) is obligated to sell 500 shares of KGP at $35 to the
call buyer at any time during the life of the option. From the time of sale to expiry, one of three outcomes will
take place: the investor could be assigned, offset the sale by purchasing the same option, or let the option expire
worthless.
The outcome the investor wants is for the price of KGP to remain at or under the strike price of $35 during the
life of the option. If it does, the call buyer will not exercise the right to buy, and the option will be worthless on
expiry, leaving the writer with a profit of $1,000.
If, however, KGP rose, for example, to $40, the call buyer could exercise, obligating the investor to sell KGP at $35
(in other words, the call buyer assigns the call writer). If the investor does not already own the underlying shares,
she would have to buy them in the market at the prevailing price of $40. A $5 loss on the purchase and sale of the
shares would result. Taking into account the $2 premium initially received, the investor would suffer a net loss of
$3 or $1,500. If she already owned KGP, the loss suffered would be an opportunity loss. Instead of being able to
sell KGP at the market price of $40, the investor would have to sell the stock at the exercise price of only $35.
The investor could also offset the initial sale by buying the same option. If, for example, KGP rose to $38, the call
option would be worth at least its intrinsic value of $3, and perhaps more if there were time value. If the investor
bought this option for $3, she would incur a net loss of $1 per contract, or $500.
EXAMPLE 6.3 | PUT OPTION BUYER

In this example, an investor buys ten MNO Bank put options from an option writer. The strike price is $60 and the
expiry is in February. The premium paid for the options is $5,000 ($5 × 10 contracts × 100 shares per contract).
Given that the market price of MNO is $58, the premium of the option consists of $2 intrinsic value and $3 time
value. The put is in-the-money by $2. (See the table below for details.)
Buy/Sell # Call/Put Underlying Expiry Month Exercise Price Premium MNO Price
Buy 10 Put 100 MNO Feb. $60 $5 $58
The options give the investor (i.e., the put option buyer) the right to sell 1,000 shares of MNO to the option
writer at the exercise price of $60 per share at any time up to the expiration day in February. From the time of
purchase to expiry, one of three outcomes will take place: the investor can exercise the option, sell the option, or
let it expire.
The desired outcome is that the price of MNO will fall under the strike price by more than the premium paid for
the option. If it does, the investor can exercise the option or sell it at a profit.
If, for example, MNO falls to a price of $53 during the life of the option, the investor can exercise the option to
sell 1,000 shares of MNO at $60. The 1,000 shares could be shares that the investor already owns, or it could be
a short sale. Either way, the investor is selling the shares for $7 more than the current market price. If the sale
results in the investor being short MNO stock, the short can be covered with the purchase of MNO at $53. The
net profit would be $7 less the $5 cost of the put, or $2 per share ($2,000 on 1,000 shares).

EXAMPLE 6.3 | PUT OPTION BUYER

The investor could also sell the puts in the market. With MNO at $53, the put option would be worth at least $7,
and perhaps more if it still retained some time value. If the investor sells the puts for $7, he will earn a net profit
of $2 per share on 1,000 shares, for a total of $2,000 – the same as the profit on exercise. If the option has time
value remaining, the investor will earn an even larger profit and will be more inclined to sell the option rather
than exercise it.
Finally, if the option is out-of-the-money or at-the-money at expiration, the investor could let it expire. If, for
example, MNO closes at $62 at expiry, the investor will obviously not exercise the option to sell the stock at $60
when he could sell at $62. He could not sell the option because it would have no value at expiry. In this case, he
would simply walk away from the option and accept a loss of $5,000, which was the initial purchase cost.
EXAMPLE 6.4 | PUT OPTION WRITER
In this example, an investor writes ten Petro-GTX (GTX) put options. The strike price is $50 and the expiry is
in December. The premium received for the options is $3,000 ($3 × 10 contracts × 100 shares per contract).
Because the market price is $49, which lower than the strike price, the option has intrinsic value of $1. The time
value comprises $2 of the premium. The put is considered in-the-money by $1. (See the table below for details.)
Buy/Sell # Call/Put Underlying Expiry Month Exercise Price Premium GTX Price
Sell 10 Put 100 GTX Dec. $50 $3 $49
If called upon to do so, the investor (i.e., the put option writer) will be obligated to buy 1,000 shares of GTX at
$50 from the put holder at any time during the life of the option. From the time of sale to expiry, one of three
outcomes will take place: the investor could be assigned, offset the sale by purchasing the same option, or let the
option expire worthless.
The outcome the investor wants is that the price of GTX will remain at or over the strike price of $50 during the
life of the option. If it does, the put buyer will not exercise the right to sell, and the option will be worthless on
expiry, leaving the investor with a profit of $3,000.
If, for example, GTX fell to a price of $40 during the life of the option, the put buyer could exercise the option to
sell 1,000 shares of GTX at $50 to the investor. If the investor then decided to sell the shares at the market price
of $40, she would incur a $10 loss. The net loss, after taking into consideration the $3,000 premium received
initially, would be $7,000.
The investor could also offset the initial sale by buying the same option. If GTX, for example, rose to $50, the
option would not have any intrinsic value; it would be worth only whatever time value remained. If the investor
bought this option for $1, she would realize a net gain of $2, or $2,000 total.
WHY INVESTORS BUY OPTIONS

Market participants buy options either to assume risk (i.e., to speculate) or to try to reduce it (i.e., to hedge).
Investors buy call options with the hope that the underlying stock will rise enough so that the option can be either
exercised or sold at a profit. They buy put options are bought with the hope that the underlying stock will fall
enough so that they can either exercise the option or sell it at a profit.

Buying an option offers investors two main advantages compared to buying or selling the underlying stock outright:
leverage and limited risk. Neither advantage is free; the investor must pay a premium to buy the option. For an
investor to make a net profit from investing in call options, the stock price must rise at least enough to offset the
call premium paid upon purchasing the option. Likewise, investors can earn a profit from a put option only if the
stock price falls at least enough to offset the put premium paid.
LEVERAGE
Leverage is the opportunity to achieve large profits on a relatively small investment. In options trading, the option
buyer can benefit from a change in the value of the underlying stock with an investment equal to only a fraction of
the cost of owning the stock itself. Example 6.5 illustrates this use of leverage
EXAMPLE 6.5 | THE BENEFITS OF LEVERAGE

On July 31, the shares of ABC Inc. closed at $65. An investor who thought the stock was going to rise over the
next several weeks decided to buy a call option with the stock underlying, rather than buying the stock outright.
The investor purchased one August 65 call $2.50. On August 3, ABC shares rose to $68.90, and the premium for
the August 65 calls had risen to $4.95. The table below compares the profit earned on the call option to what
would have been earned if the investor had bought the stock outright. Notice the impact leverage has on the
option purchase.
Call Option Stock

Bought 100 shares $6,500
Bought 1 Aug. 65 call option $250
Sold 100 shares $495 $6,890
Profit $245 $390
Return on Investment 98% 6%*
* Note that leverage could also have been used to buy the stock. Option-eligible stocks (such as this one) could be purchased for as little
as 30% of the stock cost. Not including any interest charges that would apply to the loan extended to the margin buyer, the return on
the stock investment, if only 30% were put down, would be 20%, which is still considerably less than the return on the option.
As Example 6.5 demonstrates, the cost of buying a call on a stock is substantially lower than the cost of purchasing
the stock itself. An investor who expects a significant increase in the price of the underlying stock within a particular
period can thus use leverage to achieve a higher percentage return on investment by buying the calls.
However, the advantage of greater leverage to the buyer of an option hinges on two crucial assumptions:
• The stock price will appreciate.
• The price appreciation will transpire within a particular period.
In other words, to benefit from leverage, one has to be right about both the direction and the timing of the price
change. For a call option held at expiration to have value, the stock price must exceed the exercise price. Even if it
does, however, it does not guarantee an overall profit for the holder. For the holder to make a profit from call option
investment, the excess of the stock price over the exercise price at expiration must be more than the initial premium
paid to purchase the option.
If the stock price at expiration is lower than the (fixed) exercise price, the call option will not be exercised because
it is not in the holder’s financial best interest to do so. The call holder will not pay the exercise price to acquire
the stock when it can be bought directly in the market at a lower price. When a call option expires worthless, the
investor loses the entire investment over a brief period, with no opportunity of recovering it. Had the investor

CHAPTER 6 | BASIC FEATURES OF OPTIONS 6 • 11
bought the stock itself, however, they could have held it with the hope that the price would eventually rise. In other
words, the underlying stock has an infinite expiration date, but the stock option has a short life span. By expiration,
either it will have value or it will not. Example 6.6 illustrates this disadvantage of leverage.
EXAMPLE 6.6 | THE DOWNSIDE TO LEVERAGE

Given the same investment opportunity as in Example 6.5, if, instead of rising, the ABC Inc. shares remained
unchanged at expiration, the August 65 call option would expire worthless. The implications of using leverage in
such a scenario are shown below.
Call Option Stock

Value at Option Expiration $0 $6,500
Loss $250 $0
Return on Investment –100% 0%
The risks and rewards of buying options are also influenced by the terms of the particular option purchased, namely,
the exercise price and the expiration date. The purchase of an out-of-the-money option, especially one with a
relatively short time to expiration, requires a smaller investment because the option would have no intrinsic value
and not much time value. However, such an option has little likelihood of ever becoming profitable to exercise.
Leverage also applies when buying a put. Rather than having to deposit the margin requirement for short selling
(which for option-eligible stocks is 30% plus 100% of the sale proceeds), a put buyer merely has to pay the
considerably smaller premium.
THE LESSON LEARNED FROM LEVERAGE

An option’s increased leverage is a double-edged sword. It can be attractive and profitable as an investment
strategy if the investor’s price expectation is realized by the expiration date of the option. If, however, the price
expectation is not realized, the investor can possibly lose the entire investment (i.e., the premium paid to acquire
the call option).
The lesson to be learned is that an investor should always ask the following question before investing in options:
“Do I understand the risk involved, and am I in a position to afford it?” The options market is a zero-sum game,
which means that for every winner there is a loser, and the game is biased against non-professional investors. They
are competing against professional investors and floor traders whose only business is to predict stock prices and
volatility. These professionals have tremendous analytical resources at their disposal, and they are also likely to take
the opposite side from many individual investors’ options transactions.
LIMITED RISK
Another benefit of buying options is limited risk; the maximum loss is the cost of the option premium. Example 6.7
illustrates the limited risk feature of a call option purchase.

EXAMPLE 6.7 | LIMITED RISK FEATURE OF CALL OPTIONS

In Example 6.6, it was assumed that the shares of ABC Inc. closed unchanged from the purchase price of
$65. In that case, the investor had a 100% loss from an investment in the call option, but a 0% return in an
investment in the stock itself. The table below shows what would have happened if the stock had closed at $60
when the option expired.
Call Option Stock

Loss $250 $500
Return on Investment –100% –7.70%
This example demonstrates that the most an investor can lose from investing in options is the initial (relatively
small) investment. The call buyer will not exercise the right to buy a stock at a price higher than what it is trading for
in the market. If the stock price is under the exercise price at expiration, the call buyer will merely walk away from
the option, letting it expire worthless.
On the other hand, purchasing the stock itself exposes the investor to downside risk resulting from a decline in the
market price of the stock. The lower the stock price of falls, the higher the investor’s loss from investing in the stock.
The risk to a call option buyer is limited, but the return is unlimited, as it would be in buying the stock itself. In
theory, the price of the stock could rise to infinity.
In general, the following rules apply to equity call option buyers:
• The maximum risk for the call buyer is the value of the premium multiplied by 1002.
• The maximum reward for the call buyer is unlimited.
• The break-even stock price for the call buyer when the option expires is the exercise price plus the premium.
Table 6.2 shows the risk and reward results at expiration of buying a call option compared to buying an underlying
stock. Figure 6.1 illustrates the risk and reward at option expiration of buying a call option.
Table 6.2 | Profit (Loss) from Buying 1 ABC Inc. August 65 Call Option at $2.50 or
Buying 100 ABC Inc. at $65
$ Profit (Loss)
Stock Price at Expiration Price of Call Option Call Buyer Stock Buyer
$50 $0 ($250) ($1,500)
$55 $0 ($250) ($1,000)
$60 $0 ($250) ($500)
$65 $0 ($250) $0
2
This assumes that each equity option represents 100 shares of the underlying stock. While this is the case for all North American options,
it may not necessarily apply to equity option contracts listed on exchanges outside of North America.

Table 6.2 | Profit (Loss) from Buying 1 ABC Inc. August 65 Call Option at $2.50 or
Buying 100 ABC Inc. at $65
$70 $5 $250 $500

$75 $10 $750 $1,000
$80 $15 $1,250 $1,500
$85 $20 $1,750 $2,000
Figure 6.1 | Risk and Reward Profile of Buying a 65 Call Option at $2.50
$400
$200
$0 Break-Even: $67.50
-$200
-$400
55 60 65 70 75
Share Price ($)
As shown in Example 6.8, the limited risk feature of options is even more apparent when one compares the
purchase of a put option with the sale of the underlying stock short.
EXAMPLE 6.8 | THE LIMITED RISK FEATURE OF PUT OPTIONS

On November 1, XYZ Ltd. shares were trading at $44, and the XYZ December 40 put was trading at $1. An
investor who thought that XYZ shares were overvalued and about to decline could either sell the shares short or
buy a put option. The table below illustrates the results if the shares rose to $60 by expiration.
Put Option Stock

Sold 100 shares short $4,400 (CR)
Bought 1 Dec. 40 put option $100
Loss $100 $1,600
Loss on investment –100% –121%*
* The short seller would have had to deposit 30% of the original value of the short sale as margin. This loss is based on this “investment”
of 30%, or $1,320.
The risk of short selling is unlimited because the price of an underlying security could in theory rise to infinity. The
risk of a put buyer, however, is always limited to the premium paid. The put buyer would not exercise the right to
sell a stock at a price lower than what it could be sold for in the market. If the market price was higher than the
exercise price at expiration, the put buyer would just walk away from the option, letting it expire worthless.

Whereas the risk of buying a put option is limited to the premium paid, the return, as with short selling, is limited
only by the fact that the stock cannot fall below $0. In general, the following rules apply to put buyers:
• The maximum risk for the put buyer is the premium multiplied by 100.
• The maximum reward for the put buyer is the exercise price plus the premium, multiplied by 100
• The break-even stock price for the put buyer when the option expires is the exercise price minus the premium.
Table 6.3 shows the risk and reward results at expiration of buying a put option versus selling an underlying stock.
Figure 6.2 illustrates the risk and reward at option expiration of buying a put option.
Table 6.3 | Profit (Loss) from Buying 1 XYZ Ltd. December 40 Put Option at $1 or Selling Short 100 XYZ Ltd.
at $44
$Profit (Loss)
Stock Price at Expiration Price of Put Option Put Buyer Stock Seller
$34 $6 $500 $1,000
$36 $4 $300 $800
$38 $2 $100 $600
$40 $0 ($100) $400
$42 $0 ($100) $200
$44 $0 ($100) $0
$46 $0 ($100) ($200)
$48 $0 ($100) ($400)
Figure 6.2 | Risk and Reward Profile of Buying a 40 Put Option at $1
$200
$100
-$100
-$200
36 38 40 42 44
Share Price ($)
Table 6.4 summarizes the advantages of buying a call option versus buying the underlying stock, and the
advantages of buying a put option versus selling the underlying stock short. As mentioned earlier, there are two
important considerations when deciding between an option purchase and a stock purchase or sale. First, a price is
paid for the attractive risk/return profile of an option purchase, and the movement in the underlying stock must
be enough to at least cover this cost. Second, to gain the full benefit of buying an option, the option buyer’s timing
must be much more precise than the timing of the underlying stock buyer or seller.

Table 6.4 | Buying Options Compared to Buying or Selling the Stock Outright
Strategy Risk Return Leverage

Buying a call option Limited to premium paid for Unlimited High leverage factor
the option
Buying the Limited only by the fact that Unlimited Some leverage
underlying stock the price cannot fall below $0 available
Buying a put option Limited to premium paid for Limited only by the fact that High leverage factor
the option the price of the underlying
stock cannot fall below $0
Short-selling the Unlimited Limited only by the fact that Some leverage
underlying stock the price cannot fall below $0 available
WHY INVESTORS WRITE OPTIONS

Whereas a call buyer hopes that the underlying stock will rise high enough so that the option can be either exercised
or sold at a profit, the call writer has the opposite expectation. The writer hopes that the price of the stock will
remain at a level where it will not be profitable for the call buyer to exercise. The ideal outcome for the call writer is
for the price of the underlying stock to remain at or under the strike price at expiration.
And whereas a put buyer hopes that the underlying stock will fall low enough so that the option can be either
exercised or sold at a profit, the put writer has the opposite expectation. The writer hopes that the price of the stock
will remain at a level where it will not be profitable for the put buyer to exercise. The ideal outcome for the put
writer is for the price of the underlying stock to remain at or over the strike price at expiration.
Option writers are willing to take on the risk of an obligation in return for receiving a premium from the option
buyer. Writers, however, do not believe that the underlying stock will move in such a way that they will ever have to
fulfill that obligation.
Call option writing has been compared to short-selling the underlying stock because the call writer must sell the
underlying stock when assigned. However, the two are really not very similar. The writer is not necessarily hoping
that the price of the underlying stock declines, but simply that it does not rise. The short seller, of course, hopes the
price will decline. Example 6.9 compares the risks and rewards of call option writing with those of short-selling the
underlying stock.
EXAMPLE 6.9 | LIMITED RETURN OF SELLING A CALL OPTION

On November 1, DEF Ltd. shares were trading at $35, and the DEF December 35 calls were trading at $1.75. An
investor who thought that DEF shares would remain at or under $35 up to the December option expiration date
could have either sold DEF short or written a call option. The table below illustrates the results if the shares fell
to $30 by expiration.
Call Option Stock
Sold 1 call option contract $175 (CR)
Value at option expiration $0 $3,000
Profit $175* $500
* Note that calculating a return on investment in this case requires knowledge of margin requirements, which are discussed in Volume 2
of the Derivatives Fundamentals and Options Licensing Course.

Note in Example 6.9 that the call writer earned only the initial premium received. Regardless of how low DEF
shares fell, the writer’s profit would be limited to that premium. The call buyer would not allow the writer to earn
more than the premium by exercising a right to buy shares at the strike price when the market price is lower. The
buyer would just walk away from the option, thereby freeing the writer from any obligation. The short seller’s profit,
by comparison, would increase as the price of DEF continued to fall.
EXAMPLE 6.10 | THE UNLIMITED RISK OF CALL WRITING

If, in Example 6.9, DEF shares rose to $40 by option expiration instead of falling, the result would be as shown below.
Call Option Stock

Wrote 1 call option contract $175 (CR)
Value at option expiration $500 $4,000
Loss $325 $500
Example 6.10 shows that the loss incurred by the call writer and the short seller were somewhat similar. The only
difference is that the call writer’s loss was mitigated to some extent by the premium received. In both strategies,
however, the potential loss was unlimited. In theory, the price of DEF could rise to infinity.
The value of the call option at expiration reflects the fact that the buyer could buy DEF at $35 and then resell at
the market price of $40. The value to the buyer is an obligation to the writer. A writer who is uncovered or “naked”
(meaning a writer who does not own the shares) would have to purchase them at the market price and sell them
at the lower exercise price. For a writer who is covered (meaning a writer who owns the shares), the loss will be an
opportunity loss because they will have to sell them at a price lower than market price. In either case, the higher
DEF’s share price rises, the greater the loss to the writer. In general, the following rules apply to call writers:
• Maximum risk is unlimited.
• Maximum reward is the premium multiplied by 100.
• The break-even stock price when the option expires is the exercise price plus the premium.
Table 6.5 shows the risk and reward results at expiration of writing a call option versus selling an underlying stock.
Figure 6.3 illustrates the risk and reward of writing a call option at option expiration.
Table 6.5 | Profit (Loss) from Writing 1 DEF Ltd. December 35 Call Option at $1.75 or
Selling Short 100 DEF Ltd. at $35
$Profit (Loss)
Stock Price at Expiration Price of Call Option Call Writer Stock Seller
$20 $0 $175 $1,500
$25 $0 $175 $1,000
$30 $0 $175 $500
$35 $0 $175 $0
$40 $5 ($325) ($500)
$45 $10 ($825) ($1,000)
$50 $15 ($1,325) ($1,500)
$55 $20 ($1,825) ($2,000)

Figure 6.3 | Risk and Reward Profile of Writing a 35 Call Option at $1.75
$400
$200
-$200
-$400
25 30 35 40 45
Share Price ($)
Put option writing has been compared to buying the underlying stock because a put writer who is assigned becomes
the owner of the stock. The two strategies, however, are not very similar. The writer is not necessarily hoping that
the price of the underlying stock rises, just that it does not decline, so the put can expire out-of-the-money. The
buyer of the underlying stock, on the other hand, hopes that the price will rise.
In Example 6.11, the put writer would earn only the initial premium received. Regardless how high GHI shares rose,
the writer’s profit would be limited to the premium. After all, the put buyer would not exercise a right to sell shares
at the strike price when the market price was higher. The underlying stock buyer’s profit, by comparison, would
increase as the price of GHI continued to rise.
EXAMPLE 6.11 | LIMITED RETURN OF WRITING A PUT OPTION

On November 1, GHI Inc. shares were trading at $30 and GHI December 30 puts were trading at $1.50. An
investor who thought GHI shares were likely to rise above $30 by option expiration could have either bought
GHI shares or written a put option. If the shares rose to $40 by expiration, the result would be as shown below.
Put Option Stock

Wrote 1 Dec. 30 put option $150 (CR)
Profit $150 $1,000
Example 6.12 shows that the losses incurred by the put writer and the underlying stock buyer were similar. The
only difference is that the writer’s loss was mitigated to some extent by the premium received. In both strategies,
however, the potential loss is limited only by the fact that the share price cannot fall below zero.
EXAMPLE 6.12 | RISK OF WRITING A PUT OPTION

If GHI shares had fallen to $20 in Example 6.11 instead of rising, the result would be as shown below.
Put Option Stock

Wrote 1 Dec. 30 put option $150 (CR)
Value at Option Expiration $1,000 $2,000
Loss $850 $1,000

The put option’s $1,000 value reflects the fact that the buyer could sell GHI at $30 and then buy at the market
price of $20. This value to the buyer is an obligation to the writer. The writer would be forced to buy GHI at $30,
but could only resell at the market price of $20. The lower GHI’s share price falls, the greater the loss to the writer.
In general, the following rules apply to put writers:
• Maximum risk is the exercise price minus the premium, multiplied by 100.
• Maximum reward is the premium multiplied by 100.
• The break-even stock price when the option expires is the exercise price minus the premium.
Table 6.6 shows the risk and reward results at expiration of writing a put option versus buying an underlying stock.
Figure 6.4 illustrates the risk and reward at option expiration of writing a put option.
Table 6.6 | Profit (Loss) from Writing 1 GHI Inc. December 30 Put Option at $1.50 or
Buying 100 GHI Inc. at $30
$Profit (Loss)
Stock Price at Expiration Price of Put Option Put Writer Stock Buyer
$15 $15 ($1,350) ($1,500)
$20 $10 ($850) ($1,000)
$25 $5 ($350) ($500)
$30 $0 $150 $0
$35 $0 $150 $500
$40 $0 $150 $1,000
$45 $0 $150 $1,500
$50 $0 $150 $2,000
Figure 6.4 | Risk and Reward Profile of Writing a 30 Put Option at $1.50
$150
$100
-$100
-$150
20 25 30 35 40
Share Price ($)
Table 6.7 summarizes the risk and return characteristics of writing options versus short-selling and buying the
underlying stock.

Table 6.7 | Comparison of Writing Options Versus Buying or Selling the Stock Outright
Strategy Risk Return
Writing a call option Unlimited Limited to the premium received
Short-selling the underlying stock Unlimited Limited only by the fact that the
price of the underlying stock cannot
fall below $0
Writing a put option Limited only by the fact that Limited to premium received
the price of the underlying asset
cannot fall below $0
Buying the underlying stock Limited only by the fact that the Unlimited
price cannot fall below $0
A LESSON TO BE LEARNED: THE DANGER OF UNCOVERED

OR NAKED OPTION WRITING
It is imperative that investors understand the risks involved in writing uncovered option positions. The disaster many
investors experienced in the crash of 1987 can be traced to this strategy. These investors were writing puts on stocks
in a market that was strongly bullish. The strategy worked well during the first part of the year, when the market
kept rising. This gave investors a false sense of security and encouraged them to increase their exposure. Then the
markets collapsed, exposing the investors to huge losses. Many investors were subject to assignment, meaning that
they were obligated to buy the stock at the exercise price, which was at that point much higher than the current
market price. Substantial paper losses were incurred, along with actual losses if the stock was then sold in the
market. If the puts were not assigned, the investors could have bought them back by an offsetting transaction, but
at a much higher price than the one they received for them.
Uncovered option writing is suitable only for knowledgeable investors with the following characteristics:
• They understand the risks.
• They have the financial capacity and willingness to incur and withstand potentially large losses.
• They have sufficient liquid assets to meet applicable margin requirements.
In the stock market, the term margin refers to the strategy of buying stock on credit. Options, however, cannot be
bought on credit. In the options market, margin means the cash or securities that the option writer must deposit
with the broker as collateral for the writer’s obligation to buy or sell the underlying stocks if assigned. Uncovered
option writers may have to meet calls for substantial additional margin in the event of an adverse market move.
OTHER RELATED BENEFITS OF OPTIONS

In addition to being a means for speculating on the price of an underlying stock, the leverage and limited risk
features of options offer investors the following benefits:
• Options can be used in conjunction with underlying stock positions to minimize the risk of ownership and the
risk of short-selling.
• They can be used to generate additional income on an underlying position.
• They can provide investors with a vehicle with which to fix a future underlying stock purchase or sale price.

In addition, options allow for diversification because of their low price. For the same or similar dollar outlay that is
required for purchasing one or a small number of stocks, investors can gain exposure to many stocks by buying call
options.
ADVANTAGES OF EXCHANGE-TRADED OPTIONS VERSUS

OVER-THE-COUNTER OPTIONS
The options discussed in this and the following chapters are exchange-traded options, that is, options that are
actively traded on organized exchanges. In Chapter 8 of this section, we describe options that trade OTC. Over-the-
counter options are essentially private, custom-made contracts between two parties. They differ from exchange-
traded options in that there is little opportunity for subsequent trading once a transaction is effected. In contrast,
exchange-traded options can have active trading every day.
Compared with OTC option trading, organized exchanges provide significant advantages. Four important
advantages are discussed below.
THIRD-PARTY GUARANTOR
Once an exchange-traded option is transacted between a buyer and a seller, the two cease to deal with each other.
Instead, they deal with the Canadian Derivatives Clearing Corporation (CDCC) in Canada or the Option Clearing
Corporation (OCC) in the U.S. Each is jointly owned by the exchanges where options are traded. Very similar to
futures clearinghouses, they act as guarantors of each option trade. Once the buyer and seller agree on a price, the
clearing corporation becomes the seller for every buyer and the buyer for every seller. In other words, all option
investors contract with the clearing corporation, which assures investors that all contracts will be honoured.
Clearing corporations are able to assume the role of guarantor by requiring member firms that have short option
positions to provide collateral on a daily basis. This collateral, referred to as margin, is necessary to ensure that
option writers have the necessary funds available to meet possible assignments. Member firms collect margins from
their option writer clients to turn over to the clearing corporation.
Option investors do not worry about credit worthiness because no clearing corporation has ever gone into default.
In the OTC market, however, default risk is a major concern. If one counterparty in an OTC contract defaults, the
other counterparty bears the financial loss associated with the transaction’s obligations.
INCREASED LIQUIDITY
Having a clearing corporation guarantee the financial performance of an options contract gives market participants
a high level of assurance when trading options. Along with the contract’s standardized features, the guarantee
contributes to the liquidity that makes it very easy to offset a contract.
By comparison, it is difficult and can be very expensive to offset an existing position in OTC trading. One party may
be reluctant to do so and may only overcome that reluctance if an attractive price is extracted from the party that
wishes to offset. Finding a third party to offset the position against is difficult because of the unique nature of each
OTC option.
MORE COMPREHENSIVE DISCLOSURE AND SURVEILLANCE RULES

Relative to OTC option trading, exchanges impose relatively strict trading, disclosure, and monitoring procedures.
They also keep the market flowing smoothly.

PRICE TRANSPARENCY
Once an options trade is transacted, its price is disseminated almost instantaneously by the exchange through
numerous quote vendors. Market participants are always aware of what the going market price is for a particular
option series. The same cannot be said of OTC options, where transactions are private affairs between two parties.
Option price, volume, and open interest statistics are provided daily in the financial press. Table 6.8 in the following
pages illustrates option quotations and explains how to read and interpret them.
READING OPTION QUOTATIONS

Intraday quotations are available on the websites of most exchanges and other financial sites. Table 6.8 is a model
for an intraday quotation on (fictitious) JKL options on August 24, 2015. The numbers in parentheses indicate that
these items are explained in the notes that follow the table.
Table 6.8 | Quotations of Option Prices

JKL Inc. (1) 30-Day Historical Volatility: 33% (2)
Last Price: 25.56 (3) Net change: -0,33 (4) Bid: 25.56 (5) Ask: 25.57 (6)
Calls Puts
Month/ Impl. Open Month/ Impl. Open

Strike Bid Price Ask Price Last Price Vol. Vol. Int. Strike Bid Price Ask Price Last Price Vol. Vol. Int.
(7) (8) (9) (10) (11) (12) (7) (8) (9) (10) (11) (12)
2015 SE 22.00 3.800 4.000 4.300 0 44.57 21 2015 SE 22.00 0.150 0.250 0.250 0 42.43 180
2015 SE 24.00 2.200 2.300 2.550 0 40.33 15 2015 SE 24.00 0.500 0.600 0.550 0 38.45 207
2015 SE 26.00 1.050 1.150 1.100 22 38.34 234 2015 SE 26.00 1.350 1.450 1.350 43 37.81 200
2015 SE 28.00 0.450 0.500 0.450 10 38.95 750 2015 SE 28.00 2.750 2.850 2.650 0 37.67 164
2015 SE 30.00 0.100 0.250 0.250 0 39.14 858 2015 SE 30.00 4.450 4.600 4.300 0 40.65 89
2015 SE 32.00 0.020 0.150 0.150 0 42.58 172 2015 SE 32.00 6.350 6.500 6.200 0 46.98 0
2015 OC 20.00 5.800 6.050 6.350 0 47.06 429 2015 OC 20.00 0.100 0.200 0.200 0 42.90 30
2015 OC 22.00 4.050 4.250 4.600 0 42.80 125 2015 OC 22.00 0.350 0.450 0.400 20 40.94 354
2015 OC 24.00 2.600 2.750 3.000 0 40.04 571 2015 OC 24.00 0.900 0.950 0.900 0 39.80 1684
2015 OC 26.00 1.550 1.650 1.600 20 39.81 857 2015 OC 26.00 1.800 1.850 1.750 0 39.38 1474
2015 OC 28.00 0.850 0.950 0.900 102 40.13 2680 2015 OC 28.00 3.100 3.200 3.000 25 40.68 1268
2015 OC 30.00 0.450 0.550 0.500 54 41.18 5161 2015 OC 30.00 4.650 4.800 4.600 0 41.56 543
2015 OC 32.00 0.200 0.300 0.300 40 41.18 790 2015 OC 32.00 6.450 6.600 6.350 0 44.51 105
2016 JA 20.00 6.400 6.650 6.600 25 44.23 715 2016 JA 20.00 0.450 0.600 0.600 0 41.22 110
2016 JA 22.00 4.900 5.100 5.400 0 42.65 280 2016 JA 22.00 0.900 1.050 0.900 15 40.17 311
2016 JA 24.00 3.700 3.850 3.900 4 42.03 351 2016 JA 24.00 1.600 1.750 1.650 0 39.78 4962
2016 JA 26.00 2.650 2.850 2.900 5 41.82 618 2016 JA 26.00 2.650 2.800 2.650 4 40.32 121
2016 JA 28.00 1.900 2.100 2.100 44 41.75 1201 2016 JA 28.00 3.900 4.050 3.900 0 41.96 390
2016 JA 30.00 1.400 1.450 1.400 25 41.86 1805 2016 JA 30.00 5.300 5.500 5.300 0 42.69 553
2016 JA 32.00 0.900 1.100 1.150 0 42.39 1253 2016 JA 32.00 6.900 7.100 6.850 0 43.99 236

Table 6.8 | Quotations of Option Prices
Notes:
(1) The name of the underlying stock (in this case, JKL Inc.)
(2) The underlying stock’s historical volatility, measured as the annualized standard deviation of the percentage
changes of the stock closing prices in the last 30 trading days
(3) The current market price if the underlying stock
(4) The change in the price of the underlying stock from the previous trading session’s closing price
(5) The highest price at which one or more parties are willing to buy the underlying stock
(6) The lowest price at which one or more parties are willing to sell the underlying stock
(7) The highest price at which one or more parties are willing to buy option
(8) The lowest price at which one or more parties are willing to sell the option (also known as the offer price)
(9) The last price at which the option traded*
(10) The total number of options traded during the current trading session
(11) Based on an option pricing model, the volatility implied by the mid-price between the bid and ask prices of
the option contract (i.e., the volatility that yields a theoretical value for the option equal to the mid-market
price)
(12) The total number of options outstanding (i.e., options that have not been closed out or exercised) at the
close of the previous trading session
* If no trading took place during the session, the last indicated trading price comes from an earlier session.
COMMON QUESTIONS PERTAINING TO THE OPTIONS MARKET

Some of the more commonly asked questions about option quotations are as follows:
Why do certain underlying The decision to list an option on a particular stock is solely the responsibility
stocks have options listed of the option exchange. Publicly listed companies do not have any say on the
while others do not? option listing of their stock.
Exchanges have several eligibility requirements for equity options, including a
minimum market capitalization, a minimum number of publicly held shares, a
minimum annual share trading volume, and a minimum number of shareholders.
How are expiration months Part of the initial development of exchange-traded options included standardized
chosen? expiration cycles. The option exchanges determine the specific trading cycle for
each equity option. The main determinant for selecting a cycle is the option’s
anticipated marketability at the time of listing. Options on the most popular,
heavily-traded stocks will be given a trading cycle with the greatest flexibility in
terms of the number of expiry months.
The expiration date for equity options is typically the third Friday of the
expiration month.

How are strike prices chosen? When options are introduced for trading, the exchanges select two or more
exercise prices that are close to the underlying stock’s market price. Generally,
three series of options are introduced with exercise prices at, below, and above
the current market price of their underlying stock.
Additional option series with new exercise prices are established by the
exchanges for all traded expiration months if significant movement occurs in the
market price of the stock. Therefore, at any given time, several different series of
options trade on any one stock.
How are trading units decided Option contracts on an underlying interest (asset), traded on a specific exchange
upon? and cleared through a specific clearing corporation, are all the same size. For
individual stock options, a board lot contract size of 100 shares applies to all
North American markets (except in the event of certain stock splits, when
existing 100-share contracts are adjusted for the split). For non-equity options
(i.e., currency, stock index, interest rate, and futures options), the contract size
for each underlying interest is always the same within a specific market.
When an option is purchased, For both buying and writing options, there is one business day settlement. When
when does it have to be paid an equity option is exercised, settlement is on the second business day after the
for? date that an exercise notice is tendered to the clearing corporation.
What are the steps taken To exercise an option, the holder notifies the broker, who, in turn, notifies the
when an option is exercised? clearing corporation (referred to as tendering an exercise notice). On the next
business day, the clearing corporation assigns the exercise notice to a clearing
member who has an account containing a written option in the relevant stock.
The member then assigns the notice to a customer who has a written position.
The customer must then either purchase (in the case of a put) or sell (in the case
of a call) the underlying stock at the exercise price. Settlement between member
firms will take place two business days following the tendering of the exercise
notice. Each member firm must settle with the customer.

Pricing of Options 7
CONTENT AREAS
Pricing of Options
Major Factors that Affect the Price of an Option
Intrinsic Value
Time Value
Delta
LEARNING OBJECTIVES
1 | Differentiate between intrinsic value and time value.
2 | Demonstrate the role that arbitrage plays in option pricing for both European- and American-style
options.
3 | Calculate the time value of an option.
4 | Differentiate between implied and historical volatility.
5 | Demonstrate the impact volatility has on the time value of an option.
6 | Demonstrate the impact the yield of an underlying instrument has on the time value of an option.
7 | Calculate the expected change in an option’s price given the delta and the change in the underlying
asset’s price.

KEY TERMS
delta intrinsic value
delta hedging time value
historical volatility volatility
implied volatility

CHAPTER 7 | PRICING OF OPTIONS 7•3
PRICING OF OPTIONS
In Chapter 6, we explained the circumstances in which an option would have value. To a call holder, an option has
value if it allows the holder to purchase a stock at a price lower than what it could be purchased for in the market.
To a put holder, an option has value if it allows the holder to sell a stock at a price higher than what it could be sold
for in the market.
The value just described is referred to as intrinsic value. An American-style option always trades at its intrinsic
value at least. However, there are several other factors that influence an option’s price, and option premiums
typically trade at levels that exceed their intrinsic value.
The price of options is also influenced by time value, meaning that an option with time left to expiration will trade
at a higher price than its intrinsic value.
In this chapter, we first describe the factors that influence the price of an option, and then we illustrate the impact
on prices when there is a change in one of these factors.
MAJOR FACTORS THAT AFFECT THE PRICE OF AN OPTION

Much like any financial market, many of the trading opportunities available in the options market reflect a
difference of opinion about value and price. The most significant factors affecting an option’s value are quantifiable,
albeit not necessarily known. Below are various factors that influence an option’s intrinsic value and time value.
Intrinsic Value • Difference between the strike price and the market price of the underlying interest
• Whether the option is European-style or American-style
Time Value • Time remaining to expiration

• Difference between the strike price and the current price of the underlying interest
• Volatility of the underlying instrument
• Net cost of carrying the underlying instrument, which comprises:
The risk-free rate of interest
The yield on the underlying instrument – dividend yield for equity options and bond
yield for bond options
An option’s value is largely based on quantifiable components, so it is logical that a formula would be created that
captured these variables. In 1973, shortly after listed options trading began, Professors Fischer Black and Myron
Scholes developed a pricing model for options based on all of the above-stated variables with the exception of
dividends. This formula, known as the Black-Scholes Option Pricing Formula, continues to be the most extensively
used pricing model today (usually with an adjustment to incorporate dividends). It is not essential to know how to
calculate or utilize the formula, but a general understanding of how its various components (including dividends)
influence the price of an option is recommended.
In addition to these quantifiable factors, option premiums are also influenced to a lesser degree by factors that
cannot be quantified. These include:
• The market sentiment towards a particular stock or the stock market in general
• The depth or liquidity of that particular option

INTRINSIC VALUE
Intrinsic value represents real and tangible value based on the relationship between the strike price and market price
of the underlying interest.
DIFFERENCE BETWEEN STRIKE PRICE AND MARKET PRICE

Intrinsic value is a major factor in the price of an option. It is based on the relationship of the strike price to the
market price of the underlying interest. At expiry, an option will be worth exactly its intrinsic value, whereas before
expiry it will be worth at least its intrinsic value (unless it is a European option).
Intrinsic value represents the basic worth of the option. In the case of a call, it is derived from the fact that the
market price of the underlying interest is greater than the call’s strike price. Under this condition, the call can be
exercised at the strike price, and the underlying interest can be acquired at a cost below the prevailing market value
of the underlying asset, thereby yielding an immediate profit represented by this differential.
In the case of a put, the converse is true. Intrinsic value exists when the market price of the underlying interest
is lower than the strike price of the put. Under this condition, the put can be exercised at the strike price and the
underlying interest sold at a price that is above the prevailing market value, again yielding a profit represented by
the differential.
EUROPEAN-STYLE AND AMERICAN-STYLE OPTIONS

An American-style option can be exercised at any time throughout its life, so it will always be worth at least its
intrinsic value. A European-style option cannot be exercised until expiry, so it can trade at a discount (particularly a
put option) to its intrinsic value right up to expiration.
The reason for the pricing difference between the two styles of options is the option’s exercisability feature. For
example, if an American-style call option trades below its intrinsic value, it is possible for a professional trader to
perform an arbitrage by buying the option and exercising it, while simultaneously selling the underlying interest.
Because this arbitrage strategy would yield a risk-free profit, other traders would seize the opportunity. The
collective actions of these traders will ensure that the option price moves back to at least intrinsic value.
If the call price is lower than the difference between the stock price and the exercise price, any discrepancy will
be eliminated by astute investors taking advantage of the arbitrage opportunity. The collective action of these
investors will ensure that the stock price declines or the call price rises (or both) until the value of the call is equal
to or greater than its intrinsic value. Note that no such arbitrage opportunity is available if an option trades over its
intrinsic value prior to expiry. This concept is illustrated in Example 7.1.
EXAMPLE 7.1 | INTRINSIC VALUE AND ARBITRAGE PRICING

Assume that the call option on ABC Inc., with an exercise price of $65, is selling for $10 several weeks prior to
expiry, when the stock closes at $85. In this case, the option is selling $10 under its intrinsic value, and as a result,
an arbitrageur could make the trades shown below.
Transaction Cash Flow

Buy a call option –$10
Exercise the option –$65
Sell the stock $85
Net Cash Flow $10
Arbitrage is more complicated with European-style options because they cannot be exercised prior to expiry. If a
European put option is trading at less than its intrinsic value, an arbitrageur could buy the option and the stock but

would have to wait until expiry before exercising. Of course, the wait will entail certain additional cash flows. The
arbitrageur would have to finance the purchase and the holding of the option and the stock. The put would have to
trade at enough of a discount to intrinsic value to cover these costs and make the arbitrage profitable.
TIME VALUE
Time value arises because the advantage conferred by the option contract is valuable. Option holders are willing to
pay a price for this advantage over and above the option’s intrinsic value. The advantage exists primarily as a result
of the uncertainty about what the underlying price of the option will be at expiration.
Options with time left to expiry trade at higher prices than their intrinsic value for two reasons:
• First, it is possible that the underlying price will move in-the-money, or, if already at that point, that it will move
deeper in-the-money by option expiration.
• Second, the option bestows on its holder the right, but not the obligation, to buy or sell the underlying
instrument. Because there is no obligation, the holder will exercise only when it is profitable to do so, and as a
result, can lose only what was paid for the option.
In other words, holders are willing to pay a premium over intrinsic value for the limited risk and unlimited return
profile inherent in an option.
Although time value exists as a result of price uncertainty, the amount of a particular option’s time value is
determined by the four components mentioned above and explained below.
TIME REMAINING TO EXPIRATION

The time remaining to expiration is one of the more interesting components of an option’s price. Common sense
suggests that the longer an option has until expiry, the more that option should be worth.1 This relationship must
hold because the longer option gives the holder all the advantages of the shorter option and more.
The longer the time to maturity, the higher the possibility that the stock price will exceed the exercise price at
some point before maturity, which makes the possibility of exercise valuable for a call. Equally, the longer the time
to maturity, the higher the possibility that the stock price will fall below the exercise price at some point before
maturity, which makes the possibility of exercise valuable for a put.
What would happen if the longer option were worth less than the shorter option? That would again provide an
arbitrage opportunity, as shown in Example 7.2.
EXAMPLE 7.2 | TIME TO MATURITY

On a particular day, the financial press reports that a call option with maturity in July and exercise price of $65 is
selling for $3.45, and one with the same underlying stock and same exercise price but with maturity in October is
selling for $5.65. What if the prices were reversed? In this case, the arbitrageur can make the transactions shown
in the table below.
Transaction Cash Flow

Buy the long-dated option for $3.45 –$3.45
Write the short-dated option for $5.65 +$5.65
Net Cash Flow +2.20
1
Although this is certainly true of American-style options, it may not necessarily be true of European-style options.

EXAMPLE 7.2 | TIME TO MATURITY

What happens if the option that was written is exercised? In this case, the arbitrageur can simply exercise the
long-dated option that was purchased and use the stock received to deliver on the short-dated option. This move
will guarantee that the arbitrageur can keep the $2.20 in profit, no matter what happens to the stock price.
Because this profit is certain and was earned without the arbitrageur investing any of his own money, it is an
arbitrage profit. Consequently, the short option has to be worth less than the long option; otherwise there would
be arbitrage opportunities.
Figure 7.1 | Time Value Decay
Time value decay chart

(assuming stock price remains constant)
Time Value Premium
12 6 1 0
Time Remaining Until Expiration (Months)
While it is generally true that long-dated options have more value than short-dated options, as shown in Figure 7.1,
the effect that time remaining to expiration has on the option’s price is not linear.
“Not linear” means that the time value portion of an option’s premium does not increase proportionately to the
increase or lengthening of a selected option’s life-span. Similarly, the time value portion of an option’s premium
does not decay (or decrease) in a straight line as the expiration date approaches. In fact, an option’s time value
premium decays faster the closer the option is to expiration. This decay is particularly pronounced in the last few
weeks before expiry.
The time to expiration is the most important component of time value, but it is not the only one. At any point, one
of the other time value components could influence the time value and cause the relationship between time and an
option’s time value to be less precise.
DIFFERENCE BETWEEN STRIKE PRICE AND CURRENT PRICE

OF THE UNDERLYING INTEREST
The time value of an option tends to be at its maximum when the underlying price is equal to the strike price, as
shown in Figure 7.2. The deeper in-the-money or out-of-the-money an option becomes, the more its time value
decreases.

Figure 7.2 | Call Option Pricing Curve
11 Exercise Price at $60

10
9
ve
ur
8
iceC
7
Pr
Option Price
io n
ne
6
pt
e Li
Greatest Value for
ll O
alu
5 Time Value Premium
Ca
cV
4
insi
3
I ntr
2
Shaded area represents the
1
option’s time value premium
0
50 55 60 65 70
Stock Price
Intrinsic value remains at zero
until striking price is passed
VOLATILITY OF THE UNDERLYING INSTRUMENT

Volatility is a statistical measure of the amount by which the market price of the underlying stock is expected to
fluctuate during a given period. As volatility increases, the chance that the stock will do very well or very poorly
increases. For the owner of a stock, these two outcomes tend to offset each other. Simply put, the better the stock
performance, the higher the payoff for the stock holder; and the worse the stock performance, the worse the payoff
for the stock holder. However, this is not the case for the owner of a call or a put option. The owner of a call option
benefits from price increases, but has limited downside risk in the event of a price fall because the most one can
lose is the call premium paid. Similarly, the owner of a put benefits from price declines but has limited downside risk
in the event of a price increase. Therefore, the more volatile the underlying stock, the higher the option premium
will be.
This principle is illustrated in Example 7.3.

EXAMPLE 7.3 | THE IMPACT OF VOLATILITY ON AN OPTION PREMIUM

An investor is considering buying options on one of two underlying stocks. Stock A is currently trading at $100
and it is expected with equal probability to go either up by 10% or down by 10% over the next year. Stock B is
currently also trading at $100 but is expected to either advance by 20% or fall by 20% over the next year, also
with equal probability. In other works, stock B is more volatile than stock A.
The question is, which call option should we pay more to purchase: the option on stock A or on stock B? Both
options have the same exercise price of $105 and both expire at the end of next year. The investor would like to
pay more for the option that gives the highest expected payoffs.
What are the payoffs from option A? At expiration, there is a 50% probability that the stock will rise to $110 and
a 50% probability that the stock will fall to $90. The payoff of the call option in the event of a stock increase is
$5 (i.e., $110 – $105). In the event that the stock falls, the option will expire worthless because the stock price
will be lower than the exercise price. The average payoff from such an investment will be 50% of the $5 payoff
plus 50% of the zero payoff, which is $2.50.
In a similar fashion, the average payoff from investing in option B is 50% of the $15 (i.e., $120 – $105) payoff,
plus 50% of the zero payoff, which is $7.50.
Obviously, the investor will prefer the option on stock B because, on average, it yields a higher payoff than the
option on stock A. If prices decline, B will not underperform A, whereas if prices appreciate, B will outperform A.
The value of option B, then, must be at least as much as the value of option A, but it will probably be worth more.
The only difference between the two options is the risk level (i.e., volatility) of the stock. Stock A will go up or
down by 10%, while stock B will go up or down by 20%.
Consequently, all things being equal, an option on a riskier underlying stock will be worth at least as much and
probably more than an option on a less risky stock.
There are two types of volatility that can be used to help determine an option’s price – historical volatility and
expected volatility.
As the name suggests, historical volatility is computed by using past prices of the underlying instrument. The
problem with using historical volatility in the pricing of an option is that new information in the market about the
underlying instrument may change the market’s view on future volatility. Option buyers purchasing options strictly
on the basis of historical volatility may overpay if they fail to consider the probability of volatility dropping off. By
the same token, option writers selling strictly on the basis of historical volatility may sell at too low a price if they
fail to consider the probability of volatility rising.
Rather than basing volatility solely on the underlying asset’s past price performance, in practice, most traders base
it on a projection of expected volatility.
Measuring the volatility that is built into the current price of an option is normally done by looking at the current
price of the option and, by working backwards, calculating the degree of volatility that the price is implying. The
volatility implicit in the option premium is referred to as implied volatility.
LESSONS TO BE LEARNED
Volatility is constantly changing. Both buyers and writers of options must take into consideration not only
the impact that a change in the underlying price of a stock can have on the option price, but also a change in
volatility.
This consideration is never more evident than in a sharp and sudden market correction (as in October 1987,
August 1998, or October 2000), when many put option writers can lose large amounts of money. For the most
part, these option writers are writing puts that are deep out-of-the-money and have, after steadily increasing

markets, relatively low volatility. However, as the market drops, volatility rises sharply. Put writers in many
cases are forced to offset at prices that have risen substantially because of an increase in both intrinsic value and
volatility.
IMPLIED VOLATILITY INDICES

Several implied volatility indices now exist that reflect the specific volatility of different stock market indices. The
Volatility Index (VIX) remains the most widely followed. Launched by the Cboe in 1993, it presently reflects the
implied volatility of at-the-money 30-day options on the S&P 500 Index. As with any implied volatility figure, the
VIX increases with investor anxiety and is commonly referred to as the “fear index”. It has become so popular that
the CBOE has launched options and futures based on it.
Other watched volatility indices include those based on the NASDAQ 100 (VXN), the Dow Jones Industrial Average
(VXD), and the Russell 2000 (RVX). In Canada, the Montreal Exchange introduced the MVX, an implied volatility
index calculated from current prices of at-the-money options on the iShares S&P/TSX 60 Index ETF (XIU). Because
the value of XIU mirrors the S&P/TSX 60, MVX is a good proxy of investor sentiment for the Canadian equity
market.
The success of equity-related VIX products led the Cboe to develop additional volatility indices based on interest
rates, commodities, and currencies. These indices were made possible by the increasing volume of options traded on
exchange-traded funds based on non-equity asset classes.2
COST OF CARRYING THE UNDERLYING INVESTMENT

In our discussion of forward contracts, we introduced the concept of cost of carry. This concept also applies to
options.
Because an option can be looked at as an alternative to buying or selling the underlying instrument, the costs of
holding that instrument must be taken into consideration when determining how much one is willing to pay for
the option. The net cost of carry is the difference between what it costs to finance the purchase of the underlying
investment (i.e., the borrowing rate) and income (if any) received from holding it.
THE RISK-FREE RATE OF RETURN

The rate generally used to approximate a borrowing rate is the risk-free rate of return, which has been defined as
the pure cost of money. The risk-free rate is the rate of return an investor would expect given no chance of default
on the investment. In Canada, it generally refers to the return available on Government of Canada Treasury bills. The
maturity of the T-bill used in helping to price an option is the same as the maturity left to expiration of the option
itself.
An increase in the risk-free rate of interest results in an increase in the price of a call option (everything else being
equal). The logic is that an interest rate rise increases the cost of carrying the underlying instrument, making
purchase of the call option more attractive.
The relationship between the risk-free rate of interest and put options is somewhat more complex. In a perfect
world, where all funds from a short sale can be reinvested, higher interest rates would make shorting the
underlying security more attractive than buying a put, which would place downward pressure on the premium. In
practice, however, the short trader would have to leave some, if not all, the funds in the account to cover margin
requirements. In such a case, interest rates would not have much impact on the premium of the put, if any.
The influence the risk-free rate has on option premiums is minor compared to the other factors discussed. Rarely do
interest rates move enough during the life of an option to cause significant changes in the option’s premium.
2
http://www.cboe.com/products/vix-index-volatility/volatility-indexes

THE YIELD ON THE UNDERLYING INSTRUMENT

If there is a yield on an underlying instrument (dividends for stocks and interest for bonds), the relationship between
that yield and an option premium will be, everything else being equal, as shown below.
Yield Call Option Premium Put Option Premium

Rises Declines Rises
Falls Rises Declines
The logic of this relationship is the same as that for risk-free rates of return. If an underlying yield rises, a trader
may prefer holding the underlying instrument rather than holding a call option on it. Similarly, when a rise in yield
increases the cost of shorting the underlying instrument, put options become more attractive.
For equity options, traders must be aware of their timing in regard to dividends and any possible changes in the
size of the payment. On ex-dividend dates, the underlying equity price will decline by approximately the amount
of the dividend declared. The downward adjustment in the underlying equity will have the impact of lowering call
premiums and raising put premiums. Because traders can anticipate when dividends are going to be paid, option
premiums generally reflect dividend payments well in advance of ex-dividend dates. If, however, there is any change
in the size or timing of the dividend, premiums will have to be adjusted.
As with the risk-free rate, yields play a relatively minor role in the pricing of an option. In fact, when there is no yield,
as is the case with commodity futures and some equity options, the price of the premium is based solely on the
other factors discussed above.
DELTA
Because an option develops intrinsic value only when its underlying interest rises above or falls below the exercise
price, its price relationship with the underlying interest is non-linear. In most cases, a $1 change in the price of an
underlying interest will result in less than a $1 change in the premium of the option.
One of the by-products of the Black-Scholes Pricing Model is the determination of an option’s delta, or as it is
sometimes referred to, the option’s hedge ratio. As the basic model did not include dividends, the discussion of delta
produced by this model only applies to non-dividend-paying stocks.
An option´s delta indicates how much the price of the option is expected to change, given a price change in the
underlying interest.
The delta of a call is always a positive number between 0 and 1. If an investor purchases a call with a delta of 0.50,
for example, it means that the call premium is expected to move by 50 cents for every dollar move in the price of
the underlying interest.
The delta of a put is always a negative number between 0 and –1. If a call delta on a particular underlying interest
is 0.70, the put with exactly the same terms will have a delta of –0.30. In general, the sum of a call option’s delta
and the absolute value (i.e., ignoring the negative sign) of the corresponding put option’s delta will equal 1. A dollar
decline in the price of the underlying interest means that the put option with a delta of –0.30 will rise in value by
30 cents. A one dollar rise in the price of the underlying interest means the put option will fall by 30 cents.
It is important to note that an option’s delta is not a static number; it changes as the option nears expiration, or if
any of the factors influencing the option’s market price change.
As a general rule of thumb, the larger the intrinsic value in an option’s premium, the higher an option’s delta.
Accordingly, the more an option is in-the-money, the higher the delta’s value will be. An option premium made up
entirely of intrinsic value would have a delta of 1, or very close to it. This stands to reason because, as illustrated

CHAPTER 7 | PRICING OF OPTIONS 7 • 11
earlier, a deep in-the-money option will tend to rise or fall, dollar-for-dollar, with a rise or fall in the price of the
underlying interest.
A PRACTICAL USE OF THE DELTA

The delta can be used to help compensate for an option’s non-linear relationship with its underlying interest by
determining how many options would be needed to hedge an underlying stock position. If, for example, a put
option has a delta of –0.50, the option would rise 50 cents for every dollar fall in the underlying stock. The use of
these puts as a hedge against price declines in the underlying asset would require, not one put for every 100 shares,
but two puts. The hedge ratio would be calculated by dividing the number of underlying shares by the delta, as
shown in Example 7.4.
EXAMPLE 7.4 | DELTA HEDGING

A portfolio comprises 4,500 shares of a stock selling at $65 per share. An investor, concerned that the stock price
may fall over the near term, decides to buy put options as a hedge. (The value of the put will rise if the stock falls
in value.) The investor buys January puts with a strike price of 65. The delta of the put is –0.45, therefore, 100 put
contracts are purchased, representing 10,000 shares (4,500/0.45). The premium is $1.15 per contract.
If the stock falls by 1%, it will decline by $0.65 to $64.35. The value of the stock will fall by $2,925. Given a delta
of –0.45, the $0.65 decline in the stock would result in the put rising by $0.29 (0.65 x 0.45). A $0.29 increase in
each of the 100 put contracts would result in their value rising by $2,900.
Note the following information regarding delta hedging. The delta will have to be taken into consideration only if a
hedger wants to gain, dollar-for-dollar, what an underlying interest loses. In many situations, a hedger using options
will desire protection only in the event that the price of the underlying interest falls under a certain level. In that
case, delta need not be taken into consideration. If, in Example 7.4, the investor needed protection only if the stock
fell under $60, 45 puts (covering 4,500 shares) with a strike price of $60 would have to be purchased.
Example 7.4 assumed that the delta remained unchanged. In reality, as a stock price rises or falls, and as expiration
nears, the delta will change. In a proper delta hedge, the number of contracts would be constantly adjusted to
reflect changes in the delta.

Over-the-Counter Options 8
CONTENT AREAS
Over-the-Counter Interest Rate Options
Interest Rate Caps
Interest Rate Floors
Interest Rate Collars
Exotic Options
LEARNING OBJECTIVES
1 | Contrast exchange-traded and over-the-counter option contracts.
2 | Demonstrate how an over-the-counter interest rate option works.
3 | Differentiate between traditional and exotic over-the-counter options.

KEY TERMS
Asian option floor rate
barrier option interest rate cap
caplet interest rate collar
ceiling rate interest rate floor
compound option multi-asset option
exotic option shout option

CHAPTER 8 | OVER-THE-COUNTER OPTIONS 8•3
OVER-THE-COUNTER INTEREST RATE OPTIONS

In the 1970s and early 1980s, when interest rates rose sharply, many corporations sought methods to control
their interest rate expenses. Their efforts resulted in the development of exchange-traded interest rate futures and
options, which have since become very popular. However, these instruments did not fully meet the needs of users
who required customized solutions to fit to their particular situation. Over-the-counter (OTC) interest rate options
were developed to fill this need.
Figures from the March 2015 Bank for International Settlements Quarterly Review continue to show that interest
rate options remain the largest-volume OTC option contract. In June 2014, the notional amount outstanding in OTC
interest rate options was more than twice as large as foreign exchange, commodity, and equity-linked OTC option
contracts combined.
Over-the-counter interest rate options have the following advantages:
• The terms and conditions of the options can be tailored to the specific needs of the two parties, unlike the
standardized contracts that exist in the organized exchanges.
• The OTC market is a private market in which neither the general public nor other investors, including
competitors, are aware that transactions were completed.
• Trading in these options is essentially unregulated, so government approval is not needed for new types of
options, and there are no costly constraints or bureaucratic red tape.
Because OTC contracts are entered into privately, they are usually feasible in cases where the option buyer is either
familiar with the credit worthiness of the writer or has some type of collateral guarantee to reduce credit risk.
Nevertheless, there is nearly always some credit risk faced by the buyers of these options.
In this chapter, we explore OTC interest rate options with particular emphasis on the most popular types – namely
caps (call options), floors (put options), and collars (combinations of puts and calls). We explain each type of options
and illustrate their applications through examples. We also introduce options with a more exotic flavour (referred to
as exotic options).
INTEREST RATE CAPS

Suppose that a firm’s risk exposure spans multiple periods, one following the other. Such a situation might occur
if the firm is paying a semi-annual floating rate of interest on its long-term debt and is concerned about a rise in
interest rates. How can the treasurer of a corporation hedge this exposure?
In theory, a series of single interest rate call options, one expiring every six months, can be used to hedge semi-
annual floating interest rate payments. This solution may not be practical, however, because it assumes that each
contract delivery month will be sufficiently liquid to enter a contract without substantial liquidity costs. It also
assumes that options with every required delivery month into the future, even the distant future, are currently
available. In practice, this is not generally true, although exchange-traded, long-dated options have been introduced
recently. The solution involves special OTC options such as interest rate caps traded in dealer markets.
DEFINITION OF AN INTEREST RATE CAP

An interest rate cap is really just a series of European interest rate call options that mature at dates corresponding
to interest payment dates on a firm’s long-term debt. Because they are call options, they are designed to guarantee
that the interest rate a borrower pays will not exceed a maximum rate specified by the strike price.
At each interest payment date, the holder of a cap decides whether to exercise the call option based on whether
the interest rate has risen above the exercise rate. A price is paid up front for the cap that corresponds to the sum of

the prices of the series of options that make up the cap. Each option is a separate interest rate call. These individual
component options are called caplets. The Black and Scholes model can be used to price the caplets, subject to
limitations of the model to price interest rate options.
CHARACTERISTICS OF AN INTEREST RATE CAP

Caps are bought by customers through dealers, which are typically banks. The dealer and the customer enter into
an agreement in which they specify the term for the cap, the reference rate, the exercise rate (known as the ceiling
rate), the cap’s principal, and the settlement dates. For example, the term could by two years, five years, or more,
and the reference rate could be the three-month London Inter-bank Offered Rate (LIBOR), the six-month LIBOR, or
the three-month Treasury bill.
As with any option, customers purchasing an interest rate cap pay a premium. The cap premium is, in effect, a sum
of the prices of the series of options that make up the cap.
On the first settlement date, buyers of a cap will exercise the first option if it is in their financial interest to do so.
Otherwise, they will let the option expire. If exercised, the cap writer must pay an amount to the buyer calculated as
follows:
(Current Market Rate – Ceiling Rate or Exercise Rate) × Principal Amount × Length of Payment Period
Example 8.1 illustrates a hedge using an interest rate cap.
EXAMPLE 8.1 | HEDGING USING AN INTEREST RATE CAP

On January 1, a firm borrows $250,000,000 for one year. It will make payments on April 1, July 1, October 1, and
the following January 1. On each date, starting on January 1, LIBOR in effect on that day will be the interest rate
paid over the following three months. At present, LIBOR is 3%.
Concerned that interest rates may rise over the course of the loan, the firm buys an interest rate cap. The exercise
price (i.e., ceiling rate) of the cap is 3%. If LIBOR rises over 3% at an interest payment date, the firm will exercise
and receive payment from the cap writer. The payment will offset the firm’s increased borrowing cost that
resulted from the rise in LIBOR. To guarantee that the firm’s borrowing rate will not be above 3%, the firm pays
an up-front premium, which, in this case, is $700,000.
If LIBOR is above the ceiling rate of 3%, at each interest payment date, the cap will be calculated as follows:
(Market Rate-0.03) × $250,000,000 × (Number of Days/360)
The market rate is the LIBOR rate in effect at the beginning of each quarter. The decision to exercise is made at
the beginning of the quarter, but the payoff occurs, as it does with interest rate options, at the end of the quarter.
If LIBOR is greater than 3%, the firm will exercise the option and receive a sum to help offset the higher interest
rate on the loan. Table 8.1 shows the payments associated with this interest rate cap.1
1
To simplify the calculations in all examples in this chapter, it is assumed that each three-month period has 90 days.

EXAMPLE 8.1 | HEDGING USING AN INTEREST RATE CAP

Table 8.1 | Schedule of Payments for Interest Rate Cap
Days in Interest Cap Principal Net Net Cash Flow

Date Quarter LIBOR Due Payment Repayment Cash Flow Without Cap
1/1 – 3.00% – –$700,000 $0 $249,300,000 $250,000,000
4/1 90 3.50 $1,875,000 $0 $0 –$1,875,000 –$1,875,000
7/1 90 4.25 $2,187,500 $312,500 $0 –$1,875,000 –$2,187,500
10/1 90 4.00 $2,656,250 $781,250 $0 –$1,875,000 –$2,656,250
1/1 90 – $2,500,000 $625,000 $250,000,000 –$251,875,000 –$252,500,000
For the first quarter, the firm will pay 3% based on LIBOR on January 1. Therefore, on April 1, it will owe
$1,875,000 based on 90 days from January 1 to April 1, which is calculated as follows:
$250,000,000 × (0.03) × (90/360) = $1,875,000
By April 1, LIBOR had risen to 3.50%. Because this is greater than 3%, the cap will pay off at the next interest
payment date and the holder of the cap (the firm) will receive a payment as follows:
$250,000,000 (0.035 – 0.03) (90/360) = $312,500
This amount will help offset the interest of $2,187,500, based on a rate of 3.50% for 90 days from April 1 to
July 1. LIBOR on July 1 is 4.25%, so that the cap will pay off on October 1. The net effect of these cash flows is
shown in the next-to-the-last column of Table 8.1.
On January 1, the firm received $250,000,000 from the lender and paid a premium of $700,000, or 0.28%,
for the cap, for a net cash flow of $249,300,000. It made periodic payments as shown and, on the following
January 1, repaid the principal and made the final interest payment minus the cap payoff. The effective rate that
the company actually paid can easily be calculated as 3.33%.2 The last column of the table shows what the cash
flows would have been if the company had not purchased the cap. Without the cap, the company would have
effectively have paid the rate of 3.73%. The company saved 40 basis points because interest rates over the life of
the loan were higher than they were at the time the loan was initiated.
INTEREST RATE FLOORS

An interest rate floor is a multi-period interest rate option identical to a cap, except that the floor writer pays the
floor purchaser when the reference rate drops below the contract rate, which is called the floor rate. In other words,
an interest rate floor is a series of interest rate puts designed to protect the return on a loan with multiple interest
payments. These options are useful for lenders who want protection against falling interest rates.
THE CHARACTERISTICS OF AN INTEREST RATE FLOOR

In the case of floors, the dealer will pay the customer a cash sum based on a settlement formula whenever the
reference rate falls below the floor rate. The cash settlement formula, which is repeated on each settlement date,
is as follows:
(Floor rate – Market rate) x Principal x (Days to maturity/360)
2
See Appendix 8A for a discussion of how this rate was calculated.

Example 8.2 illustrates a case involving an interest rate floor.
EXAMPLE 8.2 | HEDGING USING AN INTEREST RATE FLOOR

A bank makes a one-year, $150,000,000 loan, with payments made at LIBOR on March 1, June 1, September 1,
and the following December 1. It is currently December 1, LIBOR is 3.50%, and the floor rate specified in the
contract is 3%. The bank is concerned that rates will fall, so it buys an interest rate floor to compensate it if rates
fall under the floor rate. The cost of the floor to the bank is $280,000, which must be paid up front.
On March 1, the bank will receive $1,312,500 in interest, calculated as follows:
$150,000,000 × [0.0350 (90/360)] = $1,312,500
The new rate on that date is 2.75%. Therefore, the floor is in the money and, on the next interest payment day,
will pay off as follows:
$150,000,000 (0.03 – 0.0275)(90/360) = $93,750
This amount will add to the interest payment of $1,031,250, which is lower because of the fall in interest rates.
The results are shown in Table 8.2. The floor is in the money and is therefore exercised on each of the last three
interest payment dates.
The lender paid out $150,000,000 up front to the borrower and another $280,000 for the floor. The periodic
payments associated with the floored loan are shown in the next-to-the-last column of Table 8.2. From these
cash flows, we can calculate the interest rate made by the bank at 2.97%. The last column shows the cash flows
as if the floor had not been used. The annualized return in this case would have been 2.72%. In other words, the
floor boosted the bank’s returns by 25 basis points. Of course, in a period of rising interest rates, the bank would
have gained less from the increase in interest rates.
Table 8.2 | Schedule of Payments for Interest Rate Floor
Days in Interest Floor Principal Net Net Cash Flow

Date Quarter LIBOR Due Payment Repayment Cash Flow Without Floor
12/1 – 3.50% – –$280,000 $0 –$150,280,000 –$150,000,000
3/1 90 2.75 $1,312,500 $0 $0 $1,312,500 $1,312,500
6/1 90 2.25 $1,031,250 $93,750 $0 $1,125,000 $1,031,250
9/1 90 2.25 $843,750 $281,250 $0 $1,125,000 $843,750
12/1 90 – $843,750 $281,250 $150,000,000 $1,125,000 $150,843,750
INTEREST RATE COLLARS

An interest rate collar is a combination of a cap and a floor in which the purchaser of the collar buys a cap and
simultaneously sells a floor. Collars can be constructed from two separate transactions, one involving a cap and
another involving a floor, or they can be combined into a single transaction. A collar has the effect of locking the
collar purchaser into a floating rate of interest that is bounded on both the high side and the low side. Example 8.3
details a case involving an interest rate collar.

EXAMPLE 8.3 | HEDGING USING AN INTEREST RATE COLLAR

A firm holds fixed-rate assets yielding 5%. These assets are funded with floating-rate liabilities tied to the prime
rate. The current rate on these liabilities is 3%, and the firm wants to cap the cost at 4.50%. The cap dealer wants
an up-front premium, which translates into an effective annual percentage cost of 0.25% for the cap. The firm
feels that this is too high a price to pay. However, the firm discovers that it can sell a floor with a reference rate
of 2% for a premium equivalent to an effective annual percentage of 0.20%. Because the firm is the seller of the
floor, it receives the premium.
In this case, the firm has purchased a collar. From the firm’s perspective, its annual costs are now bounded
between 2% and 4.50%. Because its interest revenue exceeds its interest cost, it has locked in a source of net
revenue for the firm, although the amount of the revenue can vary within the bounds dictated by the collar.
When the prime rate rises above 4.50%, the dealer pays the firm the difference. When the prime falls below 2%,
the firm pays the dealer the difference.
By entering a collar, the firm is able to place an interest rate cap on its floating-rate liabilities, while
simultaneously reducing the cost of the cap with the premium received from the sale of the floor. The cost to
the firm is the payouts that it must make to the floor dealer if the reference rate falls below the floor rate. The
potential payout by the firm in a low-rate environment is often of less concern than its uncapped payouts in a
high-rate environment and, consequently, the collar is considered an attractive way to cap floating-rate debt.
EXOTIC OPTIONS
Any option that is not traded on an exchange and is not essentially identical to one traded on an exchange is
referred to as an exotic option. What distinguishes these from the options already discussed is that they offer
different types of payoffs. However, like exchange-traded options, the final payoffs at expiration on exotic options
are determined by whether a value exceeds or is lower than an exercise price. Some of these options are discussed
briefly below.
COMPOUND OPTIONS
Compound options are options on options. An option on a cap, for example, is an option on an option that is
referred to as a caption. Why do we need an option on an option? Because sometimes a firm wants to lock in the
right to interest risk protection, but it is not sure that it will need the protection, or the firm may feel that a better
alternative may become available if it waits. Example 8.4 illustrates a case involving a compound option.
EXAMPLE 8.4 | COMPOUND OPTION

A firm is considering a seven-year floating-rate financing. The company’s board may be concerned about the
firm’s exposure on a floating-rate financing, and so the firm will need an interest rate cap. The dealer suggests
a 5% interest rate cap currently available with an up-front premium of 2.25%. The board will decide on this in
two weeks, but by that time, the cost of the cap may have gone up. To deal with this risk, the dealer suggests an
option on the cap that is good for three weeks. For this option, the company agrees to pay a premium of 0.15%.
If the board approves the funding proposal, the company will notify the dealer that the option will be exercised.
The dealer then commits to a cap on the original terms – that is, an up-front fee of 2.25%. If the board rejects the
funding plan, the option will be allowed to expire.
A standard operating lease can also be considered as a compound option. The lessee and the lessor enter a lease
agreement allowing the lessee to use the lessor’s assets. The lessor cannot recoup the asset before the end of the
lease agreement unless the lessee fails to make the required lease payments on time. Therefore, with each lease
payment, the lessee is exercising an option to acquire another option, namely whether or not to make the next
lease payment.

Compound options are useful to investors who think they might need an option in the future and want to establish
a price at which the option can be bought or sold.
ASIAN OPTIONS
An Asian option, sometimes called an average price option, is an option whose payoffs are based on the average
stock price over time until expiration. There are both call and put Asian options, with values at expiration
determined as they are with regular stock options. The only difference is that the stock price at expiration in an
Asian option is an average stock price.
Asian options are useful when an investor wants to hedge against the average level of an asset’s value. For example,
if a firm grants stock options to employees and executives over a long period, it might be more economical to hedge
against the average value of those options. Some firms use Asian options on a currency to hedge the average level of
their foreign sales.
Asian options are nearly always cheaper than conventional options because the averaging process smooths out the
underlying price movements, thereby reducing volatility and, hence, the premium of the option.
BARRIER OPTIONS
Barrier options are the largest and most actively traded group of exotic options. The two main types are knock-in
barrier options and knock-out barrier options.
A knock-in barrier option is activated (“knocked-in”) and becomes capable of being exercised only if the underlying
reaches a pre-set barrier (i.e., a trigger price) before or on the expiry date. If the barrier is not reached, no standard
call or put is created. In contrast, a knock-out barrier option has the rights of a conventional option until the price of
the underlying reaches a pre-set barrier price, in which case it ceases to exist and expires (“knocked-out”).
These two types of barrier options fall into further groups:
• Up-and-ins and down-and-ins, for knock-in barrier options
• Up-and-outs and down-and-outs, for knock-out barrier options
Up-and-in barrier options are activated by upward movements through the barrier price. Down-and-in barrier
options are activated by downward movements through the barrier price. Up-and-out barrier options are
deactivated by upward movements through the barrier price. Down-and-out barrier options are deactivated by
downward movements through the barrier price.
Example 8.5 illustrates a situation involving a barrier option.
EXAMPLE 8.5 | BARRIER OPTION

An investor who buys a stock at $50 may want protection against price declines only if the path of the stock
never crosses $60. If the price does cross $60, then no downside protection is deemed necessary. Rather than
buying an ordinary put option, the investor may choose to buy an up-and-out put with a barrier of $60.
MULTI-ASSET OPTIONS
Multi-asset options consist of a family of options whose payoffs depend on the prices of more than one asset.
A best-of option is a type of multi-asset option. This option pays the holder a return based on the price change
achieved by the best performing of two or more underlying assets. Example 8.6 details a situation involving a
multi-asset option.

EXAMPLE 8.6 | MULTI-ASSET OPTIONS

An investor buys a best-of option on two equity indices and receives the returns from the better-performing
of the two.
SHOUT OPTIONS
Shout options permit the holder, at any time during the life of the option, to establish a minimum payoff that will
occur at expiration. Example 8.7 illustrates a situation involving shout options.
EXAMPLE 8.7 | SHOUT OPTIONS

An investor buys a shout call option on the British pound with an exercise price of $1.54. Assume that at some
point the exchange rate is $1.60, and the investor decides to shout. The holder is guaranteed to receive $1.60
minus $1.54 times the multiplier of the contract at the expiration date. In addition, the holder is still long in what
now is an ordinary call option with an exercise price of $1.60.
CONCLUSION
In this section, you learned that option trading on organized exchanges began in 1973, with the introduction of
options on individual stocks. Since that time, option markets have expanded greatly, with options on stock indexes,
foreign currencies, interest rates, and futures contracts now available.
There are two basic types of options, which can both be bought or sold. Ownership of a call option confers the
right to buy a given asset at a specified price for a specified period. To gain that right, option holders (i.e., buyers)
pay a price, known as the premium, to option writers (i.e., sellers). If called upon to do so, call writers must sell the
asset to the option holder. Ownership of a put option permits the sale of an asset at a specified price for a specified
period. The put holder pays a premium to the writer for this right. The writer is obligated to buy the asset at the
exercise price if called upon to do so.
The theory of option pricing is well developed. Option prices are a function of the underlying asset price, the
exercise price of the option, the time to expiration, the volatility of the underlying asset, the risk-free interest rate,
and the yield of the underlying asset.
Options are used for both speculation and hedging. For example, an investor expecting a stock price to increase can
attempt to profit by buying a call option or selling a put option on that stock.
By speculating with options, it is possible to achieve more leverage than by merely trading the stock itself. However,
an option’s increased leverage can have either positive or negative consequences. If their price expectations are
realized by the expiration date, investors can profit, but otherwise, they can lose all of their investment.
The options market is a zero-sum game; for every winner, there is a loser.
Options are also useful for controlling risk. A careful combination of options and positions in the underlying asset
can provide virtually any degree of risk desired. Further, combinations of options themselves widen the range of
payoff possibilities available to the investor.
Market participants have several tools available to them with which to achieve financial goals. Options give
speculators a method of profiting from favourable price moves in an underlying asset. Forward-based derivatives do
the same, but because they represent obligations, they carry a much higher risk. Options have limited risk because
they represent rights to their holders, rather than obligations. For this limited risk combined with the potential for
unlimited return, option holders must pay a premium. The decision to use a forward-based or option-based product
should depend on the investor’s market view and risk tolerance.

Options allow hedgers to protect themselves from adverse price changes in an underlying asset. Forwards do the
same, but they provide no avenue for windfall gains. Forwards allow hedgers to lock in a future purchase or sale
price, whereas options allow hedgers to lock in a maximum purchase price or a minimum selling price. Again, for
this flexibility, option holders must pay a price.
If a market participant decides to use options, there are multiple ways and a number of different instruments that
can be used. A corporate treasurer looking to hedge against possible interest rate increases could buy puts or sell
calls on interest rate futures contracts. As well, if appropriate, the treasurer could consider the use of an OTC option
such as an interest rate cap.

CHAPTER 8 | OVER-THE-COUNTER OPTIONS 8 • 11
APPENDIX 8A
FOR INFORMATION ONLY
The internal rate of return (IRR) on an asset is the interest rate that will make the present value of the cash flows
from the asset equal to the price (or present value) of that asset. Specifically, the IRR is determined by solving for
the variable in the following equation:
CF1 CF2 CF3 CFn
PV = 1
+ 2
+ 3
+ ... + n
(l + i ) (l + i ) (l + i ) (l + i )
Where:
PV = Present value or price paid for the asset
CF = Cash flow in periods 1 to n
n = Number of time periods
The annualized return is then calculated by compounding the IRR to convert from a periodic rate of return to an
annualized rate of return. It is calculated as follows:
m
r = (1 + i ) − 1
Where:
r = Annualized rate of return
i = Internal rate of return (i from above calculation)
m = Number of compounding periods in one year
Using a financial calculator and the cash flows that appear in the Net Cash Flow column in Table 8.1, the IRR is
calculated as follows:
1,875,000 1,875,000 1,875,000 251,875, 000
249,300,000 = + 2
+ 3
+ 4
1+ i (1 + i ) (1 + i ) (1 + i )
i = 0.82144% per quarter
Because the cash flows are quarterly, the annualized return is calculated as follows:
m
r = (1 + i ) − 1
4
= (1 + 0.0082144) − 1
= 3.33% per year

SECTION 4
SWAPS
11 Currency Swaps
12 Credit Swaps

Introduction to Swaps 9
CONTENT AREAS
Overview of the Swap Market
What Is a Swap?
Role of the Swap Dealer
History of Swaps
OTC Derivatives Market Reform
LEARNING OBJECTIVES
1 | Describe what a swap is and the market that it trades in.
2 | Explain why swaps are used.
3 | Differentiate between swaps and forward contracts.
4 | Explain the role of a swap dealer.
5 | Describe the four areas of focus of the OTC derivatives market reform.

KEY TERMS
commodity swap interest rate swap
credit default swap plain vanilla interest rate swap
credit derivatives swap
currency swap swap dealer
equity swap warehousing

CHAPTER 9 | INTRODUCTION TO SWAPS 9•3
OVERVIEW OF THE SWAP MARKET

Since the early 1980s, interest in products offered in the over-the-counter (OTC) derivatives markets has increased
dramatically. Once considered highly specialized and customizable to fulfill specific needs, these products have
become standardized and more common, with a growing number of dealers creating markets for these derivatives
by continually offering to buy and sell them. This increased liquidity, along with competition among the various
dealers, has made these products more appealing to firms that had previously been reluctant to use them.
Among the markets for the various derivative products, the swap market is the one that has evolved most
rapidly. Swaps are now used by financial corporations, industrial corporations, banks, insurance companies, world
organizations, and sovereign governments. They are used to reduce the cost of capital, exploit economies of scale,
manage risks, arbitrage the world’s capital markets, and enter new markets. They are also used to create synthetic
instruments, which are financial instruments, or portfolios of financial instruments, that have cash flows or profit/
loss characteristics that are identical to those of another financial instrument or portfolio.
WHAT IS A SWAP?
A swap is a particular type of OTC forward contract. As we discussed in Section II, a standard forward contract
involves delivery and payment of a particular asset at an upfront, agreed-upon price at a predetermined time in
the future. If the contract trades on an exchange, it is referred to as a futures contract; if it trades OTC, it is called a
forward agreement.
We also discussed the fact that some forwards are cash settled. In other words, rather than an exchange of a
physical asset for payment, all that occurs at expiration is that the losing party makes a payment to the winning
party based on the difference between the upfront, agreed-upon price and the current market price of the asset on
which the contract is based.
Most swaps are merely cash-settled forward agreements, but with a few slight twists.
First, rather than one payment date, as with a standard forward agreement, a swap has a series of predetermined
payment dates. In this sense, swaps can be thought of as a series of forward agreements.
Second, while most swaps involve a payment from loser to winner on the payment date or dates, the method of
calculating the net swap payment is more complicated than it is with regular forward agreements. We will explain
this method shortly.
The most common type of swap is the interest rate swap, which involves an exchange of cash flows between
counterparties on a series of dates that are determined when the agreement is initiated. The most basic type of
interest rate swap is referred to as a plain vanilla interest rate swap. With this type of swap, one party agrees to
pay to the other party cash flows equal to interest calculated at a predetermined, fixed rate on a certain principal
amount. In exchange, the other party agrees to pay interest calculated at a floating rate on the same principal
amount.
One reason to enter into an interest rate swap agreement is out of concern that the floating interest rate may
rise. A participant with a floating-rate loan who wants to convert it to a fixed-rate loan can do so by finding a
counterparty with the opposite outlook – in other words, a person who expects that rates may decline and wants
to change a fixed-rate loan into a floating-rate loan. By swapping their respective payments, the counterparties, in
effect, change their respective loans from floating to fixed and from fixed to floating. Figure 9.1 illustrates a simple
plain vanilla interest rate swap.

Figure 9.1 | Plain Vanilla Interest Rate Swap
Floating-Rate Payments
Counterparty A Counterparty B
Fixed-Rate Payments
Figure 9.1 shows cash flows being swapped, but in reality what is being exchanged is the net difference between
the fixed-rate and floating-rate cash flows. Because the floating rate changes with fluctuations in market rates
throughout the life of the swap, the net amount exchanged between the two parties also changes. If market rates
rise, the party contracted to pay the floating rate will be the loser and will have to make increased net payments to
the party contracted to make the fixed payment, who is the winner. This is exactly what happens in a normal, cash-
settled forward agreement. The losing party makes payments to the winning party based on the difference between
current prices and the initial price. Interest rate swaps are covered in detail in Chapter 10.
Another popular type of swap is a currency swap, which is similar to an interest rate swap but with a few
differences. First, the counterparties exchange cash flows that are denominated in different currencies. Second, in
addition to the exchange of fixed-for floating-rate payments, currency swaps can be designed so that two fixed-rate
or two floating-rate payments are exchanged. Finally, currency swaps often involve the exchange of principal at the
contract’s onset, and then a return of the principal at maturity. Interest rate swaps do not involve an exchange of
principal, just net cash flows. Currency swaps are explained in detail in Chapter 11.
The fastest-growing type of swap in the marketplace is the credit default swap, which is a type of credit derivative.
Credit derivatives are financial instruments that derive their value from an underlying credit asset or pool of credit
assets, such as bonds or mortgages. They are designed to transfer and manage credit risk. A credit default swap
(CDS) is the exchange of two cash flows, a fee payment and a conditional payment, which occurs only if certain
circumstances are met. A CDS is credit insurance that transfers the credit risk of fixed-income securities from one
party to another. The CDS buyer receives protection, and the CDS seller guarantees payment if negative credit
events occur. The cash flow and payment mechanics are the same as the plain vanilla interest rate swap, except that
payment from the credit swap seller is contingent on a credit event happening. Credit default swaps are explained in
detail in Chapter 12.
Other types of swaps covered in this section are equity swaps and commodity swaps. Both of these swaps are
discussed in detail in Chapter 13.
ROLE OF THE SWAP DEALER

Without a financial intermediary, it would be extremely difficult for two counterparties to find each other and
design a product to satisfy their objectives. The role of the swap dealer is to facilitate the process by finding and
bringing together the two sides and tailoring a product to meet the specific needs of each. The dealer acts as a
counterparty for each of the two end users and enters into separate agreements with each one. For the services
provided, the dealer charges a fee, which usually takes the form of a bid-ask spread on the fixed periodic payments.
Figure 9.2 depicts a plain vanilla interest rate swap engineered with the help of a dealer. For both end users, the
counterparty to the swap is the dealer, who earns a spread for designing the swap and matching up the two end
users. For example, if Party A pays a fixed rate of 4% to the dealer in exchange for a floating-rate payment, the
dealer will then pay a fixed rate of 3.8% to Party B. The dealer thereby earns a spread of 0.2%.

Figure 9.2 | Plain Vanilla Interest Rate Swap Arranged by a Swap Dealer
LIBOR LIBOR
Counterparty A Swap Dealer Counterparty B
4% 3.8%
In practice, a swap dealer would rarely enter into agreements with both counterparties concurrently. In fact, once
the dealer gets into an agreement with Party A, it may take some time to find and arrange an offsetting agreement
with Party B. In such cases, the dealer has to warehouse the swap and hedge its interest rate exposure until a
suitable counterparty can be found.
HISTORY OF SWAPS
The first currency swap occurred in 1979 and was engineered in London, England. During the next couple of years,
the market remained small. It was mainly a brokered market, with financial institutions finding and serving clients
with opposite needs. For example, a party that wished to convert a fixed-rate to a floating-rate obligation could
employ a swap dealer to attain its goal. In the process, the dealer would find a counterparty that wished to convert
a floating-rate into a fixed-rate obligation and would bring the two interested parties together. The broker would
earn a fee for this service.
What really boosted the market was a landmark currency swap between IBM and the World Bank in 1981. After
that, the swap market grew dramatically. It was a short time before interest rate swaps appeared and started
gaining in popularity, particularly in the United States, where the products were quickly adopted by major U.S.
firms. Understanding the potential, brokers began to assume the role of dealers by making the market and taking
one side of the swap. They would quote a bid rate and an ask rate, and they would earn a profit on the spread. The
swap brokers would be exposed to some risk, but it could be hedged in the futures and options or Treasury securities
market. The result was a tremendous increase in market liquidity and a standardization of many of the products
offered. In the 1990s, OTC derivatives on fixed-income securities accelerated with the creation of CDSs, which
are primarily responsible for the current explosive growth in credit derivatives and the global derivatives market in
general.
In 1984, commercial and investment banks initiated work on standardizing swap documentation. In 1985, this
group of leading dealers formed the International Swaps and Derivatives Association (ISDA) and published the
first standardized swap code. The code was revised in 1986 and again in 1987 when the publication of standard
form agreements took place. The first edition of the ISDA Master Agreement was published in 1992. A second
edition, published in 2002, is still the current version in use today. Standardization of the necessary documentation
drastically reduced the cost and the time requirements of engineering a swap. The notional principal of interest and
currency swaps grew from about $5 billion in 1982 to more than $344 trillion by the end of 2017.
OTC DERIVATIVES MARKET REFORM

Following the U.S. sub-prime crisis and the far-reaching credit meltdown of 2007-2008, regulators and market
observers from around the world unanimously agreed that segments of the OTC derivatives market (including
swaps) played a role in the widespread and rapid rise of counterparty and liquidity risks during the crisis. The
difficulty in quickly and correctly assessing the risks associated with large and concentrated derivative positions in
the hands of a few systemically relevant and interconnected financial institutions created significant financial stress
and market disruptions.

The financial crisis impelled finance ministers and central bank governors of the Group of Twenty (G20) countries
to propose reforms to the OTC derivatives market. In the following extract from the statement issued following the
2009 G20 meeting in Pittsburgh, the G20 leaders broke down their plan of action for “improving over-the-counter
derivatives markets” as follows:
“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where
appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts
should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital
requirements. We ask the FSB and its relevant members to assess regularly implementation and whether it is
sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market
abuse.” 1
Table 9.1 summarizes the four areas of focus of international regulatory reforms recommended by the G20 leaders,
all of which are in various stages of development in each of the G20 nations.
Table 9.1 | Outline of the OTC Derivatives Market Reform
1. All standardized OTC derivative contracts In addition to the ongoing industry effort to increase the degree of
should be traded on exchanges or standardization in OTC derivatives contracts, domestic authorities
electronic trading platforms, where are in the midst of finalizing regulations mandating the migration
appropriate. of standardized OTC derivatives transactions to electronic trading
platforms.
2. All standardized OTC derivative contracts The original deadline (2012) proved to be too challenging to
should be cleared through central meet for most countries; however, financial institutions involved
counterparties. in derivatives trading are currently getting access to domestic
or global central counterparties. As of June 2017, 11 of the 24
Financial Stability Board (FSB) jurisdictions have central clearing
requirements in place.*
3. All OTC derivative contracts should be The ongoing development of trade repositories to which market
reported to trade repositories. participants will have appropriate accesses is a key element in the
increased transparency sought by the OTC market reforms. As of
June 2017, 19 of the 24 FSB jurisdictions have comprehensive trade
reporting requirements in place.
4. Non-centrally cleared derivative (NCCD) For all non-centrally cleared derivatives contracts, counterparty
contracts should be subject to higher risk management best practices will require higher capital
capital requirements. requirements. Most jurisdictions have set higher capital
requirements for NCCDs.
* Financial Stability Board – OTC Derivatives Market Reform: Twelfth Progress Report on Implementation
http://www.fsb.org/2017/06/otc-derivatives-market-reforms-twelfth-progress-report-on-implementation/
The objective of the FSB, referred to in the 2009 G20 statement extract, is “to coordinate at the international level
the work of national financial authorities”. As an international body set up at the initiative of the G20, one of its
mandates is to issue semi-annual progress reports on the implementation of market reforms in OTC derivatives.
In Canada, the Canadian Securities Administrators and the Canadian OTC Derivatives Working Group are working
towards the implementation of the recommendations of the G20. The Canadian OTC Derivatives Working
Group is an interagency group chaired by the Bank of Canada and composed of members from the Office of
1
G20 Leaders’ Statement – September 25, 2009 (Pittsburgh, Pennsylvania) –
http://www.osfi-bsif.gc.ca/Eng/fi-if/rg-ro/gdn-ort/gl-ld/Pages/b7_gias.aspx

the Superintendent of Financial Institutions (OSFI), the federal Department of Finance, the Ontario Securities
Commission, the Autorité des marchés financiers, and the Alberta Securities Commission.
The Working Group released a key discussion paper2 in 2010 that sets out its preliminary recommendations for
implementing Canada’s G20 commitments. During this period of transition, Canadian market participants will be
invited to comment on additional discussion papers issued by the various provincial regulators.
CANADIAN IMPLEMENTATION OF OTC DERIVATIVES TRADE REPORTING

On November 14, 2013, as the first implementation phase of the OTC derivatives market reform in Canada, the
Ontario Securities Commission (OSC), Manitoba Securities Commission (MSC) and Autorité des marchés financiers
(AMF) published harmonized versions of two rules:
Rule 91-506 Rule 91-506 on Product Determination defines the types of OTC derivatives subject to reporting
requirements.
Rule 91-507 Rule 91-507 on Trade Repositories and Derivatives Data Reporting describes the reporting
obligations of counterparties transacting in reportable OTC derivatives.
The harmonized reporting rules have been adopted by the other Canadian provinces.
WHO MUST REPORT OTC DERIVATIVES TRADE DATA

Under Rule 91-507, OTC derivatives transactions involving a “local counterparty” must be reported to a designated
trade repository, an entity mandated to collect and store OTC derivatives trade information. A counterparty is
considered a local counterparty in a Canadian jurisdiction if, at the time of the transaction, one or more of the
following circumstances apply:
a. The counterparty is a person or company, other than an individual, organized under the laws of the jurisdiction.
b. The counterparty is a person or company, other than an individual, that has its head office or principal place of
business in the jurisdiction.
c. The counterparty is an affiliate of a person or company described in paragraphs (a) or (b), and such person or
company is responsible for the liabilities of that affiliated party.
d. The counterparty is registered in the jurisdiction as a derivatives dealer or in an alternative category as a
consequence of trading in derivatives.
Part 3 of Rule 91-507 prescribes the following hierarchy of reporting responsibilities for reportable transactions
involving one or two local counterparties:
1. For a transaction cleared through a clearing agency, the clearing agency is the sole reporting counterparty.
2. Otherwise, if a transaction is between two derivatives dealers, each derivatives dealer must act as a reporting
counterparty.
3. Otherwise, if the transaction is between a derivatives dealer and a counterparty that is not a derivatives dealer,
the derivatives dealer is the sole reporting counterparty.
4. In any other case, each local counterparty to the transaction must act as a reporting counterparty.
2
Reform of Over-the-Counter (OTC) Derivatives Markets in Canada: Discussion Paper from the Canadian OTC Derivatives Working Group is
available on the Bank of Canada website.

WHAT TRADE DATA MUST BE REPORTED

A reporting party must report the following items to a designated trade repository:
• Three unique identifiers:
The legal entity identifier of each counterparty (LEI)3
A unique transaction identifier (UTI)
A unique product identifier (UPI)
• Creation data:
Including data about the type of transaction, the underlying reference, notional amounts, price, execution,
and termination dates
Reportable in “real-time” or as soon as technologically practicable
• Continuation or life cycle data:

Including data necessary to fully report any event that would result in a change to previously reported data
Reportable on the day the life cycle event occurs, but no later than end of T+1 business day
• Valuation data, including mark-to-market values, collateral, and margin values; derivatives dealers or clearing
agencies report daily; non-dealers report quarterly
3
The Legal Entity Identifier (LEI) is a 20-character code used to identify entities that enter into OTC derivatives. It is an initiative endorsed by
the G20 and administered by the Global LEI System. Each entity may only receive one LEI and this identifier must be used for all derivatives
reporting in each jurisdiction where the LEI is required.

Interest Rate Swaps 10
CONTENT AREAS
Plain Vanilla Interest Rate Swap
A Note on Rate and Day Count Conventions
The Structure of an Interest Rate Swap
Pricing an Interest Rate Swap
Indication Pricing Schedule
Credit Risk
Terminating an Interest Rate Swap
Why are Interest Rate Swaps Used?
Deliverable Interest Rate Swap Futures and Centrally Cleared Swaps
Other Types of Interest Rate Swaps
Swaptions
LEARNING OBJECTIVES
1 | Demonstrate how an interest rate swap works, including how it is priced.
2 | Describe the basic features of deliverable interest rate swap futures.
3 | Differentiate between plain vanilla and other types of interest rate swaps.
4 | Describe the key features of payer and receiver swaptions.

KEY TERMS
amortizing swap credit risk
arrears swap index swap
basis swap indication pricing schedule
bilateral netting payer swaption
collateral quanto swap
comparative advantage receiver swaption
credit enhancements triggering events

CHAPTER 10 | INTEREST RATE SWAPS 10 • 3
PLAIN VANILLA INTEREST RATE SWAP

The most common type of swap is the plain vanilla interest rate swap, which involves two counterparties. Under
this agreement, counterparty A agrees to pay counterparty B periodic cash flows equal to interest, calculated at
a predetermined fixed rate, on a notional principal throughout the life of the swap. In exchange, counterparty B
agrees to pay interest, calculated at a floating rate, on the same notional principal to counterparty A.
A NOTE ON RATE AND DAY COUNT CONVENTIONS

Despite the fact that the swap market is global, its geographical centre is, by size and tradition, in London. Therefore,
rates quoted by London banks are used as the benchmark in determining the rate for the floating side of the swap.
For example, the floating-rate side in a swap agreement has been tied historically to the London Interbank Offered
Rate (LIBOR). LIBOR is the average rate of interest charged on interbank loans of Eurocurrency deposits. Often,
interbank interest rate indexes exist in each of the world’s major financial centres, including PIBOR in Paris, SIBOR in
Singapore, and so forth.
LIBOR quotes cover terms of various sizes, including one-month deposits (1-month LIBOR), three-month deposits
(3-month LIBOR), six-month deposits (6-month LIBOR), and one-year deposits (1-year LIBOR). The most common
interest rate swap involves an exchange of 6-month LIBOR for a fixed rate of interest tied to the U.S. Treasury note
rate. One point to note is that the 6-month LIBOR is quoted with semi-annual compounding on the basis of a
360-day year, whereas the Treasury note rate is quoted with semi-annual compounding on the basis of a 365-day
year. For that reason, although the two rates may be quoted at the same nominal value, the annual effective rates
corresponding to each method will be different. For the remainder of Section IV, assume that this adjustment has
been made and that rates are directly comparable. Also, for the remainder of this section, all rates are quoted on a
per-annum basis and compounded semi-annually.
THE STRUCTURE OF AN INTEREST RATE SWAP

Often, the party wanting to change a floating-rate loan to a fixed-rate loan does so based on an expectation that
rates will rise. However, another reason often cited for interest rate swaps is comparative advantage. It is crucial
for you to understand that comparative advantage is relative to absolute rate advantage differentials.
In this chapter, we explain the structure of an interest rate swap in the context of Example 10.1.
EXAMPLE 10.1 | THE STRUCTURE OF AN INTEREST RATE SWAP

Two firms, A and B, each wish to borrow $10 million for two years. After searching the market, Firm A discovers
that it can borrow at a fixed rate of 2.5% or a floating rate of 6-month LIBOR + 0.5%. At the same time, Firm B is
quoted a fixed rate of 3.5% or a floating rate of 6-month LIBOR + 1.0%. Firm A is quoted the lower rates because
it has a better credit rating.
As a result, Firm A benefits from reduced capital costs. In both the floating-rate and fixed-rate markets, Firm A
has an absolute borrowing cost advantage over Firm B; however, the rate differentials are not the same in each
market. Compared to Firm B, Firm A has a 1% rate advantage in the fixed-rate market but a lesser 0.5% rate
advantage in the floating-rate market. This superior 1% rate differential creates a comparative advantage for
Firm A to borrow in the fixed-rate market. Note that the lower credit rating of Firm B costs the firm a differential
of only 0.5% in the floating-rate market, which creates a comparative advantage for Firm B to borrow in this
market.

EXAMPLE 10.1 | THE STRUCTURE OF AN INTEREST RATE SWAP

However, these comparative advantages may not be for the type of financing desired. Firm A wants to borrow
at a floating rate and firm B at a fixed rate. In this case, each firm should borrow where it has the comparative
advantage and then transact with a swap dealer to arrange a swap. An interest rate swap agreement allows the
parties to borrow in the market where each has a comparative advantage and then convert to the method of
financing each initially wanted. If the comparative advantages did not exist, a swap that would benefit both firms
could not be designed.
In this case, Firm A agrees with the swap dealer to make payments equal to 6-month LIBOR and receive
payments from the swap dealer equal to 2.2% (on a notional principal of $10 million). This is Firm A’s swap.
Firm B agrees with the swap dealer to make payments equal to 2.3% and receive payments of 6-month LIBOR
(on a notional principal of $10 million). This is Firm B’s swap.
Figure 10.1 summarizes the swap described in Example 10.1.

Figure 10.1 | Structure of an Interest Rate Swap
6-month 6-month
LIBOR LIBOR
Firm A Swap Dealer Firm B
2.2% 2.3%
6-month LIBOR
2.5% +1.0%
(to original lenders) (to original lenders)
The net payment that each firm makes is calculated below.
Firm A
Pays 2.5% (for loan)
Receives 2.2% (from swap with swap dealer)
Pays 6-month LIBOR (from swap with swap dealer)
Total 6-month LIBOR + 0.3%
Firm A is effectively paying 6-month LIBOR + 0.3%, which is better than the 6-month LIBOR + 0.5% rate it had
been quoted in the floating-rate market.
Firm B
Pays 6-month LIBOR + 1.0% (for loan)
Receives 6-month LIBOR (from swap with swap dealer)
Pays 2.3% (from swap with swap dealer)
Total 3.3%
Firm B is effectively paying 3.3%, which is better than the 3.5% rate it had been quoted in the fixed-rate market.

Swap dealer
Pays LIBOR
Receives LIBOR
Pays 2.2%
Receives 2.3%
Total 0.1%
The swap dealer is making a profit of 0.1% per year on a $10 million notional principal.
The total gain to all parties involved is as follows:
Firm A saves 0.2% over its own floating-rate borrowing cost.

Firm B saves 0.2% over its own fixed-rate borrowing cost.
Swap dealer makes 0.1%
Total gain 0.5%
This amount of total gain is determined by the difference in the absolute advantages (1.0% – 0.5%) resulting from
the rates the firms were initially quoted in the fixed-rate and floating-rate markets:
Firm B’s fixed - Firm A’s fixed = 3.5% - 2.5% = 1%

Firm B’s floating - Firm A’s floating = (LIBOR+1%) – (LIBOR+0.5%) = 0.5%
Difference 0.5%
Although it is indicated above that the parties exchange cash flows, in reality, it is only the net difference in the
value of the payments going each way that are paid. Tables 10.1 and 10.2 illustrate the cash flows for each firm,
based on a principal amount of $10 million, a maturity of two years, and changes in LIBOR, as indicated in the
tables. Payments take place every six months.
Table 10.1 | Settlement Cash Flows for Firm A, 2-Year Fixed-for-Floating-Rate Swap*
Period LIBOR Firm A Payment Swap Dealer Payment Net Payment**

1 2.0%
2 2.5% $100,000 $110,000 ($10,000)
3 2.8% $125,000 $110,000 $15,000
4 3.0% $140,000 $110,000 $30,000
5 $150,000 $110,000 $40,000
* A party entering a fixed-for-floating-rate swap with a swap dealer agrees to pay a floating rate and receive a fixed rate.
** Firm A net payment (receipt) to (from) Swap Dealer
The subsequent rise in interest rates over the two-year period results in higher payments for Firm A since its
decision was to swap its fixed-rate loan commitments for a floating-rate exposure.

Table 10.2 | Settlement Cash Flows for Firm B, 2-Year Floating for Fixed Rate Swap*
Period LIBOR Firm B Payment Swap Dealer Payment Net Payment**

1 2.0%
2 2.5% $115,000 $100,000 $15,000
3 2.8% $115,000 $125,000 ($10,000)
4 3.0% $115,000 $140,000 ($25,000)
5 $115,000 $150,000 ($35,000)
* A party entering a floating-for-fixed-rate swap with a swap dealer agrees to pay a fixed rate and receive a floating rate.
** Firm B net payment (receipt) to (from) Swap Dealer
The subsequent rise in interest rates over the two-year period results in net receipts to Firm B since its decision
was to swap its floating-rate exposure for a fixed-rate commitment. (Firm B is paying a fixed rate of 2.3% under
the swap agreement. As LIBOR rises above this, the net receipts from the swap effectively offset the higher coupon
payments on the original floating-rate debt.)
Note several items from Tables 10.1 and 10.2. First, the exchange of cash flows (or, more accurately, the net
payment) does not take place in the period the LIBOR rate is set; it takes place at the start of the next period.
Second, Example 10.1 assumes that each period covers one-half year. To more accurately calculate cash flows, the
total number of days of each half year should be divided by 365 to calculate the fixed-rate payment and 360 to
calculate the LIBOR payment. In other words, it would be slightly less than one-half. Third, consider the fact that
both parties still must make payments to their respective original lenders. Firm A must still pay 2.5%, while Firm B
must pay LIBOR plus 1%. Finally, a swap dealer enters into many swaps with firms wanting to make fixed-rate
payments and with firms wanting to make floating-rate payments. In reality, the dealer does not need to match
each opposite party directly. All of the dealer’s outstanding swaps (swap book) taken together should cancel out,
leaving a profit. If these do not cancel each other out, the dealer itself goes into the swap market to obtain the
necessary offsetting swaps.
As shown above, an interest rate swap is an ingenious way to obtain cheaper financing. However, large investors
without an initial loan to offset can also use swaps for speculative purposes. For example, a hedge fund forecasting
higher interest rates may enter a swap where it makes fixed-rate payments and receives floating-rate payments. If
interest rates do rise, the payments the fund makes stay the same, but the payments it receives increase.
PRICING AN INTEREST RATE SWAP

Earlier, we mentioned that swaps are just forward agreements with a series of payment dates. Another way of
looking at a swap is to view it as very similar to a bond.
In the absence of default risk, a position in an interest rate swap, where the counterparty pays interest at a floating
rate equal to LIBOR and receives interest at a fixed rate, is equivalent either of two positions in a bond:
• A long position that pays a coupon equal to the fixed rate in the swap agreement
• A short position in a bond with a floating coupon rate equal to LIBOR
The maturities of the two bonds are identical to the maturity of the swap.
Consider, again, the swap depicted in Figure 10.1. Every six months, the swap is arranged, and Firm A receives from
the swap dealer interest calculated on the notional principal of $10 million at a fixed rate of 2.2%. This position
is equivalent to Firm A having bought a bond issued by the swap dealer with a face value equal to $10 million,

maturity equal to the maturity of the swap, and a coupon rate equal to 2.2%. With the long position in this bond,
Firm A would be entitled to semi-annual coupon payments calculated at a rate of 2.2%, plus Firm A would receive
the principal of $10 million at the maturity of the bond.
At the same time, Firm A has to make interest payments every six months to the swap dealer on the notional
principal of $10 million at a floating rate equal to the six-month LIBOR. The rate is determined at the beginning of
each six-month period (at the time of the previous interest payment), and the interest is paid at the end of the six-
month period (when the rate for the subsequent six-month period is determined). This arrangement is equivalent
to Firm A having sold to the counterparty a bond with the following characteristics on which it has taken a short
position:
• Face value equal to the notional principal of $10 million
• Maturity equal to the maturity of the swap
• A floating coupon rate determined by LIBOR
Because the transfers of the principal from the long and short positions cancel each other out, the only real
exchange is the exchange of coupon payments.
It can easily be shown that Firm B’s position in the swap agreement is the opposite to Firm A’s. Firm B has a long
position in a bond paying a floating coupon rate determined by the six-month LIBOR, and a short position on a
bond paying a fixed coupon rate of 2.3%.
Because a swap can be broken down into a long position in one bond and a short position in another, the pricing
of a swap is equivalent to the pricing of the long and short positions in the two bonds. Thus, the value of a swap is
calculated as follows:
V = BL – BS
Where:
V = Value of the swap
BL = Value of the bond in the long position
BS = Value of the bond in the short position
Pricing of a swap involves choosing the coupon rate in the fixed-coupon bond in such a way that the value of the
fixed-coupon bond is equal to the value of the floating-rate bond. As a result, the value of the swap is zero at the
outset. During the life of the swap, its value can become positive or negative depending on the direction of the
change in LIBOR. If LIBOR rises, the swap will gain value for the party that pays fixed and receives floating. Of
course, the value of the swap to the floating-rate payer and fixed-rate receiver will decline.
INDICATION PRICING SCHEDULE

As shown in Example 10.1, dealers play a crucial role in the swap market. They no longer charge up-front fees in
today’s competitive market conditions. Rather, they net fixed rates, which are adjusted for the credit worthiness
of the end users. By convention, the fixed rate of a plain vanilla interest rate swap is typically based on a spread
over a Treasury yield. Pricing of a swap, then, is done by determining how large a spread over the Treasury yield is
appropriate. The riskier the end user, the larger the spread.
Swap dealers typically use what is known as an indication pricing schedule. This schedule is a list of rates provided
by the swap dealer that facilitates the swap. An example of such a schedule is provided in Table 10.3.

Table 10.3 | Indication Pricing Schedule for Interest Rate Swaps
Maturity (years) Dealer Pays Fixed Rate Dealer Receives Fixed Rate Current TN Rate (%)
2 2-yr. TN sa + 20 bps 2-yr. TN sa + 30 bps 1.73
TN sa = Treasury note compounded semi-annually

bps = basis points
This particular indication pricing schedule provides a summary of rates for swaps of maturities from two to eight
years. Notice the spread that exists between the situations where the dealer pays fixed rate and the dealer receives
fixed rate. For example, the spread in a two-year swap is 10 basis points, whereas it is 15 basis points in an eight-
year swap. The dealer’s profits from its involvement in a swap are the result of this spread. Rates in the schedule are
expressed as certain basis points above the prevailing Treasury note rate and are compounded semi-annually. Also
notice that the corresponding floating rate is not indicated and is assumed to be the six-month LIBOR. Rates quoted
in the indication pricing schedule are updated regularly as interest rates change.
The spread that the swap dealer charges is primarily based on two factors: the term structure of interest rates at
that time (i.e., higher spreads for longer maturities) and the creditworthiness of the end user.
CREDIT RISK
Credit risk is non-existent in exchange-traded derivatives because the clearinghouse guarantees the transaction.
However, it is very much a factor in OTC-traded derivative instruments. For a counterparty in a swap agreement,
credit risk stems from the possibility that the swap dealer may default. For the dealers, it stems from the possibility
that one of the counterparties may default. Market risk, on the other hand, stems from movements in market
variables such as interest rates and exchange rates and can be hedged by entering into offsetting contracts. Credit
risk cannot be hedged as easily and is therefore of major importance to counterparties and dealers alike.1
Consider the situation where Firm A enters into an agreement with a swap dealer whereby it receives fixed-rate and
pays floating-rate interest payments. At the outset, the value of the swap is zero and represents neither an asset nor
a liability for either party. However, as time passes, the swap’s value might become positive or negative, depending
on the movement of interest rates. If interest rates rise, the value of the swap becomes negative and represents a
liability for Firm A. Concurrently, the same swap has positive value and represents an asset for the dealer.
In a scenario like this, the dealer is concerned with credit risk. If the firm defaults, the dealer would lose the positive
value from its involvement in the agreement. Furthermore, for hedging purposes, the dealer likely maintains an
offsetting swap agreement with another counterparty that has a negative value and represents a liability. If Firm A
defaults, the dealer must find a third party willing to take its place to maintain its hedged position. Because Firm A’s
1 A burgeoning market for OTC credit derivatives has developed since the middle part of the 1990s and will be covered in Chapter 12. A
counterparty to an interest rate swap, for example, can enter into a credit derivative that has a payoff equal to the positive value of the swap,
if any, in the case of a default by the other counterparty.

position in the contract was of negative value, the dealer would have to pay an amount approximately equal to the
negative value of the swap to induce the third party to accept Firm A’s position. In a scenario where interest rates
decline, the swap has a positive value for the firm and a negative value for the dealer. In this case, it is the firm that
is concerned with the dealer’s likelihood of default. Notice that credit risk exposure exists only for the party with
a positive swap value. For example, if the dealer’s position in the swap has a negative value (and as a consequence
Firm A’s position in the same swap has positive value), the dealer is not concerned with the counterparty’s credit
risk. Theoretically, in this example, the dealer would get rid of a liability if Firm A were to default. In practice,
however, this is unlikely to happen; instead, Firm A would likely sell the positive-value contract it holds before
defaulting.
To date, the number of incidents of actual defaults is very small. One reasons for the small number is that it is very
difficult to qualify for a swap agreement. Furthermore, to control credit risk, interested parties usually limit the
maturity of the swaps they enter to less than 10 years. Many dealers also require credit enhancements from their
counterparties.
One form of credit enhancement is collateral, which would have to be pledged by the party for which the swap
has a negative value. Collateral pledged could be in the form of assets such as securities and real estate or a line
of credit provided by another financial institution. Its value should be at least equal to the size of the liability
stemming from the swap agreement. If the value of the swap changes from negative to positive, the collateral
would be released and the other counterparty (for which the swap now represents a liability) would, in turn, have
to post collateral. The swap contract could also make provisions for triggering events. In this case, collateral must
be posted or increased if a triggering event takes place that deteriorates the credit rating of the counterparty and
increases its likelihood of default. For example, a triggering event could be a downgrading of the counterparty’s
credit ratings, which are often provided by agencies such as Moody’s and Standard & Poor’s.
Another credit enhancement tool is known as bilateral netting, which involves consolidation of all swap
agreements between two counterparties. For example, assume a dealer has two swap agreements with a firm. The
first swap has a positive value to the dealer equal to $10 million, while the second swap has a negative value to the
dealer equal to –$9 million. Bilateral netting would suggest that if the firm defaults, it owes $1 million to the dealer.
Acceptability of netting in bankruptcy decisions is not clear yet. In the United States, bankruptcy laws have been
revised to allow for cases where bilateral netting clauses exist, but in other countries the process of recognizing such
provisions is still in its infancy.
TERMINATING AN INTEREST RATE SWAP

There are times when a party to an interest rate swap wishes to terminate the agreement before its maturity.
Because swaps are an OTC instrument and, they are not as easily liquidated as an exchange-traded instrument.
However, they can still be terminated by taking a position in an offsetting swap, by finding another party willing to
take over the payments, by paying off a counterparty, or by exercising a previously purchased option that allows
the holder to terminate. All of these choices, however, would likely entail costs, which the party must take into
consideration before terminating.
WHY ARE INTEREST RATE SWAPS USED?

As noted in Example 10.1, the spread in the rates firms A and B were quoted in the fixed market was 1%, while
the spread in the floating market was quoted at 0.5%. The swap that was subsequently engineered exploited this
difference in spread differentials between the fixed and floating rates. As a result, each party was able to obtain the
financing method it needed at a rate lower than the originally quoted rate. Comparative advantage is one reason
why swaps have continued to grow in popularity.

Another reason, perhaps even more important, is that swaps are a flexible, low-cost hedging and risk management
tool. As mentioned, an interest rate swap is essentially a series of forwards. Therefore, they can be used in long-term
hedging strategies that would otherwise involve taking positions in a series of forward contracts (either futures or
forward rate agreements). In the early days of the swap market, swaps were customized and were therefore more
expensive to engineer. However, with the efforts of the International Swap Dealers Association, the standardization
of swap contracts has greatly reduced the cost of the swap to the extent that it is now often cheaper (in terms of
liquidity costs) to get into a swap agreement than to buy a series of forward contracts.
Many firms also like the flexibility of swaps. If a firm believes that rates are on the way down, it can issue floating-
rate debt. Eventually, when the firm believes rates have bottomed out, it can enter into a swap to convert its
floating-rate debt into fixed-rate debt. Also, as credit default swaps become more popular, they are increasingly
being used to hedge against credit risk. Overall, swaps are a cost-effective way to reverse previous financial
decisions, a flexibility that financial managers deem valuable.
DELIVERABLE INTEREST RATE SWAP FUTURES AND CENTRALLY

CLEARED SWAPS
As discussed in Chapter 9, important reforms are currently taking place in the OTC derivatives market, with new
regulations requiring the clearing of many standardized OTC derivative contracts. In response to this new reality,
derivative exchanges are developing new products and expanding their central clearing facilities to accommodate
OTC derivatives.
One example is the development of deliverable U.S. dollar interest rate swap futures (DSF) by the CME Group in
Chicago. The contract allows parties to set in advance the fixed rate on a plain vanilla interest rate swap to be
delivered at the maturity of the futures contract. Separate quarterly futures contracts are listed based on underlying
swaps with 2-, 5-, 10- or 30-year terms. Each contract’s fixed coupon rate is set by the exchange when it is listed for
trading. At expiration, the contracts settle with physical delivery of a CME-cleared swap.
The CME has designed its DSF contract so that the buyer of the contract will be the floating-rate payer (and fixed-
rate receiver) of the swap upon delivery, and the seller will be the fixed-rate payer (and floating-rate receiver).
This means that speculators and hedgers can use swap futures in a manner similar to other interest rate futures
contracts.
For example, to profit from an anticipated decrease in interest rates, speculators must buy interest rate futures
contracts because lower interest rates translate into higher bond prices. Speculators would similarly need to buy
DSF contracts because lower interest rates will result in a lower floating-rate payment relative to the fixed rate.
Likewise, speculators looking to profit from rising interest rates, and hedgers looking for protection from higher
interest rates, would sell DSF contracts.
OTHER TYPES OF INTEREST RATE SWAPS

The plain vanilla interest rate swap has been the focus of our analysis thus far. Variations on this basic interest rate
swap are described as follows:
Arrears swap An arrears swap is an arrangement under which interest payments are made on the day
the floating rate is determined. In contrast, with a plain vanilla swap, the floating rate is
determined six months before the interest payment date.

Basis swap In a basis swap, interest payments for both counterparties are at a floating rate;
however, the basis for determining the floating rate for each counterparty is different.
For example, one counterparty makes interest payments at a rate equal to the 3-month
LIBOR, whereas the second counterparty makes interest payments only at a rate equal
to the 90-day Treasury bill rate.
Amortizing swaps Amortizing swaps are agreements in which the notional principal is reduced over
time until it reaches zero. This type of swap prevails when one of the counterparties
makes interest payments based on a basket of mortgage-backed securities. Because the
outstanding principal of a mortgage diminishes over time, interest payments should
be based on a notional principal with a declining balance. Swaps where the notional
principal on which interest payments are based increases over time have also appeared.
This type of a swap is known as the accreting swap.
Quanto swap In a quanto swap, interest payments are determined based on the interest rate of a
currency other than the denomination of the notional principal. Thus, one party might
pay interest on a $10 million notional principal at a rate equal to the 3-month SIBOR
(Singapore interbank offered rate), whereas the second counterparty makes interest
payments on the same notional principal but at a rate equal to the 3-month LIBOR.
Index swap In an index swap, payments of one counterparty are tied to the value of a particular
index, such as the S&P 500, the S&P 100, the S&P/TSX 60 Index, or an index of
mortgage-backed securities. A party willing to receive returns associated with the
particular index could engineer the index swap by paying LIBOR and receiving a rate
equal to the return on the index.
SWAPTIONS
A swaption is an option on a swap, of which there are two variations:
• A payer swaption gives the holder the right, but not the obligation, to enter into a predetermined swap
agreement to pay the fixed rate and receive the floating rate.
• A receiver swaption gives the holder the right, but not the obligation, to enter into a predetermined swap
agreement to pay the floating rate and receive the fixed rate.
All terms of the underlying swap are determined before the parties enter into a swaption. Such terms include the fixed
rate of the underlying swap (corresponding to the strike rate of the swaption), the reference floating rate, the term of
the underlying swap, the notional amount, and the base currency. Similar to other types of options, a premium is paid
by the buyer to the seller upon entering into the swaption, and the swaption has a specified expiration date.
Table 10.4 depicts the swap positions obtained following the exercise of payer and receiver swaptions.
Table 10.4 | Swap Positions Obtained Following the Exercise of Swaptions
Payer swaption Receiver swaption
Long Fixed-rate payer Fixed-rate receiver

Floating-rate receiver Floating-rate payer
Short Fixed-rate receiver Fixed-rate payer

Floating-rate payer Floating-rate receiver

As with other types of options, swaptions can be used to hedge, speculate, or generate income. Since most end
users of swaptions are large corporations, the bulk of trading originates from hedging. Example 10.2 illustrates the
use of a payer swaption to hedge against a rise in interest rates.
EXAMPLE 10.2 | BUYING A SWAPTION TO HEDGE AGAINST RISING RATES

A company borrows $100 million for two years at a fixed rate to finance the construction of a new plant. In order
to pay a lower interest rate on the loan, the company gives the lender the right to “retract” the loan in one year’s
time. In other words, the lender has the right to force the company to pay back the loan one year earlier than it
wants to. The lender would find it advantageous to retract the loan if interest rates have risen because it could
re-lend the money to a new borrower at a higher rate of interest.
The company does not really want to pay the loan back earlier than two years from now, but it feels that the
lower interest rate is worth the risk. The risk in this case is that the company will have to repay the original lender
by taking out a new loan that would likely carry a higher interest rate than the original loan. To protect itself
from this turn of events, the company can buy a one-year payer swaption that gives it the right (but not the
obligation) to be the fixed-rate payer in a plain vanilla interest rate swap in one year’s time.
If the loan is not retracted, the company lets the option expire. If the loan is retracted, the company can borrow
$100 million for one year at a floating rate of interest. The proceeds from this loan are used to repay the original
lender. At the same time, the company will exercise its payer swaption. This arrangement enables the company
to enter into a swap in which it pays the fixed rate and receives the floating rate. This allows the company to
convert the floating-rate payments on the new loan into fixed-rate payments. With this swaption, the company
has, in effect, replaced its retractable fixed-rate debt with non-retractable fixed-rate debt.

Currency Swaps 11
CONTENT AREAS
The Structure of a Currency Swap
Currency Swaps as a Portfolio of Fixed- and/or Floating-Rate Bonds
Pricing of Currency Swaps
Reasons for Currency Swaps
LEARNING OBJECTIVE
1 | Demonstrate how a currency swap works.

CHAPTER 11 | CURRENCY SWAPS 11 • 3
THE STRUCTURE OF A CURRENCY SWAP

In this chapter, we discuss currency swaps, including their structure and their potential uses and applications.
Currency swaps differ from interest rate swaps in two important ways. First, because cash flows are denominated
in different monetary units, the principal amounts are usually exchanged at the origination and maturity dates of
the agreement. Interest rate swaps typically do not involve any exchange of principal. The second difference is that
currency swaps do not necessarily have to be fixed-for-floating but can be fixed-for-fixed.
In its simplest form, a plain fixed-for-fixed currency swap is an agreement between two counterparties in which the
first counterparty agrees to exchange principal and fixed- or floating-rate interest payments on a loan denominated
in one currency with the second counterparty’s principal and fixed- or floating-rate interest payments on a loan
denominated in a different currency. Like interest rate swaps, parties purchasing currency swaps can be motivated
by a comparative advantage. In the case of currency swaps, the advantage arises from borrowing in a specific
currency when, for any of various reasons, the party wants a loan in a different currency.
The basic structure of a fixed-for-floating currency swap is illustrated in Figure 11.1. In this example, Firms A and
B initially swap Canadian dollars for a foreign currency and vice versa. At each settlement date, A and B swap a
fixed-coupon-rate payment for a floating-rate payment. Finally, at maturity, A and B return each other’s currency
principal.
Figure 11.1 | Structure of a Fixed-For-Floating Currency Swap
At Origination
Foreign Currency Principal
Canadian Dollar Principal
On Each Settlement Date (including Maturity)

Foreign Currency Fixed-Coupon Rate
Canadian Dollar LIBOR
At Maturity
Foreign Currency Principal
Canadian Dollar Principal
Currency swaps are explained in this chapter in the context of Example 11.1.
EXAMPLE 11.1 | THE STRUCTURE OF A CURRENCY SWAP

Firm A can borrow Canadian dollars at a floating rate equal to 6-month London Inter-bank Offered Rate (LIBOR)
or Swiss francs at a fixed rate equal to 5%. Firm B can borrow Swiss francs at a fixed rate of 6% or Canadian
dollars at a floating rate equal to 6-month LIBOR. Due to special needs, Firm A needs a floating-rate dollar loan,
while Firm B needs a fixed-rate Swiss franc loan.

In this example, it is obvious that Firm A has a comparative advantage in borrowing in the fixed-rate Swiss franc
market, and Firm B has a comparative advantage borrowing in the floating-rate dollar market. Thus, Firm A
borrows Swiss francs at a fixed rate of 5%, while Firm B borrows the equivalent amount of dollars (according to the
prevailing spot exchange rate) at a floating rate equal to 6-month LIBOR.
This currency swap is engineered by a swap dealer to fulfill the requirements of the two counterparties. Initially,
with the help of a dealer, the two firms exchange the principal amounts they borrowed. As a result, Firm A receives
dollars and Firm B receives Swiss francs. Firm A agrees to make periodic interest payments to the dealer at a rate of
6-month LIBOR on the outstanding dollar principal. In exchange, it will receive periodic interest payments of 5.4%
on the outstanding Swiss franc principal. Firm B agrees to make periodic interest payments to the dealer at a rate
of 5.6% on the outstanding Swiss franc principal. In exchange, it will receive periodic interest payments at a rate of
6-month LIBOR on the outstanding dollar principal.
The end of the swap coincides with the maturities of the two loans. At that point, Firm A returns the dollar-
denominated principal amount to Firm B, and Firm B returns the Swiss franc-denominated principal amount to
Firm A. Each party returns the exact same amounts that were swapped at the beginning.
The swap has the following impact on the cash flows of each party:
FIRM A
1. Pays Swiss franc 5% to its original lenders
2. Receives Swiss franc 5.4% from the swap dealer
3. Pays dollar 6-month LIBOR to the swap dealer
Overall, Firm A has converted its original Swiss franc loan into a dollar loan at a floating rate equal to 6-month
LIBOR (0.4%). Without the swap, Firm A would have had to pay LIBOR for the floating-rate dollar loan.
FIRM B
1. Pays dollar 6-month LIBOR to its original lenders
2. Receives dollar 6-month LIBOR from the swap dealer
3. Pays Swiss franc 5.6% to the swap dealer
Overall, Firm B has converted its original dollar loan into a Swiss franc loan at a fixed rate of 5.6%. Without the
swap, Firm B would have had to pay 6% for the fixed Swiss franc loan.
SWAP DEALER
1. Receives dollar 6-month LIBOR from Firm A
2. Pays dollar 6-month LIBOR to Firm B
3. Receives Swiss franc 5.6% from Firm B
4. Pays Swiss franc 5.4% to Firm A
Overall, the swap dealer has earned 0.2% for the services it provided.
Assuming the principal size of the loan was US$10 million, Table 11.1 shows the payment schedule between Firm A
and the swap dealer for a two-year period, with payments every six months.

CHAPTER 11 | CURRENCY SWAPS 11 • 5
Table 11.1 | Cash Flows Between Firm A and the Swap Dealer
Period Current LIBOR Fixed-Rate Receipt Floating-Rate Payment

1 Exchange of Principal 2.0% US$ 10 million SF9.5 million
2 Coupon Exchange 2.5% SF256,500 $100,000
5 Coupon Exchange SF256,500 $150,000
Principal Exchange SF9.5 million US$10 million
Firm A’s payment is based on semi-annual LIBOR at the start of the period, calculated on US$10 million. Its receipt
is 5.4% (semi-annual) on SF9.5 million.
Firm B receives LIBOR and pays fixed at 5.6%. The difference between the fixed-rate amount that Firm B pays and
the fixed-rate amount that Firm A receives is the swap dealer’s profit. Table 11.2 outlines the cash flows between
Firm B and the swap dealer.
Table 11.2 | Cash Flows from Firm B to the Swap Dealer
Period Current LIBOR Floating-Rate Receipt Fixed-Rate Payment

1 Exchange of Principal 2.0% SF9.5 million US$10 million
2 Coupon Exchange 2.5% $100,000 SF266,000
5 Coupon Exchange $150,000 SF266,000
Principal Exchange US$10 million SF9.5 million
CURRENCY SWAPS AS A PORTFOLIO OF EITHER FIXED-OR

FLOATING-RATE BONDS OR BOTH
As with interest rate swaps, assuming the absence of any default risk, currency swaps can be broken down into
a position of two bonds in a manner similar to interest rate swaps. Consider again the position of Firm A in the
swap described in Example 11.1. Firm A has a long position in a bond denominated in Swiss francs with a coupon
rate of 5.4% and a short position in a bond denominated in Canadian dollars with a floating coupon rate equal to
6-month LIBOR.
PRICING OF CURRENCY SWAPS

The same concepts applied to pricing an interest rate swap are used to price a currency swap. The difference,
of course, is that when pricing a currency swap, the prevailing spot exchange rate must be taken into consideration
in addition to the term structure of interest rates in the domestic and foreign markets.
Put another way, because a currency swap can be viewed as a combination of borrowing in one currency and lending
in another, valuation of the swap involves pricing the long and short positions on the two bonds.

REASONS FOR CURRENCY SWAPS

Currency swaps evolved from back-to-back loans and parallel loans. These instruments were popular in Britain in
the 1970s as a method of circumventing foreign exchange controls imposed by the British government that were
designed to prevent the outflow of British capital.
In today’s main currency markets, foreign exchange controls imposed by governments are generally very limited.
The market for currency swaps, however, has grown dramatically, and two interrelated reasons seem to provide
an explanation for the proliferation of the product. The first reason is the hedging of the exposure to foreign
exchange risk and the second is the circumvention of barriers to capital flows. These reasons are demonstrated
in Example 11.2.
EXAMPLE 11.2 | RATIONALE FOR CURRENCY SWAPS

A Canadian multinational corporation wishes to borrow money to support the operations of its German
subsidiary. Interest and principal payments for this loan can be paid by cash flows generated by the German
subsidiary. It can borrow in the Canadian market, convert the dollar loan into Euros, and transfer the money to
the subsidiary. Cash flows (in Euros) generated by the subsidiary can be converted to Canadian dollars to meet
the interest and principal requirements of the loan. The Canadian company could also issue a Euro-denominated
loan, but certain barriers to capital flows could result in an interest rate much higher than the rate a similar
German company could get in the German market. At the same time, a similar situation exists for a German
multinational company and its Canadian subsidiary. The German multinational wants to pay its obligation
stemming from the loan with cash flows from its Canadian subsidiary. It is quoted more attractive rates for Euro-
denominated loans than for dollar-denominated ones.
In Example 11.2, it is very likely that the Canadian multinational would be able to get better interest rates in the
Canadian market. However, borrowing in the Canadian market and then paying its obligation under the loan
agreement with cash flows received from its German subsidiary in Euros would expose the Canadian company
to exchange rate risk stemming from the ever-changing relationship between the Canadian dollar and the Euro.
Borrowing directly in Euros would eliminate this source of risk. However, due to the existence of certain barriers
to capital flows, the rate the Canadian company would have to pay could be much higher than the rate a German
company would have to pay if it borrowed in Euros.
To circumvent the difficulties imposed by either the exposure to foreign exchange risk or the barriers to capital
flows, the Canadian multinational can get into a currency swap agreement with the German firm, which faces a
similar situation with its Canadian subsidiary. The two companies can borrow in their domestic markets, exchange
principals and interest payment obligations, and thus obtain favourable rates while, at the same time, eliminating
exchange risk. Currency swaps like the one described in Example 11.2 have played a major role in the integration
of the world’s capital markets.

Credit Swaps 12
CONTENT AREAS
Credit Derivatives
The Role of Credit Derivatives
The Structure of Credit Default Swaps
Index Credit Default Swaps
Uses for Credit Default Swaps
LEARNING OBJECTIVES
1 | Describe what credit derivatives are.
2 | Explain the role credit derivatives play for different users, including banks, insurance companies,
asset managers and securities dealers.
3 | Demonstrate how a standard credit default swap works.
4 | Demonstrate how an index credit default swap works.

KEY TERMS
basket CDS protection seller
credit default swap recovery rate
first-to-default CDS reference asset
index-based CDS reference entity
portfolio CDS single-name CDS
protection buyer

CHAPTER 12 | CREDIT SWAPS 12 • 3
CREDIT DERIVATIVES
Credit derivatives are financial instruments designed to transfer and manage credit risk. They derive their value from
an underlying credit asset or pool of credit assets, such as bonds or mortgages. The underlying asset being protected
is the reference asset, which is issued by the reference entity. The payouts are a function of the creditworthiness
of the issuer. In essence, credit derivatives offer credit holders or speculators a way to strip away credit risk from the
credit package. Investors are thus able to tailor the risk/reward profile of these assets to suit their investment needs.
Credit derivatives allow market participants to fine-tune the credit risk exposures associated with their credit
portfolios. Because they may be dependent on current credit conditions, a credit shock may create some liquidity
problems. Credit assets represent a sizable proportion of portfolios held by banks, portfolio management
companies, insurance firms, and hedge funds. Credit derivatives have therefore become extremely popular in the
context of significantly increased credit market volatility. In fact, they are the fastest-growing segment of that
market.
Credit derivatives have seen a very high rate of growth in financial markets since the mid-90s, where they play
a crucial role. The reason for their stellar success has been the appearance of high credit market volatility at the
end of the 1990s and into the early 2000s. At that time, investors who continued to hold bonds or mortgages
were forced to accept higher risk, which pushed the fixed-income portion of their asset mix into an undesirable
risk profile. Fixed-income took too much of the risk budget given the macroeconomic environment. As in other
derivative markets, hedgers had to pay a price to control the added risk stemming from their credit positions. At the
same time, speculators were ready to buy that risk from the hedgers to diversify their own investment portfolios
and to increase their risk profile. In exchange for the added risk, they received financial compensation. Given the
importance of fixed-income portfolios with insurance firms, asset managers, banks, and securities dealers, the
market for credit derivatives grew rapidly.
THE ROLE OF CREDIT DERIVATIVES

The fundamental role of credit derivatives is to transfer credit risk between two parties: the protection buyer, who
wishes to reduce credit risk, and the protection seller, who wishes to acquire or hold credit risk. The protection
buyer, often called the risk seller or risk hedger, is the party going short the credit. The protection seller, often called
the risk buyer, is the party going long the credit.
More precisely, as shown in Table 12.1, credit derivatives play multiple roles, depending on their holders and the
purpose for which they are being held.

Table 12.1 | Purpose of Credit Derivatives
Holder Buy Sell

Banks Banks use credit derivatives to hedge and, Banks sell protection to diversify their
therefore, buy protection from counterparties. loan portfolio (by changing their return/
They do so for the following reasons: risk profile) and to enhance yields with
respect to lending.
• To enhance their credit risk management
(by decoupling the credit positions from The credit derivatives add income in
their risk profile) addition to returns generated by the
• To retain ownership of loans, given their portfolio itself, which is somewhat
increased risk level analogous to covered call writing in
equities.
• To reduce regulatory capital requirements
(by reducing the risk budget proportion
attributable to the credit component of
the portfolio)
Insurance Similar to banks, insurance companies Insurance companies may sell protection
Companies both buy and sell protection, depending on to increase yields (once again, analogous
circumstances and on their portfolio makeup. to covered call selling in equities) and
They typically buy protection to diversify to help match assets to liabilities,
and mitigate liability concentrations, in particularly to match cash flows from
effect selling away the risk associated with one to the other.
concentrated liability commitments, rather
than reconfiguring their liability portfolio,
which may prove difficult.
Asset managers These market participants buy protection to Asset and hedge fund managers
and hedge fund manage negative expectations on positions sell protection (as do other market
managers for macroeconomic or sectoral reasons. They participants) for the following reasons:
may also establish forward trades, either long
• To increase yield and diversification
or short, to access these markets mainly as
given positive credit outlook
hedgers.
• To generate leverage on existing
portfolios
• To establish forward trades (long or
short) mainly as speculators
Securities dealers Securities dealers buy protection to cover Dealers sell protection to increase yield,
their exposure as market makers and more to better diversify their loan and asset
generally to manage the credit risk on their portfolio, and to help offset hedging
books. costs for other credits.
Source: Celent Communications, AssetCounsel
THE STRUCTURE OF CREDIT DEFAULT SWAPS

Although it shares fundamental characteristics with other swaps, the credit default swap (CDS) is different in
several respects. The cash flow and payment mechanics of a CDS are the same as those of any other swap, such as

the plain vanilla interest rate swap covered earlier. Consequently, a CDS is the exchange of two cash flows: a fee
payment and a conditional payment, which occurs only if certain circumstances are met. More precisely, the CDS
will have value for the protection buyer only if these conditions are met, whereas the protection seller will receive
the predetermined fee in all scenarios.
A CDS is analogous to a specific type of insurance option in which default of an asset triggers payment. One party
buys the protection and insures itself against the risk of default or other credit impairment on an underlying credit
instrument. The other party accepts this risk of an uncertain event in exchange for a certain fee. The protection
buyer holds a risky asset and pays a reasonable premium to reduce the severity of possible adverse outcomes.
The protection seller values the premium’s cash flows against the risk of adverse outcomes and possible payouts.
Figure 12.1 shows the structure of a single-name CDS (i.e., single-asset CDS), which is a plain vanilla CDS.
Figure 12.1 | Cash Flows of a Single-Name Credit Default Swap
Protection fee (premium)

Protection
Buyer/Owner of Protection Seller
Underlying Asset Payment only if credit event on underlying asset
occurs (bankruptcy, failure to pay, restructuring)
If a default occurs, the CDS is activated and terminates with the payment, according to the predetermined
conditions of the contract. The payment can be 100% of the face value or a percentage of the total (nominal) CDS
commitment, depending on the importance of the loss triggered by the credit event. There are two payment modes:
Physical settlement The protection buyer remits the asset to the protection seller against full face value
payment
Cash settlement The protection buyer retains the asset and receives the difference between face value
and recovery value, as established by an independent assessor
Besides these standard CDSs, there are also digital CDSs (also called binary or fixed-recovery CDSs) with a fixed cash
settlement, independent of the actual recovery value.
Based on Figure 12.1, consider the situation depicted in Example 12.1.
EXAMPLE 12.1 | SINGLE-NAME CREDIT DEFAULT SWAP

On August 15, 2007, two parties enter into a CDS. The terms of the contract are a five-year CDS, with the
protection buyer paying 120 basis points (bps) annually for protection on the referenced asset, which is a
$100 million bond position. The contract’s payment schedule calls for semi-annual payments, with physical
delivery of the bonds in the event of default. The protection buyer pays $600,000 [(120 bps × $100 million) ÷
2] every six months to the seller beginning on February 15, 2008 until the end of the contract, or until the credit
event (i.e., default) occurs. The buyer will receive a payout only if the reference entity defaults, thus triggering the
credit event. If this happens, the protection seller must buy the bonds for $100 million.
If Example 12.1 called for cash settlement rather than physical settlement, the recovery value would be determined
by an independent assessor using the recovery rate, which is the realizable rate of recovery on default. If the bonds’
recovery rate is $200 per $1000 of par value (20%) after the default, the cash payout the protection seller must
make is $80 million ($100 million – $20 million recovery value).
In addition to single-name CDSs, there are also multi-name CDSs written on several underlying assets. A common
type is the basket CDS, which offers protection on the default probabilities of a basket of assets. If the CDS pays

on the first default of any of the referenced assets, it is called a first-to-default CDS. Other types are second-to-
default and third-to-default CDSs, or more generally nth-to-default basket CDSs. Protection fees on basket CDSs,
given risk diversification, are lower than equivalent fees for individual CDSs on all assets in the basket, which makes
them attractive for protection buyers. They are also attractive for protection sellers because the fees are higher than
they would be for single-asset CDSs with moderately higher risk. Note that the CDS is terminated upon the relevant
default.
The same is not true for portfolio CDSs, which are written on a basket of underlying assets but have a
predetermined monetary amount rather than a number of defaults. This type of CDS remains active until expiration
or until the predetermined monetary amount is reached, regardless of the actual number of defaults. For example,
if a portfolio CDS covers $1.5 million of losses, a $300,000 default on one of the reference assets would bring the
remaining coverage down to $1.2 million, and the premium going forward would be adjusted accordingly. A later
default of $500,000 would bring the remaining coverage to $700,000, and so on.
INDEX CREDIT DEFAULT SWAPS

Index-based CDSs have emerged in the past few years as a result of the growing popularity of investing in the CDS
marketplace. The standardization of the contracts and a large dealer base supporting continuous and transparent
pricing have made index-based CDSs highly liquid trading instruments.
In fact, by the end of 2011, index CDSs accounted for more than 36% of the notional amounts outstanding of all
CDSs1. Even with the limited range of indices available, the volume of index CDS contracts now reaches levels
equivalent to more than 60% of the total volume of contracts traded on single-name corporate CDSs.
With this new reality, the trading prices of active index CDSs have become widely accepted corporate bond
benchmarks. By keeping track of the price trends and reversals witnessed in the most liquid index CDSs, market
participants can easily stay up to date on the current state of the credit market.
HOW ARE INDEX CDSs STRUCTURED?

Similar in many ways to stock market indices, CDS indices are designed to track the credit risk of a group of
corporate entities considered to represent a sector of the economy or a particular geographical region.
These contracts are owned, designed, and maintained by organizations that take charge of aggregating the CDS
valuation information of the various underlying entities and delivering real-time indices pricing values.
Each index CDS is defined by the following criteria, among other characteristics:
• The list of its index constituents
• The index weight of each constituent
• The term and maturity date of the index CDS
• The notional amount
• The coupon payable by the protection buyer
• The specific credit events that would trigger a settlement
Table 12.2 illustrates these points by referencing two index CDSs: the CDX.NA.IG.18 and iTraxx Europe Series 17. The
underlying indices of these two index CDSs originate respectively from the CDX family of indices, intended for North
American underlyings, and the iTraxx family of indices, intended for European underlyings. Both families are owned
and managed by the Markit Group, a major player in the field of credit indices.
1
BIS Quarterly Review, June 2012 – http://www.bis.org/statistics/otcder/dt1920a.pdf

Table 12.2 | Defining Features of Index CDSs
CDX.NA.IG.18 iTraxx Europe Series 17
Index constituents 125 North American investment grade Top 125 European investment grade
entities entities in terms of CDS volume traded
Index weight of each Equally weighted at 0.8%

constituent
Series* maturities Series 18 was released in March 2012 Series 17 was released in March 2012
with standard maturities of 1, 2, 3, 5, 7, with standard maturities of 3, 5, 7, and
and 10 years. 10 years.
Notional amounts The amounts are agreed on by the parties at the inception of each contract.
Annual coupon paid by 100 bps, or 1%, paid quarterly.

the protection buyer (More on this topic in the following section.)
Credit events that Bankruptcy or failure to make interest Bankruptcy, failure to make interest or
would trigger settlements or principal payments when due principal payments when due, or debt
restructuring
* Due to the ongoing corporate actions and rating changes that could possibly affect one or more constituents, new series of an index are
created periodically, typically every six months, with an updated list of constituents. The latest series released is referred to as the “on-the-run”
series.
Depository Trust and Clearing Corporation

For Information Only
Data from the Depository Trust and Clearing Corporation (DTCC) for the week ending July 13, 2012, show that
the weekly volume and the total gross notional value traded for both the CDX.NA.IG.18 and the iTraxx Europe
Series 17 were in the vicinity of 2,000 contracts and US$100 billion respectively, indicative of an average contract
size of approximately US$50 million. The two index CDS were the most traded and accounted for 40% of the
total volume of index contracts traded during the week.
See “DTCC Further Expands Public Release Of CDS Data” at http://www.dtcc.com/news/2010/august/02/
dtcc-further-expands-public-release-of-cds-data.aspx
The Markit Group further breaks down the 125 entities of its flagship CDX.NA.IG index into five distinct and tradable
sub-indices:
• Financials
• Consumer
• Energy
• Industrials and technology
• Media
• Telecommunications
HOW DO INDEX CDSS TRADE?

The quoting convention of index CDS contracts is similar to bonds where some trade on yields and others on price.
The published quotes for index CDSs are based on yields, or spreads, for the most part. These spreads, expressed

in bps, represent the total amount payable by the protection buyer to the protection seller. It is worth noting that
index CDSs, because of their liquidity, tend to trade at smaller bid-ask spreads than single-name CDSs.
As highlighted in Table 12.2, standardized index CDSs have fixed quarterly coupons attached to them. As for the
rate difference between a contract’s quoted spread and its stated coupon rate, the present value of this difference
is exchanged upfront at the initiation and close of contracts. This way, any change in price over the duration of an
open position is reflected in the difference in upfront cash payments. Example 12.2 illustrates this process.
EXAMPLE 12.2 | UPFRONT CASH PAYMENTS MADE AT INITIATION AND CLOSE OF CONTRACTS
A major bank lending mainly to large North American energy companies wants to hedge the risk associated with
its concentrated liability commitments. Instead of buying credit protection on the single-name CDSs individually,
the bank decides to buy protection on the whole sector using the on-the-run 5-year CDX.NA.IG Energy CDS on a
notional amount of $50 million, which represents $3,125,000 notional protection for each of the 16 names in the
index at that time.
The quoted spread on the deal is 107.56 bps, which results in an upfront cash payment of $179,870 and, for the
duration of the hedge, quarterly payments of $125,000 to the protection seller.
The $179,870 and $125,000 amounts are calculated as follows:
• The upfront cash payment of $179,870 represents the present value of 7.56 bps (107.56 bps – 100 bps)
on $50 million, over five years (or 0.0756% x $50 million = $37,800 per year, over five years).*
• The quarterly payments of $125,000 are calculated by applying the fixed annual coupon rate of 100 bps
to $50 million (1% × $50 million = $500,000) and dividing by 4.
One year later, after a sustained deterioration of the credit market and a large reduction in the size of its lending
book, the bank decides to unwind its index CDS hedge position. The CDX.NA.IG Energy CDS has now four years
left to maturity and quotes 152.37 bps, reflecting the increase in the perceived credit risk of the sector.
The unwinding of the position puts an end to the protection and the quarterly payment obligation of $125,000.
Moreover, the unwinding of the hedge position at a spread over 40% wider than that taken initially results in a
significant net gain for the bank.
The premium of 52.37 bps over the coupon rate results in an upfront cash payment, this time received by
the bank, of $996,290 (representing the present value of 0.5237% × $50 million = $261,850 per year, over
four years).
* Present values are typically calculated using the industry-approved Standard Converter available on www.cdsmodel.com. Note that no
present-value calculations will be part of the final exam.
The scenario in Example 12.2 assumes that no credit events occurred over the duration of the hedge. But what
happens when credit events do occur? Example 12.3 describes the impact of credit events on index CDS positions.

EXAMPLE 12.3 |IMPACT OF CREDIT EVENTS ON INDEX CDS POSITIONS

Consider Example 12.2 again. This time assume that, six months after the initiation of the contract, a credit event
occurs with one of the constituents of the CDX.NA.IG Energy CDS. After the applicable industry auction takes
place, the recovery value is set at 40% of the face value of the bond in default.
The confirmed credit event immediately affects the index CDS in three major ways:
• As cash settlement, the protection seller must pay the protection buyer a certain percentage of the notional
value of the index CDS.
In this case, one out of the 16 constituents of the CDX.NA.IG Energy CDS defaulted, or 6.25%. In addition,
the recovery value of 40% signifies that the protection seller must compensate on a proportion equivalent to
60%.
The final amount is calculated as follows:
$50 million × 6.25% × 60% = $1,875,000, payable by the protection seller to the protection buyer
• The number of constituents in the index is cut to 15, and the notional amount of the contract is reduced
by $46,875,000, calculated as follows:
6.25% to 93.75% × $50 million = $46,875,000
• From this point, the absolute amount of the 100-bps coupon is reduced because the calculation of
the coupon payment is now based on the lower notional amount of $46,875,000.
USES FOR CREDIT DEFAULT SWAPS

As discussed earlier, institutions use different types of CDSs to hedge or speculate. Hedging uses include credit risk
management, portfolio diversification, and reduced portfolio concentration. Speculative uses include fee pickup,
establishing positions, and leverage, among others.
Credit default swaps create an additional market to help transfer credit risk between economic agents, thereby
contributing to the efficiency of financial markets overall. As such, they have become an important risk
management tool to control portfolio risk and to help diversify or mitigate risk concentrations.

Other Types of Swaps 13
CONTENT AREAS
Equity Swaps
Commodity Swaps
LEARNING OBJECTIVES
1 | Describe what an equity swap is.
2 | Explain why equity swaps are used.
3 | Demonstrate how an equity swap works.
4 | Demonstrate how a commodity-based swap works.

KEY TERMS
commodity swap synthetic equity position
equity swap

CHAPTER 13 | OTHER TYPES OF SWAPS 13 • 3
EQUITY SWAPS
During the late 1980s, Bankers Trust, a former leader in financial innovation, began offering various risk
management products based on equity cash flows. Among these products, the equity swap had a prominent place
and was used repeatedly to create what is known as a synthetic equity position. Synthetic equity is a position that
allows an investor to earn equity returns without actually taking a position in equity.
Example 13.1 describes a situation in which a manager can achieve a goal by creating a synthetic equity position,
with the help of an equity swap.
EXAMPLE 13.1 | THE STRUCTURE OF AN EQUITY SWAP

A mutual fund manager has $100 million invested in a long-term Treasury bond, which is currently trading at par
and earning an annual coupon rate of 4.5%. The manager is considering selling the bond issue and investing the
proceeds in a market index to earn a higher return. However, high transaction costs make the manager skeptical
of such a transaction.
Instead, the fund manager enters into an agreement with a swap dealer whereby the manager makes periodic
payments to the dealer at a rate of 4.5% on a $100 million notional principal. In return, the manager receives
periodic payments from the dealer equal to $100 million multiplied by the return on a specific equity index.
The equity index in the agreement (S&P/TSX 60, S&P 500, etc.) is specified in advance.
Under this swap agreement, the fund manager:
1. Receives an 4.5% coupon from the bond
2. Pays 4.5% to the dealer
3. Receives a return equal to the index return from the dealer
As a result, the fund manager is able to convert a fixed-income investment earning 4.5% into an equity
investment earning the rate of return of the specified index.
Because the dealer receives a fixed rate and pays a floating rate equivalent to the index return, it is exposed to
risk based on fluctuations of the index returns. The dealer will have to warehouse the swap until it can engineer
an offsetting position. To do so, it will need to find another counterparty (fund B) that wishes to convert its
returns from an investment on the particular index into a fixed-rate return. In that transaction, the dealer will
agree to receive periodic payments from fund B equal to the return on the index, and, in return, it will pay fund
B a fixed rate of 4.3%. As a result, fund B will have converted its investment from an equity position to a fixed-
income position earning 4.3%, and the dealer will have received 0.2% for the service.
Equity swaps allow users to create synthetic equity and earn equity returns without taking equity on their books.
Firms use equity swaps rather than investing directly in shares for the following reasons:
Reduced transaction The cost of initially purchasing a broad-based portfolio can be substantial in terms of
costs commissions and slippage. On an ongoing basis, the portfolio would also need to be
rebalanced for changes in the underlying index weightings. In a single transaction, a swap
provides a return directly linked to the stock index, with no room for slippage.
Access to international Equity swaps enable investors to establish index funds benchmarked to foreign markets
markets without the associated costs. They also allow investors to circumvent restrictions on
foreign holdings of certain equities and withholding taxes on dividends.

Tax efficiency Tax issues often limit an investor’s ability to reorganize a portfolio. An equity swap
allows a manager to gain stock market exposure without having to sell assets or trigger
tax liabilities.
Leverage With equity swaps, the combination of large notional exposures and small collateral
commitments permits leverage beyond the margin limits normally available when
dealing directly in stocks.
Portfolio asset allocations and foreign equity market exposures can also be easily established using equity index
futures. So why would a portfolio manager opt for equity swaps instead? One reason is that not all indices have
futures based on them, but swaps can be established around tailored benchmarks or portfolios. Another reason is
the life of swaps compared with that of futures. The longer swap maturities avoid the pricing risk associated with
having to roll over the futures positions every few months.
Variants of equity swaps can be structured so that one party makes payments on the basis of one equity index
(such as the S&P 500) and receives payments on the basis of another (such as the NASDAQ 100 or a foreign index).
They can also be structured as single equity swaps. In this structure, one side of the cash flows is determined by the
rate of return for a single equity, rather than an equity index or portfolio.
COMMODITY SWAPS
In a commodity swap, one counterparty agrees to make fixed periodic payments to a second counterparty for the
use of a predetermined amount of a certain commodity. At the same time, the second counterparty agrees to make
periodic payments to the first counterparty based on the same amount of the certain commodity and calculated at
a floating unit price.
Consider the scenario described in Example 13.2.
EXAMPLE 13.2 | THE STRUCTURE OF A COMMODITY SWAP

Firm A, an oil refinery, is expected to consume 1,000,000 barrels of crude oil per year for the next three years.
It wishes to eliminate uncertainty with respect to crude oil prices. At the same time, Firm B, a crude oil producer,
wants to eliminate uncertainty about crude oil prices. The current price for crude oil is $76 per barrel.
Both Firm A and Firm B wish to eliminate uncertainty with respect to future crude oil prices.
Assume the swap in this example is arranged with the help of a swap dealer. Firm A makes periodic purchases
of the oil it needs in the spot oil market on a regular basis, as it would have without the existence of the swap.
Similarly, Firm B sells the crude it produces in the spot oil market, as it would have without the existence of
the swap. These transactions take place at the prevailing spot price of crude each time. Because it wants to
eliminate the uncertainty inherent in crude prices, Firm A agrees to pay the swap dealer, at the end of each year
during the life of the swap, $76.20/per barrel (bbl) for each barrel of oil it purchases. Based on the current price
of $76,00/bbl, the total yearly amount Firm A pays is calculated as $76.20/bbl × 1,000,000 bbls = $76,200,000.
At the same time, the swap dealer is obligated to pay Firm A an amount equal to the average spot price for oil
during the year for each barrel the firm purchases during the year, or 1,000,000 bbls per year × average spot price
during the year.
Under this swap arrangement, Firm A:
1. Pays the spot price when it purchases crude oil in the open market
2. Receives spot price from the swap dealer
3. Pays $76.20/bbl to the dealer

CHAPTER 13 | OTHER TYPES OF SWAPS 13 • 5
EXAMPLE 13.2 | THE STRUCTURE OF A COMMODITY SWAP

Firm A has thereby eliminated uncertainty with respect to oil prices by paying a fixed price of $76.20/bbl for the
next three years.
The swap dealer, however, because it receives $76.20/bbl and pays the spot price, is exposed to risk due to the
uncertainty of future oil spot prices. The dealer eliminates this risk by getting into an offsetting swap agreement
with Firm B. Under this agreement, at the end of each year during the life of the swap, Firm B pays the swap
dealer the average spot price per barrel (during the year) for each barrel of oil specified in the agreement, or
1,000,000 bbls × average spot price during the year. In return, Firm B receives a fixed cash flow equal to $75.80
per barrel for each barrel of oil specified in the agreement, or 1,000,000 bbls × $75.80/bbl = $75,800,000.
As a result, Firm B:
1. Receives spot price for oil sold in the open market
2. Pays spot price to the swap dealer
3. Receives a price of $75.80 from the dealer.
Firm B has thereby eliminated uncertainty with respect to future spot oil prices by fixing the price of oil it sells at
$75.80/bbl for the next three years.
The swap dealer:
1. Receives spot price from Firm B
2. Pays spot price to Firm A
3. Receives $76.20/bbl from Firm A
4. Pays $75.80/bbl to Firm B
In this way, the swap dealer makes a profit of $0.40/bbl or $400,000 per year for its involvement in the swap.
Because the commodity underlying the swap in Example 13.2 is the same for both counterparties, no initial
exchange of the commodity is necessary. However, a commodity swap might involve different commodities for
each counterparty. In such a case, an initial exchange of the commodities is required. As in the case of interest and
currency swaps, the swap dealer can warehouse one side of the agreement until a suitable counterparty is found. In
the meantime, the dealer seeks to hedge its exposure in the commodity futures market.

SECTION 5
HOW INVESTMENT FUNDS

AND STRUCTURED PRODUCTS
USE DERIVATIVES
14 Mutual Funds
15 Hedge Funds

Mutual Funds 14
CONTENT AREAS
Derivatives Use by Investment Funds and Structured Products
Regulatory Restrictions on Derivatives Use by Mutual Funds
Mutual Fund Use of Derivatives
Derivatives for Non-Hedging Purposes
Potential Risks of Derivatives Use by Mutual Funds
LEARNING OBJECTIVES
1 | Describe the regulatory restrictions around the use of derivatives in mutual funds.
2 | Describe the specific guidelines under regulation that permit mutual funds to use derivatives for non-
hedging purposes.
3 | Demonstrate the ways in which mutual funds use derivatives to hedge.
4 | Describe the easiest way for a mutual fund manager to establish a hedge according to regulatory
guidelines.
5 | Demonstrate the non-hedging ways in which mutual funds use derivatives.
6 | Describe the potential disadvantages or risks associated with the use of derivatives by mutual funds.

KEY TERMS
Canadian Securities Administrators NI 81-102
National Instruments structured products

CHAPTER 14 | MUTUAL FUNDS 14 • 3
DERIVATIVES USE BY INVESTMENT FUNDS AND

STRUCTURED PRODUCTS
In this section of the course, we discuss the use of derivatives by investment funds and structured products. In this
context, investment funds fall into three broad categories:
• Mutual funds
• Hedge funds (including commodity pools, also known as alternative mutual funds)
• Exchange-traded funds
The structured products category is a broad one that includes a variety of complex synthetic financial products
whose returns are linked to other assets. For our discussion, however, we use principal protected notes to represent
this type of investment. Protection of some or all of the principal invested is a common feature of structured
products.
REGULATORY RESTRICTIONS ON DERIVATIVES USE BY MUTUAL FUNDS

Mutual funds are strictly regulated in Canada, as they are in most countries around the world. Securities regulation,
including the regulation of mutual funds, is a provincial responsibility. As such, regulation of Canadian mutual funds
falls under the jurisdiction of the securities act of each province or territory. For example, the Ontario Securities
Commission is the main regulator of mutual funds in that province. It regulates all aspects of the mutual fund
industry in Ontario, including sales practices, registration of firms and portfolio managers, trading, and overall
compliance with the Ontario Securities Act.
The Canadian Securities Administrators (CSA) is a joint working group of regulators from all provinces who work
together where there are areas of uniformity and general agreement on regulation. The CSA has established a joint
set of rules and regulations specific to the mutual fund industry that applies across Canada, which it has compiled
into National Instruments (NI). The two sets of instruments that govern mutual funds and commodity pools and
their use of derivatives are NI 81-102 and NI 81-104 respectively.
NATIONAL INSTRUMENT 81-102

National Instrument 81-102 is a lengthy document that all compliance officers and portfolio managers should know
well. In the context of this textbook, three sections of the Instrument apply:
• 2.7 Transactions in Specified Derivatives for Hedging and Non-hedging Purposes
• 2.8 Transactions in Specified Derivatives for Purposes Other Than Hedging
• 2.9 Transactions in Specified Derivatives for Hedging Purposes
MUTUAL FUND USE OF DERIVATIVES

As we have noted throughout this textbook, derivatives serve two major purposes for investors: reduction of risk by
hedging investment exposure and speculation.
National Instrument 81-102 very strictly limits the use of derivatives in mutual funds to the hedging of risk, rather
than for speculation. This is in contrast to hedge funds, which often make extensive use of derivatives for speculative

purposes (as discussed in Chapter 15). NI 81-102 also forbids mutual fund managers from using the leverage
inherent in derivatives. The regulation includes the following specific details that apply to all derivative positions:
• Permitted expiry dates for derivatives
• The minimum allowable credit ratings of counterparties to over-the-counter (OTC) derivative contracts, which
must be an A rating from the Dominion Bond Rating Service or its equivalent from Fitch Ratings, Moody’s
Investors Service, or Standard & Poor’s
• The maximum exposure to an individual OTC derivatives counterparty (i.e., 10% of the net assets of a fund)
• The method used to calculate the exposure to an individual OTC derivatives counterparty, whereby exposures
must be marked-to-market daily
Within the allowable uses, mutual fund managers may use a range of derivatives, including options, futures,
forwards, and swaps. Note that additional regulations may govern how derivatives must be used within a
mutual fund.
NI 81-102 DEFINITION OF HEDGING

NI 81-102 specifically defines what qualifies as hedging in a mutual fund, as follows:
1. The derivative used must be intended to offset or reduce a specific risk associated with all or part of a position
or positions in the fund.
2. It must have a value with a high negative correlation to the value of the position being hedged.
3. It must not be expected to offset more than changes in the value of the position being hedged.
The easiest way for a mutual fund manager to establish a hedge in compliance with the NI 81-102 guidelines is to
take a derivatives position with a payoff that is offset by (i.e., opposite to) that of the position or exposure being
hedged. By definition, such a position will reduce the risk of that position and will be negatively correlated with that
position to a high degree. An appropriately sized derivatives contract ensures that the derivatives position does not
offset more than the changes in the value of the position being hedged.
The security positions that mutual funds most commonly hedge are long positions. A hedgeable “position” can also
be currency risk exposure (as shown in Example 14.1).
The following positions in derivatives have payoffs opposite to those of more traditional long positions:
• Short forward, futures, and swap contracts
• Long put option contracts
• Short call option contracts
Note that mutual funds have traditionally been allowed to take short positions in securities only under very limited
circumstances. However, more and more fund families are seeking and obtaining regulatory approval (called
exemptive relief), which allows them to short stocks in their mutual funds up to 20% of the funds’ value. Although
short-selling has traditionally been a hedge fund strategy, this ability should allow for improved risk management in
mutual funds.

EXAMPLE 14.1 | HEDGING CURRENCY EXPOSURE

An equity mutual fund manager in Canada manages a fund that invests in U.S. equities. In addition to market risk,
the investments also face currency risk. If the value of the Canadian dollar falls in relation to the U.S. dollar, the
portfolio will benefit. On the other hand, if the Canadian dollar appreciates in relation to the U.S. dollar, the fund
will suffer because each U.S. dollar in the portfolio will be worth fewer Canadian dollars when converted.
The fund manager believes the Canadian dollar will continue to rise in value over the U.S. dollar, which will have a
detrimental impact on the performance of his fund. At the same time, he is reasonably bullish on the outlook for
U.S. stocks, so he does not want to reduce his exposure to the equity market.
The fund manager wants to remove the currency risk associated with owning the U.S. equities. If the portfolio has
net assets of US$100 million, and if the Canadian dollar/U.S. dollar current spot rate is US$0.8418, the portfolio’s
value equates to C$118.79 million. Assume that, six months from today, the portfolio is worth the same US$100
million, but the value of the Canadian dollar has continued to rise and now trades at US$0.87. Now the US$100
million translates to a Canadian dollar value of $114.94 million. The portfolio would therefore have suffered a
C$3.85 million loss, or 3.24%, simply as a result of the movement in the exchange rate.
To hedge against this risk, the fund manager uses CME Canadian dollar futures contracts, which are trading at
US$0.8461, for settlement six months from now. Note that this rate is higher than the spot rate of US$0.8418.
This difference is the cost of carry, which effectively represents the cost of the hedge.
To hedge his U.S. dollar exposure, the fund manager buys Canadian dollar futures in an amount equivalent to
US$100 million, which locks in an exchange rate of US$0.8461 for the U.S. dollar exposure. The futures contracts
enable the mutual fund and its unitholders to maintain exposure to the U.S. equities, but without the currency
risk associated with them.
Example 14.1 illustrates just one way among several to hedge currency exposure. Another way is to purchase a put
option. For example, suppose the fund manager holds a stock in a portfolio and is concerned about short-term
volatility but is bullish on longer-term perspectives. By purchasing a put option, the manager locks in an effective
“floor price” for the stock. If the market price of the stock falls below the strike price of the option, the manager can
exercise the option and sell the stock at the strike price.
This strategy holds the following advantages:
1. It guarantees a minimum sale price for the stock.
2. It is simple to execute.
3. The value of the put is easy to determine because it trades every day on a public exchange.
4. It removes the problem of market impact if the manager has a sizable position in the stock because the sale
would be conducted off the exchange floor.
However, options strategies also carry imperfections as a hedge, including the following shortcomings:
1. They cost money to implement in that the put buyer pays a premium for the put.
2. The value of options usually fluctuates more, or perhaps less, than the price of the underlying stock, which
makes for an imperfect hedge. (The delta of an option is frequently less than 1, which means that it is very
difficult, if not impossible, to effectively hedge the entire exposure of a stock.)
3. Some options can be relatively illiquid, so it may not be possible to purchase sufficient puts at the quoted ask
price to hedge the equivalent number of shares held in the portfolio.

DERIVATIVES FOR NON-HEDGING PURPOSES

Hedging transactions using derivatives are intended to reduce, or hedge, investment risk. However, derivatives can
also be used to increase investment exposure to a financial asset, in which case they are classified as non-hedging
transactions. By classic definition, these types of transactions are considered speculative in nature. However, it
is important to note that this classification is somewhat misleading because the intention is to gain exposure for
investment purposes, rather than outright speculation. Derivatives allow mutual fund managers to gain investment
exposure quickly, effectively, and inexpensively.
Under NI 81-102, mutual funds may use derivatives for non-hedging purposes within specific guidelines. Derivatives
used for non-hedging purposes are most often used to gain exposure to a market without owning the underlying
securities. For example, index derivatives are often used to gain exposure to a market index without buying the
actual index constituents. In some cases, they may be used to provide additional portfolio income by selling covered
calls, or to provide access to the underlying asset at a lower price than it is currently trading.
Example 14.2 illustrates a non-hedging transaction.
EXAMPLE 14.2 | NON-HEDGING DERIVATIVES TRANSACTION

A portfolio manager is managing a Canadian-based U.S. equity balanced fund, which is benchmarked against the
S&P 500. The fund is experiencing strong cash inflows due to very strong net sales. The manager finds it difficult
to invest the large cash reserve because few stocks meet the fund’s investment requirements. She decides to use
derivatives to enter a non-hedging transaction to quickly increase market exposure without actually purchasing
stocks.
The portfolio manager wants to gain very quick market exposure because, given the large cash position, she does
not want the fund to miss out on market movements. She could gain that exposure by purchasing all 500 stocks
in the S&P 500 in exactly the same proportion as their weight in the index. This purchase would certainly provide
market exposure, but it is an inefficient way to do so given transaction costs, time to implement, and the need to
rebalance daily.
Index futures allow the manager to gain the same broad market exposure instantly and very efficiently. The S&P
500 futures represent 250 times the level of the index. Therefore, if the S&P 500 is trading at 1,820, one S&P 500
futures contract represents market exposure of US$455,000.
This Canadian fund currently contains investments in the following proportions:
• U.S. equities – US$75 million
• Canadian cash – C$25 million
Assume the current exchange rate between the Canadian dollar and the U.S. dollar is at par and that the manager
wants to increase U.S. market exposure to 85% of the total value of the fund. She must therefore increase the
fund’s U.S. market exposure by US$10 million.
Given that one futures contract equals market exposure of US$455,000, she must purchase 22 contracts
(US$10,000,000 ÷ US$455,000).
ADDITIONAL NON-HEDGING INFORMATION

Two additional regulations in NI 81-102 that relate specifically to the use of derivatives for non-hedging purposes
impose two restrictions:
• The total amount that can be invested in derivatives contracts (10% maximum of net assets of a fund)
• Appropriate portfolio holdings to ensure that leverage is not used

DERIVATIVES USE AND DISCLOSURE

Mutual funds that use derivatives must fully disclose that fact in the fund’s Simplified Prospectus. The prospectus
must also explain how derivatives will be used to achieve the mutual fund’s investment and risk objectives, and the
limits and risks involved with their use. The disclosure of risks involved in derivatives typically includes all potential
risks of most derivative instruments, even if the fund does not intend to invest in every type.
The following text is typical of the disclosure wording found in a prospectus explaining the use of derivatives by a
mutual fund for hedging and non-hedging purposes:
When using derivatives for hedging purposes, a Fund seeks to offset or reduce a specific risk associated with all, or
a portion, of an existing investment position, or group of investments or positions. A Fund’s hedging activity may
therefore involve the use of derivatives to manage interest rate risk and reduce the Fund’s exposure to underlying
interests such as securities, indices and currencies.
The Fund may also use derivatives for non-hedging purposes to gain exposure to underlying interests, such as
individual securities, asset classes, indices, currencies, market sectors and markets, without having to invest
directly in such underlying interests, in order to reduce transaction costs and to expedite changes to the Fund’s
investment portfolio. While derivatives are being used by a Fund for non-hedging purposes, the Fund must
generally hold cash, the interest underlying the derivative and/or a right or obligation to acquire such underlying
interest in sufficient quantities to permit the Fund to meet its derivative obligations without recourse to the other
assets of the Fund.
RISKS OF DERIVATIVES USE BY MUTUAL FUNDS

Derivatives offer mutual fund managers a number of useful tools with which to improve management of their
portfolios, and thereby improve efficacy for investors. However, derivatives are not without risk or cost. Listed below
are four such risks:
Basis risk Basis risk arises whenever one kind of risk exposure is hedged with an instrument that
behaves in a similar, but not necessarily identical, manner. For example, a portfolio
manager might use S&P/TSX 60 Index futures to hedge the price risk of a Canadian stock
portfolio. It is not always possible to find a hedging instrument that is a perfect match to
the risk being hedged.
Additional monitoring Mutual funds engaging in derivatives impose upon themselves an obligation to monitor
burden the derivative positions, paying particular attention to strike prices and expiration
dates. Failure to roll over derivatives contracts as they expire can potentially introduce
a significant tracking error between the returns of the derivatives and the returns of the
underlying security. In large firms with relatively complex back-office systems, this risk
may not be meaningful, but for firms less familiar with monitoring derivatives positions,
the increased effort can impose considerable costs.
Limited returns in A portfolio manager who employs covered call writing to generate further income runs
covered call writing the risk that the stock will be called away if its price rises significantly above the strike
price of the option. The covered call writer keeps the premium received but loses out on
any appreciation above the strike price, which may limit performance.

Hedging costs Like insurance, derivatives protect against some potential adverse events. The cost of
this insurance is either the forgone opportunity to generate windfall gains (as with the
locked-in prices associated with forwards and futures hedging) or cash losses (in the
form of outlays for the purchase of option premiums). To evaluate the cost of hedging
accurately, the manager must consider it in light of the implicit cost of not hedging –
that is, relative to the potential loss and its impact on the overall performance of the
fund.

Hedge Funds 15
CONTENT AREAS
What Is a Hedge Fund?
Hedge Fund and Commodity Pool Regulation
How Hedge Funds Use Derivatives
Risks of Derivatives
Advantages of Derivatives
Disadvantages of Derivatives
LEARNING OBJECTIVES
1 | Define the term hedge fund.
2 | Identify the three main hedge fund product structures.
3 | Identify the basic aspects of securities regulation that govern the distribution of commodity pools
in Canada.
4 | Describe how hedge funds and commodity pools use derivatives.
5 | Demonstrate the primary potential risks associated with the use of derivatives in hedge fund and
commodity pool management.

KEY TERMS
closed-end fund hedge fund
commodity pool NI 81-104

CHAPTER 15 | HEDGE FUNDS 15 • 3
WHAT IS A HEDGE FUND?

The term hedge fund is almost guaranteed to inspire strong feeling, whether positive or negative, among people
both within and outside the investment industry. Despite wide familiarity and media attention, however, the term
has no legal standing or definition in Canada. It is commonly used to describe lightly regulated pools of capital that
have great flexibility in their choice of investment strategies. These strategies are often referred to as alternative
investment strategies.
Some hedge funds are conservative; others are more aggressive; and, despite the name, some funds do not hedge
their positions at all. For that reason, it is best to think of a hedge fund as a type of fund structure rather than a
particular investment strategy.
As discussed briefly in Chapter 5, hedge funds are not constrained by the rules that apply to mutual funds. Hedge
fund managers can take short positions, use derivatives for leverage and speculation, perform arbitrage transactions,
and invest in almost any situation in any market where they see an opportunity to achieve positive returns. Because
hedge fund managers have tremendous flexibility in the types of strategies they can employ, the manager’s skill
tends to be more important in hedge funds than in almost any other type of managed product.
HEDGE FUND PRODUCT STRUCTURES

Hedge funds sold in the retail market are usually structured as one of three types: commodity pools, closed-end
funds, or principal-protected notes (PPNs). The three structures are defined as follows:
Commodity pools Retail investors can gain access to some hedge fund strategies through commodity
pools, which are a special type of mutual fund that can use derivatives in a leveraged
manner for speculation. Commodity pools can also sell (net) short, whereas mutual
funds generally cannot. Unlike conventional mutual funds, commodity pools must be
sold under a long-form prospectus, and special proficiency requirements are imposed on
mutual fund salespeople who sell them.
Closed-end funds To avoid mutual fund investment restrictions, a hedge fund may be structured as a
closed-end fund. Redemptions by such a fund, if any, occur only once a year, or even
less frequently. Closed-end funds can be offered to retail investors by prospectus, but
they are not subject to the investment restrictions that apply to mutual funds. To
provide liquidity to fund investors, closed-end funds are often listed on the Toronto Stock
Exchange, which allows retail investors to gain access to them through the secondary
market.
Principal-protected The PPN is a popular structure not subject to securities law restrictions. Such products
notes can provide investors with exposure to the returns of one or more hedge funds and a
return of principal on maturity. The principal is guaranteed by a bank or other highly
rated issuer of debt securities, such as the Canadian Wheat Board or the Business
Development Bank. These products are not defined as a security and are therefore not
subject to the rules and restrictions of securities laws. As a result, the PPN is a popular
structure through which retail investors can gain access to hedge fund strategies. These
products are discussed further in Chapter 16.

HEDGE FUND AND COMMODITY POOL REGULATION

National Instrument 81-104 (NI 81-104) was introduced in 2002 and amended in 2019 with the coming into
force of the CSA’s modernization of investment fund product regulation1. The 2019 amendments modernized
the commodity pool regime by designating commodity pools as alternative mutual funds and by expanding the
scope of alternative strategies in which such funds may invest. Permitted activities include more aggressive use of
specified derivatives and the use of leverage.
In Canada, managed futures funds, which are often thought of as a type of hedge fund, can be structured as
commodity pools. Commodity pools can be sold as mutual funds to general investors, not just accredited or
sophisticated investors, as is the case with most hedge funds. However, regulators require commodity pools to provide
greater disclosure of the risks of derivative usage and leverage. As well, the proficiency requirements for mutual fund
companies and agents who sell these products are higher than the same requirements for conventional mutual funds.
Hedge funds, however, have few regulatory constraints on the types of strategies they use, and derivatives may be
used in any manner within any type of strategy. Derivatives are used more often by managed futures, global macro,
emerging markets (if derivatives are available), fixed, income arbitrage, and equity market-neutral strategies. The
implementation of the strategies depends on the fund’s managers, the specifics of the markets in which the fund is
active, and the perceived opportunities in that market.
DISTRIBUTIONS
In Canada, if a trade of securities is a distribution, it must be done with a prospectus unless properly exempted.
The term distribution generally refers to an issue of securities that were not previously issued. Hedge funds are
distributed without a prospectus, primarily in the exempt market, to high-net-worth and institutional investors.
There are three commonly used prospectus exemptions:
Minimum investment The minimum investment exemption allows hedge funds to sell securities without a
exemption prospectus to investors who make a prescribed minimum investment. The amount
prescribed differs among the provinces and territories.
Accredited investor In many provinces, an accredited investor generally includes pension funds, trust
exemption companies, and corporations with net assets of at least $5 million (according to recent
financial statements). Individuals are also accredited investors if they beneficially
own, alone or with a spouse, financial assets having an aggregate realizable value
(before taxes, but net of any related liabilities) exceeding $1 million. Individuals may
also be accredited investors if they have net income before taxes exceeding $200,000
($300,000 if combined with a spouse’s income) in each of the two most recent years,
and a reasonable expectation of exceeding the same net income level in the current year.
Check in your local jurisdiction for specific requirements.
Offering memorandum All jurisdictions except Ontario, Quebec, and Yukon have a rule granting a prospectus
exemption exemption under two conditions:
• The issuer must deliver an offering memorandum to investors in a prescribed form
and within a prescribed time.
• The issuer must obtain a signed acknowledgement of risk from those investors.
An offering memorandum is a legal document stating the objectives, risks, and terms of
investment involved with a private placement.
1 CSA Notice of Amendments – Modernization of Investment Fund Product Regulation – Alternative Mutual Funds. (https://www.osc.gov.
on.ca/en/SecuritiesLaw_csa_20181004_81-102_alternative-mutual-funds.htm)

HOW HEDGE FUNDS USE DERIVATIVES

Hedge fund strategies range from simple to downright esoteric. Many of the strategies used by the hedge fund
Long Term Capital Management involved derivatives and were quite complex. The fund ultimately lost more than
US$4 billion of its investors’ money. Both market and credit events underscored serious weaknesses in some of its
strategies.
Conversely, the derivative strategies that sank Amaranth Advisors were relatively straightforward calendar spreads
and next-month arbitrage. Amaranth had very concentrated positions in a specialized market and, because of the
high number of contracts held, they could not unwind positions without adversely affecting prices when the market
moved against them. Within one week, Amaranth’s wrong-way natural gas bet lost US$4.6 billion. Losses upon
liquidation several weeks later totalled US$6.6 billion.
It is important to note that, regardless of the strategy employed, hedge funds use derivatives to speculate, hedge,
arbitrage, and gain market exposure, just like other derivatives users. It is their minimal regulation, ability to short-
sell or take highly concentrated positions, and use of leverage that sets them apart from mutual funds.
Hedge fund strategies can generally be categorized into three basic groups, as follows:
Relative value strategies Equity market-neutral, convertible arbitrage, and fixed-income arbitrage strategies
Event-driven strategies Merger or risk arbitrage, distressed securities, and high-yield bond strategies
Directional strategies Long/short equity, global macro, emerging markets, managed futures, and dedicated
short bias strategies
Example 15.1 illustrates a global macro fund’s use of derivatives.
EXAMPLE 15.1 | RELATIVE PERFORMANCE STRATEGY

The manager of a global macro hedge fund is bullish on Mexican equities and bearish on French equities. Rather
than buying the major stocks in the Mexican index and shorting the major stocks in the French index, the hedge
fund manager buys Mexican stock index futures and sells French stock index futures, using the maximum
leverage available.
If the manager’s view is correct and the Mexican equity market outperforms the French equity market, this
strategy will be profitable to the fund. If the manager’s view turns out to be wrong, the fund can quickly exit both
positions. Note that this strategy is established so that its profitability depends only on the relative performance
of the two markets. It is not necessary for the Mexican market to go up and the French market to go down in
order to be profitable. If the Mexican market rises by more than the French market, or the Mexican market
declines by less than the French market, the strategy will still be profitable for the hedge fund.

Another derivatives strategy often used by hedge fund managers is to exploit the shape of the yield curve or credit
spreads in a particular market. This strategy is illustrated in Example 15.2.
EXAMPLE 15.2 | YIELD CURVE STRATEGY

A hedge fund manager believes that the U.S. Treasury yield curve will flatten, meaning that long-term Treasury
yields will fall relative to short-term Treasury yields. As in Example 15.1, it is not necessary for long-term yields to
fall and short-term yields to rise. If the yields move in the same direction, the yield curve will flatten as long as
the decline in long-term yields is greater than the decline in short-term yields, or as long as the increase in long-
term yields is less than the increase in short-term yields.
The manager establishes a position to profit from this view by buying forwards or futures on long-dated Treasury
securities, and by selling forwards or futures on short-dated Treasury securities. If the yield curve flattens, as the
hedge fund manager expects, the derivatives based on long-dated Treasury securities will rise in value relative
to the derivatives based on short-dated Treasury securities. The hedge fund manager will close out the trades
when either a sufficient profit has been earned or losses reach an unacceptable level. The strategy can also be
terminated when the forwards mature. Alternatively, it can be continued indefinitely by rolling the contracts
forward.
RISKS OF DERIVATIVES
The minimal information that hedge fund managers are required to distribute puts the onus on investors and
their advisors to research a hedge fund manager before making an investment. Investors should read the offering
memorandum or other documentation carefully to understand the potential for loss.
One of the difficulties of hedge fund investing, other than lack of transparency, is that many hedge fund managers
employ complex investment strategies. As a result, an investor may not fully understand the techniques, risks,
or potential returns associated with the positions taken by the fund. Both the investor and the advisor must
undertake due diligence to understand the intended strategies of the hedge fund manager and the implications for
the investor.
However, the most thorough due diligence can fail if either the hedge fund manager or the strategies employed
change. For this reason, investors and advisors should maintain ongoing contact with the hedge fund manager
before and after making an investment. Informed contact allows them to determine what strategies or techniques,
if any, have changed and to assess the risks and rewards accordingly. Unfortunately, many, or even most, hedge fund
managers are reluctant to share specific details of their strategies and techniques.
ADVANTAGES OF DERIVATIVES
The use of derivatives by hedge fund managers (including commodity pool managers) provides benefits and
opportunities that might not otherwise be available, or that might only be available at greater cost. The use of
derivatives provides the following advantages for hedge fund managers:
• Variety and availability of strategies
• Separation of risks
• Liquidity
• Reduced time and cost to implement

DISADVANTAGES OF DERIVATIVES
Because of the risks associated with their use, not all hedge fund managers use derivatives.
The biggest concern is the potential for loss from leverage. Derivatives themselves do not necessarily increase the
risk of loss for an investor. However, derivatives are often used in conjunction with or as a way to facilitate leverage.
It is leverage that increases the risk.
Because derivatives are contractual agreements with rights and responsibilities beyond those of ordinary securities,
some additional considerations are required. Potential investors in hedge funds that use derivatives must consider
the following aspects:
• Leverage
• Transparency
• Performance attribution
• Liquidity
• Price limits
• Manager skill
• Volatility of returns

Principal Protected Notes
(PPNs) 16
CONTENT AREAS
What Are Principal-Protected Notes?
Structures of Principal-Protected Notes and the Use of Derivatives
Key Differences Between the Two PPN Structures
LEARNING OBJECTIVES
1 | Describe a principal-protected note.
2 | Identify the party that provides the principal protection at the PPN’s maturity.
3 | Describe the two main PPN structures.
4 | Identify the main components of the zero-coupon plus call option PPN.

KEY TERMS
Constant Proportion Portfolio Insurance principal-protected note
market-linked GICs zero-coupon bond plus call option
participation rate

CHAPTER 16 | PRINCIPAL-PROTECTED NOTES 16 • 3
WHAT ARE PRINCIPAL-PROTECTED NOTES?

Principal-protected notes (PPNs) are debt instruments that provide a return that is linked to the performance
of a specific underlying asset, such as a market index, a basket of stocks, or a mutual fund. As the name implies,
the issuer of a PPN guarantees the return of at least the principal value of the PPN on its maturity date. As a debt
instrument, any return is paid in the form of interest. In some cases, the issuer may guarantee a minimum positive
level of return, but otherwise the total return on the instrument is known only on or close to the maturity date.
Principal-protected notes began to emerge as a product type popular among advisors and retail investors in the
early 2000s. Since then, they have been issued with a return linked to mutual funds, hedge funds, stock market
indexes, commodity indexes, baskets of stocks, and many different combinations thereof.
ISSUERS OF PPNs
In Canada, PPNs are issued almost exclusively by Schedule I banks, although in the past they have been issued
by Schedule II banks, as well as Canadian Crown Corporations such as the Canadian Wheat Board and Business
Development Bank. Banks provide a guarantee on PPNs equal to that of its deposits, including savings accounts and
guaranteed investment certificates (GICs). However, unlike many of those deposits, including the closely related
market-linked GICs, PPNs are not insured by the Canada Deposit Insurance Corporation. In all cases, the value of the
guarantee is a function of the creditworthiness of the issuer.
REGULATION OF PPNs
Prior to the introduction of Principal Protected Note Regulations (PPN Regulations) as part of the Bank Act (Canada)
in 2008, PPNs were lightly regulated because they were not (and are still not) considered securities according to
securities legislation. The PPN Regulations require issuers to disclose to clients, both orally and in writing, certain
information about the PPN. Oral disclosure is required before the time of sale and written disclosure must be
delivered within two days of the sale. Because PPNs are sold through advisors, the onus is on the advisors to deliver
the oral disclosure and the advisors’ firms to deliver the written disclosure. Issuers of PPNs now include oral scripts
in PPN offering documents that meet the requirements of the PPN Regulations.
RELATIONSHIP TO MARKET-LINKED GICs

Many Canadian banks issue market-linked GICs through their branch networks and in the advisor market. Market-
linked GICs are GICs whose interest is linked to the performance of a market index, mutual fund, basket of
securities, or some other underlying asset. If this sounds similar to the definition of PPNs, it should; apart from
some basic structural and operational differences, market-linked GICs and PPNs are essentially the same product.
They are normally designed and managed by the same group that runs the bank’s PPN program and can be built
using the same techniques. So, although this chapter focuses on PPNs, most of the concepts also apply to market-
linked GICs.
STRUCTURES OF PRINCIPAL-PROTECTED NOTES AND THEIR USE OF

DERIVATIVES
The method that PPN issuers use to ensure that they can return investors’ principal and pay the return, if any, is
often referred to as the PPN’s structure. There are two broad structures used by PPN issuers:
1. Zero-coupon bond plus call option
2. Constant proportion portfolio insurance

ZERO-COUPON BOND PLUS CALL OPTION

The zero-coupon bond plus call option is both the oldest and the simplest PPN structure. A zero-coupon bond
(also called a strip bond) is a debt instrument that, like a Treasury bill, is purchased at a discount from its maturity
value. It does not pay interest from the time it is created until it matures. The difference between the purchase price
and the always-higher maturity value represents the interest earned on the bond. For example, if a zero-coupon
bond is trading at $95 and matures at $100, the $5 difference paid at maturity represents interest.
In the zero-coupon bond plus call option structure, the PPN issuer invests most of the proceeds in a zero-coupon
bond that has the same maturity as the PPN. The zero-coupon bond guarantees the return of principal on maturity.
The remainder of the proceeds from the sale of the PPN is invested in a call option on the underlying asset, which
provides the upside for the PPN.
Note that in Canada banks do not actually buy a zero-coupon bond and do not buy a call option from another bank in
the over-the-counter market or on an options exchange. What they do, however, is create the exact same exposures
internally and then manage the risk inherent in taking on the liability of the future payment to investors. The bank’s
structured products group manage this risk by “selling” a portion of the PPN proceeds to the bank’s funding desk in
return for a fixed, higher payment (the PPN’s principal) on the maturity date. In effect, the structured products group
has bought a zero-coupon bond issued by the funding desk. The structured products group then buys the relevant
exposure on the underlying asset from its derivatives desk. In effect, the derivatives desk writes the option itself and
manages the risk of this specific option in the context a larger book of related market exposures. These exposures can
originate from other PPNs and market-linked GICs the bank has issued, as well as individual over-the-counter options
it has written for its corporate and institutional clients. It is the derivatives desk’s responsibility to manage the bank’s
risk dynamically over time, using a combination of positions in both the cash and derivatives markets. So, although the
derivatives desk does not offset an option directly related to an individual PPN, it does actively buy and sell options,
and it trades individual stocks and exchange-traded funds to manage the overall exposure of its entire derivatives book.
SAMPLE ZERO-COUPON BOND PLUS CALL OPTION PPN #1

Assume that a bank’s structured products group wants to issue a simple 5-year PPN whose return is tied to the
S&P/TSX 60 Index, which is currently at 850. The bank’s funding desk says that it will pay $100 in five years in
return for a payment of $78.35 today. At the same time, the bank’s derivatives desk quotes a price of $18 on
a 5-year call option on the S&P/TSX 60 Index with a strike price of 850 and a notional value of $100. When
combined, the structured products group can pay $96.35 for a $100 PPN that provides exposure to the upside of
the S&P/TSX 60 Index above 850.
Zero-Coupon Bonds $78.35

ATM Call Option on S&P/TSX 60 Index $18.00
Total Cost $96.35
Investors are charged $100 for this PPN, leaving $3.65 left over. But banks do not create PPNs for free, and advisors
who sell PPNs to their clients expect to get paid for their efforts. The leftover amount, therefore, is used to pay
commissions to advisors and provide a profit margin to the bank.
After five years, either of two outcomes can occur:
• First, the S&P/TSX 60 Index can be equal to or below 850. In this case, the bank is only required to return the
principal value of the PPN to the owners of the PPN. The structured products group will obtain the principal
value from the bank’s funding desk and simply pass it along to investors in the PPN.
• Alternatively, the S&P/TSX 60 Index can be above 850. Assume it is 1100, representing an increase of 250
points, for a total return of 29.41%. This amount is equivalent to 5.29% on a compound annual basis. In this
case, the structured products group will receive a payment of $29.41 [((1100 – 850) / 850) × $100] from the
derivatives desk, on top of the $100 from the funding desk. The total amount of $129.41 per PPN is passed
along to investors in the PPN.

This direct, uncapped exposure to an equity index, with no downside risk, is the one of the simplest forms of
PPN possible. However, there is one problem with this example in the current market environment. The imputed
annual interest rate on a payment of $78.35 today in return for $100 in five years is 5%. In today’s low-rate
environment, a more realistic rate is closer to, say, 2%, which translates to $90.57 per $100. As you can see,
lower interest rates leave a lot less money left over to pay for the option, the bank’s profit margin, and the
advisors’ commissions.
Now the structured products desk is faced with a situation where it costs $90.57 for principal protection and $18
for the option, which, when taken together, is $8.57 more than what it can raise from investors for direct, uncapped
exposure to the S&P/TSX 60 Index. And this is without accounting for advisors’ commissions and the bank’s profit
margin.
What can the structured products desk do in this case? As it turns out, a lot. First, it must be recognized that the
cost of principal protection is essentially fixed for the length of the term chosen. The structured products group is a
price taker when it comes to the cost of principal protection. If the funding desk says it costs $90.57 to provide $100
in five years, then that is what it costs.
Assuming $3.65 is needed to pay advisor commissions and generate a profit for the bank, the structured products
group must now figure out what kind of exposure to the S&P/TSX 60 Index it can get for just $5.78 per $100 PPN.

The first thing the structured products group can do is to introduce what is called a participation rate into the
structure. A participation rate is expressed as a percentage and describes the portion of the upside growth in the
underlying asset that will be paid to investors in the PPN. In the original example, with direct, uncapped exposure,
the participation rate was effectively 100%, meaning that investors would receive all of the growth in the S&P/TSX
60 Index above the starting level of 850.
With only $5.78 per $100 PPN available to pay for the option, however, a 100% participation rate is not possible.
To determine what participation rate could be offered on this PPN, the structured products group must divide the
amount available to pay for the option by the cost of the option that provides 100% participation. In this case,
$5.78 / $18 is 32%, which means that a PPN could be offered where only 32% of the growth in the S&P/TSX 60
Index would be payable to investors at maturity.
As with the original case, there are two possible outcomes:
• If the index is at or below 850, then the outcome is the same as in the original example: the structured products
group receives $100 from the funding desk and passes it on to investors in the PPN.
• If the index is above 850, then the derivatives desk pays the structured products group only 32% of the
difference. Suppose, once again, it is 1100, representing at 29.41% total return. With a 32% participation rate,
the derivatives desk will pay the structured products group $9.41 per $100 PPN. This amount, combined with
the $100 from the funding desk, is returned to investors.

The structured products group might find it hard to sell a PPN with a 32% participation rate, so what they might
do instead is build the PPN so that there is a capped return payable to investors. This type of PPN offers 100%
participation above the starting level until the underlying asset reaches a predetermined maximum that equates to
the capped return. If the underlying asset is above this level at maturity, then investors receive the capped return
only.
So how does the structured products group build a PPN with a capped return? What they need to do is buy the
5-year call option on the S&P/TSX 60 Index with a starting level of 850 for a price of $18. They then write or sell a
5-year call option on the S&P/TSX 60 Index with a higher starting level, such that the option will bring in around
$12.22. The overall cost of the package of options will then be close to the $5.78 available to spend.

Suppose the derivatives desk offers the following call options on the S&P/TSX 60 Index:
Starting Level Price per $100 PPN

850 $18.00
875 $16.59
900 $15.26
925 $14.01
950 $12.85
975 $11.77
Assume that the structured products group agrees to forego some of the bank’s profit margin and decides to write
the call option with a starting level of 975. The combined cost of the two call options is $6.23. This PPN will provide
investors with 100% participation above a level of 850, up to a level of 975. Investors in the PPN do not participate
in the growth of the index above 975. Given that 975 is 14.7% above the current level of 850, and this is the most
that investors can receive, this structure is usually marketed as a PPN linked to the S&P/TSX 60 Index, with a
maximum return of 14.7%.
Now consider the possible outcomes at maturity:
• Once again, if the S&P/TSX 60 Index is below 850 the structured products group will receive $100 from the
funding desk and pay this amount to investors in the PPN.
• If the S&P/TSX 60 Index is at, say, 950, the call option with a starting level of 850 will be worth $11.76, and the
call option with a starting level of 975 will be worthless. The derivatives desk will pay $11.76 to the structured
products group, who will return this, along with the $100 from the funding desk to the PPN investors.
• If, however, the index is at 1100, the call option with a starting level of 850 will be worth $29.41, and the
call option with a starting level of 975 will be worth $14.71, calculated as [((1100 – 975) / 850) × $100]. The
derivatives desk subtracts $14.71 from $29.41 and pays the difference of $14.70 to the structured products
group, who returns this amount, along with the $100 from the funding desk, to the PPN investors.
If this sort of return profile sounds familiar, it should. What the structured products group has essentially done is
enter into a bull call spread with the derivatives desk. The 850 call option was purchased and the 975 call option was
sold, thereby limiting the return on the PPN to the 125 index points between these two levels. This maximum return
is realized when the S&P/TSX 60 Index finishes at or above 975 at maturity in five years.
CONSTANT PROPORTION PORTFOLIO INSURANCE

A second PPN structure, known as constant proportion portfolio insurance (CPPI), can also be used to provide
exposure to an underlying asset while ensuring that the principal value of the investment is available at maturity.
The structure of a CPPI is based on portfolio insurance techniques. Such techniques provide for monitoring the risk
of a portfolio and deciding when to switch from more risky to less risky investments to ensure that the principal
is protected. Generally, as the value of the risky asset increases, or as interest rates rise, the allocation to the risky
asset increases, and the allocation to the risk-free asset decreases. Likewise, as the value of the risky asset falls, or
as interest rates fall, the allocation to the risky asset falls, and the allocation to the risk-free asset increases. (Recall
that a risk-free asset’s price decreases when interest rates rise and increases when interest rates fall.)
The key difference between the two PPN structures is that, in the zero-coupon bond plus call option structure, the
principal guarantee is provided by the investment in an actual zero-coupon bond. In the CPPI structure, the zero-
coupon bond is purchased only if the value of the underlying asset falls and principal protection is required. In the
case of the CPPI structure, the issuer continually tracks how much it would cost to buy the zero-coupon bond to

guarantee the principal at maturity. As long as the value of the investment in the risky asset remains above this so-
called “floor value”, the issuer can stay invested in the risky asset with the objective of matching the performance of
the underlying asset.
As with the zero-coupon bond plus call option structure, the first step in building a CPPI structure is to determine
the initial price of the zero-coupon bond. Because interest rates should be nearly identical regardless of the
structure used, the calculation for the bond portion is the same. The ending value at maturity of the PPN, also
known at issuance, is 100% of the initial assets raised, or the initial value of the PPN.
The CPPI structure, then, assumes that the theoretical initial value of the bond is a minimum asset value. Consider
the bond plus call option example using a 5-year term with interest rates at 2%. Likewise with CPPI, for every dollar
raised, as long as 90.57 cents is invested in a zero-coupon bond, the principal of the invested capital is protected.
The CPPI structure simply compares the value of the PPN’s assets with the theoretical value of what the bond
would be worth as time elapses between issue and maturity. As long as the value of the PPN’s assets is above the
theoretical value of the bond (i.e., the floor value), most of the PPN’s assets remain invested in the underlying asset.
At maturity, the issuer is able to pay investors a return equal to the performance of the underlying asset, as shown
in Figure 16.1.
Figure 16.1 | CPPI Structure, PPN Assets Staying Above Floor Value
$ PPN’s assets
Cushion
Floor value
Time
In Figure 16.1, the issuer never needs to buy the zero-coupon bond. However, if the value of the PPN’s assets falls,
the issuer may sell some of these underlying assets to invest the funds in the zero-coupon bond. The sale would
shelter part of the PPN’s assets from the decline in the underlying asset, thereby protecting the value of the PPN’s
assets. If the value of the PPN’s assets declines to the floor value, the issuer must invest all of the assets in the zero-
coupon bond to ensure that the PPN can provide the principal guarantee on its maturity date. Because no assets
would then be invested in the underlying asset, there would be no opportunity to earn any return on the original
investment. In this case, the PPN’s investors would not receive any return on their original investment.
Prior to the financial crisis of 2008-2009, a lot of PPNs in Canada were issued using the CPPI structure. When
markets suffered significant losses, the issuers of these PPNs were forced to invest the assets of the PPN in zero-
coupon bonds, so that the principal could be returned at maturity. Many investors and advisors were surprised to
learn that their investment in these PPNs would provide no return, even though many of them were several years
away from maturing. Issuers have since abandoned the use of the CPPI structure in Canada.

KEY DIFFERENCES BETWEEN THE TWO PPN STRUCTURES

The two main structures used to construct PPNs differ in several important ways. The first difference is in the
certainty of the final payoff. In the zero-coupon bond plus call option structure, the value of the PPN at maturity
can be calculated for every given value of the underlying asset at maturity. The option ties the return of the
structure very closely to the return of the underlying asset. Conversely, a CPPI structure has a payoff that is
unpredictable given the performance of the underlying asset because its exposure to the underlying asset varies.
Another difference between the two main structures is their opposite performance throughout the term of the PPN
under different interest rate environments. Using the zero-coupon bond plus option structure, a rising interest rate
environment will have a detrimental effect on the post-issue performance because rising rates will force the value of
the zero-coupon bond (which accounts for the large majority of the PPN’s assets) to drop. Falling rates, on the other
hand, cause the value of the zero-coupon bond to rise and therefore have a positive effect on the value of a PPN.
The CPPI structure, in contrast, behaves in exactly the opposite way. Rising rates force the cost of the theoretical
bond lower, which can increase the cushion, resulting in a greater allocation of assets of the note to the risky
underlying asset. Falling rates, on the other hand, decrease the cushion, and thus the allocation to the risky asset.
Finally, within a CPPI structure, once the PPN’s assets become fully invested in the zero-coupon bond, the PPN
ceases to have any exposure to the underlying asset. Even if the underlying asset subsequently recovers, the
PPN will not benefit from the recovery. For that reason, the investor could earn no return, even if the price of the
underlying asset at maturity is higher than its price on the date of issue.
RISKS INHERENT IN PPNs

Principal-protected notes carry with them the following risks for investors that are distinct from those faced by
investors in traditional investments:
Liquidity risk Issuers of most PPNs claim there is a secondary market for investors to sell their PPNs before
maturity; however, they are under no binding obligation to repurchase a PPN from an investor
wishing to cash out. To protect themselves from market disruptions, issuers usually reserve the
right not to maintain a secondary liquid market.
Performance risk Investors risk earning no return because of poor performance of the underlying asset, or
they may earn a lower return than that of the underlying due to features like participation
rates and capped returns. Consequently, advisors should perform a detailed analysis, as they
would before recommending any other investment, and not get too swayed by the principal
protection feature.
Inflation risk Protection of the principal applies only to the nominal value of the principal, not its real value.
The purchasing power of the investment could erode over the term of the PPN if the return is
lower than the rate of inflation.
Timing risk With most PPNs, the investor’s return depends on the underlying asset’s price at only one point
in time – the maturity date. If the price of the underlying asset rises steadily over the term of
the PPN, then drops sharply just before maturity, the return will be adversely affected.
Credit risk The principal protection afforded by PPNs is always subject to the creditworthiness of the
issuer. Unlike bank deposits, PPNs are not covered by deposit insurance. The issuer is the only
party to which investors can turn for the repayment of the principal and the payment of the
return. Thus, the investor is exposed to the credit risk associated with the issuer.

Derivative-Based
Exchange-Traded Funds 17
CONTENT AREAS
Introduction
Commodity Exchange-Traded Funds
Swap-Based ETFs and the Synthetic Replication of Indexes
Leveraged and Inverse ETFs
LEARNING OBJECTIVES
1 | Describe how futures may be used in the creation of an ETF.
2 | Describe how swaps may be used in the creation of an ETF.
3 | Explain the unique risks to investors of derivative-based ETFs.

KEY TERMS
collateral basket unfunded swap
funded swap

CHAPTER 17 | DERIVATIVE-BASED EXCHANGE-TRADED FUNDS 17 • 3
INTRODUCTION
Over the past few years, exchange-traded funds (ETFs) have become increasingly popular. Traditional and derivative-
based ETFs now offer investors the ability to take bullish, bearish, and leveraged positions on an ever-larger range
of indexes and benchmarks. With this increased variety of offerings comes an elevated duty of care for advisors in
determining whether these products are at all times suitable for their clients. As always in the financial industry, it is
crucial that advisors fully understand the products and transactions they recommend. This chapter helps meet that
need by explaining how derivatives, namely futures and swaps, are used in popular, non-traditional ETFs such as
commodity-based, swap-based, leveraged, and inverse ETFs.
COMMODITY EXCHANGE-TRADED FUNDS

Commodity ETFs are designed to provide direct exposure to the price movements of an underlying commodity or
commodity index. Exposure is achieved through either of two ways: physical ownership or synthetic replication.
PHYSICAL OWNERSHIP
With physical ownership, the ETF actually invests in, and holds stocks of, a physical commodity stored in vaults
or warehouses. Shares in the ETF represent fractional interest in the trust that has ownership of the physical
commodity. The most popular ETF of this type is the State Street Gold Trust (symbol: GLD). Its gold is held in
London, England in the vaults of the fund’s custodian.
SYNTHETIC REPLICATION
In the case of synthetic replication, the ETF has no physical holdings of the commodity. Instead, the ETF holds
combinations of futures, swaps, and options that track the commodity price movement. For that reason, synthetic
replication ETFs are sometimes called derivatives-based ETFs. One of the best-known commodity ETFs using
synthetic replication is the United States Oil Fund ETF (symbol: USO). This ETF holds the near-month NYMEX crude
oil futures contract.
Futures contracts are the most common type of derivative used to synthetically replicate the performance of a
commodity index. There are two reasons for their popularity. First, the most commonly replicated commodity
indexes, such as the Dow Jones-UBS Commodity (DJ-UBS) Indexes and the S&P GSCI Indices, are themselves
constructed from the prices of futures contracts. It makes sense, then, to use futures contracts to attempt to
replicate their performance. Second, some commodities, including most agricultural commodities, are costly to
own and store but have established and active futures contracts available on them. Given the need to actually own
the commodity under the physical ownership model of commodity ETFs, the use of futures contracts and synthetic
replication is often a better alternative and can significantly reduce the cost and complexity of providing exposure.
THE FUTURES CURVE

When dealing with commodity ETFs that use futures contracts for synthetic replication, an important consideration
is how the shape of the futures curve affects the performance of the ETF relative to the performance of the
underlying commodity.
A futures curve is a graphical depiction of the price of the different maturities of a futures contract, from the nearest
maturity to the furthest maturity. At different periods, the curve of a particular futures contract may slope upward,
in which case the commodity is said to be in contango, or downward, in which case it is in backwardation. An upward
slope indicates that the futures price is increasing as the contract’s term to maturity increases, whereas a downward
slope indicates that the price is decreasing as the contract’s term to maturity increases.

For derivatives-based ETFs that use futures contracts, the slope of a futures curve has a direct impact on the total
return achieved by the ETF. As the contracts held by the ETF near expiration, the ETF must roll its position forward
into a deferred contract, which means it replaces the contracts it owns with the next available maturity. The slope
of the futures curve will dictate whether this rolling action produces a positive or negative return.
For futures markets that are most often in contango – sometimes severely so – each roll produces a negative return
and represents a financial drag on performance. This occurrence is known as negative roll yield. In such a situation,
investors must have a highly positive outlook on the underlying commodities to compensate for the anticipated loss
from rolling the underlying futures contracts.
Example 17.1 illustrates a scenario where the cost of rolling the futures contracts of a commodity in contango adds
to the downside tracking error of an ETF.
EXAMPLE 17.1 | NEGATIVE ROLL YIELD AND DOWNSIDE TRACKING ERROR

Consider a new ETF that is launched with an objective of replicating the return on gold using gold futures
contracts. The ETF’s strategy involves buying the most active near-term futures contract and rolling it to the
next-most-active futures contract as soon as the current contract enters the delivery month. Assume that it
is early January and that gold is trading at $1,500 per ounce in the spot market. The following active futures
contracts are available:
Contract Month Price

February $1505
April $1510
June $1515
The ETF has $10 million in assets at the start of January and buys enough February gold futures contracts at a
price of $1,505 to give it a $10-million exposure to the price of gold. During the month of January, the spot price
of gold rises 5% to $1,575, and at the end of the month the futures contracts are trading at the following prices:

February $1576
April $1580
June $1585
The ETF now rolls the February contracts into April contracts by selling the February contracts at $1,576 and
buying the April contracts at $1,580.
During February and March, the spot price of gold continues to increase, reaching $1,600 by the end of March. At
this point, the futures prices are as follows:

April $1601
June $1605
The ETF rolls its futures position again, selling the April contracts at $1,601, and buying the June contracts
at $1,605.

EXAMPLE 17.1 | NEGATIVE ROLL YIELD AND DOWNSIDE TRACKING ERROR

During April and May, the price of gold in the spot market keeps rising, finishing in May at $1,650. The June gold
futures contract is trading at $1,651, and the ETF sells its June futures at this price before rolling them into the
next active contract.
But now consider what has happened during the first five months of the year. The spot price of gold has risen
10% from $1,500 to $1,650. The ETF, in its attempt to replicate the price of gold using futures contracts on a
commodity in contango, has only been able to earn a return of 9.15%, calculated as follows:
 $1,576   $1,601   $1,651 
 × ×  − 1 = 0.0915 = 9.15%
 $1,505   $1,580   $1,605 
 
What is going on here? By having to continuously buy futures contracts that are consistently priced higher than
the spot price, the ETF is essentially locking the commodity’s carrying costs into the futures contracts every
time it rolls its futures position. It does not really matter whether the price goes straight up or down or is quite
volatile. As long as the market is in contango, the ETF will always underperform the spot price using the futures
roll strategy.
For markets that are in consistent backwardation, the exact opposite occurs. That is, with the futures price lower
than the spot price, the replication strategy always outperforms the spot price.
THE ROLL WINDOW

Because futures-based ETFs must periodically roll their holdings as described above, there is a real risk of
frontrunning by savvy market participants. Rollover periods are specified in prospectuses (for example, two weeks
before expiration), which gives traders a defined opportunity to buy the next month’s contract ahead of the ETF in
an attempt to profit from the tide of large buy orders from the ETF. As a result, the ETF may end up overpaying for
these contracts. In addition, the front runners add to market volatility. Investors wishing to trade futures-based ETFs
should be aware of the potential for this activity around roll dates.
SPREADING OUT EXPOSURE

In an effort to reduce the price impact of repeatedly rolling a large futures position, newly structured futures-based
ETFs increasingly spread their core holdings over multiple contract months.
SWAP-BASED ETFs AND THE SYNTHETIC REPLICATION OF INDEXES

Similar to the equity and commodity swaps covered in Chapter 13, ETFs make increasing use of total return swaps
(TRS) to replicate an index synthetically, rather than owning the physical assets. In the global ETF market, two basic
TRS structures serve as reference models: the unfunded swap and the funded swap.
UNFUNDED SWAP ETF STRUCTURE

With an unfunded swap ETF structure, the ETF first transfers cash equal to the notional exposure desired to the
swap counterparty. In return, the swap counterparty transfers a basket of collateral assets to the ETF (Figure 17.1a).
The assets in the collateral basket could be completely unrelated to the index the ETF is trying to replicate. The
total return on this collateral basket is then transferred to the swap counterparty in exchange for the index return
(Figure 17.1b).

Figure 17.1 | Unfunded Swap
Figure 17.1a
Cash
Swap
ETF
Counterparty
Collateral Basket
Figure 17.1b
Collateral Basket Return
Swap
ETF
Counterparty
Index Return
FUNDED SWAP ETF STRUCTURE

Under the funded swap ETF structure, the ETF transfers cash equal to the notional exposure to the swap
counterparty, which then provides the market return of the index the ETF is trying to replicate. The swap
counterparty must post collateral that is pledged to the ETF (Figure 17.2). If the swap counterparty defaults, the ETF
will claim the collateral. Because no returns are transferred from the ETF to the swap counterparty, the funded swap
structure resembles an index-linked note issued by the swap counterparty.
Figure 17.2 | Funded Swap
Cash
Swap
ETF
Counterparty
Index Return
Collateral
Posted
COUNTERPARTY RISK AND THE COLLATERAL BASKET

In both structures, the ETF relies on the swap counterparty to provide the performance of the index the ETF is trying
to replicate. In a way, the ETF exchanges tracking risk for counterparty risk. If the swap counterparty defaults, the
level of protection for ETF investors will depend on three conditions:
• How rapidly the ETF can access the collateral basket
• The quality of the securities in the collateral basket
• How easily these securities can be liquidated at a fair price in a potentially distressed market

To help investors evaluate the quality of the securities in the collateral basket, ETF providers usually release the list
of the securities held in collateral either annually or semi-annually, and on request.
LEVERAGED AND INVERSE ETFs

Leveraged ETFs are structured to provide daily returns that are two or three times the rate of return of the reference
portfolio. Inverse ETFs are structured to provide rates of return that are opposite to that of the reference portfolio.
Inverse ETFs can be either leveraged or unleveraged. Both leveraged and inverse ETFs generally use total-return
swaps to achieve the leveraged or inverse return effect (or both). Futures contracts can be used in addition to or
instead of total return swaps.
It is important to note that, for most of the leveraged and inverse ETFs currently available, the return magnified
or inversed is the daily return of the reference portfolio. They are designed to achieve their stated objectives on a
daily basis. The effect of compounding over longer periods can result in significantly different performance from the
performance (or inverse of the performance) of the underlying index or benchmark.1
Exhibits 17.1 and 17.2 are used to highlight the important note contained in IIROC Notice 09-0172 with the help of
three-day market price scenarios.
Exhibit 17.1 shows the changes in value of a $1,000 investment in an inverse ETF. The investment is made at the end
of Day 1 and held to the end of Day 3.
Exhibit 17.1 | Changes in Value of a $1,000 Investment in an Inverse ETF
In Scenario A, the market suffers a 2% drop on Day 2, then reverses up and closes on Day 3 at the level of Day 1.
Scenario B is similar except for an increase in volatility, with a drop of 10% on Day 2. Under both scenarios,
the compounding effect of the daily yield calculation used by leveraged and inverse ETFs produced a lag in the
performance of the ETF over the two-day holding period. But what happens if the market goes up first and then
goes down? The numbers from Scenarios C and D bear similar results.
Scenario Day Index Closing Inverse ETF Scenario Day Index Closing Level Inverse ETF
Level
Day 1 1000 $1,000.00 Day 1 1000 $1,000.00
A Day 2 980 $1,020.00 B Day 2 900 $1,100.00

Day 3 1000 $999.18 Day 3 1000 $977.78
Day 1 1000 $1,000.00 Day 1 1000 $1,000.00
C Day 2 1020 $980.00 D Day 2 1100 $900.00

Day 3 1000 $999.22 Day 3 1000 $981.82
The same market scenarios of Exhibit 17.1 are repeated in Exhibit 17.2, but this time with an investment of $1,000 in
a 2x inverse ETF.
1 IIROC Notice 09-0172 Rules Notice – Guidance Note – Sales Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds
http://www.iiroc.ca/Documents/2009/E786AB09-D19F-41B5-A63E-496352FF040C_en.pdf

Exhibit 17.2 | Changes in Value of a $1,000 Investment in a 2X Inverse ETF
The results clearly reveal that the lag in performance is amplified when leverage is employed.
Scenario Day Index Closing 2 x Inverse Scenario Day Index Closing 2 x Inverse
Level ETF Level ETF
Day 1 1000 $1,000.00 Day 1 1000 $1,000.00
A Day 2 980 $1,040.00 B Day 2 900 $1,200.00

Day 3 1000 $997.55 Day 3 1000 $933.33
Day 1 1000 $1,000.00 Day 1 1000 $1,000.00
C Day 2 1020 $960.00 D Day 2 1100 $800.00

Day 3 1000 $997.65 Day 3 1000 $945.45
In periods where the market exhibits high volatility and numerous price reversals, the lag in performance will
increase dramatically the longer the ETF position is held.
DAILY RESET TO MAINTAIN CONSTANT LEVERAGE

In both exhibits above, the inverse ETFs did exactly what they were supposed to do – they produced daily returns
that were 1x and 2x the inverse of the daily index returns. At the daily and intraday level, almost all leveraged and
inverse ETFs perform exceptionally well. To fully understand why these ETFs suffer potentially severe performance
lag in longer holding periods, it is imperative that you understand how they deliver their returns.
EXAMPLE 17.2 | DAILY RESET TO MAINTAIN CONSTANT LEVERAGE

In Scenario A of Exhibit 17.2, assume that the 2x inverse ETF investment consists of 1 ETF share valued at $1,000,
with an equal net asset value-per-share (NAVPS). Let’s also assume that the ETF uses futures contracts to make
daily adjustments to the derivative position delivering the ETF’s leveraged market exposure.
At the end of Day 1, the ETF uses the $1,000 of NAVPS as collateral for a $2,000 per share short derivative
exposure on the underlying index (i.e., 2x inverse leverage of the NAVPS). On Day 2, the 2% drop in the index
creates a mark-to-market gain of $40 per share and, consequently, a new ETF NAVPS of $1,040. The short
derivative exposure is now valued at $2,040 per share, giving it a leverage ratio of 1.96x ($2,040/$1,040 =
1.96). But this is not enough for the ETF to offer a 2x leverage ratio for the following day. The ETF must then
sell futures contracts to increase its short exposure to $2,080 per share, so that the leverage is restored to 2x
($2,080/$1,040).
On Day 3, the market reverses, and the index goes up 20 points (2.0408%), generating a marked-to-market loss
of $42.45 per ETF share ($2,080 × 2.0408%) and an ETF NAVPS below $1,000, at $997.55 ($1,040 – $42.45).
What happens to the ETF leverage ratio at the end of Day 3? At 2.04 [($2,080 – $42.45) / ($1,040 – $42.45)],
the leverage ratio is now too high, and the short derivative exposure must be reduced accordingly. The ETF must
buy back enough futures contracts to reduce the short derivative exposure to $1,995.10 per share, which restores
the leverage ratio of 2x ($1,995.10 / $997.55).

REBALANCING IN THE SAME DIRECTION OF THE MARKET

The necessity of buying after an up day and selling after a down day to be able to maintain a constant daily-reset
leverage ratio applies to both inverse and long-leveraged ETFs. The only difference is that long ETFs will buy and sell
(offset) contracts to maintain an appropriate long futures position, whereas inverse ETFs will buy (offset) and sell
contracts to maintain an appropriate short futures position.
Highly volatile markets with numerous trend reversals become treacherous for leveraged and inverse ETFs. In
such a trading environment, ETFs must frequently offset positions just taken, and they will do so at a loss. These
compounded losses are the main culprit for the severe performance lag sometimes found with leveraged and
inverse ETFs over longer periods.

PART 2 | WORKBOOK
SECTION 1
CHAPTER SUMMARIES
AND REVIEW QUESTIONS

An Overview of Derivatives 1
By the end of this chapter, you should be able to:

• Describe generally what derivatives are, the commonalities and differences between the various types
and how they are used.
A derivative is a financial instrument whose value is based on an underlying interest or asset.
• Describe the features that are common to all derivatives.

All derivatives:
are contractual agreements between two parties known as counterparties;
have a specific time to expiration;
establish a price or formula today for exchanging payments at some point in the future;
facilitate the use of leverage;
are zero-sum games.
• Differentiate between option-based and forward-based derivatives.

An option gives the holder the right, but not the obligation, to either buy (in the case of a call option) or sell
(in the case of a put option) a specified amount of an underlying interest at a specified price within a certain
time frame.
A forward contract obligates one party to buy and the other to sell a specified amount of an underlying interest
at an agreed upon price at a specified time in the future.
There are three primary differences between options and forward contracts:
Option-based contracts give their holders the right to buy (calls) or sell (puts), while forwards represent
obligations to buy or sell.
Options have value at expiration only if the price of the underlying interest is above (in the case of calls) or
below (in the case of puts) a trigger price known as the exercise price. Forwards develop value as soon as the
forward price changes relative to the entry or delivery price.
There is a cost to enter an option contract known as the premium. As forwards have no value upon entry
(delivery price equals forward price), there is no cost to enter a forward contract.

1•2 DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | VOLUME 1 • WORKBOOK
• Differentiate between exchange-traded and over-the-counter derivatives.
Item Exchange-Traded OTC

Contract Standardized Custom designed
Trade info Public Private
Early termination Easily done Not easily done
Third-party guarantor Clearinghouse None
Performance bond Always required Not required in many cases
Settlement Daily End of contract
Regulation Heavy Less regulated
Delivery Rare Usually takes place
Commissions Visible Earns a spread
The lines between OTC and exchange-traded derivatives however have become more blurred in recent years as OTC
derivatives reform continues to take hold.
• Identify the various financial needs clients may have that derivatives can address.
Reduce risk (i.e., hedge)
Hedging is accomplished by taking the appropriate position in a derivative so that potential losses in the cash
market are offset by gains in the derivative.
Reduce costs (e.g., exploit comparative advantages)
Swaps can be used to help companies reduce financing costs.
Efficiently enter and exit a market
Derivatives can be used to enter or exit a market more efficiently than using the actual underlying asset.
Enhance yield
Selling options provides additional income to portfolios.
Speculate
Taking a long or short position in any derivative will expose speculators to that market’s price movements.
Derivatives provide a low cost, leveraged, and efficient way to speculate in financial and commodity markets.
Arbitrage
Derivatives can be used to simultaneously buy and sell the same or related asset on two different markets to
exploit price inefficiencies.
Product Structuring
The use of derivatives allows product engineers to provide investors with highly focused investments that are
targeted to the investors risk profile, return requirements and market expectations.
• Identify the operational considerations firms that use derivatives must consider.
The use of derivatives must be integrated into an overall risk management program.
Organizations planning on using derivatives must establish strong internal controls and monitoring of its
derivatives operation.

SECTION 1 | CHAPTER SUMMARIES AND REVIEW QUESTIONS 1•3
KEY TERMS
Key terms are defined in the Glossary.
arbitrage over-the-counter
call option performance bond
comparative advantage premium
counterparties put option
exchange-traded swap
forward contract time to expiration
hedging underlying interest
leverage zero-sum game
option
By the end of this chapter, you should be able to answer the following questions:
1. List five features that all derivative instruments share.
2. An investor is trying to decide between purchasing an option or a forward contract on a Government of Canada
bond. List three differences between options and forwards.

3. If a speculator bought an ABC Co. call option with an exercise price of $60 and paid a premium of $2, over
what price would ABC stock have to rise in order for the speculator to earn a profit on the exercise of that
option?
4. When does a forward contract begin to develop value for the two counterparties?
5. A Canadian company has just exported US$800,000 worth of merchandise to the U.S. Payment is to be
received three months later in U.S. funds. The company is considering hedging its risk exposure because the
Canadian dollar may strengthen against the U.S. dollar over the next three months. To protect against a
potential rise in the Canadian dollar, the exporter can take a long position in Canadian dollar futures contracts
or use OTC forward exchange agreements. List and briefly explain four key differences between derivatives that
trade on an exchange and those that trade over-the-counter.
6. A dress manufacturer anticipates needing 1,000 pounds of cotton in three months. Cotton currently trades
in the spot market at US$0.52 per pound, and at this price will provide the manufacturer with the minimum
desired profit margin on its products. The company has decided to use cotton futures to hedge its price risk.
i. If the manufacturer did not hedge the future purchase, which of the following spot prices for cotton in three
months would put the company at risk?
a. US$0.45 per pound
b. US$0.50 per pound
c. US$0.52 per pound
d. US$0.65 per pound

ii. How would the company hedge its price risk using cotton futures?
a. Go long enough cotton futures to cover the entire purchase.
b. Go short enough cotton futures to cover the entire purchase.
c. Go long enough cotton futures to cover the first half of the purchase and go short enough cotton
futures to cover the second half of the purchase.
d. Go short enough cotton futures to cover the first half of the purchase and go long enough cotton
futures to cover the second half of the purchase.
iii. What other factors should the company consider before making the decision to hedge?
7. In three months, a Canadian importer will be buying US$1 million worth of new product from an American
supplier. The importer will be paying for the product in U.S. dollars. It wishes to hedge its currency risk between
now and when the invoice has to be paid. Currently $1 Canadian buys US$0.97.
i. Is the importer at risk if the Canadian dollar appreciates or depreciates relative to the U.S. dollar?
ii. If the importer decides to use a Canadian dollar option-based derivative to hedge the currency risk, what
should it do?
a. Buy a call option on the Canadian dollar.
b. Write a call option on the Canadian dollar.
c. Buy a put option on the Canadian dollar.
d. Write a put option on the Canadian dollar.

iii. Describe the advantages and disadvantages of using option-based derivatives versus forward-based
derivatives.
8. List two reasons why a portfolio manager may prefer entering and exiting an equity market by using a stock
market index derivative as opposed to buying or selling individual equities in the conventional way.
9. Distinguish between academic arbitrage and “real-world” arbitrage.
10. List two steps that a company embarking on a derivatives program should take to limit the potential danger
of derivatives.

Basic Features of Forward
Agreements and Futures 2
Contracts
• Discuss why forward markets developed.
Forward markets developed to help producers and consumers reduce or eliminate price uncertainty.
• Describe and distinguish the similarities and differences between futures contracts and forward
agreements.
All forward-based derivatives represent contracts between counterparties whereby one agrees to buy and one
agrees to sell an underlying asset at a predetermined future date at a price known as the delivery price.
The delivery price and the forward price are the same at the onset of the contract, therefore, a forward initially
has no value. It develops value as the forward price deviates from the delivery price agreed to in the forward
agreement.
Forward agreements:
are tailored to the specific needs of the counterparties;
have payoffs that occur only at the end of the contract;
are not easily transferable because they are custom designed;
have no third-party guarantor.
Futures contracts:
are standardized by the exchange where they trade;
have payoffs that occur on a daily basis (marking-to-market);
are easily transferable because they are standardized;
have a clearinghouse to acting as a third-party guarantor.
• Calculate the value of a forward agreement at any point in time.

At any point in time, the value of a forward agreement is equal to the difference between the delivery price of
the forward agreement and the current price of a forward agreement with identical terms. This includes the
asset underlying the contract and the maturity date.
At maturity, this value is equal to the difference between the delivery price and the spot price of the underlying
asset, because at maturity, the current price of a forward agreement with identical terms (in this case,
immediate delivery) is the same as the spot price of the asset.

• Explain how delivery works.

For futures contracts that have a deliverable underlying interest (almost all commodity futures and some
financial futures), the window during which delivery can be made usually lasts from three weeks to one month.
The delivery process is initiated by the short futures holder who, at anytime on or after first notice day, can
tender a delivery notice to the clearinghouse who in turn assigns it to a long futures holder. On delivery day the
short delivers the underlying asset to the long in exchange for a certified cheque.
Some futures contracts call for cash settlement. When a cash settled contract expires, an exchange of cash
is made between the long futures holder and the short futures holder. The amount of cash is based on each
individual participant’s entry price and the settlement price of the underlying interest. The most active cash
settled contracts are stock index futures.
• Explain the concepts of offset, margin, leverage, marking-to-market and trading limits.
Offset
Delivery is one way of settling the obligation of a futures contract. The other, more popular method is through
an offsetting transaction. For those parties with long positions, offset is accomplished by selling the same
futures contract. For those parties with short positions, offset is accomplished by buying the same futures
contract. Once a position is offset, there is no obligation to make or take delivery.
Margin
A margin deposit, or performance bond, is required upon entry into a futures contract, and is the same for
both a long futures position and a short futures position. The amount of the deposit is known as original or
initial margin. Maintenance margin refers to the minimum margin balance required in an account during the
life of the contract.
Leverage
The amount of leverage is indicated by the size of the margin deposit relative to the full value of the
underlying interest. Most futures contracts have initial margin requirements ranging from 3 to 10% of the
full contract value. The use of leverage results in larger swings in a trader’s profit or loss for any given change
in the price of the futures contract. This is why leverage is sometimes referred to as a double-edged sword. It
should be clear that the degree of leverage any individual market participant takes on is his or her own choice.
Leverage can be decreased by depositing more than the initial margin, and leverage can be avoided altogether
by depositing the full value of the contract.
Marking-to-market
Marking-to-market is the daily transfer of funds from losing positions to winning positions based on the
settlement price of the futures contract. If a losing position’s account falls under its maintenance margin level,
the account must have funds deposited to restore the account back to the original margin level.
Trading Limits
Most, but not all, contracts have daily price limits on the amount by which prices can move, either up or down,
during one day’s trading session. When these price limits are reached, trading does not necessarily stop.
Trading can occur at the limit, below the upper limit (if the market has traded limit up) or above the lower
limit (if the market has traded limit down).

• Calculate the profit or loss from a futures trade.

The profit or loss from a futures trade is calculated as the difference between the initial delivery price (also
known as the entry price) and the offsetting delivery price (also known as the offset price) multiplied by the
size of each contract and the number of contracts traded. It is recommended that the “buy” price be subtracted
from the “sell” price when calculating a profit or loss. This way, the “sign” (i.e., plus or minus) of the answer will
immediately inform you as to whether there has been a profit or a loss from the completed trade.
EXAMPLE
If a trader buys 1 March S&P Canada 60 futures contract ($200 × the index) at 650 and sells it one week later
at 660, the profit or loss will be calculated as follows:
(660 – 650) × $200 × 1 = +$2,000 = $2,000 profit
• Interpret a futures quotation page.

The following features of futures contracts are found on a futures quotation page:
Delivery months Change from previous settlement price

Opening price Open interest and volume
High and low prices Contract size and value
Settlement price
KEY TERMS
cash settlement margin
daily price limit marking-to-market
delivery notice offsetting transaction
delivery price original margin
first notice day settlement price
long position short position
maintenance margin warehouse receipt

1 • 10 DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | VOLUME 1 • WORKBOOK
By the end of the chapter, you should be able to answer the following questions:
1. Why did forward markets develop?
2. Two counterparties enter into a 3-month forward contract on gold with a delivery price of $580 per ounce.
i. What is the contract worth to both the buyer and seller at onset?
ii. With one month remaining on the contract the spot price of gold is $585 per ounce and 1-month gold
forwards are trading at $587.50 per ounce. What is the value of the contract in dollars per ounce to the long
holder?
a. –$7.50
b. –$5
c. $5
d. $7.50
3. An oil refining company that anticipates needing 1,000 barrels of crude oil in six months is concerned that
crude oil prices may change significantly in the interim.
i. Is the refiner concerned that prices might rise or fall?
ii. How would the company hedge its price risk using crude oil futures?
a. Go short enough crude oil futures to cover the entire purchase.
b. Go long enough crude oil futures to cover the entire purchase.
c. Go long or short depending the company’s outlook for crude oil prices.
d. Any of the above.
iii. If the refiner entered into a 6-month crude oil futures contract (1,000 barrels of crude oil per contract)
at $56 per barrel, what profit or loss would result if the refiner offset the contract at $58 per barrel?
a. $2,000 loss.
b. $2 loss.
c. $2 profit.
d. $2,000 profit.

SECTION 1 | CHAPTER SUMMARIES AND REVIEW QUESTIONS 1 • 11
4. Questions i) to iv) below are based on lumber futures, details of which are as follows.
Trading unit 110,000 board feet

Minimum tick size $0.10 per 1,000 board feet = $11 per contract
Daily price limit $10 per 1,000 board feet
i. In dollar terms, what is the value of one lumber futures contract given a price of $340 per 1,000 board
feet?
a. $374
b. $37,400
c. $74,800
d. $340,000
ii. Given a current price of $340, at what minimum price above $340 could the next trade occur?
a. $340.10
b. $341.10
c. $350.00
d. $350.10
iii. Given a previous day settlement price of $340, what is the lowest price lumber can trade at during the
current session?
a. $329.90
b. $330.00
c. $330.90
d. $340.00
iv. A trader sells 10 lumber futures at $340. If the trader offsets the position at $320, what is the profit or loss
on the trade?
a. $22,000 loss.
b. $20,000 loss.
c. $20,000 profit.
d. $22,000 profit.
5. A speculator buys 1 lumber futures contract at $330 and deposits original margin of $2,000.
i. What percentage of the value of the futures contract has the speculator deposited as margin?
a. Less than 1%
b. 2.9%
c. 3.6%
d. 5.5%

ii. If the speculator sells the lumber contract at $345, what is his return on the original margin deposit?
a. –75%
b. –82.5%
c. 82.5%
d. 500%
iii. If the speculator wants to earn a return on margin of 110%, at what price must the contract be sold?
a. $275
b. $300
c. $350
d. $406
6. If there are currently 30 open long futures positions and 30 open short futures positions in a particular futures
contract, what is the open interest?
a. 15
b. 30
c. 60
d. 900
7. A speculator sells 5 S&P Canada 60 futures ($200 × the index) at 620. At expiration the index settles at a level
of 610. What is the speculator’s profit or loss?
a. $10,000 profit.
b. $2,000 profit.
c. $2,000 loss.
d. $10,000 loss.
8. A hedger sells 5 May coffee futures (37,500 lbs. per contract) at $1.20 per lb. If the hedger tenders a delivery
notice on a day when May coffee futures settle at $1.30 per lb., what is the amount of the certified cheque
that the hedger will receive from the assigned long futures holder upon delivery?
a. $18,750
b. $45,000
c. $225,000
d. $243,750
9. A speculator buys 1 November canola futures (20 tonnes per contract) at $420 per tonne. If the speculator
sells the contract and ends up with a profit of $400, at what price was the contract offset?
a. $400
b. $440
c. $460
d. $820

10. If a short futures holder decides to make delivery, what information about the deliverable asset must be
conveyed to the clearinghouse?

Pricing of Futures Contracts 3
NOTE
Most of the concepts in this chapter can be applied to both exchange-traded and OTC forward agreements.
The chapter is presented from the perspective of exchange-traded forwards (i.e., futures contracts) only.

• Explain why futures differ from spot prices.
Futures prices represent the current price of the underlying asset adjusted for the cost of carry that arises from
delayed delivery of the asset.
• Describe the basic cost of carry model and explain how it works.
The cost of delayed settlement includes financing costs and storage and insurance costs. As well, any other
cash flows associated with owning the underlying asset must be considered.
The cost of carry model starts with the spot price of an asset and calculates the fair value futures price based
on these costs from the present until the maturity of the futures contract. The difference between a spot price
and a futures price is referred to as the basis.
• Explain how arbitrage keeps futures prices in line with the basic cost of carry model.
As the only difference between buying in the futures market and buying in the spot market is the delayed
settlement, it stands to reason that futures prices should be the same as spot prices adjusted for the costs of
the delayed settlement.
If futures prices deviate significantly from fair value, market participants will either buy the “cheap” alternative
or sell the “expensive” alternative or do both simultaneously. When participants buy and sell the same asset
simultaneously, it is referred to as arbitrage.
The collective actions of market participants attempting to buy low and sell high helps keep spot and futures
prices in line with one another during a futures contract’s life.
• Identify an arbitrage opportunity.

If a futures contract is trading at a price different than its fair value, an arbitrage opportunity may exist. In
general, the futures price must differ from its fair value price by more than the transaction costs involved in
executing the arbitrage before arbitrageurs will try to take advantage of the discrepancy.
• Explain how to exploit an arbitrage opportunity.

If the futures price is greater than its fair value price, the futures contract should be sold and the underlying
asset should be bought in the cash market. This is known as cash and carry arbitrage.

If the futures price is lesser than its fair value, the futures contract should be bought and the underlying asset
should be sold short in the cash market. This is known as reverse cash and carry arbitrage.
• Describe situations where the cost of carry model may not apply.
The cost of carry model applies to futures markets that display the following characteristics:
ease of short selling;
a large supply of the underlying interest;
high storability;
non-seasonal production and/or consumption.
When these conditions exist, arbitrage is easy to implement and futures prices will trade on the basis of fair
value as determined by the cost of carry model.
When these conditions do not exist, arbitrage may be very difficult or even impossible to implement. Futures
contracts based on these markets will trade more on the basis of expectations of the future spot price of the
underlying asset.
• Describe and calculate the basis of a futures contract.

The basis is a numerical measure of the difference between a cash price and a futures price.
As mentioned above, the basis is simply the difference between the spot price and the futures price.
• Explain the concepts of normal market, inverted market and convergence.

A normal commodity futures market (also referred to as a contango market) is one where futures prices trade at
a premium to spot prices reflecting all or at least some of the costs of carry.
An inverted commodity futures market (also referred to as a market in backwardation) is one where spot prices
are higher than futures prices. An inverted market places an increased value on owning the physical asset. This
value is known as a convenience yield.
Convergence is the process whereby futures prices gradually merge with cash prices as expiration of the
futures contract approaches.
KEY TERMS
arbitrage cost of carry
backwardation fair value
basis inverted market
cash and carry arbitrage normal market
contango reverse cash and carry arbitrage
convenience yield spot price
convergence

1. Questions i) and ii) below pertain to copper futures and are based on the following information.
Annual financing rate 4%

Spot price of copper $3.60 per pound
Storage costs $0.005 per pound per month
Insurance $0.015 per pound per month
i. What are the total monthly carrying costs for copper?

a. 1.2¢ per pound.
b. 2.0¢ per pound.
c. 2.7¢ per pound.
d. 3.2¢ per pound.
ii. What is fair value for 3-month copper futures?

a. $3.504 per pound.
b. $3.660 per pound.
c. $3.696 per pound.
d. $3.744 per pound.
2. In a contango commodity futures market, would the basis narrow or widen as the futures expiration
approaches?
3. As a general rule, are futures prices more easily underpriced or overpriced relative to fair value?
Explain your answer.

4. Which of the following situations would present an opportunity for risk-free profits from a cash and carry
arbitrage strategy?
a. The spot price is lower than the futures price.
b. The spot price is lower than its fair value.
c. The futures price is higher than its fair value.
d. The futures price is lower than its fair value.
5. If 6-month gold futures are trading at $775 per ounce and the spot price is $760 per ounce, what is the implied
annualized cost of carry rate?
6. A farmer is currently holding 600 tonnes of canola. An elevator is offering to pay the farmer $400 per tonne
for the canola. The 3-month canola futures contract is trading at $420 per tonne. The cost of carrying canola
is $5 per tonne per month.
i. What is the better option, selling the canola to the elevator or holding the canola and selling the futures
contract (and then making delivery against the futures contract in three months’ time)?
ii. At what futures price is the farmer indifferent between the two options?
a. $395
b. $405
c. $410
d. $415
7. In an inverted commodity futures market, convergence dictates that futures prices will _____________ relative
to cash prices.

8. With which of the following is the concept of convenience yield most closely associated?
a. Contango markets.
b. Convergence.
c. Cash and carry arbitrage.
d. Inverted markets.
9. List three reasons why a commodity futures price may trade lower than its cash price.

Hedging with
Futures Contracts 4

• Explain how futures contracts are used to reduce risk.
Futures can be used to reduce the risk of holding a particular asset for future sale or they can be used to reduce
the risk involved in anticipating the purchase of a particular asset. Both of these are accomplished through
hedging, which is achieved by combining the position in an underlying asset with the opposite position in a
futures contract.
• Define short and long hedges.

A short hedge is executed by someone who owns an asset that will be sold at some point in the future, and as
a result is at risk if the asset’s price falls. To offset or reduce this risk, the short hedger sells a futures contract.
A long hedge is executed by someone who anticipates owning an asset at some point in the future, and as a
result is at risk if the asset’s price rises. To offset or reduce this risk, the long hedger buys a futures contract.
• Calculate the net profit or loss from a hedged transaction.

The overall profit or loss from a hedged transaction is derived from two sources: the cash transaction and the
hedge transaction.
• Define perfect and imperfect hedges.

A perfect hedge will occur with certainty if the following two conditions are met:
1. The end of a hedger’s holding period matches the expiration date of the futures contract.
2. The asset being hedged matches the asset underlying the futures contract.
Even if one or both of these conditions are not met a hedge may still turn out to be perfect if the basis
behaves as expected by the hedger.
An imperfect hedge occurs when the basis behaves unexpectedly. Hedges may turn out to be imperfect if
there is a difference between the asset underlying the futures contract and the asset being hedged, or if the
assets match but the hedge is lifted early and the basis has changed unexpectedly.
A cross hedge is implemented with a futures contract whose underlying asset does not exactly match the
asset that is being hedged.
• Explain and differentiate between market risk and basis risk.

Market risk is the risk of adverse changes in the price of an asset that is currently owned or that will be owned
in the future.
Basis risk is the risk of unexpected changes in the basis.
A hedge can only be justified if it can reasonably be expected that basis risk will be lower than market risk.

• Explain why some futures contracts are more prone to basis risk than others.
The easier it is to arbitrage a particular market, the more likely futures prices will trade in a predictable manner
relative to spot prices (on the basis of the cost of carry).
Where arbitrage is difficult or impossible to implement, futures prices may trade in an unpredictable manner
relative to spot prices, leaving a hedged position exposed to considerable basis risk.
Futures markets that have the following characteristics are easily arbitraged and as a result do not have
significant basis risk. When these conditions are not apparent, basis risk can be considerable.
Large supply of underlying asset
Storability
Non-seasonal production and consumption
Ease of short selling
• Define the optimal hedge ratio.

The optimal hedge ratio is a number used to calculate the correct number of futures contracts to use in a hedge.
The ratio is calculated by studying the historical correlation between the price of the asset being hedged and
the futures price.
• Calculate an optimal hedge ratio given the required inputs.

An optimal hedge ratio, H, is calculated as follows:
σ 
H = ρ ×  P 
 σF 
where:
σP = the standard deviation of changes in the spot price of the asset to be hedged
σF = the standard deviation of changes in the futures price
ρ = the correlation coefficient between changes in P and F
KEY TERMS
basis risk long hedge
cross-hedge optimal hedge ratio
hedging perfect hedge
imperfect hedge short hedge

1. A home builder anticipates the need for lumber in three months’ time.
i. What kind of price risk is the builder facing?
ii. Using lumber futures, would the home builder employ a short hedge or a long hedge to reduce or eliminate
this price risk?
2. Under what two conditions will a hedger know with certainty that a hedge will turn out to be perfect?
3. An orange juice distributor anticipates needing 75,000 pounds of orange juice in six months’ time.
i. Which of the following hedge strategies would the distributor employ using orange juice futures contracts
(15,000 pounds per contract)?
a. Sell 5 orange juice futures.
b. Buy 5 orange juice futures.
c. Sell 50 orange juice futures.
d. Buy 50 orange juice futures.
ii. The distributor entered into the appropriate number of orange juice futures at $1.90 per pound. Six months
later, just prior to the contracts’ expiration, the distributor offsets the contracts at $1.80 per pound. What
is the total dollar profit or loss on the futures contracts?
a. $7,500 loss
b. $1,500 loss
c. $1,500 profit
d. $7,500 profit

iii. Upon liquidation of the futures contracts, the distributor bought 75,000 pounds of orange juice in the cash
market at $1.80 per pound. What is the distributor’s net effective purchase price per pound after taking
into account the futures profit or loss?
a. $1.70
b. $1.80
c. $1.90
d. $2.00
4. On April 15, a Manitoba farmer begins to implement a hedging plan for his canola crop, which will be harvested
in October. The farmer expects the canola crop to yield approximately 1,000 metric tonnes.
i. Will the farmer implement a long hedge or a short hedge?
ii. Given that the size of one canola futures contract is 20 tonnes, how many canola futures contracts should
the farmer use in his hedging program?
iii. The farmer implements the hedge at a futures price of $390. In October the harvested canola is sold at a
price of $400 per metric tonne and the futures contracts are offset at $410 per metric tonne. What is the
farmer’s net total dollar amount received for the 1,000 metric tonnes?
a. $380,000
b. $390,000
c. $400,000
d. $410,000
5. In a normal commodity futures market, will a long hedger gain or lose the basis as the futures contract nears
expiration?

6. A large, Canadian-based silver mining company knows that it will be selling 50,000 ounces of silver in six
months’ time. The spot price of silver is currently $13.00 per ounce, while the 6-month silver futures contract
is trading at $13.60 per ounce. The cost of carrying silver is $0.10 per ounce per month.
i. If the company uses silver futures to hedge its price risk, would it be a long or short hedge?
ii. Because of significant increases in worker productivity, the company is able to bring the silver to market
after four months. The company sells the silver in the cash market at $12.25 per ounce. If this hedge is to
be considered perfect, at which of the following silver futures prices would the company need to offset the
futures contracts?
a. $12.05
b. $12.25
c. $12.45
d. $12.65
7. A confectioner that specializes in making fine chocolate anticipates a need for 1,000 metric tonnes of cocoa in
three months’ time. The confectioner is concerned that cocoa prices may move in an adverse way leading up
to the time the cocoa is needed. The confectioner has gathered the following information:
Current spot cocoa price $1,800 per tonne

Current 3-month cocoa futures price $1,845 per tonne
Total cost of carry ($15/tonne/month) $45
Contract size 10 tonnes
i. If the confectioner decides to hedge, will it be a long hedge or a short hedge? How many contracts are
needed?
ii. If the hedge is implemented, what is the profit or loss on the futures contracts if they are offset at a price
of $1,815 per tonne with one month left to expiration?
a. $30,000 loss.
b. $3,000 loss.
c. $3,000 profit.
d. $30,000 profit.

iii. If at the same time the futures contracts are offset the physical cocoa is purchased at $1,800 per metric
tonne, what is the confectioner’s net purchase price per metric tonne?
a. $1,785
b. $1,815
c. $1,830
d. $1,845
iv. How did the basis change over the life of the hedge?
a. It stayed the same.
b. It narrowed by $15 per tonne.
c. It narrowed by $30 per tonne.
d. It widened by $30 per tonne.

Speculating with
Futures Contracts 5

• Explain and list the reasons why speculators are attracted to futures markets.
Speculators are attracted to futures markets for a variety of reasons. The primary reasons include:
i. ease of entry and exit;
ii. a wide variety of opportunities;
iii. leverage; and
iv. excitement.
• Describe the different types of futures speculators.

Locals
Locals operate from the floor of the exchange and generally have a very short time horizon for their trades.
Day traders
Day traders tend to take more risk than locals, and try to liquidate all positions by the end of each trading day.
Position traders
Position traders attempt to profit from longer-term price swings and in the process avoid getting whipsawed
as much as day traders and locals.
Spread traders
Spread traders try to profit from changing relationships between two or more futures contracts. Once a
potential trade opportunity is identified, spread traders buy the underpriced futures contract and sell the
overpriced futures contract.
Managed product investors

Managed product investors invest in the futures market through professionally managed vehicles, including
managed accounts, managed futures funds, and commodity pools.
• Explain what a futures spread strategy is.

A futures spread strategy involves the purchase of one futures contract and the simultaneous sale of one or
more different futures contracts that are related in some fashion.
Each individual futures contract in a spread is referred to as a leg of the spread.

• Identify the four different types of futures spread strategies.

There are four types of futures spreads:
Intramarket Spreads (also known as time or calendar spreads)
An intramarket spread involves the purchase and sale of futures contracts that have the same underlying asset
but different delivery months.
Intercommodity Spreads
An intercommodity spread involves the purchase and sale of futures contracts that have different but related
underlying assets.
Intermarket Spreads
An intermarket spread involves the purchase and sale of futures contracts with the same underlying asset
trading on different exchanges.
Commodity Product Spreads

A commodity product spread involves the purchase and/or sale of a commodity futures contract with an
opposite position in the futures contracts of the products of that commodity.
• Calculate the profit or loss from a futures spread strategy.

For most types of spreads, the profit or loss on the spread strategy can be calculated in one of two ways.
First, a profit or loss from each leg of the spread can be calculated separately. Adding up the separate profits
and/or losses results in an overall profit or loss for the spread.
Second, the profit or loss can be derived from a single calculation using the spread prices directly.
• Explain the differences between fundamental and technical analysis.

Fundamental analysis is the study of an asset’s supply and demand factors to help forecast future price
movements. Technical analysis involves the study of price, open interest and volume to help forecast future price
movements. Rather than attempting to understand the supply and demand factors that cause price movements
(as fundamental analysis does), technical analysis focuses on the price movements themselves.

KEY TERMS
commodity pools managed futures accounts
commodity product spread managed futures funds
day traders mini contracts
fundamental analysis position traders
intercommodity spread spread
intermarket spread spread traders
intramarket spread technical analysis
locals (scalpers) whipsaw
1. If a speculator bought 1 June gold futures contract (100 ounces) at a price of $570.65 and offset the contract
at $578.20, what is the return on margin if the speculator had made a margin deposit of $1,800?
a. –57.68%
b. –41.94%
c. 41.94%
d. 57.68%
2. A speculator bought 3 November canola futures (20 tonnes per contract) at $402.50. The speculator
subsequently sold the contracts at $421.70 per tonne and as a result earned a 20% return on margin. What
total initial margin deposit did the speculator make?
a. $1,152
b. $1,920
c. $3,840
d. $5,760
3. If a speculator wants to profit from relative price changes in different delivery months of the same underlying
commodity, what type of spread would she enter into?

4. A trader bought 5 July canola futures (20 tonnes per contract) at $406.80 per tonne and simultaneously sold
5 November canola futures at $422.10 per tonne. The trader subsequently offset the spread with November
canola trading $28.50 per tonne higher than July canola. What is the trader’s overall profit or loss on the
spread trade?
a. $2,640 loss
b. $1,320 loss
c. $1,320 profit
d. $2,640 profit
5. A speculator bought 10 soybean futures (5,000 bushels per contract) at $6.45 per bushel, sold 11 soybean
meal futures (100 tons per contract) at $165.80 per ton, and sold 9 soybean oil futures (60,000 lbs. per
contract) at $0.2763 per lb.
Two weeks after implementing the spread, the speculator sells 10 soybean futures at $6.5475, buys 11 soybean
meal futures at $168.70 per ton, and buys 9 soybean oil futures at $0.2765 per lb.
What is the speculator’s overall profit or loss on the spread?
a. $8,173 loss
b. $1,577 loss
c. $1,577 profit
d. $8,173 profit
6. List three limitations of fundamental analysis.

Basic Features of Options 6

• Discuss the history of options trading.
Equity options were available OTC only, from the early 1900s until the opening of the CBOE in 1973. The
Montreal Exchange was the first exchange to list options for trading in Canada in 1975.
• Define and describe the importance of key option terms.

Options are contracts between a buyer, or holder, and a seller, or writer. The holder of the option is said to be
long the option and the writer is said to be short the option.
Holders of call options have the right, but not the obligation, to buy the underlying asset from the writer within
a specified period of time that ends on the expiration date. Holders of put options have the right to sell the
underlying interest. The price at which option holders can buy or sell the underlying asset as part of the option
contract is referred to as the exercise, or strike, price.
To enforce the terms of the contract, option holders must exercise the option. This is an instruction to the writer
of the option to sell (in the case of a call) or buy (in the case of a put) the underlying asset to or from the option
holder at the strike price.
Buyers of options pay writers a premium. The size of the premium is determined in a competitive marketplace
and takes into account a number of different factors.
An exchange-traded option’s trading unit represents the standardized size of the underlying interest. All equity
options in North America have 100 shares of the underlying stock as their underlying interest. Other types of
options have various trading units.
Options that can be exercised at any time up to and including the expiration date are called American-style
options. All equity options traded in North America are American-style options. Options that can be exercised
only at expiration are called European-style options. Most, but not all, stock index options are European-style
options.
A new option position (either long or short) is established by way of an opening transaction. A closing
transaction (selling a long position or buying back a short position) in the same option contract is required to
offset any rights or obligations associated with a position established as part of an opening transaction.
Option premiums can consist of intrinsic value and time value. Intrinsic value is the tangible worth of an option
and cannot be less than zero. Any excess of the premium over the intrinsic value is time value. A call option’s
intrinsic value is defined as the underlying asset price minus the call option’s strike price. A put option’s intrinsic
value is defined as the put option’s strike price minus the underlying asset price. The time value of both calls and
puts is defined as the option premium minus intrinsic value.

If an option has positive intrinsic value, it is in-the-money. Option holders will only consider exercising an option
if it is in-the-money. It would not make financial sense to do so otherwise. Call options are in-the-money when
the price of the underlying asset is higher than the call’s strike price. Put options are in-the-money when the
price of the underlying asset is lower than the put’s strike price. When an option’s (call or put) strike price is
equal to the underlying asset’s price, it is considered to be at-the-money. Finally, when a call option’s strike price
is above the underlying asset’s price, it is considered out-of-the-money. Put options are out-of-the-money when
the underlying asset is trading above the put’s strike price.
• Apply key option terms to various option positions and strategies.

Examples 13.1 – 13.4 in the text provide a good application of key option terms to the four basic option
strategies: call option buyer, call option writer, put option buyer and put option writer.
• List and explain why options are purchased.

Leverage
Options give purchasers the opportunity to achieve large profits on a relatively small investment because the
premium paid for options is usually only a fraction of the price of the underlying interest.
Limited risk
Option buyers know that the most that can be lost is the cost of the option premium because they have the
right to let the option expire without taking any further action.
• List and explain why options are written.

Additional income
Options are primarily written to collect the premium income received when they are written.
• List and explain the advantages of exchange-traded options versus OTC options.
Exchange-traded options have the same advantages over OTC options as exchange-traded forwards
(i.e., futures) have over OTC forwards. Specifically, exchange traded options offer:
a third-party guarantor;
increased liquidity;
more comprehensive disclosure and surveillance rules; and
price transparency.
• Read and interpret an options quotation page.

Table 13.8 in the textbook displays a typical option quotation page from an option exchange website. You
should be able to answer questions about options given the information in an option quotation page.

KEY TERMS
American-style intrinsic value
assigned out-of-the-money
at-the-money time value
covered trading unit
European-style uncovered
in-the-money
1. XYZ stock is trading at $51 and XYZ 50 puts are trading at $3. How much time value is built into the price of
the XYZ 50 puts?
a. $0
b. $1
c. $2
d. $3
2. ABC stock is trading at $59 and ABC 60 calls are trading at $2. What is the intrinsic value of the ABC 60 calls?
a. $0
b. $1
c. $2
d. $3
3. DEF 80 call options are trading at $3.50. For these options to be considered in-the-money, at what price must
DEF stock be trading?
a. At any price above $80
b. At any price below $80
c. At any price above $83.50 only
d. At any price below $76.50 only

4. What is the primary difference between an American-style option and a European-style option?
5. A speculator wrote 5 CEB 60 call options at $2. Two weeks later, CEB common stock is trading at $63 and
the speculator liquidates the calls at a price equal to their intrinsic value plus $0.50 of time value. What is
the speculator’s profit or loss on the transactions?
a. $750 loss.
b. $150 loss.
c. $350 profit.
d. $750 profit.
6. A speculator is short 5 GHI 40 puts. With GHI stock trading at $35, the speculator is assigned on
the five options. Which of the following will occur as a result of the assignment?
a. The speculator will buy 500 shares of GHI and pay $17,500.
b. The speculator will buy 500 shares of GHI and pay $20,000.
c. The speculator will sell 500 shares of GHI and receive $17,500.
d. The speculator will sell 500 shares of GHI and receive $20,000.
7. Why is the risk for a buyer of a put or a call limited to the premium paid?
8. Why is the risk for a naked call option writer unlimited?

9. How does the risk and reward from buying an equity call option compare to buying the underlying stock?
10. A speculator is trying to decide whether she should sell a stock short or write call options on the stock. The
stock is currently trading at $50 and she is interested in the May 50 calls on the stock that are currently
trading at $3.
How does the risk and reward potential of short selling the stock at $50 compare with the sale of May 50 call
options at $3?
a. The short selling alternative has more risk and a greater reward.
b. The short selling alternative has more risk and a smaller reward.
c. The short selling alternative has less risk and a smaller reward.
d. The short selling alternative has less risk and a greater reward.

Pricing of Options 7

• Describe the difference between intrinsic value and time value.
Intrinsic value represents the real and tangible value of an option and is based solely on the relationship
between and option’s strike price and the price of the underlying asset.
Time value is the amount that an option is trading in excess of its intrinsic value. The time value of an option
depends on several factors, as noted below. As the level of uncertainty about where the underlying price will
be at expiration increases, the amount of time value built into an option’s premium increases.
• List the factors that affect intrinsic value and time value.
Intrinsic Value
If an option is in-the-money, intrinsic value is the difference between the strike price and the underlying price.
Prior to expiration, all American-style options and virtually all European-style options trade at a price that is
at least equal to their intrinsic value.
Occasionally (although very rarely), a European-style option will trade at a discount to its intrinsic value. This
“discount” can be thought of as negative time value. The fact that a discount can arise is a direct result of the
two different exercise features.
Time Value
The time remaining to expiration has an important effect on the time value of an option. The longer an option
has until expiry, the more the option will be worth. However, the relationship between time and an option’s
value is not linear. An option’s time value decays faster the closer the option is to expiration.
In terms of dollars, the time value of an option is at its maximum when the underlying price is equal to the
strike price (i.e., the option is at-the-money). As the option moves in-the-money or out-of-the-money, the
dollar amount of time value decreases (although the percentage of an option’s premium represented by time
value may go up or down).
Perhaps the most important variable affecting time value is the expected volatility of the underlying asset. All
else being equal, the more volatile the market expects the underlying asset to be over the life of the option,
the more time value will be built into the option premium and the more the option will be worth. This is true
for both calls and puts. Historical volatility is the actual past volatility exhibited by the price of the underlying
asset. Traders will sometimes use the historical volatility as an estimate of the future volatility when using
option-pricing models. To understand what level of volatility the market is building into the price of an option,
the price of the option is fed into an option-pricing model and the model is solved for volatility. The volatility
figure arrived at through this process is known as the option’s implied volatility.

The net cost of carrying the underlying asset is also a determinant of the amount of time value built into an
option’s premium. The cost of carrying most underlying assets consists of the risk-free rate of interest and any
yield on the underlying instrument.
• Explain how changes in these factors affect an option’s value.

Holding all other variables the same, changes in the factors that affect an option’s value impact call and put
premiums as follows:
An increase in the volatility of the underlying asset increases both call and put premiums. A decrease in the
volatility of the underlying asset decreases both call and put premiums.
An increase in the risk-free interest rate increases call premiums and decreases put premiums. A decrease in
the risk-free interest rate decreases call premiums and increases put premiums.
An increase in the yield of the underlying asset decreases call premiums and increases put premiums.
A decrease in the yield of the underlying asset increases call premiums and decreases put premiums.
• Describe and explain the importance of an option’s delta.

An option’s delta is a number that measures the approximate change in the value of an option premium given a
1-unit change in the price of the underlying asset.
Option deltas are important for a variety of reasons. First, option deltas allow option traders to estimate how
much an option value will change given a change in the price of the underlying asset. If an option trader has an
opinion on the price of the underlying asset, this can be used to estimate the return on an option position.
Second, an option’s delta acts like a hedge ratio, allowing hedgers to estimate the number of contracts required
to hedge a position in the underlying asset. To use the delta as a hedge ratio, divide the option-adjusted size
of the exposure being hedged by the option’s delta. The option-adjusted size of the exposure is the size of the
exposure divided by the option’s trading unit.
Because deltas change as the price of the underlying asset changes, a delta hedging program needs to be
constantly monitored for changes in option deltas.
• Calculate an option’s delta given all the inputs.

The inputs required to calculate an option’s delta are: the change in the price of the underlying asset and the
corresponding change in the price of the option.
Change in Price of the Option
Delta =
Change in Price of the Underlying Asset
• Calculate the expected change in an option’s price given the delta and the change in the underlying
asset’s price.
A simple rearrangement of the above formula provides the following formula for calculating the expected
change in an option’s price given the delta and the change in the underlying asset’s price:
Change in Price of an Option = Delta × Change in Price of the Underlying Asset

KEY TERMS
delta intrinsic value
delta hedging time value
historical volatility volatility
implied volatility
1. DEF 50 call options are trading at $5. DEF stock is trading at $56. If DEF options have an American-style
exercise feature, which of the following steps must be taken to exploit the arbitrage opportunity?
a. Buy DEF 50 call options at $5 and sell DEF stock short at $56.
b. Sell DEF 50 call options at $5 and buy DEF stock at $56.
c. Buy DEF 50 call options at $5, sell DEF stock short at $56 and exercise the options.
d. Sell DEF 50 call options at $5, buy DEF stock at $56 and exercise the options.
2. XYZ stock is trading at $40. Which of the following options (all expiring in the same year) will have the
greatest dollar amount of time value built into its price?
a. XYZ March 35 calls
b. XYZ March 40 calls
c. XYZ June 35 calls
d. XYZ June 40 calls
3. ABC Inc. has just announced an increase in its dividend payable. All else being equal, what effect will this have
on ABC option premiums?
a. ABC call option premiums will increase and ABC put option premiums will decrease.
b. ABC call option premiums will decrease and ABC put option premiums will decrease.
c. ABC call option premiums will increase and ABC put option premiums will increase.
d. ABC call option premiums will decrease and ABC put option premiums will increase.
4. If the delta of a call option is 0.6 and the price of the underlying asset rose from $45 to $50, what would you
expect to happen to the price of the call option?
a. Increase by $0.60.
b. Increase by $1.50.
c. Increase by $3.00.
d. Increase by $8.33.

5. The price of JKL stock has increased from $20 to $22. At the same time, the price of JKL 20 put options
decreased by $0.40. What was the put option’s delta prior to the change in the stock price?
a. –1
b. –0.4
c. –0.2
d. 0.2
6. PQR May 35 calls have a delta of 0.6. What is the corresponding delta of PQR May 35 puts?
a. –0.6
b. –0.4
c. 0.4
d. 0.6
7. When would a hedger utilize a delta hedging technique?
8. A portfolio manager owns 10,000 shares of MNO Inc. The stock is currently trading at $65. The manager
wants to buy MNO 65 put options to protect the portfolio from a sharp decline in the price of MNO. If the
MNO 65 puts have a delta of –0.5, how many option contracts will give the portfolio manager dollar for dollar
protection from a decline in the price of MNO?
a. 50
b. 100
c. 200
d. 500

Over-the-Counter Options 8

• Describe what interest rate caps, floors and collars are.
• Explain how interest rate caps, floors and collars can be used to hedge interest rate risk.
Interest Rate Caps
An interest rate cap is a series of European-style OTC interest rate call options that mature on dates
established by the two counterparties. Interest rate caps establish a maximum interest rate that will be paid
by the holder of the cap for the term of the contract. The individual options within an interest rate cap are
referred to as caplets.
An issuer of floating-rate debt, or any party that is at risk that a floating interest rate will rise, can purchase an
interest rate cap to set the maximum interest rate that the issuer will pay on the debt in a rising interest rate
environment.
Interest Rate Floors

An interest rate floor is a series of European-style OTC interest rate put options that mature on dates
established by the two counterparties. Interest rate floors establish a minimum interest rate that will be
received by the holder of the floor for the term of the contract.
Any party that is at risk that a floating interest rate will fall can purchase an interest rate floor to set the
minimum rate to be received in a declining interest rate environment.
Interest Rate Collars

An interest rate collar is a combination of a cap and a floor in which the purchaser of the collar buys a cap and
simultaneously sells a floor. The seller of the collar is on the other side of the transaction: selling the cap and
buying the floor.
An interest rate collar can be purchased by an issuer of floating-rate debt who wants to cap the maximum
interest rate on the loan, but finds the cost of an interest rate cap too expensive. To effectively reduce the cost
of the cap, an out-of-the-money interest rate floor can be sold, and the proceeds can be applied against the
cost of the cap.
• Calculate the payoffs from interest rate caps, floors and collars given all the inputs.
The buyer of an interest rate cap will receive a payoff from the writer of the cap at the end of an interest
payment period if the reference rate was above the ceiling rate at the beginning of the interest payment period.
The payoff is calculated as follows:
Payoff = (Reference Rate – Ceiling Rate) × Principal × Length of the Payment Period

The buyer of an interest rate floor will receive a payoff from the writer of the floor at the end of an interest
payment period if the reference rate is below the floor rate at the beginning of the interest payment period.
The payoff is calculated as follows:
Payoff = (Floor Rate – Reference Rate) × Principal × Length of the Payment Period
The buyer of a collar will receive payments from the cap when the reference rate is above the ceiling rate, but
will be required to make payments on the floor when the reference rate is below the floor rate.
• List and describe the main features of exotic options.

Compound options are options on options.
Asian options are options whose payoffs are based on the average price of the underlying security during the
term of the contract.
Barrier options are options whose payoffs depend on whether or not the underlying asset reaches a
predetermined “barrier” price during the life of the option.
Multi-asset options are options whose payoffs depend on the prices of more than one asset.
Shout options are options that permit the holder at any time during the life of the option to establish,
on his/her choice, a minimum payoff that will occur at expiration.
KEY TERMS
Asian option floor rate
barrier option interest rate cap
caplet interest rate collar
ceiling rate interest rate floor
compound option multi-asset option
exotic option shout option

By the end of this chapter you should be able to answer the following questions:
1. On June 1, Year 1, ABC Corp. borrows $10 million for one year. On September 1, December 1, March 1 and
June 1, ABC will pay its lenders interest at a rate equal to 3-month LIBOR at the beginning of each period.
ABC’s treasurer is concerned about the impact of rising interest rates over the remaining term of the loan, so it
approaches an OTC derivatives dealer and inquires about the cost of an interest rate cap. Three-month LIBOR
is currently quoted at 6%.
The treasurer of ABC decides to purchase an interest rate cap with a ceiling rate of 6.50%. The cap is based
on a notional principal of $10 million and is for a one-year period. ABC Corp. paid $100,000 to the dealer for
the cap.
i. Complete the following table of cash flows for ABC’s loan and the cap. Assume that each period has
90 days and that the loan and the cap are based on a 360-day year.
3-Month Interest Due Cap Principal Net Cash Flow Net Cash Flow
LIBOR Rate on Loan Payments Payments With Cap Without Cap
Date % $ $ $ $ $
Jun. 1 6.00
Sep. 1 6.75
Dec. 1 7.50
Mar. 1 7.00
Jun. 1 7.25
ii. Did ABC benefit by entering into this cap? What number can you calculate to support your answer?
iii. How much would ABC have received in total cap payoffs if 3-month LIBOR never rose above 6.50%?

2. It is January 1, Year 1, and XYZ Bank has just made a 2-year $25 million dollar loan to a corporate customer.
The customer will pay interest on the loan equal to the bank’s prime rate, which is currently 10%. The loan
will pay interest on a semiannual basis. The prime rate applicable to each period is also reset on a semiannual
basis. The treasurer of XYZ Bank decides to purchase an interest rate floor on the loan to provide protection
against a decline in the prime rate. The floor has a floor rate of 9.50% and costs XYZ $250,000. The floor is for
a two-year term and is based on a $25 million notional principal amount.
i. Complete the following table of cash flows for this floor. Assume that each period has 180 days and that
the loans and the floor are based on a 360-day year.
Prime Interest Due Floor Principal Net Cash Flow Net Cash Flow
Rate on Portfolio Payments Repayment With Floor Without Floor
Date % $ $ $ $ $
Jan. 1 10.00
Jul. 1 9.00
Jan. 1 8.50
Jul. 1 9.75
Jan. 1 9.25
ii. All else being equal, would the floor have cost more or less if the floor rate was 9.25% instead of 9.50%?
Why?
3. It is March 1, Year 1, and DEF Corp. has just finalized the details on a US$100 million loan from MNO Bank. The
term of the loan will be one year, and DEF will pay MNO interest every three months equal to 3-month LIBOR
+ 0.75%.
The treasurer of DEF is concerned that interest rates may increase sharply over the next two years and would
like to protect the company using OTC interest rate options.
i. What should the treasurer of DEF do to protect the company from an increase in interest rates?
a. Buy an interest rate cap.
b. Sell an interest rate cap.
c. Buy an interest rate floor.
d. Sell an interest rate floor.

ii. What type of exercise style do the options listed in Question i) have?
a. American.
b. European.
c. Bermudan.
d. Asian.
DEF contacts an OTC derivatives dealer and enters into the appropriate option position. For a premium of
US$300,000, the option will have a reference rate of 3-month LIBOR and an exercise rate of 6.75%. Currently,
3-month LIBOR is 6.25%.
The loan has interest payment dates of June 1, September 1, December 1, and March 1. Assume that each
three-month period has 90 days and that the loan and the option agreements stipulate that payments will be
made on the basis of a 360-day year.
On March 2, Year 2 (at expiration of the option position), the treasurer of DEF is analyzing the decision she
made to enter into the option position one year earlier. To aid her in the analysis, she produces the following
table (with certain numbers missing):
3-month Interest Option Principal Net Cash Flow Net Cash Flow
LIBOR on Loan Payments Payments With Option Without Option
Date % $ $ $ $ $
Mar. 1 6.25 – –300,000 100,000,000 99,700,000 100,000,000
Jun. 1 6.75 0 0
Sep. 1 –1,875,000 0 0 –1,875,000 –1,875,000
Dec. 1 7.25 –2,062,500 187,500 0 –1,875,000 –2,062,500
Mar. 1 – –2,000,000 125,000 -100,000,000 –101,875,000 –102,000,000
iii. What was 3-month LIBOR on September 1, Year 1?

a. 6.75%
b. 7.00%
c. 7.50%
d. 7.75%
iv. What interest payment did DEF make on June 1, Year 1?

a. US$1,562,500
b. US$1,687,500
c. US$1,750,000
d. US$1,875,000
v. How much did DEF gain or lose, in undiscounted dollar terms, by entering into the option position?
a. Lost US$300,000.
b. Lost US$12,500.
c. Gained US$12,500.
d. Gained US$300,000.

vi. All else being equal, would the premium for the option have been larger or smaller if it had an exercise rate
of 6.50%? Why?
a. Smaller because the option would have been less in-the-money.
b. Smaller because the option would have been further out-of-the-money.
c. Larger because the option would have been further in-the-money.
d. Larger because the option would have been less out-of-the-money.

Introduction to Swaps 9

• Describe what a swap is.
A swap is a particular type of OTC forward contract. In the most basic type of interest rate swap (referred to as
a “plain vanilla interest rate swap”) two parties agree to “swap” cash flows based on two different interest rates
on a certain principal amount referred to as the “notional” amount.
• List the differences and common features of a swap versus standard forward agreements.
The following table compares swaps and standard forward agreements:
Swaps Forward Agreements
fixes or establishes a price for a specified series of fixes or establishes a price for a specific point in time
time periods in the future in the future
potential cash payments on each coupon payment one cash payment on settlement date
date or upon triggering of credit event
cash payment is difference between reference rate cash payment is difference between contract rate and
and fixed rate current rate
• Describe the role of a swap dealer.

The role of a swap dealer is to facilitate the entire swap process by finding and bringing together the two parties
of a swap agreement and designing a product tailor-made to the needs of the two end-users.
• Describe the four areas of focus of the OTC derivatives market reform.
The four areas of focus of the OTC derivatives market reform are:
All standardized OTC derivatives should trade on exchanges or electronic trading platforms.
All standardized OTC derivatives should be cleared through central counterparties.
All OTC derivatives should be reported to trade repositories.
Non centrally cleared derivatives should be subject to higher capital requirements.

KEY TERMS
commodity swap interest rate swap
credit default swap (CDS) plain vanilla interest rate swap
credit derivatives swap
currency swap swap dealer
equity swap warehousing
1. Why is the principal amount on which a swap based referred to as a “notional” principal amount?
2. How is a swap dealer generally paid for the services it provides in facilitating a swap?
3. Describe what it means for a dealer to “warehouse” a swap.

4. List four typical uses of swaps.
5. What four areas of focus are addressed by the OTC derivatives market reforms introduced by the Group of
Twenty (G20) countries?

Interest Rate Swaps 10

• Describe what an interest rate swap is,
An interest rate swap is an agreement between two counterparties. In a typical plain vanilla interest rate swap,
one of the counterparties agrees to pay periodic cash flows based on a fixed rate of interest in return for periodic
cash flows from the other counterparty based on a floating rate of interest. Interest rate swaps only require a
net payment from the counterparty that owes the larger of the two cash flows.
Other interest rate swaps can be an exchange of payments based on two different fixed rates or two different
floating rates.
• Explain how interest rate swaps are priced,

Interest rate swaps are priced according to bond pricing techniques. In a plain vanilla interest rate swap, the
counterparty that pays interest at a floating rate and receives interest at a fixed rate has a position that is
equivalent to a long position in a bond with a coupon equal to the fixed rate and a short position in a bond with
a coupon equal to the floating rate. The other counterparty has the exact opposite position.
The pricing of an interest rate swap involves choosing the fixed rate coupon in such a manner that the value of
the fixed rate bond equals the value of the floating rate bond.
• Calculate interest rate swap cash flows given all the inputs,
The inputs required are the two interest rates, the notional principal amount and the number of days in the
period. Two separate payments can be calculated, one with the floating rate of interest and one with the fixed
rate. The party that is required to make the larger of the two payments makes the only payment equal to the
difference between the two amounts.
Alternatively, the net payment can be calculated directly by applying the following formula:
Payment = Notional Principal × (Fixed Rate – Floating Rate) × (Number of Days / 360)
If this number is positive, the party making the fixed-rate payments makes the single net payment. If it is
negative, the party making the floating-rate payments makes the single net payment.
NOTE
Most U.S. dollar interest rate swaps base the fixed-rate payment on a 365-day year and the floating-rate
payment on a 360-day year. Any cash flow questions on the exam will provide you with the correct day count
to use.

• Calculate a company’s post-swap cost of financing.

Most end-users who are using interest rate swaps do so in conjunction with some kind of borrowing or lending.
The swap is intended to change the effective cash flows on the borrowing or lending to a fixed rate or floating
rate, whatever the particular case may be.
To calculate a company’s post-swap cost of financing, three different interest rates are required: the fixed and
floating rates from the swap and the interest rate on the borrowing or lending. Two of these rates – either two
fixed or two floating – will “net” out, leaving some small residual. This residual should be either added to or
deducted from the third interest rate to arrive at the company’s post-swap cost of financing.
• Explain why interest rate swaps are used.

Interest rate swaps are a flexible and low-cost hedging and risk management tool. Some of the popular uses are
to reduce financing costs and to reverse previous financial decisions.
• Describe the basic features of deliverable interest rate swap futures.

The CME’s deliverable interest rate swap futures contract (DSF) allows parties to set in advance the fixed rate
on a plain vanilla interest rate swap to be delivered at maturity of the contract. Upon delivery of the underlying
swap, the buyer of the DSF will be the floating-rate payer (and fixed-rate receiver) and the seller of the DSF will
be the fixed-rate payer (and floating-rate receiver).
• Describe some variations to the basic interest rate swap.

An arrears swap is a swap in which interest payments are made on the day the floating rate is determined
(in contrast to the plain vanilla swap where the floating rate is determined prior to the interest payment date).
A basis swap is an interest rate swap where the interest payments for both counterparties are based on
different floating rates of interest.
An amortizing swap is an interest rate swap in which the notional principal amount is reduced over time until
it reaches zero.
A quanto swap is an interest rate swap where the interest rate payments on the notional principal are
determined based on the interest rate of a currency other than the one the notional is denoted in.
An index swap is swap where the payments of one counterparty are tied to the value of a particular index such
as the S&P 500 or the S&P/TSX 60 Index.
• Describe the key features of payer and receiver swaptions.

A payer swaption gives the holder the right but not the obligation to enter into a predetermined swap
agreement to pay the fixed rate and receive the floating rate.
A receiver swaption gives the holder the right but not the obligation to enter into a predetermined swap
agreement to pay the floating rate and receive the fixed rate.

KEY TERMS
amortizing swap credit risk
arrears swap index swap
basis swap indication pricing schedule
bilateral netting payer swaption
collateral quanto swap
comparative advantage receiver swaption
credit enhancements triggering events
1. Two companies, West Co. and East Co., want to borrow $10 million for a one-year term. The firms can borrow
in the fixed and floating rate markets at the following rates:
Fixed Rate Market Floating Rate Market

West Co. 5.20% 3-month LIBOR + 0.20%
East Co. 6.00% 3-month LIBOR + 0.80%
Difference 0.80% 0.60%
East Co. is a higher credit risk and is accordingly quoted a higher interest rate in both the fixed and floating
rate markets.
Although West Co. can borrow at a lower interest rate (than East Co.) in the fixed-rate market, it would like
to have floating-rate financing. East Co. has the comparative advantage in the floating-rate market but wants
fixed-rate financing. East Co.’s comparative advantage in the floating rate market is demonstrated by the fact
that it only has to pay an additional 0.60% (versus West Co.) in the floating-rate market versus the additional
0.80% it must pay in the fixed-rate market.
Each firm borrows in the market where it has the comparative advantage. West Co. borrows $10 million in the
fixed-rate market at 5.20%, while East Co. borrows $10 million in the floating rate-market at 3-month LIBOR
+ 0.80%.
In order to reduce their respective borrowing costs, the two companies enter into the following swap
agreement:
West Co.:
« pays 5.20% per annum to original lenders,
« receives 5.10% per annum from East Co. and,
« pays 3-month LIBOR to East Co.

East Co.:
« pays 3-month LIBOR + 0.80% to original lenders,
« receives 3-month LIBOR from West Co. and,
« pays 5.10% to West Co.
i. Label the following diagram with all of the pertinent information regarding this swap:
West Co.
ii. Complete the following table showing the settlement cash flows for the 1-year interest rate swap. A swap
dealer is not involved. The floating rate is reset on a quarterly basis. Assume each period has 90 days and all
of the swap cash flows are based on a 360-day year.
West Co. Payment East Co. Payment Net Payment*

Period 3-Month LIBOR $ $ $
1 4.50%
2 5.25%
3 6.50%
4 6.00%
5 –
* West Co. Net payment (receipt) to (from) East Co.

iii. Compared to its original quotes, by what amount did West Co. change its financing rate as a result
of this swap?
iv. Compared to its original quotes, by what amount did East Co. change its financing rate as a result
of this swap?
2. It is June 1, Year 1, and KLM Corp. wants to borrow US$50 million for two years, preferably at a fixed rate. KLM
can borrow US$ for two years at a fixed rate of 7.75% or at a floating rate of 6-month LIBOR + 0.50%.
PQR Inc. also wants to borrow US$50 million for two years, but would prefer to pay a floating rate of interest.
PQR can borrow US$ for two years at a fixed rate of 8.75% or a floating rate of 6-month LIBOR + 2%.
i. What derivative would lower the borrowing costs for both KLM and PQR?
a. Forward rate agreement.
b. Index swap.
c. Currency swap.
d. Interest rate swap.
ii. Which of the following statements best describes the relationship between KLM’s borrowing rates and
PQR’s borrowing rates?
a. KLM has both an absolute and comparative advantage in the floating-rate market.
b. KLM has a comparative advantage in the fixed-rate market.
c. PQR has an absolute advantage in both the fixed- and floating-rate markets.
d. PQR has both an absolute and comparative advantage in the fixed-rate market.

The treasurers of both KLM and PQR contact an OTC derivatives dealer for advice.
After studying each company’s situation, the derivatives dealer designed the following deal, which each
company has agreed to.
KLM Corp. PQR Inc.

pay original lenders 6-month LIBOR + 0.50% pay original lenders 8.75%
receive 6-month LIBOR from the dealer receive 6.85% from the dealer
pay 6.95% to the dealer pay 6-month LIBOR to the dealer
Net payments between each company and the dealer will occur every six months. Assume that each year has
360 days and that each six-month period has 180 days.
Over the two-year term of the derivative, the following 6-month LIBOR rates prevailed:
Date 6-month LIBOR

June 1, Year 1 6.50%
December 1, Year 1 6.00%
December 1, Year 2 5.25%
iii. What payment would have occurred between KLM and the dealer on June 1, Year 2?
a. KLM would have paid the dealer US$1,737,500 and the dealer would have paid KLM US$1,500,000.
b. KLM would have paid the dealer US$237,500.
c. KLM would have paid the dealer US$1,737,500 and the dealer would have paid KLM US$1,375,000.
d. KLM would have paid the dealer US$362,500.
iv. What payment would have occurred between PQR and the dealer on December 1, Year 2?
a. The dealer would have paid PQR US$1,712,500 and PQR would have paid the dealer US$1,312,500.
b. The dealer would have paid PQR US$400,000.
c. The dealer would have paid PQR US$1,712,500 and PQR would have paid the dealer US$1,375,000.
d. The dealer would have paid PQR US$337,500.
v. Compared to its original quotes, how much did KLM Corp. save by entering into the derivative with
the dealer?
a. 0.10%
b. 0.30%
c. 0.50%
d. 6-month LIBOR.

vi. Compared to its original quotes, how much did PQR Inc. save by entering into the derivative with the dealer?
a. 0.10%
b. 0.30%
c. 0.50%
d. 6-month LIBOR.
vii. How much will the dealer earn for its services over the life of the deal?
a. US$25,000
b. US$50,000
c. US$75,000
d. US$100,000
viii. What can PQR Inc.’s position in the derivative be equated to for the purposes of pricing (or valuing)
the derivative?
a. Long a fixed-rate bond with a coupon of 8.75% and short a floating-rate bond with a coupon
of 6-month LIBOR.
b. Long a fixed-rate bond with a coupon of 6.85% and short a floating-rate bond with a coupon
of 6-month LIBOR.
c. Short a fixed-rate bond with a coupon of 8.75% and long a floating-rate bond with a coupon
of 6-month LIBOR.
d. Short a fixed-rate bond with a coupon of 6.85% and long a floating-rate bond with a coupon
of 6-month LIBOR.
3. A bank buys a CME-listed deliverable U.S. dollar interest rate swap futures (DSF) contract and holds the
position to expiry. What position will the bank receive upon settlement?
4. What is a payer swaption?

a. An instrument that requires the writer to be the fixed-rate payer in a predetermined swap agreement,
if called upon to do so by the holder of the payer swaption.
b. An instrument that requires the writer to be the floating-rate payer in a predetermined swap agreement,
if called upon to do so by the holder of the payer swaption.
c. An instrument that gives the holder the right but not the obligation to be the fixed-rate receiver in
a predetermined swap agreement.
d. An instrument that gives the holder the right but not the obligation to be the floating-rate payer in
a predetermined swap agreement.

Currency Swaps 11
By the end of this chapter you should be able to:

• Describe what a currency swap is.
A currency swap is an exchange of cash flows based on notional principals denominated in two different
currencies. A plain vanilla currency swap involves a floating rate of interest on one currency and a fixed rate of
interest on the other currency.
Unlike an interest rate swap, currency swaps almost always involve an exchange of the principal amounts at
the origination of the swap and at the end of the swap. Also, because payments are based in two different
currencies, there is no netting of the cash flows. Each counterparty makes a payment on each payment date to
the other counterparty.
• Explain how currency swaps are priced.

Currency swaps can be viewed as a position in two bonds in a manner similar to interest rate swaps. The major
exception is that the two bonds are denominated in different currencies. Accordingly, the prevailing term
structure of interest rates in the two respective interest rate markets affect the value and pricing of the currency
swap. The prevailing spot exchange rate between the two currencies also affects the pricing of the swap.
• Calculate currency swap cash flows given all the inputs.

This is calculated in exactly the same manner as with interest rate swaps. Both counterparties make the full
payment to the other counterparty. There is no netting of cash flows.
• Calculate a company’s post-swap cost of financing.

This is also calculated in a manner similar to the discussion on interest rate swaps.
• Explain why currency swaps are used.

Currency swaps are used primarily when it is more financially advantageous for two companies to reduce their
respective cost of financing via a swap versus borrowing directly in the desired currency market.

1. Rex Co. wants to borrow US$250 million at a floating rate for a two-year term. Spot Co. wants to borrow
200 million Euros (€) at a fixed rate for a two-year term.
Rex can borrow U.S. dollars at a floating rate of 6-month LIBOR or Euros at a fixed rate of 8.00%. Spot can
borrow Euros at a fixed rate of 8.75% or U.S. dollars at a floating rate of 6-month LIBOR + 0.15%.
Spot has a higher credit risk and must pay a higher interest rate in both markets. However Spot has a
comparative advantage in the floating-rate U.S. dollar market.
Rex borrows €200 million at a fixed rate of 8.00% and Spot borrows US$250 million at 6-month LIBOR
+ 0.15%. The spot €/U.S. dollar exchange rate is €1.25.
Rex Co., Spot Co. and a swap dealer enter into the following currency swap agreement:
Rex Co.:
« pays €8.00% to the original lenders
« receives €8.25% from the dealer
« pays 6-month LIBOR to the dealer
Spot Co.:
« pays 6-month LIBOR + 0.15% to its original lenders
« receives 6-month LIBOR from the swap dealer
« pays €8.35% to the swap dealer
Swap Dealer:
« receives 6-month LIBOR from Rex
« pays €8.25% to Rex
« receives €8.35% from Spot
« pays 6-month LIBOR to Spot
i. Label the following diagram with all of the pertinent information regarding this swap:
Rex Co.

ii. Complete the following tables showing the settlement cash flows for Rex Co. and the swap dealer, and
Spot Co. and the swap dealer. The floating rate is reset on a semiannual basis. Assume each period has
180 days and that all of the cash flows are based on a 360-day year.
Rex Co. Versus the Swap Dealer
Period 6-Month Dealer’s Rex Co.’s

LIBOR (%) Payments Payments
1 Principal Exchange 6.00
2 6.50
3 7.50
4 7.00
5 Coupon Plus
Principal Exchange
Spot Co. Versus the Swap Dealer
Period 6-Month Dealer’s Spot Co.’s

LIBOR (%) Payments Payments
1 Principal Exchange 6.00
2 6.50
3 7.50
4 7.00
5 Coupon Plus
Principal Exchange

Credit Swaps 12
By the end of this chapter you should be able to:

• Describe what credit derivatives are.
Credit derivatives are financial instruments that have an underlying credit asset, or pool of credit assets such as
bonds, loans or mortgages. Payouts are a function of the creditworthiness of the issuer or referenced asset. They
are designed to transfer and manage credit risk exposure. The protection buyer is the party seeking to reduce or
transfer the credit risk, and the protection seller is the party seeking to acquire or hold the credit risk.
• Explain the role credit derivatives play for different users including banks, insurance companies, asset
managers and securities dealers.
Credit derivatives serve multiple purposes, depending on who is holding them and for what purpose:
Banks will use credit derivatives to hedge and will thus buy protection from counterparties. Banks do this to
enhance their credit risk management, to retain ownership of loans given their increased risk level, and to
reduce regulatory capital requirements. They will also sell protection when they wish to diversify their loan
portfolio and to enhance yields with respect to lending.
Insurance Companies, similar to banks, will both buy and sell protection depending on circumstances and
their portfolio makeup. They typically buy protection to mitigate liability concentrations (in effect selling
away the risk associated with concentrated liability commitments), rather than reconfiguring their liability
portfolio, which may prove difficult since some loans aren’t very marketable. They may sell protection to
increase yields and to help match assets to liabilities, particularly to match cash flows.
Asset and Hedge Fund Managers will buy protection to manage negative expectations on positions, for
macroeconomic or sectoral reasons. They will sell protection, as other market participants will, to increase
yield and diversification given a positive credit outlook, to generate leverage on existing portfolios, and to
establish speculative positions.
Securities Dealers will buy protection to cover their exposure as market makers and to more generally manage
the credit risk on their books. They will sell protection to increase yield, to better diversify their loan and asset
portfolio, and to help offset hedging costs for other credits.
• Demonstrate how a standard credit default swap works

A credit default swap (CDS) is the exchange of two cash flows: a fee payment and a conditional payment, which
occurs only if certain circumstances are met. The CDS will have value for the protection buyer only if these
conditions are met, whereas the protection seller will always receive the premiums. Think of a CDS as a type of
insurance in which default of an asset triggers payment.

If default occurs, the CDS is activated, it terminates with the payment according to the predetermined
conditions of the contract. Payment can be 100% of the underlying’s face value, or a percentage of the total
(nominal) CDS commitment. There are two payment modes: physical settlement (the protection buyer remits
the asset to the protection seller against full face value payment) and cash settlement (the protection buyer
retains the asset and receives the difference between face value and recovery value).
A basket CDS, offers protection on the default probabilities of a basket of assets (multi‑name). If the CDS pays
upon the first default of any of the referenced assets, it is a first-to-default CDS. Other types are second-to-
default and third-to-default CDSs, etc. Fees on basket CDSs, given risk diversification, are lower than equivalent
fees for individual CDSs on all assets in the basket. This makes them attractive for protection buyers (cheaper
protection) and for protection sellers (higher fees than single-asset CDSs with moderately higher risk).
A portfolio CDS is written on a basket of underlying assets as well, but has a predetermined monetary
amount to be paid rather than a number of defaults. This type of CDS remains active until expiration, or the
predetermined monetary amount is reached, regardless of the actual number of defaults.
• Demonstrate how an index credit default swap works.

The indices on which index CDSs are based on are designed to track the credit risk of a group of corporate
entities considered to represent a sector of the economy or a particular geographical region. CDS indices prices
are calculated from the prices of the underlying constituents CDSs and have become widely accepted credit risk
benchmarks.
An index CDS is defined, among other criteria, by:
the list of its index constituents;
the index weight of each constituent;
the term and maturity date of the index CDS;
the notional amount;
the coupon payable by the protection buyer; and
the specific credit events that would trigger a settlement.
Index CDSs generally trade on a spread basis, expressed in basis points. These spreads represent the total
amount payable by the protection buyer to the protection seller. As credits quality deteriorate, quoted spreads
increase.
All index CDSs have fixed coupons attached to them, payable quarterly over the duration of the contract. The
present value of the difference between a contract coupon rate and its quoted spread is exchanged upfront at
the initiation or close of a contract.
When a credit event occurs with one of the constituents underlying an index CDS, the protection seller must
pay the protection buyer a percentage of the notional value of the index CDS corresponding to the index weight
of the constituent. This amount is adjusted by a ratio of [1 – the confirmed recovery rate of the face value of the
bond in default].
Formula: Notional x index weight of the constituent x [1 – the recovery rate] = amount payable by the
protection seller to the protection buyer on default of one constituent.
The notional amount used for calculations is then be reduced by a factor corresponding to the index weight
of the constituent in default and the number of constituents in the index is reduced by one, the constituent
in default.

KEY TERMS
basket CDS protection seller
first-to-default CDS recovery rate
index-based CDS reference asset
portfolio CDS reference entity
protection buyer single-name CDS
1. Label the following diagram with all the pertinent information regarding a standard single-name credit
default swap:
a.
c.
Protection Buyer
b.
2. An insurance company wishes to protect a $50 million portfolio containing 5 reference assets each valued at
$10 million. The CDS’s terms specify that the first $10 million in losses is covered over five years. The annual
fees are set at 1% of the coverage.
Within the first year, one asset defaults, causing a loss of $4,000,000 to the protection buyer. In year three,
another asset defaults, causing another loss of $7,000,000.
i. What type of CDS is this?

a. Single-name CDS
b. Basket CDS
c. First-to-default CDS
d. Portfolio CDS
ii. What is the first annual premium the protection buyer pays?
a. $50,000
b. $100,000
c. $250,000
d. $500,000

iii. How much will the seller pay out on the first year default?
a. $2,000,000
b. $4,000,000
c. $5,000,000
d. $10,000,000
iv. What is the premium paid in the second year?

a. $30,000
b. $50,000
c. $60,000
d. $100,000
v. How much will the buyer receive for the third year default?
a. $3,000,000
b. $3,500,000
c. $6,000,000
d. $7,000,000
3. List 4 defining characteristics of an index CDS.
4. A $20 million notional value index CDS just had 1 of its 50 equally-weighted underlying constituents declared
in default. What amount a protection seller holding the contract would be expected to pay if the recovery rate
on the failed reference asset is set at 30%?

Other Types of Swaps 13

• Describe what an equity swap is.
An equity swap is an agreement in which one counterparty agrees to make periodic payments at a fixed rate
of interest on a notional amount of principal for the duration of the swap. The other counterparty agrees to
make periodic payments equal to the return (or some fraction thereof) on an equity index (e.g., S&P 500,
NASDAQ 100, S&P/TSX 60) on the same notional amount of principal.
Entering into an equity swap in which the equity return is received is equivalent to a “synthetic equity” position
in the index.
• Describe what a commodity swap is.

A commodity swap is an agreement in which one counterparty agrees to make periodic payments based
on a fixed price to a second counterparty for the use of a predetermined amount of a certain commodity.
Simultaneously, the other counterparty agrees to make periodic payments based on a floating price to the first
counterparty based on the same amount of the same commodity.
KEY TERMS
commodity swap synthetic equity position
equity swap

By the end of this chapter, you should be able to answer the following question:
1. Describe what a synthetic equity position is. How is it created with the use of an equity swap?

Mutual Funds 14

• Describe the regulatory restrictions around the use of derivatives in mutual funds.
Regulatory restrictions limit mutual funds to the use derivatives for hedging rather than speculation. To qualify
as a hedge, the derivative that is used must:
be intended to offset a or reduce a specific risk associated with all or part of a position or positions in
the fund;
have a value with a high degree of negative correlation to the value of the position being hedged; and
not be expected to offset more than changes in the value of the position being hedged.
• Demonstrate the ways in which mutual funds use derivatives to hedge.

Mutual funds will mostly use derivatives to hedge long positions in an underlying asset with:
short forward, futures, and swap contracts;
long put option contracts; and
short call option contracts.
• Describe the easiest way for a mutual fund manager to establish a “hedge” according to the guidelines
in NI 81-102.
According to the guidelines in NI 81-102, the easiest way for a mutual fund manager to establish a hedge is to
take a derivatives position with a payoff that is opposite to that of the position or exposure being hedged. Using
an appropriately sized derivatives contract will ensure that the derivatives position does not offset more than
the changes in the value of the position being hedged.
• Describe the specific guidelines, under NI 81-102, that permit mutual funds to use derivatives for
non-hedging purposes.
If a mutual funds uses derivatives for non-hedging purposes, it must ensure that the value of the derivatives
position does not exceed 10% of the net assets of the fund and that leverage is not being used.
• Demonstrate the non-hedging ways in which mutual funds use derivatives.

Mutual funds typically use derivatives for non-hedging to gain investment exposure quickly, effectively and in
a cost-efficient manner. In some cases, derivatives may also be used to provide additional portfolio income
(by selling covered calls) or to provide the opportunity to buy the underlying asset at a lower price than it is
currently trading.

• Describe the potential disadvantages or risks associated with the use of derivatives by mutual funds.
Some of the risks associated with the use of derivatives include:
1. Basis risk, which arises whenever one kind of risk exposure is hedged with an instrument that behaves in
a similar, but not necessarily identical, manner.
2. The burden of additional monitoring, especially for firms less familiar with monitoring derivatives positions.
The increased effort can, in some cases, impose considerable costs.
3. Potentially limited returns from a strategy such as covered call writing.
4. The cost of hedging, which is either the foregone opportunity to generate windfall gains (as with the
locked-in prices associated when hedging with forwards and futures) or cash losses (outlays for the purchase
of option premiums).
KEY TERMS
Canadian Securities Administrators (CSA) NI 81-102
National Instruments structured products

1. Which of the following statements about the use of derivatives to hedge in a mutual fund is not true?
a. The derivative must be intended to offset a specific risk of a position in the fund.
b. The value of the derivative position must be strongly negatively correlated with the value of the position
being hedged.
c. The derivative must not be expected to offset more than changes in the value of the position being hedged.
d. The derivative must be offset before the position that is being hedged is offset.
2. A mutual fund has $100 million in net assets. What is the maximum value of derivatives it can hold for
non-hedging purposes?
3. Describe four potential risk associated with the use of derivatives by mutual funds.

Hedge Funds 15

• Define the term hedge fund.
While the term hedge fund has no legal standing or definition in Canada, it is commonly used to describe lightly
regulated pools of capital that have great flexibility in their choice of investment strategies.
• Identify the three main hedge fund product structures.

Hedge funds can be structured as commodity pools, closed-end funds or principal protected notes:
Commodity pools are a special type of mutual funds that can use derivatives in a leveraged manner for
speculation. They can also sell short, whereas mutual funds generally cannot.
Closed-end funds are investment funds with redemptions, if any, that occur once a year or even less
frequently. To provide liquidity to fund investors, closed-end funds are often listed on an exchange.
Principal-protected notes provide investors with exposure to the returns of one or more hedge funds and a
return of principal on maturity that is guaranteed by a bank or other highly-rated issuer of debt securities.
• Identify the basic aspects of securities regulation that governs the distribution of commodity pools
in Canada.
National Instrument 81-104 was introduced in 2002 and amended in 2019 with the coming into force of the
CSA’s modernization of investment fund product regulation. The 2019 amendments modernized the commodity
pool regime by designating commodity pools as alternative mutual funds and by expanding the scope of
alternative strategies in which such funds may invest. Permitted activities include more aggressive use of
specified derivatives and the use of leverage.
• Describe how hedge funds and commodity pools use derivatives.

Like other derivatives users, hedge funds use derivatives to speculate, hedge, arbitrage, gain market exposure,
and create new trading strategies.

• Demonstrate the primary potential risks associated with the use of derivatives in hedge fund and
commodity pool management.
The biggest risk is the potential for loss from leverage. Other risks include:
Transparency – how much do managers reveal about their derivatives strategies?
Performance attribution – how do managers report the impact that derivatives had on the performance of
the fund?
Liquidity – how easily, if at all, can the managers get out of their derivatives positions?
Price limits – do price limits on certain exchange-traded derivatives have the potential to reduce the
effectiveness of the derivaties position?
Manager skill – do the managers understand derivatives and are they able to use them skilfully?
Volatility of returns – are investors prepared for the volatility in returns that can accompany a fund that uses
derivatives?
KEY TERMS
closed-end fund hedge fund
commodity pool NI 81-104

1. List and describe the three main hedge fund structures.
2. A hedge fund manager expects the price of gold to decline in U.S. dollar terms, but appreciate in terms of
the Swiss franc. Which of the following futures positions will allow the hedge fund manager to profit from
this view?
a. Long gold futures and long Swiss franc futures
b. Long gold futures and short Swiss franc futures
c. Short gold futures and long Swiss franc futures
d. Short gold futures and short Swiss franc futures

Principal Protected Notes 16
(PPNs)
• Describe a PPN.
A PPN is a debt instrument that provides a return that is linked to the performance of a specific underlying asset
such as a market index, a basket of stocks or a mutual fund. As the name implies, the issuer of a PPN guarantees
the return of at least the principal value of the PPN on its maturity date. As a debt instrument, any return is
paid in the form of interest. In some cases the issuer may guarantee a minimum positive level of return, but
otherwise the total return on the instrument is known only on or close to the maturity date.
• Identify who normally acts as “guarantor” and provides the principal protection at maturity for the PPN.
In Canada, PPNs are issued almost exclusively by Schedule I banks, although in the past they have been issued
by Schedule II banks as well as Canadian Crown Corporations such as the Canadian Wheat Board and Business
Development Bank. Banks provide a guarantee on PPNs equal to that of its deposits, including savings accounts
and guaranteed investment certificates (GICs). However, unlike many of those deposits, including the closely
related market-linked GICs, PPNs are not insured by the Canada Deposit Insurance Corporation. In all cases, the
value of the guarantee is a function of the creditworthiness of the issuer.
• Describe the two main PPN structures.

In the zero-coupon bond plus call option structure, the PPN issuer invests most of the proceeds in a zero-
coupon bond that has the same maturity as the PPN, which guarantees the return of principal at maturity.
The remainder of the proceeds is invested in an option on the underlying asset, which provides the upside for
the note.
With a constant proportion portfolio insurance (CPPI) structure, the issuer initially invests all of the proceeds
into the underlying asset. Generally, as the value of the investment in the underlying asset increases – or
interest rates rise – the allocation to the underlying asset increases and the allocation to a zero-coupon
bond, if any, decreases. Likewise, as the value of the investment in the underlying asset falls – or interest
rates decline – the allocation to the underlying asset is reduced and the allocation to the a zero-coupon bond
increases.
• Identify the main components of the zero- coupon plus call option PPN.
The main components of the zero-coupon plus call option PPN are the zero-coupon bond and the call option.
The zero-coupon bond provides the principal protection and the call option provides the upside potential.

KEY TERMS
Constant Proportion Portfolio Insurance principal-protected note (PPN)

(CPPI)
zero-coupon bond plus call option
market-linked GICs
participation rate
1. Briefly describe the relationship between PPNs and market-linked GICs.
2. Bank A issues a 5-year PPN based on the S&P/TSX Composite Index at a time when 5-year interest rates are
at 5%. Six months later Bank B issues a similar PPN, except that 5-year interest rates are now 6%. All else
being equal, which bank can offer its investors more exposure to the S&P/TSX Composite Index? Why?
3. A 7-year PPN was issued with a CPPI structure. Two years into the PPN, about 80% of the note’s assets are
invested in the underlying asset. Which of the following statements is most likely true?
a. The value of the underlying asset has gone down and/or interest rates have risen.
b. The value of the underlying asset has gone up and/or interest rates have risen.
c. The value of the underlying asset has gone down and/or interest rates have fallen.
d. The value of the underlying asset has gone up and/or interest rates have fallen.

Derivative-Based 17
Exchange-Traded Funds
• Describe how futures contracts may be used in the creation of an ETF.
In the case of synthetic replication, ETFs have no physical holdings of the underlying assets. Instead, if the
underlying assets are costly to own and have established and active futures contracts available on them, ETFs
hold futures contracts to track and deliver the underlying asset returns.
Futures contracts are the most popular type of derivative used in commodity ETFs.
• Describe how swap agreements may be used in the creation of an ETF.

Leveraged and inverse ETFs typically use swap agreements to deliver the leveraged and/or inverse return of an
underlying asset.
In an unfunded swap structure, an ETF obtains the leveraged or inverse return from a swap provider in
exchange of the return of a portfolio chosen by the swap provider. The portfolio is detained by the ETF and
serves as collateral in case of default by the swap provider.
In a funded swap structure, an ETF also obtains the leveraged or inverse return from a swap provider but
against a cash deposit that the swap provider utilizes to hedge its risk exposure. The swap provider has to post
collateral that is pledged to the ETF.
• Explain the unique risks to investors of derivative-based ETFs.

For derivatives-based ETFs that use futures contracts, the slope of a futures curve has a direct impact on the
return achieved by the ETF. For futures markets that are in contango, rolling forward contracts represents a
financial drag on performance as ETFs must absorb losses on the rolls.
With swap-based ETFs, the swap counterparties have to post collateral. Should a swap counterparty default,
the level of protection for ETF investors will depend on 1) how rapidly the ETF can access the collateral basket,
2) the quality of the securities in the collateral basket, and 3) how easily these securities can be liquidated at a
fair price in a potentially distressed market.
Since most leveraged and inverse ETFs reset daily, their performance over longer holding periods of time can
differ significantly from the performance of their underlying index or benchmark over comparable periods
of time.
The necessity for a leveraged long ETF to constantly increase its long derivative market exposure after an
up day and decrease its long derivative market exposure after a down day makes highly volatile markets
with numerous trend reversals treacherous and costly. The same goes for a leveraged inverse ETF that has
to increase its short derivative market exposure after a down day and decrease its short derivative market
exposure after an up day. In highly volatile markets, ETFs have to frequently offset at a loss positions
just taken.

KEY TERMS
collateral basket unfunded swap
funded swap
1. Explain how the shape of a futures curve can affect positively or negatively the total return of a futures-based
ETF.
2. Explain the necessity for daily-reset leveraged and inverse ETFs to rebalance their derivative position in the
same direction of the daily price changes of their underlying assets.
3. Should the swap counterparty in a swap-based ETF default, which of the following elements is a not a key
factor in determining the level of protection of ETF investors?
a. The quality of the securities in the collateral basket.
b. How rapidly the ETF can access the collateral basket.
c. The fact that an ETF is leveraged but not inverse.
d. How easily these securities can be liquidated at a fair price.

SECTION II
ANSWERS TO QUESTIONS

1. All derivatives:
are contractual agreements between two parties.
have a specific time to expiration.
establish a price or formula today for exchanging payments at some point in the future.
facilitate the use of leverage.
are zero-sum games.
2. Three differences between options and forwards include:

Option-based contracts give their holders the right to buy or sell while forwards represent obligations.
Options only have value at expiration if the price of an underlying asset is above (in the case of calls) or
below (in the case of puts) a trigger price known as an exercise price.
There is a cost to entering an option contract known as the premium. There is no cost to entering a forward
contract.
3. $62. The price of ABC must be above the strike price plus the premium paid for the call option in order for the
speculator to earn a profit upon exercise.
4. A forward contract develops value (either positive or negative) as soon as the forward price starts to deviate
from the contract’s delivery, or entry, price.
5. Four key differences between exchange-traded and OTC derivatives include:

Exchange-traded derivatives are standardized while OTC derivatives are custom designed.
Exchange-traded derivatives are guaranteed by a third-party while OTC derivatives have no third-party
guarantor.
Exchange-traded derivatives have daily settlement. OTC derivatives are settled only at the end of the contract.
Exchange-traded derivatives can in most cases be easily terminated prior to expiry. OTC derivatives are not
as easily offset.
6. i. d. US$0.65 per pound.

Since the manufacturer needs to purchase cotton in the future, a higher price than US$0.52 per pound
will result in a lower than desired profit margin.
ii. a. Go long enough cotton futures to cover the entire purchase.

Since the manufacturer needs to purchase cotton in the future, it should go long enough cotton futures
to cover the entire purchase.
iii. The size of the hedge, the timing match between the anticipated purchase and the expiration of the futures
contract, and how much basis risk the company is willing to accept.

7. i. The importer is at risk that the Canadian dollar will depreciate relative to the U.S. dollar, which means that
it will take more Canadian dollars to buy the US$1 million.
ii. c. Buy a put option on the Canadian dollar.

To protect itself from a decline in the value of the Canadian dollar, the importer should buy a Canadian
dollar put option. If the Canadian dollar does decline, the put option should show a profit to help offset
or reduce the increased cost for Canadian dollars in the spot market.
iii. The major advantage of using an option-based derivative is that the user can experience windfall gains.
For example, if the Canadian dollar rose the importer would let the put option expire worthless and would
be able to buy the US$1 million with fewer Canadian dollars. If a forward contract was used the importer
would be locked in to the lower rate.
Another advantage of buying options versus buying or selling forward-based derivatives is that the
purchase of options will not result in any margin calls.
Options have two major disadvantages relative to forwards. The first is that an up-front fee (known as the
premium) has to be paid. Forwards have no such fee.
The second disadvantage is that options have a non-linear relationship with the underlying interest. At
expiration, the underlying price must exceed (in the case of calls) or fall under (in the case of puts) the strike
price in order for the option to have value. Forwards have a linear relationship with their underlying asset.
8. Two reasons include:

Less transaction costs.
Buying or selling large numbers of equities may induce adverse price pressures.
9. Academic arbitrage involves no investment, and locks in a risk-free profit. Real-world arbitrage usually involves
some investment and is not always risk-free.
10. First, the use of derivatives should be incorporated into an overall risk management program. Second, the
organization must establish strong internal controls and monitoring for its derivatives operation.

SECTION 2 | ANSWERS TO QUESTIONS 2•5

1. Forward markets developed to help producers and consumers reduce or eliminate price uncertainty.
2. i. At onset, forward contracts have no value to either party.

ii. d. $7.50
The original 3-month forward is now a 1-month forward. The value of the long holder’s position in the
contract is equal to the current 1-month gold forward price ($587.50) minus the forward contract’s
delivery price ($580).
3. i. Since the refiner needs to buy crude oil in six months, it is concerned that the price of crude oil will rise.
ii. b. Go long enough crude oil futures to cover the entire purchase.
A long position will protect the company from a rising crude oil price. If the price of crude oil rises, the
futures should show a profit, which will help to reduce the cost of the crude oil in the cash market.
iii. d. $2,000 profit.

($58 – $56) × 1,000 barrels per contract × 1 contract
4. i. b. $37,400
(110,000 ÷ 1,000) × $340
Because the price quotes are “per 1,000 board feet,” we must divide the contract size by 1,000 before
multiplying by the price of the contract.
ii. a. $340.10
The minimum tick size is $0.10. The lowest price above $340 is $340 plus the minimum tick size.
iii. b. $330.00
The lower limit of a futures price on any given day is the previous day’s settlement price minus the daily
price limit.
iv. d. $22,000 profit.

($340 – $320) × (110,000 ÷ 1,000) × 10 contracts
5. i. d. 5.5%
$2,000 ÷ ($330 × 110,000 ÷ 1,000)
At a price of $330, the futures contract has a “value” of $36,300. A margin deposit of $2,000
represents 5.5% of this value.
ii. c. 82.5%
(($345 – $330) × (110,000 ÷ 1,000) × 1) ÷ $2,000 = 0.8250 = 82.5%
Calculate the dollar profit or loss first, then divide by the margin deposit.

iii. c. $350
$330 + ($2,200 ÷ (110,000 ÷ 1,000))
A 110% return on a margin deposit of $2,000 represents a $2,200 profit (1.1 × $2,000). To earn a
$2,200 profit on one long lumber futures contract, the price must rise by $20 per 1,000 board feet
($2,200 ÷ (110,000 ÷ 1,000)) to $350 ($330 + $20).
6. b. 30
Open interest is the total number of contracts outstanding at any point in time. Since there are always two
sides to a contract, open interest is calculated by summing either the open long positions or the open short
positions. Both methods have to produce the same result.
7. a. $10,000 profit.
(620 – 610) × $200 × 5
8. d. $243,750
$1.30 × 37,500 × 5
The amount of the certified cheque is determined by the settlement price on the day the delivery is
tendered.
9. b. $440
$420 + ($400 ÷ 20)
Since the contract represents 20 tonnes of canola, the price of the futures must rise by $20 per tonne
($400 ÷ 20) to produce a profit of $400.
10. Within what is allowed by the terms of each contract, the short futures holder who decides to make delivery
must inform the clearinghouse of the exact grade of the asset being delivered, the location of delivery, and the
timing of delivery. (Because most deliverable futures contracts allow delivery notices to be submitted on any
day within a predetermined time period, the short indicates the exact timing of delivery by choosing the date
to submit the delivery notice within this time period. The actual timing of the delivery is usually a fixed number
of days following submission of the delivery notice.)


1. i. d. 3.2¢ per pound.
(($3.60 × 0.04 ÷ 12) + $0.015 + $0.005) × 100
Multiply by 100 to convert the answer to cents.
ii. c. $3.696 per pound.

$3.60 + ($0.032 × 3)
The $0.032 is the monthly costs calculated in Question i) above.
2. Regardless of the type of market (contango or inverted), the basis always narrows as futures expiration
approaches.
3. Futures are generally more easily underpriced, due to the fact that for some commodities it is often difficult if
not impossible to do a reverse cash and carry arbitrage.
4. c. The futures price is higher than its fair value.

Arbitrage opportunities arise when the futures price deviates from its fair value price. Cash and carry
arbitrage will produce risk-free profits when the futures price is higher than its fair value price.
5. The implied cost of carry rate is simply the annualized basis divided by the cash price. In this case, it is 3.95%
(($775 – $760) × 2 ÷ $760).
6. i. The better option is the option that will bring the farmer the maximum price after taking into consideration
any carrying costs. The farmer in this case has two choices: sell the canola now at $400 per tonne, or sell a
futures contract at $420 per tonne and deliver the canola in three months’ time. For the second option, the
farmer will incur $15 worth of carrying costs, so his net price received is $405 ($420 – $15). This is greater
than $400, so the second option, selling the futures and delivering the canola in three months, is better.
ii. d. $415
The futures price at which the farmer is indifferent is equal to the cash price plus the costs of carrying
the underlying asset (in other words, the futures fair value price).
7. Rise. In an inverted commodity futures market, the futures price is lower than the cash price. As expiration of the
futures approaches, the price must rise relative to the cash price to ensure that the two are equal at expiration.
8. d. Inverted markets.
A convenience yield is the benefit from holding the cash commodity when there is excess demand for the
commodity relative to supply. When this happens, the cash price could rise above the futures price, thereby
creating an inverted market.
9. A commodity futures price may trade lower than its cash price for any one of the following reasons:
Arbitrage may be very expensive or not possible. As a result reverse cash and carry arbitrage (buying the
futures and selling short the cash asset) may not be carried out, meaning that futures prices can remain
under cash prices.
The market may put a premium on holding the cash asset due to supply tightness.
Market participants may feel prices will decline in the future.


1. i. The home builder is facing the risk that the price of lumber will rise.
ii. Since the home builder is at risk that prices could rise, a long hedge is needed. If prices do rise, the futures
position should show a profit to help offset the increased price in the cash market.
2. A hedger will know with certainty that a hedge will be perfect if there is an asset match and a maturity match.
3. i. b. Buy 5 orange juice futures.

The distributor would buy the contracts because it is at risk that the price of orange juice will rise
over the next six months. Five contracts are needed because the distributor needs price protection
on 75,000 pounds, and each contract covers 15,000 pounds (75,000 ÷ 15,000).
ii. a. $7,500 loss.

($1.80 – $1.90) × 15,000 × 5
iii. c. $1.90
$1.80 cash price + $0.10 ($1.80 – $1.90) loss on the futures contracts. The loss must be added to the
cash price because this, in effect, increases the cost of the cash purchase. If a profit was earned, it would
be subtracted from the cash price, thereby lowering the effective purchase price.
4. i. The farmer will eventually sell his canola crop in the cash market. A short hedge should be implemented to
protect the farmer from a decline in the price of canola.
ii. Since each contract represents 20 tonnes of canola, 50 contracts (1,000 tonnes ÷ 20 tonnes per contract)
should be used.
iii. a. $380,000
Cash Market: $400 × 1,000 tonnes = $400,000
Futures Market: ($390 – $410) × 20 × 50 = $20,000 loss
A loss on the futures position is subtracted from the cash market proceeds to arrive at the net total
dollar amount received for the 1,000 metric tonnes.
5. In a normal commodity futures market, the futures price is higher than the cash price (reflecting the cost of
carry). Long hedgers are long the futures because they are at risk that the cash price will rise (and therefore are
effectively – if not actually – short the cash commodity). As the futures contract nears expiration, the futures
price will fall (relative to the cash price) and the long hedger will lose the basis.
6. i. Since the mining company will be selling the cash commodity in the future, it should implement a short
hedge to protect itself from falling cash prices.
ii. c. $12.45
A perfect hedge implies no unexpected changes in the basis. The futures contracts have two months
remaining (the hedge was placed with six months remaining and lifted after four months), so
the hedge would be considered perfect if the futures contract had two months’ worth of carrying
costs ($0.10 per month × 2 months) built into its price. This equates to a futures price of $12.45
($12.25 cash price + $0.20 total carrying costs).

7. i. The confectioner will need to implement a long hedge by buying 100 contracts (1,000 tonnes ÷ 10 tonnes
per contract).
ii. a. $30,000 loss.

($1,815 – $1,845) × 10 × 100
iii. c. $1,830
$1,800 cash price + $30 ($1,815 – $1,845) loss on the futures contracts.
iv. c. It narrowed by $30 per tonne.

The basis was initially $45 ($1,845 – $1,800) and it narrowed to $15 ($1,815 – $1,800) by the time the
contracts were offset.

1. c. 41.94%
(($578.20 – $570.65) × 100 × 1) ÷ $1,800
2. d. $5,760
Total dollar profit: ($421.70 – $402.50) × 20 × 3 = $1,152
Total margin deposited: $1,152 ÷ 20% = $5,760
3. An intramarket spread offers speculators the chance to profit from a relative price change in the different
delivery months of the same underlying commodity.
4. b. $1,320 loss.
($15.30 – $28.50) × 20 × 5
The spread was initiated by selling the November contracts at a premium (i.e., higher price) of $15.30
($422.10 November price – $406.80 July price) over the July price. Because the trader is short the higher-
priced contract, she wants the spread to narrow (i.e., the November premium relative to July to get smaller)
to earn a profit. In this case, the spread actually widened to a $28.50 November premium, and the trader
realized a loss.
5. c. $1,577 profit.
Soybeans: ($6.5475 – $6.45) × 5,000 × 10 = $4,875 profit
Soybean meal: ($165.80 – $168.70) × 100 × 11 = $3,190 loss
Soybean oil: ($0.2763 – $0.2765) × 60,000 × 9 = $108 loss
Total profit is $1,577 ($4,875 – $3,190 – $108).
6. Three limitations of fundamental analysis include:

Imprecise in forecasting specific price levels.
Imprecise as to the timing of an expected price move.
It is difficult to build all of the factors that could potentially impact prices into a fundamental forecast.


1. d. $3
The put is out-of-the-money because the strike price is lower than the current market price of XYZ stock.
All of the premium is time value.
2. a. $0
This option is also out-of-the-money. Therefore the intrinsic value is zero.
3. a. At any price above $80.

Definitions of the in-, at- or out-of-the-money depend on the relationship between the underlying price
and the strike price only. The size of the premium does not matter.
4. The primary difference is the time frame during which they can be exercised. European-style options can be
exercised only at maturity, while American-style options can be exercised at any time up to and including
maturity.
5. a. $750 loss.
($2 – $3.50) × 100 × 5
The calls were bought back at $3.50. With the stock trading at $63, the 60 calls had $3 of intrinsic value
and $0.50 of time value.
6. b. The speculator will buy 500 shares of GHI and pay $20,000.
An assigned writer of puts will have to buy the underlying asset at the strike price.
7. Buyers of options have rights, not obligations. If the owner of an option does not want to exercise it, they may
let the option expire and they will forfeit only the premium originally paid to buy the option.
8. The risk for a naked call option writer is unlimited because the price of the underlying security could rise
infinitely before the option expires. If it does, the owner of the call will exercise and the writer will be forced
to buy the stock in the open market at the infinitely high price and then turn around and sell it at the exercise
price.

SECTION 2 | ANSWERS TO QUESTIONS 2 • 11
9. Both have limited risks and unlimited potential rewards. The risk of a long call is limited to the premium paid
for the option. This can never exceed the price of the stock, so it entails less risk. However, the potential reward
of a long call option position is lower than the potential reward from owning the underlying stock by the
amount of the premium paid.
10. a. The short selling alternative has more risk and a greater reward.
Both options have an unlimited risk potential and a limited reward. The risk of a short call is lower than the
short stock position by the premium received from writing the option. The reward for a short call is limited
to the premium received, while the short seller’s reward is limited to the price at which the stock was sold
short.
1. c. Buy DEF call options at $5, sell DEF stock short at $56 and exercise the options.
2. d. XYZ June 40 calls.

All else being equal, at-the-money options have the greatest dollar amount of time value built into their
price. All else being equal, options with a longer time to expiration will have a higher premium than options
with a shorter time to expiration.
3. d. ABC call option premiums will decrease and ABC put option premiums will increase.
4. c. Increase by $3.00.
($50 – $45) × 0.6
5. c. –0.2
–$0.40 ÷ ($22 – $20)
6. b. –0.4
The sum of the absolute values of the deltas of a call and a put with the same expiry and the same strike
price is 1.
7. A hedger would utilize a delta hedging technique when dollar-for-dollar protection is required from an adverse
change in the price of the underlying asset.
8. c. 200
(10,000 ÷ 100) ÷ –0.5

1. i.
3-Month Interest Due Cap Principal Net Cash Flow Net Cash Flow
LIBOR Rate on Loan Payments Payments With Cap Without Cap
Date % $ $ $ $ $
Jun. 1 6.00 –100,000 10,000,000 9,900,000 10,000,000
Sep. 1 6.75 –150,000 – – –150,000 –150,000
Dec. 1 7.50 –168,750 6,250 – –162,500 –168,750
Mar. 1 7.00 –187,500 25,000 – –162,500 –187,500
Jun. 1 7.25 –175,000 12,500 –10,000,000 –10,162,500 –10,175,000
ii. ABC did not benefit by entering into the cap because the payoffs received from the cap ($6,250 + $25,000
+ $12,500) were less than the cost of the cap ($100,000).
iii. Zero, because there would not have been any payoffs from the cap since the reference rate (3-month
LIBOR) never rose above the ceiling rate of 6.50%.
2. i.
Interest Due Floor Principal Net Cash Flow Net Cash Flow
Prime Rate on Portfolio Payments Repayment With Floor Without Floor
Date % $ $ $ $ $
Jan. 1 10.00 – –250,000 –25,000,000 –25,250,000 –25,000,000
Jul. 1 9.00 1,250,000 – – 1,250,000 1,250,000
Jan. 1 8.50 1,125,000 62,500 1,187,500 1,125,000
Jul. 1 9.75 1,062,500 125,000 1,187,500 1,062,500
Jan. 1 9.25 1,218,750 – 25,000,000 26,218,750 26,218,750
ii. The floor would have cost less if it had a floor rate of 9.25% rather than 9.50%. All else being equal, a
floor with a lower floor rate provides less protection (i.e., is either less in-the-money or further out-of-the-
money) than one with a higher rate and therefore must cost less.

3. i. a. Buy an interest rate cap.

Since protection from rising rates is required, an interest rate cap should be purchased.
ii. b. European.
iii. c. 7.50%
($2,062,500 ÷ $100,000,000) × (360 ÷ 90) – 0.0075
This is a rearrangement of the calculation that would be used to solve for the interest on the loan
payable on December 1, Year 1. That calculation would have been solved with the following formula:
(3-month LIBOR + 0.0075) × $100,000,000 × (90 ÷ 360)
iv. c. US$1,750,000
(0.0625 + 0.0075) × $100,000,000 × (90 ÷ 360)
v. c. Gained US$12,500.
The total of cap payoffs (US$187,500 + US$125,000) exceeded the cost of the cap (US$300,000)
by US$12,500.
vi. d. Larger because the option would have been less out-of-the-money.
All else being equal, a cap rate of 6.50% provides more protection than a cap rate of 6.75% and
therefore must cost more.

1. It is referred to as “notional” because the principal amounts are not generally exchanged in a swap transaction
and the notional amount is only used in determining the amount of the periodic payments.
2. A swap dealer charges a fee in the form of a bid-ask spread on its fixed-rate quotes.
3. When a dealer warehouses a swap, it is taking on one side of the swap without entering into a second
offsetting swap. This usually occurs when a swap dealer is unable to find a third party to assume the
“counterparty role” to a swap that the swap dealer has already entered into. Under these circumstances, the
swap dealer must temporarily assume the counterparty role and places the swap on its own balance sheet.
4. Uses of swaps include:

risk reduction/hedging;
cost reduction;
creation of synthetic instruments; and
speculation.
5. The OTC derivatives market reforms introduced by the G20 countries focus on the trading of standardized OTC
derivatives, the clearing of standardized OTC derivatives, the trade reporting of OTC derivatives and the capital
requirements for non centrally cleared derivatives.


1. i.
5.10%
West Co. East Co.
3-month
LIBOR
3-month LIBOR
5.20%
+0.80%
Original Lenders Original Lenders
ii.
West Co. Payment East Co. Payment Net Payment*

Period 3-Month LIBOR $ $ $
1 4.50% – – –
2 5.25% 112,500 127,500 (15,000)
3 6.50% 131,250 127,500 3,750
4 6.00% 162,500 127,500 35,000
5 – 150,000 127,500 22,500
* West Co. Net payment (receipt) to (from) East Co.
iii. Prior to entering the swap, West Co. was quoted a rate of 3-month LIBOR + 0.20% for a floating-rate loan.
Combining the swap and the loan, West Co. is effectively paying a floating rate of 3-month LIBOR + 0.10%
(3-month LIBOR + 5.20% – 5.10%). Therefore, West Co. has reduced its financing rate by 0.10%, or 10 basis
points.
iv. Prior to entering the swap, East Co. was quoted a rate of 6.00% for a fixed-rate loan. Combining the swap
and the loan, East Co. is effectively paying a fixed rate of 5.90% (5.10% + 3-month LIBOR + 0.80% –
3-month LIBOR). Therefore, East Co. has reduced its financing rate by 0.10%, or 10 basis points.
2. i. d. Interest rate swap.
ii. a. KLM has both an absolute and comparative advantage in the floating-rate market.
KLM can borrow more cheaply than PQR in both the fixed and floating-rate markets. Therefore, it has an
absolute advantage in both markets. KLM also has a comparative advantage in the floating-rate market
because this is the market in which KLM’s absolute advantage is greater (1.50% vs. 1%).

iii. b. KLM would have paid the dealer US$237,500.

(0.06 – 0.0695) × US$50 million × (180 ÷ 360)
Only one net payment is made on each of the interest payment dates. KLM’s fixed rate payment of
6.95% is greater than the dealer’s payment of 6%, so KLM must make the net payment to the dealer.
The rate that applied at the beginning of the period is the rate used to calculate the floating rate.
iv. d. The dealer would have paid PQR US$337,500.

(0.0685 – 0.055) × US$50 million × (180 ÷ 360)
v. b. 0.30%
7.75% – (6-month LIBOR + 0.50% – 6-month LIBOR + 6.95%)
vi. a. 0.10%
6-month LIBOR + 2% – (8.75% – 6.85% + 6-month LIBOR)
vii. d. US$100,000
(0.0695 – 0.0685) × US$50 million × 2 years
The dealer is receiving 6.95% from KLM and paying 6.85% to PQR.
viii. b. Long a fixed-rate bond with a coupon of 6.85% and short a floating-rate bond with a coupon of
6-month LIBOR.
PQR is receiving fixed-rate payments from the dealer. This is equivalent to owning a bond with a fixed
coupon. PQR is also making floating rate payments to the dealer. This is equivalent to being short a
bond with a floating coupon.
3. As the buyer of a CME-listed DSF contract the bank will become a counterparty to a CME‑cleared U.S. dollar
interest rate swap in which it is the floating-rate payer and fixed‑rate receiver
4. b.

11 Currency Swaps
1. i.
€8.25% €8.35%
Swap
Rex Co. Spot Co.
6-month Dealer 6-month
LIBOR LIBOR
6-month LIBOR
€8.00%
+0.15%
Original Original
Lenders Lenders
ii.
Rex Co. Versus the Swap Dealer
6-Month Dealer’s Rex Co.’s

Period LIBOR (%) Payments Payments
1 Principal Exchange 6.00 US$250 million €200 million
2 6.50 €8,250,000 US$7,500,000
3 7.50 €8,250,000 US$8,125,000
4 7.00 €8,250,000 US$9,375,000
5 Coupon Plus €8,250,000 US$8,750,000
Principal Exchange + €200 million + US$250 million
Spot Co. Versus the Swap Dealer
6-Month Dealer’s Spot Co.’s

Period LIBOR (%) Payments Payments
1 Principal Exchange 6.00 €200 million US250 million
2 6.50 US$7,500,000 €8,350,000
3 7.50 US$8,125,000 €8,350,000
4 7.00 US$9,375,000 €8,350,000
5 Coupon Plus US$8,750,000 €8,350,000
Principal Exchange + US250 million + €200 million

12 Credit Swaps
1.
Premium
(protection fee)
Protection Buyer Protection Seller
Payment
upon credit event only
2. i. d. This is an example of a portfolio CDS.
ii. b. The first premium paid by the protection buyer is 1% × $10 million = $100,000 annually.
iii. b. The protection seller will pay the full defaulted amount of $4,000,000
iv. c. Since $4,000,000 has been paid out, the coverage amount will ”reset” to $6,000,000. The premium will
reset as well at 1% × $6,000,000 = $60,000. Therefore, $60,000 is the premium paid in the second year.
v. c. Although $7,000,000 is the default loss, there is only $6,000,000 of protection coverage remaining.
An amount of $6,000,000 will be paid out by the protection seller and the CDS will terminate. The
$10,000,000 protection amount has been attained.
3. An index CDS is defined, among other criteria, by:

the list of its index constituents;
the index weight of each constituent;
the term and maturity date of the index CDS;
the notional amount;
the coupon payable by the protection buyer; and
the specific credit events that would trigger a settlement.
4. Notional amount × index weight of the constituent × [1 − the recovery rate]

$20 million × (1/50) × (1 − 30%) = $20 million × 0.02 × 0.70 = $280,000


1. A synthetic equity position allows an investor to earn equity returns without actually taking a position in
the equity markets. A typical equity swap would have an investor paying a fixed coupon to a counterparty in
exchange for the periodic rate of return (or some fraction thereof) on a particular equity market index such as
the S&P 500.
14 Mutual Funds
1. d. The derivative must be offset before the position that is being hedged is offset.
While a mutual fund cannot maintain a derivatives position for hedging purposes if the position that it is
supposed to be hedging is offset, it can offset the derivative at about the same time that the underlying
position is offset.
2. The derivative may hold up to 10% of the net asset value of the fund in derivatives for non-hedging purposes.
In this case that is $10 million.
3. Four potential risks are as follows:

i. Basis risk, which arises whenever one kind of risk exposure is hedged with an instrument that behaves in a
similar, but not necessarily identical, manner.
ii. The burden of additional monitoring, especially for firms less familiar with monitoring derivatives positions.
The increased effort can, in some cases, impose considerable costs.
iii. Potentially limited returns from a strategy such as covered call writing.
iv. The cost of hedging, which is either the foregone opportunity to generate windfall gains (as with the
locked-in prices associated when hedging with forwards and futures) or cash losses (outlays for the
purchase of option premiums).

15 Hedge Funds
1. The three main hedge fund structures are as follows:
i. Commodity pools (alternative mutual funds) are a special type of mutual funds that can use derivatives in a
leveraged manner for speculation. They can also sell short, whereas mutual funds generally cannot.
ii. Closed-end funds are investment funds with redemptions, if any, that occur only once a year or less. To
provide liquidity to fund investors, closed-end funds are often listed on an exchange.
iii. Principal-protected notes provide investors with exposure to the returns of one or more hedge funds and a
return of principal on maturity that is guaranteed by a bank or other highly-rated issuer of debt securities.
2. d. Short gold futures and short Swiss franc futures.

If the price of gold is expected to fall in U.S. dollar terms, the only way to profit from this is to sell gold
futures. If at the same time the price of gold is expected to increase in terms of the Swiss franc, then it must
be the case that the Swiss franc is declining even faster than the price of gold in U.S. dollar terms. Therefore,
Swiss franc futures should be sold as well.
16 Principal-Protected Note (PPNs)

1. Apart from some basic structural and operational differences, market-linked GICs and PPNs are essentially the
same product. In Canada, both are issued by banks and both provide a return that is linked to the performance
of a specific underlying asset such as a market index, a basket of stocks or a mutual fund. Both market-linked
GICs and PPNs provide a guaranteed return of principal at maturity, and any return is paid in form of interest.
Finally, market-linked GICs are normally designed and managed by the same group that runs the bank’s PPN
program, and can be built using the same techniques.
2. All else being equal, Bank B would be able to offer investors more exposure to the S&P/TSX Composite Index
because 5-year interest rates are higher than they were when Bank A issued its PPN. The higher interest rate
means that the price of a 5-year zero-coupon is lower, which in turn means that Bank B has more to spend
on the option component of the structure. With more to spend on the option component, Bank B can offer
investors more exposure to the underlying index.
3. c. The value of the underlying asset has gone down and/or interest rates have fallen.
In a CPPI structure, the issuer must lower the exposure of the note’s assets to the underlying asset when
the value of the underlying asset goes down and/or when interest rates fall.


1. In a futures market in backwardation, an ETF rolling its contracts would buy the next month’s contracts for a
lower price than it sells the current month’s contracts. This creates what is known as positive roll yield and will
add to the total return of the ETF. In a futures market in contango, an ETF rolling its contracts would buy the
next month’s contracts at a higher price than it sells the current month’s contracts, creating net losses on each
roll and representing a severe financial performance drag for the ETF.
2. Market price changes affect proportionally more the NAVPS of a leveraged fund than the market value
exposure of the derivative position used to deliver the leverage.
To maintain a stated leverage ratio after an up day, a leveraged ETF must adjust upward its long derivative
market exposure and a leveraged inverse ETF must reduce (buy back) part of its short derivative market
exposure.
To maintain a stated leverage ratio after a down day, a leveraged ETF must reduce (sell back) part of its
long derivative market exposure and a leveraged inverse ETF must adjust upward its short derivative market
exposure.
3. c.

Glossary
At-the-Money
A C
When the exercise price of either a
put or a call option is the same as the
Alternative Investment-Linked market price of the underlying asset. Calendar Spread
Notes See Intramarket Spread.
A category of principal protected notes
in which the return may be linked to Call Option
commodities, managed futures or B The right to buy (and lock in a
income-producing notes. purchase price) is referred to as a call
Backwardation option as the call buyer has the right
American-Style to call the underlying asset from the
See Inverted Market.
A type of option that can be exercised call writer (seller) during the life of the
at any time up to the expiration of the contract.
option. Bankers’ Acceptance
A short-term promissory note issued Canadian Securities Administrators
Amortizing Swap by a corporation that has been backed (CSA)
by a chartered bank.
An interest rate swap in which the A forum for the 13 securities regulators
notional principal amount is reduced of Canada’s provinces and territories to
over time until it reaches zero. Barrier Option coordinate and harmonize regulation
An option where the payoff depends of the Canadian capital markets.
Arbitrage on whether or not the underlying asset
reaches a pre-defined barrier during Caplets
Academic or pure arbitrage refers
the life of the option.
to the simultaneous purchase and The individual option components of
sale of instruments that are perfect an interest rate cap.
equivalents in the hope of taking Basis
advantage of pricing discrepancies The difference between the current Cash and Carry Arbitrage
between them to earn a risk-free cash price and the futures price.
Arbitrage that involves buying the
profit. Most real world arbitrage, underlying asset and selling the
however, is not pure. There usually is Basis Risk futures contract to take advantage of
some element of risk. The risk of unexpected changes in the a situation where futures are priced
basis. higher than fair value.
Arrears Swap
An arrangement where interest Basis Swap Cash Settlement
payments are made on the day the An interest rate swap where A feature of certain types of futures
floating rate is determined (in contrast the interest payments for both and option contracts that allow
to the plain vanilla swap where the counterparties are determined by a delivery or exercise to be conducted
floating rate is determined prior to the floating rate. with an exchange of cash rather
interest payment date). than by delivery of a physical asset
Basket CDS in exchange for payment. Stock
Asian Option A CDS that offers protection on the index futures contracts are the most
An option whose payoff is based on default probabilities of a basket of predominant type of cash-settled
the average price of the underlying assets. contract.
asset over time until expiration. Also
known as an average price option. Bilateral Netting
The consolidation of all swap
Assignment agreements between two
When an option holder exercises, the counterparties.
writer is assigned to either buy or sell
the underlying asset.

G•2 DERIVATIVES FUNDAMENTALS AND OPTIONS LICENSING COURSE | VOLUME 1 • TEXTBOOK
Clearinghouse Commodity Product Spread Convenience Yield

An organization that takes care of A spread that involves the purchase or The benefit from owning the physical
financial settlement and helps ensure sale of a commodity futures contract commodity. The value of the benefit
that markets operate efficiently. against the opposite position in the is dependent upon the probability
Clearinghouses can be set up either products of the commodity. of shortages of the commodity. If
as a separate corporation or as a the commodity is currently in short
department of an exchange. The Commodity Swap supply and that shortage is expected
primary functions of a clearinghouse A swap in which one counterparty to continue, the convenience yield will
are to guarantee financial performance agrees to make fixed periodic be high.
of each contract, clear all trades, and payments to a second counterparty for
handle deliveries. the use of a predetermined amount of Convergence
a certain commodity. Simultaneously, The narrowing of the basis as a futures
Closed-End Fund the second counterparty agrees to contract nears expiration.
A fund with a fixed number of shares make periodic payments to the first
outstanding. The shares are bought counterparty which are based on the Cost of Carry
and sold on a stock exchange instead same amount of a certain commodity Term associated with the cost of
of being issued and redeemed the way but calculated at a floating unit price. holding a commodity or financial asset
a typical mutual fund does. until it is sold or delivered. The cost of
Comparative Advantage holding a commodity typically includes
Collateral The mechanism through which the financing, storage and insurance
A form of credit enhancement. cost of new or existing debt may be charges. The cost of holding a financial
Collateral would have to be pledged reduced by an interest rate or currency asset typically includes financing costs
by the party for which the swap has swap. Specifically, two companies with less income received such as dividends
a negative value. The collateral could complementary relative advantages for stocks and interest for debt
be pledged in the form of assets such may come together and design a swap instruments.
as securities and real estate or a line to reduce the financing costs of both
of credit provided by another financial companies. Counterparties
institution. Its value should be at The buyer and seller of a derivative
least equal to the size of the liability Compound Option contract.
stemming from the swap agreement. An option on an option.
Covered
Collateral Basket Constant Proportion Portfolio When an investor writes an option and
A basket of collateral assets pledged Insurance (CPPI) has an underlying asset position that
to or received by a swap-based An investment in which the principal would satisfy the obligation in case of
ETF, reducing this way the ETF’s is guaranteed by the use of a trading assignment.
counterparty risk exposure to the swap strategy in which allocations to a
provider. risky asset and a risk-free position are Covered Call
adjusted periodically. Adjustments The purchase of an underlying asset
Combination to the allocations are based on the and the sale of a call option on that
See Long Combination and Short market value of the risky exposure underlying asset.
Combination. and the cost of buying a zero-coupon
risk-free bond which can be used to Credit Enhancements
Commodity Futures repay the principal of the security at
In order to control credit risk, dealers
Futures contracts that are based on a maturity This technique is often used
often require credit enhancements
physical or “hard” asset such as gold, to create principal-protected notes
such as collateral from their
soybeans or crude oil. based on hedge fund investments.
counterparties.
Commodity Pool Contango Market

Credit (or Counterparty) Risk
Mutual funds that are allowed to use A market where the forward or futures
For a counterparty, credit risk
derivatives in a leveraged manner for price is higher than the spot price.
stems from the possibility that
speculation; pay incentive fees based For commodity futures contracts,
the swap dealer may default. For
on the total return of the fund since contango markets are considered
the swap dealer, credit risk stems
the last fee was paid; and to restrict normal as there is typically a cost to
from the possibility that one of the
redemption rights for a period up to six carrying or holding a commodity.
counterparties may default.
months after the initial purchase.

GLOSSARY G•3
Credit Default Swap (CDS) Delivery Price Exchange-traded Derivatives

The exchange of two cash flows – a The price that the purchaser of a Forward and option products that
fee payment and a conditional forward-based contract agrees to trade on an organized exchange.
payment – which occurs only if certain pay to the seller of the contract upon
circumstances are met. A CDS is credit delivery. Exercise Price
insurance; it transfers credit risk. The price at which an underlying
Delta security can be bought or sold if an
Credit Derivatives Indicates how much the price of an option contract is exercised. Also
Financial instruments that derive their option is expected to change, given a known as the strike price.
value from an underlying credit asset price change in the underlying interest.
or pool of credit assets, such as bonds Exotic Option
or mortgages, and are designed to Delta Hedging Any option that is not traded on
transfer and manage credit risk. Adjusting the number of contracts an exchange and is not essentially
used in an option hedge to reflect the identical to one traded on an exchange.
Cross-Hedge option’s delta.
A hedge where the futures contract Expiration Date
used has an underlying asset which Derivative The date on which a derivative
is similar to but not the same as the Financial instruments created by contract becomes void.
physical commodity being hedged. market participants so that they can
trade and/or manage more easily the
Currency Swap asset upon which these instruments
In its simplest form, a plain fixed- are based. Their values are derived F
for-fixed currency swap agreement solely from an underlying interest
is an agreement between two which may be a commodity such as
Fair Value
counterparties in which the first wheat or a financial product such as a
counterparty agrees to exchange bond or stock, a foreign currency, or an If a futures contract is trading at a price
principal and fixed-rate interest economic/stock index. that reflects full carry, it is said to be
payments on a loan denominated trading at fair or theoretical value.
in one currency with the second
counterparty’s principal and fixed- Financial Futures
rate interest payments on a loan E Futures contracts that have a financial
denominated in a different currency. asset such as a bond, index or currency
as their underlying interest.
Equity Swap
An equity swap effectively creates First Notice Day
a “synthetic” equity position. In an
D equity swap, counterparty A will make
The day that the futures contract
delivery process begins. Long position
interest payments to counterparty B
Daily Price Limit holders who maintain their positions
calculated at a fixed rate of interest
on and after first notice day may have
In a futures contract, the maximum on a notional amount of principal for
to accept delivery of the underlying
amount the price is allowed to rise or the duration of the swap. In return,
asset from the seller of the contract.
fall in one day. counterparty B will make payments
to counterparty A equal to the return
First-To-Default CDS
Day Trader (or some fraction thereof) of the same
notional amount of the agreed upon A CDS that pays upon the first default
A type of speculator whose time
equity index. of any of the referenced assets.
horizon is a single day.
Eurodollar Foreign Currency Option

Delivery Notice
A U.S. dollar deposited in a bank An option on an exchange rate or
When a short futures position holder
outside of the U.S. The bank could exchange rate index.
wants to make delivery he/she notifies
his/her broker who in turn tenders either be a foreign bank or a branch or
a subsidiary of a U.S. bank. Foreign Exchange Agreement
a delivery notice to the clearing
corporation which then allocates the A forward agreement based on a
notice to a broker that has an account European-Style Option currency.
who is long that particular futures A type of option that can only be
contract. Allocation by the clearing exercised at expiration.
corporation and the broker is often
done on a first-in first-out basis (FIFO).

Forward In-the-Money
H
In a forward transaction, two parties The amount of intrinsic value an option
agree to terms of a trade which is to has. A call option is in-the-money if
be carried out some time in the future. Hedge Fund the market price of the underlying
The buyer does not pay the agreed A term commonly used to describe asset is higher than the exercise price.
upon price right away, nor does the lightly regulated pools of capital that A put option is in-the-money if the
seller deliver the underlying interest. have great flexibility in their choice of market price is lower than the exercise
Payment and delivery take place at a investment strategies. price.
specified date in the future, known as
the delivery date. The delivery price Hedge Fund-Linked Notes Index Option
is agreed upon when the contract is Principal protected notes in which the Option contract on a stock index or
entered into. Forwards that trade on return is linked to the performance other financial index.
an exchange are typically referred to of an underlying hedge fund, or more
as futures contracts. Forwards that commonly, a portfolio of hedge funds. Index Swap
trade OTC are typically referred to as
A swap where payments of one
forward agreements. Hedge Ratio counterparty are tied to the value of a
See Optimal Hedge Ratio. particular index.
Forward Agreement
When a forward-based derivative is Hedging Index-based CDS
traded over-the-counter, it is generally An attempt to reduce risk by making Credit default swap (CDS) on an index
referred to as a forward agreement. transactions that reduce exposure to designed to track the credit risk of a
market fluctuations. Hedging with group of corporate entities considered
Forward Rate Agreement derivatives involves taking an opposite to represent a sector of the economy
A forward agreement that is based on position in the derivative instrument of or a particular geographical region.
interest rates. The parties to a forward the asset to be hedged (or one that is
rate agreement are able to fix an very close to it) that is equal in size. Index-linked Notes
interest rate for a transaction that is
Principal protected notes in which the
going to take place at some point in Historical Volatility return is linked to the performance of
the future. Past or historical volatility of an an equity index, such as the S&P/TSX
underlying asset, measured by taking 60 Index.
Fundamental Analysis the standard deviation of price changes
The study of an asset’s current and over a set period of time. Indication Pricing Schedule
expected supply and demand situation
A schedule of rates provided by a swap
in order to help forecast future price
dealer.
movements.
I Intercommodity Spread
Funded Swap ETF Structure
A spread that involves the purchase
Under a funded swap ETF structure, a Imperfect Hedge and sale of futures contracts that have
swap-based ETF transfers cash equal
The result of a hedge that does not different but related underlying assets.
to a desired notional exposure to the
perform as the hedger expected due The two contracts may trade on the
swap provider, which then provides
to unexpected changes in the basis. A same or different exchanges.
the market return of the index the
hedge may turn out to be imperfect if
ETF is trying to replicate. To offset the
there is a difference between the asset Interest Rate Cap
counterparty risk exposure, the swap
underlying the futures contract and Essentially a series of European call
provider has to post collateral that is
the asset being hedged, or if the assets options on interest rates (as opposed
pledged to the ETF.
match, but the hedge is lifted early and to call options on an underlying debt
the basis has changed unexpectedly. instrument). The holder of the cap
Futures Contract
gets paid on each settlement date the
A forward-based derivative that trades Implied Forward Rate amount, if any, by which the reference
on an exchange.
A rate of interest derived from current interest rate is above the exercise or
spot rates that is applicable to a future strike price.
Futures Exchange
time period.
An organized exchange where futures Interest Rate Collar
contracts and options on futures Implied Volatility A combination of a cap and a floor
contracts are traded.
The volatility implicit in an option’s created by purchasing a cap, while
premium. simultaneously selling a floor.
Futures Option
An option on a particular futures
contract.

GLOSSARY G•5
Interest Rate Floor Margin

L
Essentially a series of European put An amount of money deposited by
options on interest rates (as opposed both buyers and sellers of futures
to put options on an underlying debt Leverage contracts to ensure performance of the
instrument). The holder of the floor The ability to control large dollar terms of the contract (the delivery or
gets paid on each settlement date the amounts of an underlying interest taking of delivery of the commodity
amount, if any, by which the reference with a comparatively small amount of or offset of the contract). Margin
interest rate is below the exercise or capital. Leverage can greatly magnify is not a payment of equity, merely
strike price. the effect of price changes in an a performance bond or good faith
underlying interest. deposit.
Interest Rate Swap
An interest rate swap involves two Liquidity Risk Market Risk
counterparties, A and B. Under a plain Risk that a derivative cannot be The risk that any market-related factor
vanilla interest rate swap, counterparty purchased or sold quickly enough or in will change the value of a derivatives
A agrees to pay counterparty B the required quantity at a fair price. position.
periodic cash flow equal to interest,
calculated at a predetermined Locals (Scalpers) Market-linked GICs
fixed rate, on a notional principal Floor traders who trade for their own GICs whose interest is linked to the
throughout the life of the swap. accounts. performance of a market index, mutual
Meanwhile, counterparty B agrees to fund, basket of securities or some
pay interest, calculated at a floating Long Hedge other underlying asset.
rate, on the same notional principal to A hedge that involves buying the
counterparty A. Only net cash flows futures contract in anticipation of Marking-to-Market
are exchanged. buying the physical asset at some The process in a futures market in
point in the future. Long hedgers which the daily price changes are paid
Intermarket Spread are concerned that the price of the by the parties incurring losses to the
A spread that involves the purchase underlying asset will rise in the future, parties earning profits.
and sale of futures contracts that have making it more expensive to buy.
the same underlying asset but trade on Mini Contracts
different exchanges. Long Position Derivative contracts representing a
For forward-based derivatives, the fraction (typically 1/5 or 1/10) of a
Intramarket Spread party that agrees to buy the asset has standard futures or options contract.
Also known as a calendar or time the long position in the contract. For
spread. Involves buying and selling option-based derivatives, the party Multi-Asset Options
futures contracts that trade on the that pays the premium has the long Consists of a family of options whose
same exchange and that have the position in the contract. payoffs depend on the prices of more
same underlying interest but different
than one asset.
expiry months.
Mutual Fund-Linked Notes
Intrinsic Value M Principal protected notes in which the
For a call option, intrinsic value is
return is linked to a particular mutual
calculated by subtracting the exercise Maintenance Margin fund or portfolio of mutual funds.
price from the market price. For a put
The minimum balance for margin
option, intrinsic value is calculated by
required during the life of a futures
subtracting the market price from the
contract.
exercise price. For both calls and puts,
intrinsic value cannot be less than zero. N
Managed Account
Inverted Market (or Backwardation) Individual accounts where a client National Instruments
gives discretionary authority over to a A set of rules and regulations
A commodity market where the
commodity trading professional. established by the Canadian Securities
forward or futures price is lower than
the cash or spot price. Also known as Administrators that is legally binding in
backwardation. Inversions occur in Managed Futures Fund all jurisdictions in Canada.
commodity futures markets largely Essentially mutual funds that invest in
due to low near-term supply or high futures markets. Net Equity
demand of the physical commodity, The net equity in a futures account is
relative to forward supply and demand. defined as the cash deposited plus/
minus any open futures positions’
profit/loss.

NI 81-102 Over-the-Counter Market Principal-Protected Note (PPN)

A set of rules and regulations that A market that generally consists of a A debt-like instrument with a maturity
must be complied with by publicly loosely connected network of brokers date on which the issuer agrees
offered investment funds. and dealers who negotiate transactions to repay investors the principal. In
directly with one another primarily addition to the principal, investors
NI 81-104 over telephone lines and/or computer may receive interest, the rate of
Introduced in 2002, National terminals. which is tied to the performance of an
Instrument 81-104 sets out the underlying asset.
rules that govern the operation of
commodity pools. It allows them to Protection Buyer
invest in commodities and use leverage P The party wanting to reduce credit risk
and derivatives in ways not permitted in the use of credit derivatives.
for conventional mutual funds. Participation Rate
Percentage indicating the portion Protection Seller
Normal Market of the upside growth in a PPN’s The party wanting to acquire or
See Contango Market. underlying asset that will be paid to hold credit risk in the use of credit
the PPN’s investors. derivatives.
Payer Swaption Put Option

O Option giving its holder the right The right to sell (and lock in a sale
but not the obligation to enter into a price) is referred to as a put option
Offsetting Transaction predetermined swap agreement to pay as the put buyer has the right to put
A futures or option transaction that the fixed rate and receive the floating the underlying asset to the put writer
is the exact opposite of a previously rate. (seller) during the life of the contract.
established long or short position.
Perfect Hedge
Optimal Hedge Ratio A hedge in which the futures price
Represents the ratio used to calculate behaved exactly as expected relative to Q
how many futures contracts should the cash price.
be used in a particular hedge by Quanto Swap
comparing price volatility of the Performance Bond An interest rate swap where the
futures and cash price. What is often required upon entry into interest rate payments on the
a futures contract is a performance notional principal are determined
Option bond or good-faith deposit, which based on the interest rate of a currency
A derivative instrument that gives gives the parties to a transaction a other than the one the notional is
the purchaser the right, but not the higher level of assurance that the denominated in.
obligation to, buy or sell an underlying terms of the contract will eventually
asset at a certain price (exercise price) be honored. The performance bond is
on or before an agreed upon date. often referred to as margin.
For this right the purchaser pays a R
premium to the seller (writer) of the Plain Vanilla Interest Rate Swap
option. The writer has an obligation, if A term used to describe the most basic Receiver Swaption
called upon to do so by the purchaser, type of interest rate swap. Option giving its holder the right
to buy, in the case of puts, or sell, in but not the obligation to enter into
the case of calls, at the exercise price. Portfolio CDS a predetermined swap agreement to
A CDS written on a basket of pay the floating rate and receive the
Original Margin underlying assets but that has a fixed rate.
The required deposit when a futures predetermined monetary amount,
contract is entered into. rather than a number of defaults. Recovery Rate
The realizable rate of recovery of the
Out-of-the-Money Position Trader underlying asset(s), as determined
A call option is considered out-of- A type of speculator who is hoping to by an independent assessor, if a cash
the-money if the market price of profit from longer-term price trends. settled CDS is activated.
the underlying asset is lower than
the exercise price. A put option is Premium Reference Asset
considered out-of-the-money if the The price of an option. The underlying asset(s) being
market price is higher than the exercise protected in a credit derivative.
price.

GLOSSARY G•7
Reference Entity Shout Option Synthetic Equity Position

The issuer of the underlying asset(s) An option that permits the holder at A position that allows an investor to
being protected in a credit derivative. any time during the life of the option earn equity returns without actually
to establish a minimum payoff that taking a position in equity.
Reverse Cash and Carry Arbitrage will occur at expiration.
Arbitrage that involves buying the
futures contract and selling the Single-Name CDS
underlying asset to take advantage of a A plain vanilla single asset CDS, T
situation where the futures contract is which is basically credit protection
underpriced relative to fair value. (insurance). Technical Analysis
The study of past price and volume
Spot Price data in order to anticipate future
The price of an asset on the spot market movements.
S market.
Time to Expiration
Segregation of Compensation Spread Trader All derivative contracts have a specific
A crucial principle that should be Trader simultaneously taking a long time to expiration. Both parties must
followed in any effective internal position in one asset and a short honour the contract’s obligations,
control and monitoring system. position in a related asset. or, if they plan to, exercise the
Compensation for back-office rights (i.e., the buying or selling of a
personnel should be independent from Spreading specified underlying interest) of the
those who work in the front office. As Describes a market strategy that contract by expiration. The contract
well, individuals who are responsible attempts to take advantage of relative is automatically terminated upon
for monitoring and controlling price changes between two different expiration.
derivatives must not receive a bonus but similar futures contracts.
or other reward from the profits Time Value
generated from traders. Strike Price The premium of the option less its
See Exercise Price. intrinsic value.
Settlement Price
The settlement price is determined Structured Products Trading Limits
at the end of each trading day by the Investment instruments that combine Exchanges set limits on the amount by
“Pit Committee” of the Exchange. The at least one derivative with traditional which most futures can move, either
price usually represents the average of assets such as equity and fixed- up or down, during one day’s trading
futures prices for trades made toward income securities. The value of the session. If the price moves down by an
the end of the day. derivative(s) depend on one or more amount equal to the daily limit, the
underlying assets. contract is said to be limit down. If it
Short Hedge reaches the upper limit then it is said
A hedge that involves selling the Swap to be limit up. The limits are designed
futures contract in anticipation of A private, contractual agreement to calm market panic, and to give
selling the physical asset at some between two parties used to exchange market participants time to absorb
point in the future. Short hedgers (swap) periodic payments in the future new information that may have been
are concerned that the price of the based on an agreed to formula. Swaps disseminated.
underlying asset will decline in the are essentially equivalent to a series of
future, meaning they will not receive forward contracts packaged together. Trading Unit
as high a price when they are ready to The size of the asset underlying
sell the underlying asset. Swap Dealer the derivative contract. All North
A swap dealer is a financial American-listed equity options, for
Short Position example, have a trading unit of 100
intermediary who facilitates the entire
For forward-based derivatives, the swap process by finding and bringing shares of the underlying stock.
party that agrees to sell the asset has together the two sides of a swap
the short position in the contract. For agreement and tailoring a product to Triggering Events
option-based derivatives, the party meet the specific needs of the end- A swap contract may call for collateral
that receives the premium has the users. The swap dealer simplifies the to be posted or increased if a triggering
short position in the contract. process by acting as a counterparty for event takes place such as a downgrade
each of the two end-users. of a counterparty’s credit rating.

Writer
U W
An investor who sells an option as an
opening transaction. The writer may be
Uncovered Warehouse Receipt obligated to either buy (put writer) or
When an investor writes an option Even if an individual decides to take sell (call writer) the underlying asset
without having an underlying position delivery, what is received/delivered in if called upon to do so by the option
that would satisfy the obligation in the case of most physical commodities buyer.
case of assignment. is a warehouse receipt which the seller
endorses over to the buyer. The receipt
Underlying Interest is issued by a storage point authorized
The value of a derivative instrument is by the exchange which confirms Z
based on an underlying interest which the presence and ownership of the
may be a commodity such as wheat underlying asset.
Zero-Coupon Bond Plus Call Option
or a financial product such as a bond
Warehousing The oldest PPN structure and the
or stock, a foreign currency, or an
simplest. When this type of PPN is
economic/stock index. When a swap dealer enters into an
issued, a large portion of the principal
agreement with one party, it typically
is used to purchase a zero-coupon
Unfunded Swap ETF Structure takes some time before it finds and
bond whose maturity date and value
Under an unfunded swap ETF arranges an offsetting agreement with
matches that of the PPN, thereby
structure, a swap-based ETF transfers another party. In such cases the dealer
guaranteeing the PPN principal is
cash equal to a desired notional has to warehouse the swap and hedge
returned. The remaining funds—minus
exposure to the swap provider, which its exposure.
fees—are then used to purchase call
then transfers a basket of collateral options on a risky underlying asset to
assets to the ETF. The total return Weather Derivatives
provide a return.
on this collateral basket is then A financial instrument whose value is
transferred to the swap provider in derived from the behaviour of weather Zero-Sum Game
exchange for the market return of the patterns.
Describes the fact that, commission
index the ETF is trying to replicate.
fees and bid-ask spreads aside, the
Whipsaw
gain from a derivative contract by one
Situation where a speculator is forced counterparty is exactly offset by the
to close out a position due to an loss to the other counterparty.
V adverse price movement, only to see
the price quickly rebound back in the
Volatility favoured direction.
A statistical measure of how much
a given security or market index
fluctuated during a given time period.

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THE CANADIAN SECURITIES INSTITUTE

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ONE ENROLMENT, ONE LEARNING PLATFORM AND ONE EXAM

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CSI’S DERIVATIVES EDUCATION MISSION

STRUCTURE OF VOLUME 1 AND VOLUME 2 OF THE DFOL

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11. Calculate margin requirements and margin calls.

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Table of Contents | Volume 1 | Part 1

1•3 WHAT IS A DERIVATIVE?

1•3 COMMON FEATURES OF ALL DERIVATIVE INSTRUMENTS

1•4 TYPES OF DERIVATIVE INSTRUMENTS

1•7 EXCHANGE-TRADED AND OVER-THE-COUNTER DERIVATIVES

1 • 10 TYPES OF UNDERLYING INTERESTS

1 • 22 WHO USES DERIVATIVES AND TO WHAT EXTENT ARE THEY USED?

© CANADIAN SECURITIES INSTITUTE (2019)

SECTION 2 | FUTURES CONTRACTS

2 Basic Features of Forward Agreements and Futures Contracts

2•3 A HISTORY OF FORWARDS

2•4 WHAT IS A FORWARD AGREEMENT?

2•6 WHAT IS A FUTURES CONTRACT?

2•7 ORGANIZED FUTURES MARKETS

2•9 BUYING AND SELLING A FUTURES CONTRACT

2 • 11 MARGIN REQUIREMENTS AND MARKING-TO-MARKET

2 • 12 FUTURES TRADING AND LEVERAGE

2 • 12 READING A FUTURES QUOTATION PAGE

2 • 13 CONTRACT SIZE AND THE VALUE OF THE UNDERLYING INTEREST

3 Pricing of Futures Contracts

3•3 FUTURES MARKET VERSUS CASH MARKET

3•3 COST OF CARRY

3•7 REVERSE CASH AND CARRY ARBITRAGE

3•8 CONDITIONS THAT FACILITATE ARBITRAGE

3•8 INVERTED MARKETS

© CANADIAN SECURITIES INSTITUTE (2019)

4 Hedging with Futures Contracts

4•3 TYPES OF HEDGES

4•8 OPTIMAL HEDGE RATIO

5 Speculating with Futures Contracts

© CANADIAN SECURITIES INSTITUTE (2019)

SECTION 3 | EXCHANGE-TRADED OPTIONS

6 Basic Features of Options

6•5 KEY OPTION TERMINOLOGY AND DEFINITIONS

6•7 APPLICATION OF KEY TERMS AND DEFINITIONS

6•9 WHY INVESTORS BUY OPTIONS

6 • 20 ADVANTAGES OF EXCHANGE-TRADED OPTIONS VERSUS OVER-THE-COUNTER

6 • 22 COMMON QUESTIONS PERTAINING TO THE OPTIONS MARKET

7•3 MAJOR FACTORS THAT AFFECT THE PRICE OF AN OPTION

7•4 INTRINSIC VALUE

© CANADIAN SECURITIES INSTITUTE (2019)

8•3 INTEREST RATE CAPS

9•3 WHAT IS A SWAP?

9•4 ROLE OF THE SWAP DEALER

9•5 HISTORY OF SWAPS