Chapter Ten

Derivative Securities
Markets

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 Derivative Securities: Chapter
Overview

• Derivative security
– a financial security whose payoff is linked to
another previously issued security
• An agreement between two parties to
exchange a standard quantity of an asset at a
predetermined price at a specified date in the
future

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 Examples of Derivatives

• Forward and futures contracts

– currency forwards and futures
– interest rate futures
• Options contracts
– call option
– put option
• Swaps
– currency swap
– interest rate swap
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 Forwards and Futures

• Both are agreements to deliver (or take

delivery of) a specified asset at a future date
• Prices of both are tied to the current price of
the asset in the “spot” market
• Spot contract
– agreement to purchase (or sell) an asset
immediately

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 Forward Markets

• Forward contract
– an agreement to transact, involving the future
exchange of a set amount of assets at a set price
– participants hedge the risk that the future spot
price of an asset will move against them
• FI’s are the major forward market
participants and make a profit on the spread
between the price at which they originate
and sell forward contracts
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 Futures Markets

• Futures contract
– an agreement to transact, involving the future
exchange of a set amount of assets for a price that
is resettled daily - marked to market daily
• Initial margin
– a deposit required on futures trades to ensure terms
of any futures contract will be met
• Maintenance margin
– the margin a futures trader must maintain once a
futures position is taken.

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 Futures Trading

• Occurs on organized exchanges such as CBT and

CME or IMM
• Open-outcry auction - traders face each other and
“cry out” their offer to buy or sell
• Floor broker - Exchange members who place
trades from the pubic
• Professional traders - Exchange members who
trade for their own account
• Position traders - take a position in the futures
market based on their expectations of future prices

(continued)
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 • Day traders - exchange members who take a position
within a day and liquidate it before day’s end
• Scalpers - exchange members who take positions for
very short periods of time, sometimes only minutes, in
an attempt to profit from active trading
• Long position - a purchase of a futures contract
• Short position - a sale of a futures contract
• Clearinghouse - the unit that oversees trading on the
exchange and guarantees all trades made by the
exchange traders
• Open interest - total number of futures, put options, or
call option contracts outstanding at the beginning of the
day

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 Futures Contracts Outstanding, 1992-2001

7000
6000
5000
4000
3000
2000
1000
0
1992 1995 1996 1997 1998 1999 2000 2001

Financial instruments Currencies

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 Options

• A contract that gives the holder the right, but

not the obligation, to buy or sell an asset at a
prespecified price for a specified price within
a specified period of time
• American option - can be exercised at any
time before the expiration date
• European option - can only be exercised on
the expiration date

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 Definitions of a Call and a Put

• Call option
– an option that gives a purchaser the right, but not
the obligation, to buy the underlying security
from the writer of the option at a prespecified
exercise price on a prespecified date
• Put option
– an option that gives a purchaser the right, but not
the obligation, to sell the underlying security to
the writer of the option at a prespecified price on
a prespecified date
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 Payoff Function for Call Options

Payoff Payoff function

Gain for Buyer
+
C
0 Stock Price
X A S at expiration

C
-
Payoff Payoff function
Loss for writer

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 Payoff Function for Put Options

Payoff
Gain Payoff function
for Writer
+P
0 Stock Price
D X at expiration

-P
Payoff function
Payoff for buyer
Loss

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 Option Values

• Intrinsic value of an option

– Call Option: the difference between the
underlying asset’s price and an option’s exercise
price (zero if difference is negative)
– Put Option: the difference between the option’s
exercise price and the underlying asset’s price
(zero if difference is negative)
• Time value of an option
– the difference between an option’s price (or
premium) and its intrinsic value
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 Intrinsic value vs. the Before Exercise
Value of a Call Option
Value intrinsic value
(option (stock price - exercise price)
premium) Before exercise
price
$12.50 Time Value
$10.00 ($2.50)

X = $50 S = $60 Stock Price

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 Option Markets

• Options traded on the floor of CBOE by floor

brokers, professional traders or a market maker for
the particular option being traded
• Stock options - the underlying asset on a stock option
contract is the stock of a publicly traded company,
generally 100 shares
• Stock index options - the underlying asset on a stock
index option is the value of a major stock market
index (e.g., the DJIA or S&P 500)
• Options give investors a way to hedge their existing
stock portfolios
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 Options Market Activity, 1992-2001
(in thousands)
120000
100000
80000
60000
40000
20000
0
1992 1995 1996 1997 1998 1999 2000 2001

Avg month-end contracts outstanding

Number of contracts traded
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 Regulation of Futures and Options
Markets
• The Commodity Futures Trading Commission
(CFTC) is the primary regulator of futures markets
– protects the trading public by seeking to prevent
misrepresentation and/or market manipulation
– approves proposed contracts to ensure they have economic
purpose; conducts economic studies; enforces rules and
provides regulatory surveillance
• The Securities and Exchange Commission (SEC) is
the main regulator of stock options
– regulates trading of stock options and stock index options

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 Swaps

• An agreement between two parties to

exchange assets or a series of cash flows for
a specific period of time at a specified
interval
• Allow firms to better manage their interest
rate, foreign exchange, or credit risk
• Basic principle involves the transacting
parties restructuring their asset or liability
cash flows in a preferred direction

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 Swaps Definitions

• Interest rate swap - an exchange of fixed-interest

payments for floating-interest payments by two
counterparties
• Swap buyer - a party that makes the fixed-rate
payments in an interest rate swap transaction
• Notional principal - principal amount involved in a
swap
• Swap seller - a party that makes the floating-rate
payments in an interest rate swap transaction
• Currency swap - used to hedge exchange rate risk
from mismatched currencies on assets and liabilities
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 Swap Transactions

Direct arrangement of swap

Floating-Rate Payments
Money Center Bank Thrift
Fixed-Rate Payments

Swap arranged by third-party intermediary (swap agent)

Floating-Rate Floating-Rate
Payment Payment
Money Center Bank Swap Agent Thrift
Fixed-Rate Fixed-Rate
Payment Payment

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 Fixed-Floating Rate Swap

Money Center Bank Thrift

10%
Short-Term Assets fixed Long-Term Assets
(C&I indexed loans) (fixed-rate mortgages)

Long-Term Liabilities Short-Term Liabilities

(5-year, 10% notes) LIBOR + 2% (1-year CDs)

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 Caps, Floors, and Collars

• Cap
– a call option on interest rates, often with multiple
exercise dates
• Floor
– a put option on interest rates, often with multiple
exercise dates
• Collar
– a position taken simultaneously in a cap and a
floor
McGraw-Hill /Irwin 10-23 Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.