©2007, The McGraw-Hill Companies, All Rights Reserved Chapter Ten Derivative Securities Markets

©2007, The McGraw-Hill Companies, All Rights Reserved 10-2 McGraw-Hill/Irwin Derivative Securities: Chapter Overview Derivative 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 Derivatives are contracts whose value is linked to and derived from something else. The ‘something else’ is usually a security, a portfolio or an index. Derivative 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 Derivatives are contracts whose value is linked to and derived from something else. The ‘something else’ is usually a security, a portfolio or an index.

©2007, The McGraw-Hill Companies, All Rights Reserved 10-3 McGraw-Hill/Irwin Derivatives are financial contracts or financial instruments whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index, or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit

©2007, The McGraw-Hill Companies, All Rights Reserved 10-4 McGraw-Hill/Irwin Derivatives may be used for different purposes For instance, mortgage backed derivatives are often created to improve the marketability of existing loans, thereby improving a FI’s liquidity. The primary purpose of most derivative markets is however to reallocate risk from parties who do not wish to bear some or all of the risk arising from their underlying lines of business (hedgers) to other parties who are willing to bear the risk (speculators).

©2007, The McGraw-Hill Companies, All Rights Reserved 10-5 McGraw-Hill/Irwin Derivatives uses Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation

©2007, The McGraw-Hill Companies, All Rights Reserved 10-6 McGraw-Hill/Irwin Hedging Derivatives allow risk about the value of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract. (Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counterparty risk.)

©2007, The McGraw-Hill Companies, All Rights Reserved 10-7 McGraw-Hill/Irwin Speculation and arbitrage Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and by regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution.

©2007, The McGraw-Hill Companies, All Rights Reserved 10-8 McGraw-Hill/Irwin Types of derivatives; OTC and exchange- traded Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way

©2007, The McGraw-Hill Companies, All Rights Reserved 10-9 McGraw-Hill/Irwin OTC2 The OTC derivative market is the largest market for derivatives, and is unregulated. According to the Bank for International Settlements, the total outstanding notional amount is $596 trillion (as of December 2007). Of this total notional amount, 66% are interest rate contracts, 10% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin OTC3 OTC derivatives are largely subject to counterparty risk, as the validity of a contract depends on the counterparty's solvency and ability to honor its obligations.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Derivatives traders at the Chicago Board of Trade

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 Forward and futures contracts –currency forwards and futures –interest rate futures Options contracts –call option –put option Swaps –currency swap –interest rate swap

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin History Although commodity futures have a long history in the U.S., options were not widely traded until the development of the Black-Scholes Option Pricing Model in the early 1970s. In modern times derivatives have developed as the need to manage the risk of a given commodity or exposure grew.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin For instance, currency futures were introduced by the International Monetary Market (IMM), a subsidiary of the Chicago Mercantile Exchange (CME) as the collapse of the Bretton Woods Agreement led to higher currency volatility. Interest rate derivatives were created after the Fed stopped targeting interest rates in 1979

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin As stock trading grew, stock index derivatives were introduced in the early 1980s With the extreme increases in short term interest rates in the early 1980s, institutions became interested in swaps to manage interest rate risk. In the 1990s, credit risk derivatives were created that pay the holder if the credit risk on an underlying asset increases. Enron was a major trader in credit risk derivatives. Trading gains from these derivatives were used to help mask losses on other business lines at Enron

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Banks are major players in derivative markets, particularly in certain OTC derivatives and in mortgage backed securities. Derivatives usage among banks however is limited to the largest 600 or so banks and 95% of derivatives held by banks are written by just 5 banks.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin in some contracts the volume of electronic trading is now exceeding the volume of traditional exchange trading Derivatives are now being traded on electronic exchanges. Eurex (a European exchange) launched a fully electronic exchange in Chicago offering futures and options on U.S. T-notes and T-bonds as well as contracts on Euro interest rates. The CME’s Globex system is growing as well. Electronic trading is gaining ground on traditional pit trading;.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Forwards and Futures –Spot Markets A spot contract is a contract for immediate payment and delivery. Settlement is usually within two to three business days.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 FIs agree to take the opposite side of the contract as the customer for a fee and to earn the bid-ask spread 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 FIs agree to take the opposite side of the contract as the customer for a fee and to earn the bid-ask spread

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin forward rate agreement Forward contracts can specify interest rates on future borrowings as well as prices on specified assets. A forward rate agreement (FRA) is a forward contract for loans that fixes the interest rate today on a loan that will be originated in the future

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Forward contracts are custom arrangements negotiated by the buyer and seller. Both parties are at risk if the counterparty fails to perform as promised; hence, both parties should evaluate the creditworthiness of the counterparty. If the counterparty is not known to the bank, collateral may be required.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Futures Markets Futures contract Initial margin Maintenance margin Futures contract Initial margin Maintenance margin

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Futures Trading Open-outcry auction Floor broker Professional traders Position traders Day traders Scalpers Long/Short position Clearinghouse Open interest Open-outcry auction Floor broker Professional traders Position traders Day traders Scalpers Long/Short position Clearinghouse Open interest

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin A buyer of a futures contract (long position) incurs the obligation to pay the extant futures price at the time the contract is purchased. Payment is made at contract maturity in exchange for receipt of the underlying commodity.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin A seller of a futures contract (short position) incurs the obligation to deliver the underlying commodity at contract maturity in exchange for receiving the futures price that was outstanding at the time the contract was enacted.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin initial margin requirement On a forward contract, no cash is paid or received until contract maturity. Buyers and sellers of futures contracts however must post an initial margin requirement (IMR) to enter into a futures deal. The IMR is usually set at about 3%-5% of the face value of the contract, depending on the volatility of the underlying commodity and whether there are daily price limits on the futures contracts.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin maintenance margin requirement Participants must also maintain minimum margin requirements called the maintenance margin requirement (usually about 75% of the IMR). Futures contracts are marked to market daily, which means that gains or losses on the contracts are realized daily. This may require additional cash outlays if the customer’s margin falls below the minimum required.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Gambling? Most futures contracts do not result in delivery; indeed some contracts do not even allow delivery. The long position is eliminated by selling the same contract. The clearinghouse nets the position (1 long and 1 short) to zero. Likewise, the short seller simply purchases the same contract and the clearinghouse nets their position to zero

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin It is just a gambling Because of the lack of delivery, futures contracts are really bets on the way the price of the underlying commodity will move. The purchaser (seller) of a futures contract agrees to receive (pay) any increase in the value of the underlying commodity and agrees to pay (receive) any decrease in value between contract origination and termination.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Why delivery is not an issue on futures contracts I go long and default the pound futures contract F = futures price, S = spot price at time = 0 (today) or time = T at expiration. Suppose F0=$110,000 but at contract expiration ST = $108,000 and I renege and refuse to pay $110,000 to receive £62,500 (contract size) when I could buy them in the spot for $108,000. The seller of the pounds could sell the pound spot and receive $108,000 and the seller has ALREADY gained $2,000 from the daily marking to market. The net proceeds to the seller are $110,000, the same as if no default occurred.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin I go short and default the Pound futures contract: F0= $110,000 but ST = $112,000 and I renege and refuse to deliver £62,500 in order to receive $110,000 when I could receive $112,000 in the spot. The buyer of the pounds could buy the pound spot and pay $112,000 and (s)he (buyer) has ALREADY gained $2,000 from the daily marking to market. Net cost to buyer $110,000.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Settlement Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract: Physical delivery - Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position (Use of an option in a trading strategy in the underlying asset which is already owned). The Nymex crude futures contract uses this method of settlement upon expiration. Cash settlement

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin open interest The amount of open interest on a contract is the amount of long (short) positions that have not executed offsetting trades. Open interest is useful as a measure of liquidity on the contract

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin clearinghouses An agency associated with an exchange, which settles trades and regulates delivery Clearing corporations, or clearinghouses, provide operational support for securities and commodities exchanges. They also help ensure the integrity of listed securities and derivatives transactions in the United States and other open markets. For example, when an order to buy or sell a futures or options contract is executed, the clearinghouse compares the details of the trade. Then it delivers the product to the buyer and ensures that payment is made to settle the transaction

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin open outcry auction Futures trading uses an open outcry auction where traders communicate with each other via oral communications (usually shouted) and a variety of hand signals

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin An observer would think the trading process rather chaotic but it seems to work. Trading is very stressful, with hundreds or thousands of dollars quickly changing hands and emotions can run high, indeed fisticuffs are not unheard of on the exchange. The NYSE, while it can be extremely busy, is typically much more quiet than trading in the futures and options pits. The Chicago markets still hearken back to the style and zest of Chicago’s earlier days

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Professional traders Position traders that maintain positions in a contract for longer than a day, Day traders that liquidate their positions by the end of the day, Scalpers who hold positions only a matter of minutes and attempt to profit from either very small price changes or the bid-ask spread. Scalpers who hold their positions for more than 3 minutes typically lose.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Day traders and position traders often use proprietary models to estimate which way they believe prices will move. They normally will not disclose what their trading models.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin floor brokers Similar to the NYSE, floor brokers process public orders to buy and sell.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Today, there are more than 75 futures and futures options exchanges worldwide trading to include: Chicago Mercantile Exchange(CME) London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) Tokyo Commodity Exchange (TOCOM). CME Group (formerly CBOT and CME) -- Currencies, Various Interest Rate derivatives (including US Bonds); Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork, Cattle, Butter, Milk); Index (Dow Jones Industrial Average); Metals (Gold, Silver), Index (NASDAQ, S&P, etc)

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin ICE Futures - the International Petroleum Exchange trades energy including crude oil, heating oil, natural gas and unleaded gas and merged with IntercontinentalExchange(ICE)to form ICE Futures. Liffe South African Futures Exchange - SAFEX Sydney Futures Exchange London Commodity Exchange - softs: grains and meats. Inactive market in Baltic Exchange shipping. Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures) Tokyo Commodity Exchange TOCOM Tokyo Financial Exchange TFX (Euroyen Futures, OverNight CallRate Futures, SpotNext RepoRate Futures) Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures) London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel,tin and steel New York Board of Trade - softs: cocoa, coffee, cotton, orange juice, sugar New York Mercantile Exchange - energy and metals: crude oil, gasoline, heating oil, natural gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium Dubai Mercantile Exchange Singapore International Monetary Exchange (SIMEX) Futures on many Single-stock futures

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Futures Contracts Outstanding,

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Who trades futures? Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Hedgers typically include producers and consumers of a commodity For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin The social utility The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator for example.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Definitions of a Call 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. –The call buyer must pay the option premium (C) to the call writer. The option buyer may exercise the option and purchase the underlying spot commodity by paying the exercise or strike price (X). 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. –The call buyer must pay the option premium (C) to the call writer. The option buyer may exercise the option and purchase the underlying spot commodity by paying the exercise or strike price (X).

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin The option has intrinsic value if the underlying spot price (S) is greater than X. In this case the option is said to be ‘in the money.’ If at expiration S > X, the option will be exercised, if not the option expires worthless. In either case, the initial call price C is a sunk cost.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Call options will not normally be exercised prior to maturity unless the underlying commodity pays a large enough cash flow prior to maturity, even if they are in the money. This is so because the option is worth more “alive” (unexercised) than “dead” (exercised); the option has both time value and intrinsic value. The time value is forfeited if the option is exercised. An option holder wishing to terminate their option position could simply sell the option instead of exercising it. Mathematically, this is equivalent to stating that C > Max (0, S-X) for a call prior to maturity

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Purchasing a call option is a bullish strategy that makes money if the underlying commodity price rises. Writing a call is a neutral or bearish strategy. Buying a call is a limited loss strategy with a potentially unlimited gain, writing a call is the opposite.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Options are wasting assets, their time value erodes as expiration approaches. Option prices are also directly related to the level of underlying spot price volatility.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Suppose an at the money American style Swiss franc (Sfr) call option has the following terms: Exercise price 1Sfr = $0.655 Option Premium = 2¢/Sfr Contract size = 62,500 Sfr Expiration = 90 days This option gives the buyer the right to purchase 62,500 Sfr at any time within the next 90 days at an exercise (or strike) price of 62,500 Sfr  $0.655/Sfr = $40, The price the option buyer must pay to obtain this right (the premium) is 62,500 Sfr  $.02/Sfr = $1,250.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 Payoff Payoff function Gain for Buyer +  C 0 Stock Price X A S at expiration C -  Payoff Payoff function Loss for writer

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Tip A majority of options expire worthless and many institutions write calls to generate additional income to improve their current period rate of return.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Definitions of a Put 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 –The put buyer must pay the option premium (P) to the put writer. The option buyer may exercise the option and sell the underlying spot commodity by delivering the commodity in exchange for the exercise or strike price (X).

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin The option has intrinsic value if the underlying spot price (S) is less than X. If at expiration S < X the option will be exercised, if not the option expires worthless. Similar to calls, put options will not normally be exercised prior to maturity unless the option is deep in the money

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Purchasing a put option is a bearish strategy that makes money if the underlying commodity price falls. Writing a put is a neutral or bullish strategy. Buying a put is a limited loss strategy with a potentially large gain, writing a put is the opposite.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Payoff Function for Put Options Payoff Gain Payoff function for Writer +  P 0 Stock Price market D =10 X =14 at expiration -  P Payoff function Payoff for buyer Loss Payoff Gain Payoff function for Writer +  P 0 Stock Price market D =10 X =14 at expiration -  P Payoff function Payoff for buyer Loss

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Option Values Intrinsic value of an option –Call Option –Put Option Time value of an option –the difference between an option’s price (or premium) and its intrinsic value Intrinsic value of an option –Call Option –Put Option Time value of an option –the difference between an option’s price (or premium) and its intrinsic value

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin The intrinsic value of a call option is the maximum of zero or S-X. The intrinsic value of a put option is the maximum of zero or X-S.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin time value An option also has time value because the option’s returns are asymmetric. An out of the money option that has not yet expired may yet wind up in the money, an in the money option may wind up further in the money. If not, the option is simply not used. As a result, normally an option is worth more than its intrinsic value. The option’s time value is calculated as the option premium minus the intrinsic value.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin time value1 The time value is representative of the right to purchase the security or not, depending upon whether it is profitable to do so. It literally represents the probability that the commodity price will increase and move the option further in the money. Time value is greatest for an at the money option. For deep out of the money options, the time to expiration provides little likelihood that an option will be exercised; for deep in the money options, the ability to not exercise the option has little value.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Options on individual common stocks and stock indexes Options on individual common stocks and stock indexes are popular today for both hedgers and speculators. Hedgers may use long put options or written call options on individual stocks or indexes to hedge a long stock position. Stock index options are cash settled and the major S&P500 contract is a European option. Index options allow the investor to hedge systematic risk and partial hedges can be used to adjust a portfolio’s beta up or down.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Options exist on futures Options exist on futures contracts as well. The buyer of a call (put) option on a futures contract has the right, but not the obligation, to purchase (sell) a futures contract at the exercise price. Options on futures are popular because it is often cheaper to deliver the futures contract rather than the underlying commodity. The futures contract is typically more liquid than the underlying spot and more information about supply and demand for futures may be available than can be easily found for the underlying commodity or security.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Option Markets Options traded on the floor of Chicago Board Options Exchange (CBOE) by floor brokers, professional traders or a market maker for the particular option being traded Stock options Stock index options Options give investors a way to hedge Options traded on the floor of Chicago Board Options Exchange (CBOE) by floor brokers, professional traders or a market maker for the particular option being traded Stock options Stock index options Options give investors a way to hedge

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Options Market Activity, (in thousands)

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Regulation of Futures and Options Markets The Commodity Futures Trade Commission (CFTC) is the main regulator of futures contracts and options on futures contracts. The CFTC seeks to eliminate trading abuses and prevent market manipulation. The Securities Exchange Commission (SEC) regulates options on stocks and stock indexes. Neither party directly regulates OTC derivatives The Commodity Futures Trade Commission (CFTC) is the main regulator of futures contracts and options on futures contracts. The CFTC seeks to eliminate trading abuses and prevent market manipulation. The Securities Exchange Commission (SEC) regulates options on stocks and stock indexes. Neither party directly regulates OTC derivatives

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Swaps A swap is an agreement whereby two parties agree to pay each other specified cash flows for a set period of time. They are custom designed contracts primarily used to hedge currency and/or interest rate risk

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin the major types Interest rate swaps, currency swaps, credit risk swaps, commodity swaps ( a producer wishes to fix his income and would agree to pay the market price to a financial institution, in return for receiving fixed payments for the commodity, The vast majority of commodity swaps involve oil) equity swaps (An equity swap is a swap where a set of future cash flows are exchanged between two counterparties. The two cash flows are usually referred to as "legs". One of these cash flow streams can be pegged to floating rate of interest or pay a fixed rate (named "floating leg"). The other will be based on the performance of a share of stock or stock market index (named "equity leg").

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Interest rate swaps As of 2004 the notional principal of interest rate swap contracts outstanding was $ trillion. Interest rate swaps are by far the largest single component of the OTC derivatives market

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin plain vanilla interest rate swap In a plain vanilla interest rate swap one party agrees to pay a fixed interest rate on a given notional principle to the counterparty, and the counterparty agrees to pay a variable rate of interest on the same notional principle. Swap maturities range from a few months to many years

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Interest rate swap Definitions Swap buyer The party making a fixed interest payment. Swap seller the party making a variable payment. Notional principal since Principal is not normally exchanged this term designates only the amount used to calculate the dollars of interest paid Only net payments are actually transferred Swap buyer The party making a fixed interest payment. Swap seller the party making a variable payment. Notional principal since Principal is not normally exchanged this term designates only the amount used to calculate the dollars of interest paid Only net payments are actually transferred

©2007, The McGraw-Hill Companies, All Rights Reserved Example An institution that has too many rate sensitive liabilities relative to its holdings of rate sensitive assets is at risk from an interest rate increase (the typical position of a mortgage lender that is funding the mortgages with deposits). This FI may seek a swap where the FI agrees to pay a fixed rate of interest in exchange for receiving a variable rate of interest. If their own liability costs rise with rising interest rates, the swap payments received will also rise but their swap outflows are fixed. Large money center banks are often willing to serve as a counterparty to a bank or thrift in need of a swap. The intermediary banks may also act as brokers by finding a suitable counterparty McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved Credit risk exposure Credit risk exposure on a swap is less than on a loan since no principal is involved and only net interest payments are at risk but credit risk is still present. The agent bank may guarantee swap payments for a fee McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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) 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)

©2007, The McGraw-Hill Companies, All Rights Reserved Currency Swaps Currency swaps may be used to hedge mismatches in the currency of a FI’s assets and liabilities or other commitments. As of 2004 the notional principal of currency swap contracts outstanding (adjusted for double counting) was $26,997 billion McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved Fixed for fixed currency swaps involve a swap of principle and interest between two parties at a fixed rate of exchange. Fixed for floating currency swaps can be used to hedge both currency and interest rate exposure simultaneously McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved Swap dealers greatly facilitate the market for swaps. Large commercial banks and investment banks are the primary swap dealers. Swap dealers usually guarantee payments on both sides of the swap (for a fee) McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved Regulation Regulators have worried that the swap market is largely unregulated and some of the specific terms of swap agreements may not be publicly available. Since the swap market involves U.S. banks, swap market activities are indirectly regulated through the normal bank regulatory process McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved Caps, floors and collars are options on interest rates. The majority of these contracts have between 1 and 5 years, although some have longer expirations McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved Cap A cap is an OTC call option on interest rates. Conceptually, it may also be thought of as a put option on bond prices. If interest rates rise above a specified minimum (the strike “price” or “cap rate”), the seller of the cap pays the buyer the difference between the market interest rate and the strike interest rate times the notional value. Settlement (payment) dates may be at the end of contract, annually, or at other times negotiated by the parties McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved Floor A floor is an OTC put option on interest rates. Conceptually, it may also be thought of as a call option on bond prices. If interest rates fall below a specified minimum (the strike “price” or “floor rate”), the seller of the floor pays the buyer the difference between the strike and the market interest rate times the notional value McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved Collar Collar: A collar is a simultaneous position in a cap and a floor. If a FI is at risk from rising (falling) interest rates they may wish to buy a cap (floor). To offset some of the cost of purchasing the cap (floor) the FI may simultaneously sell a floor (cap) McGraw-Hill/Irwin

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin