Chapter 21 Derivative Securities Lawrence J. Gitman Jeff Madura Introduction to Finance

21-1 Copyright © 2001 Addison-Wesley Explain how call options are used by investors. Explain how put options are used by investors. Explain how financial futures are used by investors. Learning Goals

21-2 Copyright © 2001 Addison-Wesley Background Derivative securities are securities that are neither debt nor equity and whose values are derived from the values of other, related securities. Derivative securities are not used by corporations to raise funds. Rather, they serve as a useful tool for managing certain aspects of firm risk. Two of the most popular types of derivative securities are options and financial futures.

21-3 Copyright © 2001 Addison-Wesley Options An option is an instrument that provides its holder with an opportunity to purchase or sell a specified asset at a stated price on or before a set expiration date. Options are probably the most popular type of derivative security. Three basic forms of options are rights, warrants, and calls and puts. This section will focus on call and put options.

21-4 Copyright © 2001 Addison-Wesley Call Options A call option is an option to purchase a specified number of shares of stock (typically 100) on or before a specified future date at a stated price. They usually have initial lives of 1 to 9 months. The striking price is the price at which the holder of a call can buy the stock at any time prior to the option’s expiration date. The striking price is usually set at or near the prevailing market price of the stock at the time it is issued.

21-5 Copyright © 2001 Addison-Wesley Call Options Executing Call Option Transactions  Investors purchase call options in the same way they purchase stocks—by calling their broker.  The price of the call option is called an option premium.  American-style call options are call options that can be exercised at any time throughout the life of the option.  European-style call options are options that can be exercised only on the expiration date.

21-6 Copyright © 2001 Addison-Wesley Figure 21.1 Call Options Source: Wall Street Journal, January 21, 2000, p. C13.

21-7 Copyright © 2001 Addison-Wesley Table 21.1 Classifying Call Options

21-8 Copyright © 2001 Addison-Wesley Speculating with Call Options Bill Warden purchased a call option on Flight stock for $4 per share, with an exercise price of $60 per share. He plans to exercise his option at the expiration date of the stock price at the time it is above $60. He plans to sell immediately the stock he receives from exercising the option. Bill wants to determine what his profit per share would be under various possible outcomes for the price of Flight stock.

21-9 Copyright © 2001 Addison-Wesley Speculating with Call Options Table 21.2

21-10 Copyright © 2001 Addison-Wesley Speculating with Call Options Figure 21.2

21-11 Copyright © 2001 Addison-Wesley Speculating with Call Options Table 21.3

21-12 Copyright © 2001 Addison-Wesley Speculating with Call Options Table 21.4

21-13 Copyright © 2001 Addison-Wesley Speculating with Call Options Figure 21.3

21-14 Copyright © 2001 Addison-Wesley Speculating with Call Options Factors that Affect the Call Option Premium  Stock price relative to exercise price  Time to expiration  Stock price volatility

21-15 Copyright © 2001 Addison-Wesley Put Options A put option is an option to sell a specified number of shares of stock (typically 100) on or before a specified future date at a stated price. They usually have initial lives of 1 to 9 months. The striking price is the price at which the holder of a put can sell the stock at any time prior to the option’s expiration date. The striking price is usually set at or near the prevailing market price of the stock at the time the put option is issued.

21-16 Copyright © 2001 Addison-Wesley Classifying Put Options Table 21.5

21-17 Copyright © 2001 Addison-Wesley Speculating with Put Options Emma Rivers purchased a put option on Zector stock for $3 per share, with an exercise price of $40 per share. She plans to exercise her option at the expiration date if the stock price at that time is below $40. She plans to purchase the stock just before exercising her put option. Emma wants to determine what her profit per share would be under various possible outcomes for the price of Zector stock.

21-18 Copyright © 2001 Addison-Wesley Speculating with Put Options Table 21.6

21-19 Copyright © 2001 Addison-Wesley Speculating with Put Options Figure 21.4

21-20 Copyright © 2001 Addison-Wesley Speculating with Put Options Table 21.7

21-21 Copyright © 2001 Addison-Wesley Speculating with Put Options

21-22 Copyright © 2001 Addison-Wesley Put Options Factors that Affect the Put Option Premium  Stock price relative to exercise price  Time to expiration  Stock price volatility

21-23 Copyright © 2001 Addison-Wesley Financial Futures A financial futures contract is a contract in which one party agrees to deliver a specified about of a specified financial instrument to the other party at a specified price and date. The buyer of the financial futures contract receives the financial instrument on the settlement date. The seller delivers the financial instrument and receives payment on the settlement date.

21-24 Copyright © 2001 Addison-Wesley Financial Futures Transactions Financial futures are traded on exchanges such as the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). Brokerage firms require that investors maintain a deposit (margin) to cover any loss that might result from a futures position. Buyers (sellers) can “close out” a position by selling (buying) an identical contract before the settlement date.

21-25 Copyright © 2001 Addison-Wesley Financial Futures Quotations Figure 21.5 Source: Wall Street Journal, January 20, 2000, p. C22.

21-26 Copyright © 2001 Addison-Wesley Speculating with Treasury Bond Futures As of October 10th, Rita Richards expects that the price of Treasury bonds will rise over the next month. She can presently purchase a Treasury bond futures contract with a December settlement date for 101. The futures contract represents Treasury bonds with a par value of $100,000 that pay 8% and have 15 years to maturity. The price of 101 implies that $101 will be paid for every $100 of par value, so the total price to be paid by Rita on the settlement date is $101,000.

21-27 Copyright © 2001 Addison-Wesley Speculating with Treasury Bond Futures Over the next month, Treasury bond prices rise and the price specified in a Treasury bond futures contract with a December settlement date at this time for 103. Rita will receive $103,000 as of the settlement date as a result of this contract. Rita now has one contract to buy Treasury bonds on the settlement date and another contract to sell Treasury bonds on the settlement date. The contracts offset each other. However, the amount she receives from selling the Treasury bonds exceeds the amount she paid by $2000.

21-28 Copyright © 2001 Addison-Wesley Speculating with Treasury Bond Futures

21-29 Copyright © 2001 Addison-Wesley Speculating with Stock Index Futures On July 8th, Al Barnett notices that the DJIA futures contract with a September settlement date specifies an index level of 10,000, which is similar to the existing index today. Al expects stock prices to decline, so he anticipates that the price specified in the DJIA futures contract will decline in the future. Therefore, he sells a futures contract today. The sale of the futures contract creates a short position, in which the underlying instrument that will be sold is not presently owned by the seller.

21-30 Copyright © 2001 Addison-Wesley Speculating with Stock Index Futures By August 24th, stock prices have declined, and the DJIA futures contract with a September settlement date specifies an index level of 9,400. Al does not expect further declines, so he purchases the DJIA index futures to offset his short position. The dollar value of the DJIA index specified in the futures contract is $10 times the index level.

21-31 Copyright © 2001 Addison-Wesley Speculating with Stock Index Futures Thus, Al’s gain is:

21-32 Copyright © 2001 Addison-Wesley Hedging with Financial Futures Stanford Mutual Fund manages a large portfolio of stocks. The portfolio managers anticipate that the prices of stocks will decline over the next month but will rebound afterward. They would like to hedge their portfolio against a loss over the next month. A stock index futures contract with one month to settlement is available on the DJIA at an index level of 10,000, so Stanford decides to sell a futures contract on the index because it is highly correlated with its mutual fund portfolio.

21-33 Copyright © 2001 Addison-Wesley Hedging with Financial Futures In one month, just before the contract expires, Stanford will purchase the same contract. If stock prices decline over this period, the index will decline as well, and so will the futures contract on the index. Stanford will gain on its futures position because the price it paid for the index at settlement will be less than the future price at which it sold the index. After one month, the market declined as expected and the futures price of the DJIA is at an index level of 10,000.

21-34 Copyright © 2001 Addison-Wesley Hedging with Financial Futures DJIA futures contracts are valued at $10 times the DJIA index, so Stanford’s positions are as follows:

Chapter 21 End of Chapter Lawrence J. Gitman Jeff Madura Introduction to Finance