McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9 Derivatives: Futures, Options, and Swaps

9-2 The Basics: Defining Derivatives A derivative is a financial instrument whose value depends on – is derived from – the value of some other financial instrument, called the underlying asset. The purpose of derivatives is to transfer risk from one person or firm to another.

9-3 Forwards and Futures A forward, or forward contract, is an agreement between a buyer and a seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date. Because they are customized, they are very difficult to resell to someone else

9-4 Forwards and Futures a future, or a futures contract, is a forward contract that has been standardized and sold through an organized exchange

9-5 Forwards and Futures A futures contract specifies that the seller – called the short position – will deliver some quantity of a commodity or financial instrument to the buyer – called the long position – on a specific date called the settlement or delivery date, for a predetermined price. No payments are made initially when the contract is agreed to. The seller/short position benefits from declines in the price of the underlying asset, while the buyer/long position benefits from increases

9-6 Forwards and Futures Instead of making a bilateral arrangement, the two parties to a futures contract each make an agreement with a clearing corporation A clearing corporation reduces the risk buyers and sellers face.

9-7 Forwards and Futures Margin Accounts and Marking to Market the clearing corporation requires both parties to a futures contract are required to place a deposit with the corporation itself. This practice is called posting margin in a margin account. The margin deposits serve as a guarantee that when the contract comes due, the parties will be able to meet their obligations

9-8 Forwards and Futures Hedging and Speculating with Futures insure against declines in the value of an asset. Futures contracts are popular tools for speculation because they are cheap. The fact is, an investor needs only a relatively small amount of investment – the margin – to purchase a futures contract that is worth a great deal

9-9 Forwards and Futures Arbitrage and the Determinants of Futures Prices The practice of simultaneously buying and selling financial instruments in order to benefit from temporary price differences is called arbitrage, and the people who engage in it are called arbitrageurs. the futures price must move in lock step with the market price of the bond.

9-10 Forwards and Futures

9-11 Options Options are agreements between two parties. There is a seller, called an option writer, and a buyer, called an option holder. option writers incur obligations option holders obtain rights. Two basic options, puts and calls.

9-12 Options A call option is the right to buy – “call away” – a given quantity of an underlying asset at a predetermined price, called the strike price, on or before a specific date. A put option gives the holder the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date.

9-13

9-14 Options The likelihood that an option will pay off depends on the volatility, or standard deviation, of the price of the underlying asset

9-15 Options

9-16 Swaps Interest rate swaps are agreements between two counterparties to exchange periodic interest rate payments over some future period, based on an agreed ‑ upon amount of principal – what’s called the notional principal. The effect of this agreement is to transform fixed-rate payments into floating-rate payments, and vice versa.

9-17 Swaps Users of interest-rate swaps government debt managers who find long- term fixed-rate bonds cheaper to issue, but prefer short-term variable-rate obligations for matching revenues with expenses The second group uses interest rate swaps to reduce the risk generated by commercial activities

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9 End of Chapter