1. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-1 Chapter Ten Derivative Securities Markets

2. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-2 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 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

3. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-3 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

4. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-4 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 Futures are standardized while Forwards are customized on an individual basis 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 Futures are standardized while Forwards are customized on an individual basis

5. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-5 Futures Trading Occurs on organized exchanges –(CBT, CME & NYMEX) Open-outcry auction 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 Contract secured with an initial and subsequent maintenance margin Occurs on organized exchanges –(CBT, CME & NYMEX) Open-outcry auction 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 Contract secured with an initial and subsequent maintenance margin (continued)

6. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-6 Futures Contracts Outstanding, 1992-2001

7. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-7 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

8. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-8 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 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

9. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-9 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

10. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-10 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 Payoff Gain Payoff function for Writer +  P 0 Stock Price D X at expiration -  P Payoff function Payoff for buyer Loss

11. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-11 Option Values Intrinsic value of an option –The difference between asset’s price and option’s exercise price Time value of an option –the difference between an option’s price (or premium) and its intrinsic value Other Factors –Risk –Stock Price –Risk-free rate Intrinsic value of an option –The difference between asset’s price and option’s exercise price Time value of an option –the difference between an option’s price (or premium) and its intrinsic value Other Factors –Risk –Stock Price –Risk-free rate

12. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-12 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

13. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-13 Options Market Activity, 1992-2001 (in thousands)

14. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-14 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 Allows firms to better manage their interest rate, foreign exchange, or credit risk exposure An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval Allows firms to better manage their interest rate, foreign exchange, or credit risk exposure

15. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-15 Swap Definitions Interest rate swap - an exchange of fixed- interest payments for floating-interest payments by two counterparties Currency swap - used to hedge exchange rate risk from mismatched currencies on assets and liabilities Interest rate swap - an exchange of fixed- interest payments for floating-interest payments by two counterparties Currency swap - used to hedge exchange rate risk from mismatched currencies on assets and liabilities

16. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-16 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

17. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-17 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)

18. Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10-18 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