1. THE ROLE OF DERIVATIVE ASSETS CHAPTER SEVENTEEN Practical Investment Management Robert A. Strong

2. South-Western / Thomson Learning © 2004 17 - 2 Outline  Background  The Rationale for Derivative Assets  Uses of Derivatives  The Options Market  Options Terminology  The Financial Page Listing  The Origin of an Option  The Role of the Options Clearing Corporation  Standardized Option Characteristics

3. South-Western / Thomson Learning © 2004 17 - 3 Outline  The Futures Market  Futures vs. Options  Market Participants  Keeping the Promise  Categories of Futures Contracts  Financial Futures  Stock Index Futures  Interest Rate Futures  Foreign Currency Futures

4. South-Western / Thomson Learning © 2004 17 - 4 Outline  Derivative Assets and the News  Current Events  Risk of Derivative Assets  Listed vs. Over-the-Counter Derivatives

5. South-Western / Thomson Learning © 2004 17 - 5  Derivative assets get their name from the fact that their value derives from some other asset.  The best-known derivative assets are futures and options contracts.  Derivatives are not all the same. Some are inherently speculative, while some are highly conservative. Introduction

6. South-Western / Thomson Learning © 2004 17 - 6 Background : The Rationale for Derivative Assets  The first organized derivatives exchange in the United States was developed in order to bring stability to agricultural prices, by enabling farmers to eliminate or reduce their price risk.

7. South-Western / Thomson Learning © 2004 17 - 7 Background : Uses of Derivatives  Risk management : The equity manager’s market risk or the bond manager’s interest rate risk is analogous to the farmer’s price risk.  Risk transfer : Derivatives provide a means for risk to be transferred from one person to some other market participant who, for a price, is willing to bear it.  Derivatives may provide financial leverage.

8. South-Western / Thomson Learning © 2004 17 - 8 Background : Uses of Derivatives  Income generation : Some people use derivatives as a means of generating additional income from their investment portfolio.  Financial engineering : Derivatives can be stable or volatile depending on how they are combined with other assets.  What’s next?

9. South-Western / Thomson Learning © 2004 17 - 9 Background : Uses of Derivatives Insert Figure 17-1 here.

10. South-Western / Thomson Learning © 2004 17 - 10 Options Terminology  A call option gives its owner the right to buy a specified quantity of the underlying asset at a set price within a set time period.  A put option gives its owner the right to sell a specified quantity of the underlying asset at a set price within a set time period.  The set price is called the striking price or exercise price, and the last day the option is valid is called the expiration date.  The price of the option is the premium.

11. South-Western / Thomson Learning © 2004 17 - 11 Options Terminology  Options trade in units called contracts, each of which normally covers 100 shares.  An option’s volume indicates how many option contracts changed hands over some period of time. It measures trading activity.  An option’s open interest indicates how many option contracts exist.  Open interest goes up when someone creates an option and does down when two people trade and each close out an options position.

12. South-Western / Thomson Learning © 2004 17 - 12  The owner of an option will ultimately do one of three things with it:  sell it to someone else;  let it expire; or  exercise it. Options Terminology

13. South-Western / Thomson Learning © 2004 17 - 13 The Origin of an Option  Options can be created, or destroyed. The quantity of options in existence changes everyday.  The first trade someone makes in a particular option is called an opening transaction. If an investor sells an option as an opening transaction, it is called writing the option.  Options are fungible, meaning that, for a given company, all options of the same type with the same expiration and striking price are identical.

14. South-Western / Thomson Learning © 2004 17 - 14 The Role of the Options Clearing Corporation OCC BuyerSellerTrading Floor  The Options Clearing Corporation positions itself between every buyer and seller and acts as a guarantor of all option trades.

15. South-Western / Thomson Learning © 2004 17 - 15 Standardized Option Characteristics  Options have standardized expiration dates, striking prices, and lot size.  option premium = intrinsic value + time value  If an option has no intrinsic value, it is out-of- the-money. Otherwise, it is either in-the- money or at-the-money.

16. South-Western / Thomson Learning © 2004 17 - 16 Standardized Option Characteristics Intrinsic Value Time ValueOption Premium += Components of an Option Premium

17. South-Western / Thomson Learning © 2004 17 - 17 Standardized Option Characteristics  An American option can be exercised anytime prior to the expiration of the option. A European option, on the other hand, can only be exercised at expiration.  The option holder decides if and when to exercise.  Valuable options are usually sold rather than exercised.

18. South-Western / Thomson Learning © 2004 17 - 18 Standardized Option Characteristics Fig 17-4 here

19. South-Western / Thomson Learning © 2004 17 - 19  The initial seller of the contract promises to deliver a quantity of a standardized commodity to a designated delivery point during a certain delivery month.  The other party to the trade promises to pay a predetermined price for the goods upon delivery.  The person who promises to buy is said to be long, while the person who promises to deliver is said to be short. The Futures Market  A futures contract is a promise.

20. South-Western / Thomson Learning © 2004 17 - 20 The Futures Market  Futures vs. options : Futures contracts do not expire unexercised. Note that the contract obligation may be satisfied by making an offsetting trade.  Market participants :  Hedgers use futures to reduce price risk.  Speculators assume risk in the hope of making a profit.  Marketmakers provide liquidity for the marketplace.

21. South-Western / Thomson Learning © 2004 17 - 21 The Futures Market Insert Figure 17-5 here.

22. South-Western / Thomson Learning © 2004 17 - 22 The Futures Market  Keeping the promise : Each exchange has a Clearing Corporation which ensures the integrity of the futures contract when a member is in financial distress.  Categories of futures contracts :  Agricultural e.g. wheat, cotton, cattle.  Metals and petroleum e.g. platinum, copper, natural gas, crude oil.  Financial e.g. foreign currency, stock index, interest rate.  Others e.g. electricity, catastrophe, swap.

23. South-Western / Thomson Learning © 2004 17 - 23 Financial Futures : Stock Index Futures  A stock index future is a promise to buy or sell the standardized units of a specific index at a fixed price at a predetermined future date.  Unlike most other commodity contracts, there is no actual delivery mechanism when the contract expires. For practicality, all settlements are in cash.

24. South-Western / Thomson Learning © 2004 17 - 24 Financial Futures : Stock Index Futures Insert Table 17-2 here.

25. South-Western / Thomson Learning © 2004 17 - 25 Financial Futures : Interest Rate Futures  Interest rate futures contracts are customarily grouped into short-term, intermediate-term, and long-term categories.  The two principal short-term contracts are Eurodollars and U.S. Treasury bills.  The Treasury bill futures contract calls for the delivery of $1 million par value of 90- day T-bills on the delivery date of the futures contract.

26. South-Western / Thomson Learning © 2004 17 - 26 Financial Futures : Interest Rate Futures Insert Table 17-3 here.

27. South-Western / Thomson Learning © 2004 17 - 27 Financial Futures : Interest Rate Futures  The contract on U.S. Treasury notes is the only intermediate-term contract, while Treasury bonds are the principal long-term contracts.  The Treasury bond futures contract calls for the delivery of $100,000 face value of U.S. Treasury bonds with a minimum of 15 years until maturity (and, if callable, with a minimum of 15 years of call protection). Bonds that meet these criteria are said to be deliverable.

28. South-Western / Thomson Learning © 2004 17 - 28 Financial Futures : Interest Rate Futures Insert Table 17-4 here.

29. South-Western / Thomson Learning © 2004 17 - 29 Financial Futures : Interest Rate Futures invoice price settlement price conversion factor accrued interest = [ x ] +  Bonds are standardized as follows:  T-bonds are not all fungible. At any given time, several dozen bonds are usually eligible for delivery on a T-bond futures contract. Normally, only one of these bonds will be cheapest to deliver.

30. South-Western / Thomson Learning © 2004 17 - 30 Financial Futures : Interest Rate Futures Insert Table 17-5 here.

31. South-Western / Thomson Learning © 2004 17 - 31 Financial Futures : Foreign Currency Futures  Foreign currency futures contracts call for delivery of the foreign currency in the country of issuance to a bank of the clearing house’s choosing.  Most major corporations face at least some foreign exchange risk and quickly discovered the convenience of these futures as a hedging vehicle, while speculators saw the contracts as easy to understand and use.

32. South-Western / Thomson Learning © 2004 17 - 32 Derivative Assets and the News  Newspapers in recent months have been full of reports on various businesses that have lost billions “investing in derivatives.”  Derivatives are neutral products. Their risk depends on what an investor does with them.  Exchange-traded derivative assets and over-the-counter derivatives are markedly different.

33. South-Western / Thomson Learning © 2004 17 - 33 Review  Background  The Rationale for Derivative Assets  Uses of Derivatives  The Options Market  Options Terminology  The Financial Page Listing  The Origin of an Option  The Role of the Options Clearing Corporation  Standardized Option Characteristics

34. South-Western / Thomson Learning © 2004 17 - 34 Review  The Futures Market  Futures vs. Options  Market Participants  Keeping the Promise  Categories of Futures Contracts  Financial Futures  Stock Index Futures  Interest Rate Futures  Foreign Currency Futures

35. South-Western / Thomson Learning © 2004 17 - 35 Review  Derivative Assets and the News  Current Events  Risk of Derivative Assets  Listed vs. Over-the-Counter Derivatives

36. South-Western / Thomson Learning © 2004 17 - 36 Appendix: Option Pricing  Fig. 17A-1

37. South-Western / Thomson Learning © 2004 17 - 37 Appendix: Option Pricing  Black-Scholes Options Pricing Model  Insert table 17A-1

38. South-Western / Thomson Learning © 2004 17 - 38 Appendix: Option Pricing  Insert fig. 17A2

39. South-Western / Thomson Learning © 2004 17 - 39 Appendix: Option Pricing  Delta: the change in option premium expected from a small change in the stock price, all other things being equal