1. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter Ten Derivative Securities Markets

2. Chapter Outline 1.Overview 2.Futures and Forwards 3.Options 4.Regulation of Futures and Options Markets 5.Swaps 1.Overview 2.Futures and Forwards 3.Options 4.Regulation of Futures and Options Markets 5.Swaps

3. 1. Derivative Securities: Overview Derivative security –a financial security whose payoff is linked to another previously issued security Forward and futures contracts –currency forwards and futures –interest rate futures Options contracts –call option –put option Swaps –currency swap –interest rate swap Derivative security –a financial security whose payoff is linked to another previously issued security Forward and futures contracts –currency forwards and futures –interest rate futures Options contracts –call option –put option Swaps –currency swap –interest rate swap

4. Uses of Derivatives Hedging – Reducing risk Speculating – Increasing risk Arbitrage – Taking advantage of pricing differences between markets Leverage – With derivatives you can control a large amount of the underlying asset with at relatively small initial investment Hedging – Reducing risk Speculating – Increasing risk Arbitrage – Taking advantage of pricing differences between markets Leverage – With derivatives you can control a large amount of the underlying asset with at relatively small initial investment

5. 2. 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 Spot contract –agreement to purchase (or sell) an asset immediately 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 Spot contract –agreement to purchase (or sell) an asset immediately

6. 2.1 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 future spot prices on an asset will move against them FI’s are the major forward market participants and make a profit on the spread between the price at which they originate and sell forward contracts 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 future spot prices on an asset will move against them FI’s are the major forward market participants and make a profit on the spread between the price at which they originate and sell forward contracts

7. 2.2 Futures Markets Futures contract –an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily - marked to market daily Futures trading –Occurs on organized exchanges such as CBT and CME or IMM –Clearinghouse oversees trading on the exchange and guarantees all trades made by the exchange traders Futures contract –an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily - marked to market daily Futures trading –Occurs on organized exchanges such as CBT and CME or IMM –Clearinghouse oversees trading on the exchange and guarantees all trades made by the exchange traders

8. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Futures Trading Open-outcry auction - traders face each other and “cry out” their offer to buy or sell Long position - a purchase of a futures contract Short position - a sale of a futures contract Initial margin - a deposit required on futures trades to ensure terms of any futures contract will be met Maintenance margin - the margin a futures trader must maintain once a futures position is taken. Open-outcry auction - traders face each other and “cry out” their offer to buy or sell Long position - a purchase of a futures contract Short position - a sale of a futures contract Initial margin - a deposit required on futures trades to ensure terms of any futures contract will be met Maintenance margin - the margin a futures trader must maintain once a futures position is taken. (continued)

9. 3. Options A contract that gives the holder (option buyer) the right, but not the obligation, to buy or sell an asset at a prespecified 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 (option buyer) the right, but not the obligation, to buy or sell an asset at a prespecified 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

10. 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

11. Copyright © 2001 by The McGraw-Hill Companies, Inc. 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

12. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Payoff Function for Put Options Payoff Gain Payoff function for Writer 0 Stock Price D X at expiration Payoff function Payoff for buyer Loss Payoff Gain Payoff function for Writer 0 Stock Price D X at expiration Payoff function Payoff for buyer Loss

13. Option Markets Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded Stock options - the underlying asset on a stock option contract is the stock of a publicly traded company, generally 100 shares Stock index options - the underlying asset on a stock index option is the value of a major stock market index (e.g., the DJIA or S&P 500) Options give investors a way to hedge their existing stock portfolios Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded Stock options - the underlying asset on a stock option contract is the stock of a publicly traded company, generally 100 shares Stock index options - the underlying asset on a stock index option is the value of a major stock market index (e.g., the DJIA or S&P 500) Options give investors a way to hedge their existing stock portfolios

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

15. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4. Regulation of Futures and Options Markets The Commodity Futures Trading Commission (CFTC) is the primary regulator of futures markets –protects the trading public by seeking to prevent misrepresentation and/or market manipulation –approves proposed contracts to ensure they have economic purpose; conducts economic studies; enforces rules and provides regulatory surveillance The Securities and Exchange Commission (SEC) is the main regulator of stock options –regulates trading of stock options and stock index options The Commodity Futures Trading Commission (CFTC) is the primary regulator of futures markets –protects the trading public by seeking to prevent misrepresentation and/or market manipulation –approves proposed contracts to ensure they have economic purpose; conducts economic studies; enforces rules and provides regulatory surveillance The Securities and Exchange Commission (SEC) is the main regulator of stock options –regulates trading of stock options and stock index options

16. 5. Swaps An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified price. Allow firms to better manage their interest rate, foreign exchange and credit risk Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified price. Allow firms to better manage their interest rate, foreign exchange and credit risk Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction

17. Swaps Definitions Swap buyer - a party that makes the fixed-rate payments in an interest rate swap transaction Swap seller - a party that makes the floating- rate payments in an interest rate swap transaction Notional principal - principal amount involved in a swap Swap buyer - a party that makes the fixed-rate payments in an interest rate swap transaction Swap seller - a party that makes the floating- rate payments in an interest rate swap transaction Notional principal - principal amount involved in a swap

18. Swaps Definitions Interest rate swap - an exchange of fixed- interest payments for floating-interest payments by two counter parties Currency swap - used to hedge against 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 counter parties Currency swap - used to hedge against exchange rate risk from mismatched currencies on assets and liabilities

19. 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

20. Copyright © 2001 by The McGraw-Hill Companies, Inc. 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)

21. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Pound/Dollar Currency Swap U.S. FI U.K. FI Dollar Assets Pound Assets Dollars Pound Liabilities Dollar Liabilities (L100m, 6% coupon) Pounds ($200m, 6% coupon) U.S. FI U.K. FI Dollar Assets Pound Assets Dollars Pound Liabilities Dollar Liabilities (L100m, 6% coupon) Pounds ($200m, 6% coupon)