1. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 14 Financial Derivatives

2. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-2 2 The Nature of Derivative Securities Derivative securities are used –to minimize or eliminate an investor’s or a firm’s exposure to various types of risk that they may be exposed to. Derivatives are –financial securities whose values are based upon or derived from underlying securities. Risk can be caused by –interest rate changes, foreign exchange rate changes, commodity prices or stock prices

3. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-3 Hedging Engage in a financial transaction that reduces or eliminates risk Long position Short position Hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position

4. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-4 Derivatives markets 4

5. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-5 5 Spot versus Forward Market Trading for immediate or very-near-term delivery is called the spot market. Trading for future delivery - forward market.

6. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-6 Interest-Rate Forward Contracts Agreements by two parties to engage in a financial transaction at a future (forward) point in time Specification of the actual debt instrument that will be delivered at a future date Amount of the debt instrument to be delivered Price (interest rate) on the debt instrument when it is delivered Date on which delivery will takes place

7. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-7 Pros and Cons of Forward Contracts Can be as flexible as the parties involved would like Difficult to find a counterparty Subject to default risk

8. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-8 8 Futures Contracts and Markets Buying/selling of standardized contracts specifying the amount, price, and future delivery date of a currency, security, or commodity. Buyers/sellers deal with the futures exchange, indirectly with each other. –Less riskier than Forward contract Delivery seldom made –buyer/seller offsets previous position before maturity. Futures contracts expire on specific dates. Margin requirements exist – varies by contract type.

9. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-9 Financial Futures Contracts and Markets Similar to an interest-rate forward contract but differs in ways that overcome some of the liquidity and default problems At the expiration date of a futures contract, the price of the contract converges to the price of the underlying asset to be delivered

10. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-10 Hedging with Financial Futures Holding $5M of 6s 2030 March 2010 6s of 2030 are long term bond to be delivered in the CBT futures contract expiring in one year: March 2011. Interest is expected to stay at 6% for the next year so the 6s of 2030 and the futures contract are selling at par. Need to offset the long position in the bond with a short positions (selling a futures contract). If interest rates increase over the next year to 8% Value on March 2011 @ 8% interest rate $4,039,640 Value on March 2010 @ 6% interest rate-$5,000,000 Loss -$ 960,360

11. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-11 Hedging with Financial Futures (cont’d) Short position in the futures contracts has value of $4,039,640 (the value of the $5M in bonds after the interest rate rises) but the buyer of the futures contract agreed to pay you $5M on the maturity date. Your gain is $960,360, this has been a successful hedge.

12. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-12 Organization of Trading in Financial Futures Markets Organized exchanges Regulated by the Commodity Futures Trading Commission (CFTC) –Ensure prices are not manipulated –Registers and audits brokers, traders, and exchanges –Approves proposed futures contracts to ensure they serve the public interest Trading has become internationalized and done 24 hours a day

13. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-13 Table 1 Widely Traded Financial Futures Contracts in The United States

14. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-14 Explaining the Success of Futures Markets Quantities delivered and delivery dates are standardized(liquidity) A futures contract can be traded again (liquidity) A range of Treasury bond eligible for delivery(liquidity) –with >15 year maturity and not callable for 15 years –limits the possibility of cornering the market

15. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-15 Explaining the Success of Futures Market (cont’d) Buyer and seller make the contract with a clearinghouse –Margin requirement that is marked to market every day Most futures contracts do not result in delivery of the underlying asset on the expiration date –Reduces transaction costs

16. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-16 Options Contract purchaser’s option (right, not obligation) to buy or sell the underlying financial instrument at a specified price (exercise or strike price) within a specific period of time (term to expiration). Contract seller is obligated to buy or sell the financial instrument if the buyer of the option exercises the right to sell or buy. The buyer does not have to exercise the option.

17. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-17 17 An option –An American option Can exercise the option at any time between the date of writing and the expiration or maturity date. –A European option can be exercised only on its expiration date, not before. –In the money an option that would be profitable if exercised immediately Premium –Paid to the writer of the option a to secure the option –buyer can lose only the premium and the commission paid Options

18. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-18 Options Stock options Futures options –More liquid than debt instrument markets Regulated by the SEC (stocks) and the CFTC (futures)

19. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-19 19 Reading Option Quotes

20. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-20 Options Contracts Call option gives the owner the right to buy a financial instrument at the exercise price within a specific period of time Put option gives the owner the right to sell a financial instrument at the exercise price within a specific period to time

21. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-21 21 Gains and Losses in Options & Futures

22. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-22 FIGURE 1 Profits and Losses on Options Versus Futures Contracts

23. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-23 Differences Between Options and Futures Contracts For a futures contract the profits grow by an equal dollar amount for every point increase in the price of the underlying financial instrument For the option contract profits do not always grow by the same amount for a given change in the price of the underlying financial instrument because of the protection afforded from losses

24. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-24 Differences Between Options and Futures Contracts (cont’d) Initial investment on the contracts differ –Futures - margin requirement –Options - premium Money changes hands daily in the futures market; only once for the option contract (when the option is exercised).

25. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-25 Pricing Option Premiums The higher the strike price, everything else being equal, the lower the premium on call (buy) options and the higher the premium on put (sell) options The greater the term to expiration, everything else being equal, the higher the premiums for both call and put options The greater the volatility of prices of the underlying financial instrument, everything else being equal, the higher the premiums of both call and put options

26. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-26 Swaps Financial contracts that obligate each party to the contract to exchange a set of payments (not assets) it owns for another set of payments owned by another party Currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency

27. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-27 Interest-Rate Swap Contracts Interest rate swap specifies –Interest rate on the payments that are being exchanged –Type of interest payments (fixed - variable) –The amount of notional principal –The time period over which the exchanges continue

28. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-28 FIGURE 2 Interest-Rate Swap Payments

29. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-29 Advantages of Interest-Rate Swaps Large transactions costs from rearranging balance sheets are avoided Informational advantages are maintained Possible to hedge interest-rate risk over a very long horizon

30. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-30 Disadvantages of Interest- Rate Swaps Lack of liquidity(counterparty, trade again) Subject to default risk Need for information about counterparties has thus attracted intermediaries –Investment banks –Large commercial banks

31. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-31 Credit Derivatives Credit options –Right to receive profits tied either to the price of an underlying security or to an interest rate Credit swap –Increases diversification and lowers overall risk （？） –Credit default swap Arcane Market Is Next to face Big Credit Test (New York Times) Naked truth on Default Swaps(NYTimes) Credit-linked notes （ combination of a bond and a credit option ）

32. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-32 When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? Allows financial institution to increase their leverage (AIG case) Banks have holdings of huge notional amounts of financial derivatives that greatly exceed the amount of bank capital –However, derivatives exposure at banks has not been a serious problem, even in the recent crisis.

33. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 14-33 When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? Conclusions: –Financial derivatives pose serious dangers to the financial system. –Some of these dangers have been overplayed. –Regulators would like to see more information disclosure about the exposure to derivatives contracts. –Derivatives need to have a better clearing mechanism (credit derivatives).