Chapter 13, 14, 15

Derivative Markets

1

Background on Financial Futures

A financial futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date.

Financial futures contracts are traded on organized exchanges, which establish and enforce rules for such trading.

The operations of financial futures exchanges are regulated by the Commodity Futures Trading Commission (CFTC).

2

Exhibit 13.1 Stock Index Futures Contracts

3

Source: Republished with permission of Dow Jones & Company, Inc., from The Wall StreetJournal, January 7, 2009, C9; permission conveyed through the Copyright Clearance Center, Inc.

Background on Financial Futures

Purpose of Trading Financial Futures

■ Financial futures are traded to speculate on prices of securities or to hedge existing exposure.

■ Speculators in financial futures markets take positions to profit from expected changes in the futures prices.

■ Day traders attempt to capitalize on price movements during a single day.

■ Position traders maintain their futures positions for longer periods of time.

■ Hedgers take positions in financial futures to reduce their exposure to future movements in interest rates or stock prices.

Background on Financial Futures

Trading FuturesCustomers open accounts at brokerage firms and establish margin deposits with the brokers

■ Type of Orders■ With a market order, the trade is executed at

the prevailing price.■ With a limit order, the trade is executed if the

price is within the limit specified by the customer.

■ How Orders Are Executed■ Although most trading now takes place

electronically, some trades are still conducted on the trading floor.

■ Floor brokers receive transaction fees in the form of a bid–ask spread.

5

Interest Rate Futures Contracts

Hedging with Interest Rate Futures

In the short run, an institution may consider using financial futures to hedge its exposure to interest rate movements.

■ Using Interest Rate Futures to Create a Short Hedge - Financial institutions commonly take a position in interest rate futures to create a short hedge, which represents the sale of a futures contract.

■ Cross-Hedging

■ The use of a futures contract on one financial instrument to hedge a position in a different financial instrument.

■ The effectiveness of a crosshedge depends on the correlation between the changes in market values of the two instruments.

6

Stock Index Futures

The purchase of an S&P 500 futures contract obligates the purchaser to purchase the S&P 500 index at a specified settlement date for a specified amount.

Stock index futures contracts have settlement dates on the third Friday in March, June, September, and December.

The securities underlying the stock index futures contracts are not actually deliverable, so settlement occurs through a cash payment.

Like other financial futures contracts, stock index futures can be closed out before the settlement date by taking an offsetting position.

7

Risk of Trading Futures Contracts

Market Risk

■ Refers to fluctuations in the value of the instrument as a result of market conditions.

Basis Risk

■ The risk that the position being hedged by the futures contracts is not affected in the same manner as the instrument underlying the futures contract.

■ Applies only to those firms or individuals who are using futures contracts to hedge.

Liquidity Risk

■ Refers to potential price distortions due to a lack of liquidity.

8

Risk of Trading Futures Contracts

Credit Risk

■ The risk that a loss will occur because a counterparty defaults on the contract.

■ This type of risk exists for over-the-counter transactions in which a firm or individual relies on the creditworthiness of a counterparty.

Prepayment Risk

■ Refers to the possibility that the assets to be hedged may be prepaid earlier than their designated maturity.

Operational Risk

■ The risk of losses as a result of inadequate management or controls.

9

Globalization of Futures Markets

Currency Futures Contracts

■ A standardized agreement to deliver or receive a specified amount of a specified foreign currency at a specified price (exchange rate) and date.

■ The settlement months are March, June, September, and December.

■ Purchasers of currency futures contracts can hold the contract until the settlement date and accept delivery of the foreign currency at that time, or they can close out their long position prior to the settlement date by selling the identical type and number of contracts before then.

10

Homework

■ explain how stock index futures contracts are used to speculate or hedge based on anticipated stock price movements

■ explain how single stock futures are used to speculate on anticipated stock price movements

■ describe the different types of risk to which traders in financial futures contracts are exposed

■ explain how interest rate futures contracts are used to speculate or hedge based on anticipated interest rate movements

11

Background on Options

Call Option: right to buy underlying financial instrument at exercise price (or strike price) within a specified period of time.

■ In the money when market price > exercise price

■At the money when market price = exercise price

■Out of the money when market price < exercise price

Put Option: right to sell underlying financial instrument at exercise price (or strike price) within a specified period of time.

■ In the money when market price < exercise price

■ At the money when market price = exercise price

■ Out of the money when market price > exercise price

12

Background on Options

Comparison of Options and Futures

■ To obtain an option, a premium must be paid in addition to the price of the financial instrument.

■ The owner of an option can choose to let the option expire on the expiration date without exercising it.

13

Exhibit 14.8 Potential Gains or Losses on a Call Option: Exercise Price = $115, Premium = $4

14

Hedging with Stock Options

Hedging with Covered Call Options

■ Call options on a stock can be used to hedge a position in that stock.

■ When the stock declines in value, the premium received from selling the call partially offsets the losses incurred on the stock.

■ When the stock increases in value, the call will be exercised and the stock will be sold to the purchaser of the call option.

15

Exhibit 14.13b Risk-Return Trade-off from Covered Call Writing

16

Hedging with Stock Options

Hedging with Put Options

■ Put options are used to hedge when portfolio managers are concerned about a temporary decline in a stock’s value.

■ Hedging with LEAPs

■ Long-term equity anticipations (LEAPs) are options that have longer terms to expiration, usually between two and three years from the initial listing date.

■ These options are available for some large capitalization stocks, and they may be a more effective hedge over a longer term period than using options with shorter terms to expiration.

17

Options on ETFs and Stock Indexes

Hedging with Stock Index OptionsFinancial institutions and other firms commonly take positions in options on ETFs or indexes to hedge against market or sector conditions that would adversely affect their asset portfolio or cash flows.

Dynamic Asset Allocation with Stock Index Options

Dynamic asset allocation involves switching between risky and low-risk investment positions in response to changing expectations. Some portfolio managers use stock index options as a tool for dynamic asset allocation.

18

Options on Futures Contracts

■ An option on a particular futures contract gives its owner the right (but not an obligation) to purchase or sell that futures contract for a specified price within a specified period of time.

■ Options are available on stock index futures.

■ Options on indexes have become popular for speculating on general movements in the stock market.

■ Options are also available on interest rate futures, such as Treasury note futures or Treasury bond futures.

19

Homework

explain why stock option premiums vary

■ explain how stock options are used to speculate

■ explain how stock options are used to hedge

■ explain the use of stock index options

■ explain the use of options on futures

■ Q&A: 1, 3, 4, 9, 11, 14 Interp: a, c

20

Chap 15 - Swaps

An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another.

The provisions of an interest rate swap include:

■ The notional principal value to which the interest rates are applied to determine the interest payments involved.

■ The fixed interest rate.■ The formula and type of index used to determine

the floating rate.■ The frequency of payments, such as every six

months or every year.■ The lifetime of the swap.

21

Background

■ An example of a swap is an agreement to exchange 11 percent fixed-rate payments for floating payments at the prevailing one-year Treasury bill plus 1 percent based on $30 million notional principal.

■ Swap payments are usually netted.

■ The market for swaps is facilitated by over-the-counter trading rather than trading on an organized exchange.

■ Interest rate swaps became popular in the early 1980s when corporations were experiencing large fluctuations in interest rates.

22

Background

Use of Swaps for Hedging

■ Financial institutions in the U.S. with more interest rate sensitive liabilities than assets were adversely affected by increasing interest rates.

■ Financial institutions in Europe had more access to long-term fixed rate funding and used the funds for floating-rate loans and were adversely affected by declining interest rates.

■ Interest rate swaps allowed both types of financial institutions to reduce exposure to interest rate risk.

23

Types of Interest Rate Swaps

Plain Vanilla Swaps (fixed-for-floating swap)

■ Fixed-rate payments are periodically exchanged for floating-rate payments.

Forward Swaps

■ Involves an exchange of interest payments that does not begin until a specified future time.

■ Useful for financial institutions or other firms that expect to be exposed to interest rate risk at some time in the future.

24

Types of Interest Rate Swaps

Callable Swaps■ Gives the party making the fixed payments

the right to terminate the swap prior to its maturity.

■ It allows the fixed-rate payer to avoid exchanging future interest payments if it desires.

Putable Swaps■ Gives the party making the floating-rate

payments the right to terminate the swap.■ A putable swap allows the institution to

terminate the swap in the event that interest rates rise (see

25

Types of Interest Rate Swaps

Equity Swaps

■ Involves the exchange of interest payments for payments linked to the degree of change in a stock index.

26

Risks of Interest Rate Swaps

Basis Risk■ The interest rate of the index used for an interest

rate swap will not necessarily move perfectly in tandem with the floating-rate instruments of the parties involved in the swap.

■ When this happens, the higher payments received do not offset the increase in the cost of funds.

■ Basis risk prevents the interest rate swap from completely eliminating the financial institutions exposure to interest rate risk.

27

Risks of Interest Rate Swaps

Credit Risk■ There is risk that a firm involved in an interest rate

swap will not meet its payment obligations.■ Concerns about a Swap Credit Crisis - The

willingness of large banks and securities firms to provide guarantees has increased the popularity of interest rate swaps, but it has also raised concerns that widespread adverse effects might occur if any of these intermediaries cannot meet their obligations.

28

Risks of Interest Rate Swaps

Sovereign Risk

■ Reflects potential adverse effects resulting from a country’s political conditions.

■ Sovereign risk differs from credit risk because it depends on the financial status of the government rather than on the counterparty itself.

29

Interest Rate Caps, Floors, and Collars

Interest Rate Caps

■ Offers payments in periods when a specified interest rate index exceeds a specified ceiling (cap) interest rate.

■ The payments are based on the amount by which the interest rate exceeds the ceiling, multiplied as usual by the notional principal specified in the agreement.

■ The buyer of a cap is a financial institution that would be adversely affected by rising interest rates.

■ The seller of a cap receives the fee and is obligated to provide payments when rates exceed the ceiling rate.

30

Interest Rate Caps, Floors, and Collars

Interest Rate Floors

■ Offers payments in periods when a specified interest rate index falls below a specified floor rate.

■ The payments are based on the amount by which the interest rate falls below the floor rate, which is multiplied by the notional principal specified in the agreement.

■ The buyer of an interest rate floor will receive payments when interest rates decline below the floor.

■ The seller of an interest rate floor receives a fee and is obligated to provide periodic payments when the interest rate falls below the floor rate specified in the agreement.

31

Interest Rate Caps, Floors, and Collars

Interest Rate Collars

■ Involves the purchase of an interest rate cap and the simultaneous sale of an interest rate floor.

■ Because the collar also involves the sale of an interest rate floor, the financial institution is obligated to make payments if interest rates decline below the floor.

■ Q&A: 2, 5, 7, 10, 13, 15, 16

32