Chapter 6

Derivative Securities Market


 AAderivative
derivativeisisaacontract
contractbetween
betweentwo
twoparties
partieswhose
whosevalue
valueisis
based
basedononsome
someunderlying
underlyingasset
assetprice
priceor
orcondition
condition

 In
Inaaderivative,
derivative,two
twoparties
partiesagree
agreeto
toexchange
exchangeaastandard
standard
quantity
quantityofofan
anasset
assetat
ataapredetermined
predeterminedprice
priceat
ataaspecific
specificdate
date
in
inthe
thefuture
future

 An
Anoption
optionto
tobuy
buyAwash
AwashBank
Bankstock
stockin
inthe
thefuture
futureisisaaderivative,
derivative,as
as
isisaacontract
contractto
tobuy
buyChinese
ChineseYuan
Yuansix
sixmonths
monthsfrom
fromnow.
now.

 The
Thevalue
valueof
ofthe
theAwash
Awashoption
optiondepends
dependson onthe
theprice
priceof
ofIBM’s
IBM’sstock,
stock,
and
andthe
thevalue
valueof
ofthe
theChinese
ChineseYuan
Yuan“future”
“future”depends
dependsononthe
the
exchange
exchangerate
ratebetween
betweenyen
yenand
anddollars.
dollars.

 The
Themarket
marketfor
forderivatives
derivativeshas
hasgrown
grownfaster
fasterthan
thanany
anyother
other
market
marketin
inrecent
recentyears,
years,providing
providingcorporations
corporationswith
withnew
new
opportunities
opportunitiesbut
butalso
alsoexposing
exposingthem
themto
tonew
newrisks.
risks.
Derivatives’ Uses

 Derivatives
Derivativesare
areleveraged
leveragedinstruments
instrumentswhere
whereparticipants
participantsput
putup
upaa
small
smallamount
amountofofmoney
moneyand
andobtain
obtainthe
thegain
gainor
orloss
losson
onaamuch
muchlarger
larger
position
position
 Derivatives

Derivativesare
areused
usedfor
forspeculation
speculationand
andfor
forhedging
hedging
 Hedging:

Hedging:Entering
Enteringinto
intoaaderivatives
derivativescontract
contractto
toreduce
reducethe
therisk
risk
associated
associatedwith
withpositions
positionsor
orcommitments
commitmentsin intheir
theirline
lineof
ofbusiness.
business.
Suppose

Supposean animporter’s
importer’snet
netincome
incometends
tendstotofall
fallwhenever
wheneverthethe
dollar
dollarfalls
fallsrelative
relativetotobirr.
[Link]
Thatcompany
companycould
couldreduce
reduceits
itsrisk
risk
by
bypurchasing
purchasingderivatives
derivatives(a (aput
putoption
optionthat
thatgives
givesher
herthe
theright
right
to
tosell
sellthe
thedollar
dollaratataaspecified
specifiedexchange
exchangerate)
rate) that
thatincrease
increase
in
invalue
valuewhenever
wheneverthe thedollar
dollardeclines.
declines.
Speculation:

Speculation:Buying
Buyingor
orselling
sellingaaderivative
derivativecontract
contractin
inorder
order
to
toearn
earnaaleveraged
leveragedrate
rateof
ofreturn.
[Link]
Speculatorsgamble
gambleon
on
future
futureprice
pricemovements
movements
Forwards and Futures

 AAspot
spotcontract
contractisisan
anagreement
agreementto
totransact
transactinvolving
involvingthe
theimmediate
immediateexchange
exchange
of assets and funds.
of assets and funds.
 AAspot
spotbond
bondquote
quoteofof$97
$97for
foraa20-year
20-yearmaturity
maturitybond
bondisisthe
theprice
pricethe
thebuyer
buyermust
must
pay
pay the seller, per $100 of face value, for immediate (time 0) delivery of the20-
the seller, per $100 of face value, for immediate (time 0) delivery of the 20-
year bond.
year bond.

 AAforward
forwardcontract,
contract,ononthe
theother
otherhand,
hand,isisaanon-standardized
non-standardizedagreement
agreementto to
buy or sell an asset in the future, with the terms of the deal set when
buy or sell an asset in the future, with the terms of the deal set when thethe
contract
contractisiscreated.
[Link]
Theprice
priceof
ofthe
theforward
forwardcontract
contractisisfixed
fixedover
overthe
thelife
lifeof
of
the
thecontract.
contract.
 For
Forexample,
example,ininaathree-month
three-monthforward
forwardcontract
contractto todeliver
deliver$100
$100face
facevalue
valueofof10-
10-
year bonds, the buyer and seller agree on a price and amount today (time
year bonds, the buyer and seller agree on a price and amount today (time 0), but 0), but
the
thedelivery
delivery(or
(orexchange)
exchange)ofofthe
the10-year
10-yearbond
bondforforcash
cashdoes
doesnot
notoccur
occuruntil
untilthree
three
months into the future. This is the price the buyer must pay and the seller
months into the future. This is the price the buyer must pay and the seller must must
accept
acceptno
nomatter
matterwhat
whathappens
happensto tothe
thespot
spotprice
priceof of10-year
10-yearbonds
bondsduring
duringthe
thethree
three
months between the time the contract is entered into and the time the
months between the time the contract is entered into and the time the bonds are bonds are
delivered
deliveredfor
forpayment.
payment.

 Forwards
Forwardsare:
are:custom
customcontracts
contracts(lack
(lackstandard
standardterms),
terms),not
nottraded
traded(so
(so
participants
participantsmust
mustperform),
perform),risky
risky(have
(havepotential
potentialcounterparty
counterpartycredit
creditrisk).
risk).
Forwards and Futures


 AAfutures
futurescontract
contractisisaastandardized,
standardized,exchange-traded
exchange-tradedversion
versionof
ofaaforward
forward
contract
contract
 Futures

Futurescontracts
contractsdiffer
differfrom
fromforwards
forwardsininthat
thatfutures
futuresare:
are:
 Marketable

Marketable
 Have

Haveno
nodefault
defaultrisk
riskas
asthe
thefutures
futuresexchange
exchangeguarantees
guaranteesto
toindemnify
indemnify
counterparties
counterpartiesagainst
againstcredit
creditor
ordefault
defaultrisk.
risk.
 Employ

Employmargin
marginrequirements
requirementsandanddaily
dailymarking
markingto tomarket.
[Link]
Thismeans,
means,
the contract’s price is adjusted each day as the price of the asset
the contract’s price is adjusted each day as the price of the asset
underlying
underlyingthe
thefutures
futurescontract
contractchanges
changesand
andas asthe
thecontract
contractapproaches
approaches
expiration.
expiration.
margin
marginrequirement
requirementisisaaperformance
performancebondbondposted
postedbybyaabuyer
buyerand
andaa
seller
sellerof
ofaafutures
futurescontract
contract
Futures Markets

 Futures
Futures contract
contract trading
trading occurs
occurs in
in trading
trading “pits”
“pits” using
using
an
an open-outcry
open-outcry auction
auction among
among exchange
exchange members
members

floor
floorbrokers
brokers place
placetrades
tradesfor
forthe
thepublic
public

professional
professionaltraders
traders trade
tradefor
fortheir
theirown
ownaccounts
accounts

position
positiontraders
traders take
takeaaposition
positionininthe
thefutures
futuresmarket
market
based on their expectations about the future direction
based on their expectations about the future direction
of
ofthe
theprices
pricesof
ofthe
theunderlying
underlyingassets
assets

day
daytraders
traders take
takeaaposition
positionwithin
withinaaday
dayand
andliquidate
liquidate
ititbefore
beforeday’s
day’s end
end

scalpers
scalpers take
takepositions
positionsfor
forvery
veryshort
shortperiods
periodsof
oftime,
time,
sometimes
sometimesonly onlyminutes,
minutes,in inan
anattempt
attemptto toprofit
profitfrom
from
active
activetrading
trading
Futures Contracts

 AAlong

long position
position isis the
the purchase
purchase of
of aa futures
futures
contract
contract
 AAshort

short position
position isis the
the sale
sale of
of aa futures
futures contract
contract
 AAclearinghouse

clearinghouse isis thethe unit
unit that
that oversees
oversees trading
trading
on
on the
the exchange
exchange and and guarantees
guarantees all all trades
trades made
made
by
by the
the exchange
exchange
 Open

Open interest
interest isis the
the total
total number
number of of the
the futures,
futures,
put
put options,
options, or
or call
call options
options outstanding
outstanding at at the
the
beginning
beginning of
of the
the day
day
Futures Contracts


 An
Aninitial
initialmargin
margin isisaadeposit
depositrequired
requiredon
onfutures
futurestrades
tradesto
to
ensure
ensurethat
thatthe
theterms
termsof
ofthe
thecontracts
contractswill
willbe
bemet
met


 Maintenance
Maintenancemargin:
margin: The
Themargin
marginaafutures
futurestrader
tradermust
must
maintain
maintainonce
onceaafutures
futuresposition
positionisistaken.
[Link]
lossesononthe
the
customer’s
customer’s futures
futuresposition
positionoccur
occurandandthe
thelevel
levelof ofthe
thefunds
funds
in
inthe
themargin
marginaccount
accountdrop
dropbelow
belowthe themaintenance
maintenancemargin,
margin,
the
thecustomer
customerisisrequired
requiredto todeposit
depositadditional
additionalfunds
fundsinto
intohis
his
or
orher
hermargin
marginaccount,
account,bringing
bringingthe
thebalance
balanceback
backupupto tothe
the
initial
initialmargin.
margin.
Example -- Futures Contract Terms
Delivery Contract Deliverable
Contract Exchange IMR MMR
Months Size Instrument

T-Bond CBOT M,J,S,D $ 100,000 See below* $3,713 $2,750

Contract:
Contract:30
30year
yearTreasury
TreasuryBond
Bondcontract
contract
Exchange:
Exchange:Chicago
ChicagoBoard
Boardof
ofTrade
Trade
Delivery
DeliveryMonths:
Months: Contract
Contractmaturity
maturitymonths
monthsare
areMarch,
March,June,
June,
September,
September,December
December
Contract
ContractSize:
Size:Contract
Contractcalls
callsfor
fordelivery
deliveryof
of$100,000
$100,000face
facevalue
value
Deliverable
DeliverableInstrument:
Instrument:Treasury
Treasurybonds
bondsthat
thatmature
maturein
inno
nomore
more
than
than25
25years
years
IMR:
IMR:Exchange
Exchangemandated
mandatedinitial
initialmargin
marginrequirement
requirementof
of$3,713
$3,713
(brokers
(brokersmay
mayrequire
requireaahigher
highermargin)
margin)
MMR:
MMR:Exchange
Exchangemandated
mandatedmaintenance
maintenancemargin
marginrequired
requiredto
tokeep
keep
the
theaccount
accountopen
open
Long and Short Positions

Delivery Contract Deliverable

T-Bond CBOT M,J,S,D $ 100,000 See below* $3,713 $2,750

IfIfan
aninvestor
investorbuys
buysor
orgoes
goes“long”
“long”one
oneJune
Junecontract,
contract,they
theyare
are
agreeing
agreeingtotobuy
buy$100,000
$100,000par
paror
orface
facevalue
valueof
ofT-Bonds
T-Bondsat
atthe
the
original
originalfutures
futurescontract
contractprice
pricewhen
whenthe
thecontract
contractexpires
expiresininJune.
June.

IfIfan
aninvestor
investorsells
sellsor
orgoes
goes“short”
“short”one
oneJune
Junecontract,
contract,they
theyare
are
agreeing
agreeingto todeliver
deliver$100,000
$100,000par
paror
orface
facevalue
valueof
ofT-Bonds
T-Bondsand
and
receive
receivethe
theoriginal
originalfutures
futurescontract
contractprice
pricewhen
whenthe
thecontract
contract
expires
expiresininJune.
June.
Each
Eachinvestor
investormust
mustput
putup
upthe
theIMR
IMRof
of$3,713
$3,713when
whenthey
theyopen
openthe
the
contract.
contract.
Each
Eachinvestor
investormust
mustmaintain
maintainthetheMMR
MMRof
of$2,750
$2,750in
intheir
theirmargin
margin
account
accountwhile
whilethe
theposition
positionisisopen.
open.
T-Bond Futures Quote Sheet

Source: CBOT
Prev
Last Change Settle Open High Low Close
Jun 124’26 -0’01 124’27 124’28 124’28 124’16 124’26
Sep 123’20 +0’02 123’18 123’20 123’20 123’20 123’20

 Price
 Pricequotes
quotesare
arein
indollars
dollarsand
and32nds
32ndsas
asaapercent
percentof
offace
facevalue.
value.
 (For
(Forexample
example123’20
123’20means
means123
123++20/32
20/32==123.625.
[Link]
thisapplies
appliesto
toaa$1000
$1000
[Link], the quote comes to 1.23625*1000= $1236.25.)
Bill, the quote comes to 1.23625*1000= $1236.25.)
 ‘Open’
 ‘Open’price
pricefor
forthe
theJune
Junecontract
contractof
of124.
124.28
28isis$124
$12428/32
28/32
percent
percentof
of$100,000
$100,000==$124,875
$124,875
 IfIfyou
 youbuy
buythe
thecontract
contractat
atthe
theopen,
open,what
whatare
areyou
youagreeing
agreeingto
todo?
do?
 IfIfyou
 yousell
sellthe
thecontract
contractat
atthe
theopen,
open,what
whatare
areyou
youagreeing
agreeingto
todo?
do?
Marking to Market
 Gains
 Gainsand
andlosses
lossesare
arerecognized
recognizeddaily
daily

IMR
IMR==$3,713,
$3,713,MMR
MMR==$2,750
$2,750
 Suppose
 Supposeyou
youbuy
buyoneoneJune
Junecontract
contractat
atthe
theopen
openof of$124,875,
$124,875,
Monday’s
Monday’sclose
closeisis124’26,
124’26,and
andTuesday’s
Tuesday’sclose
closeisis122’29.
122’29. What
Whatisisin
in
your
yourmargin
marginaccount
accountafter
afterTuesday’s
Tuesday’ssettle?
settle?
Underlying Price Margin
Settle Value Change Acct
OPEN 124’28 $124,875.00 $3,713.00
Mon. 124’26 $124,812.50 -$ 62.50 $3,650.50
Tues. 122’29 $122,906.25 -$1,906.25 $1,744.25
MARGIN CALL (beneath $2,750) add cash = $1,968.75
$3,713.00
Options

 An

Anoption
option isisaacontract
contractthat
thatgives
givesthe
theholder
holderthe
theright,
right,but
but
not
notthe
theobligation,
obligation,to tobuy
buyororsell
sellthe
theunderlying
underlyingasset
assetat
ataa
specified
specifiedprice
pricewithin
withinaaspecified
specifiedperiod
periodof
oftime
time
 AAcall

calloption
option isisan
anoption
optionthat
thatgives
givesthe
thepurchaser
purchaserthe
theright,
right,
but
butnot
notthe
theobligation,
obligation,to to buy
buythetheunderlying
underlyingsecurity
securityfrom
from
the
thewriter
writerofofthe
theoption
optionat
ataaspecified
specifiedexercise
exerciseprice
priceon
on(or
(or
up
upto)
to)aaspecified
specifieddate
date
 AAput

putoption
option isisan
anoption
optionthat
thatgives
givesthe
thepurchaser
purchaserthe
theright,
right,
but
butnot
notthe
theobligation,
obligation,to to sell
sell the
theunderlying
underlyingsecurity
securityto
tothe
the
writer
writerofofthe
theoption
optionatataaspecified
specifiedexercise
exerciseprice
priceon
on(or
(orupup
to)
to)aaspecified
specifieddate
date
Profit Diagrams for Call Options

Payoff
Payoff Payoff
Payofffor
for
profit
profit call
callbuyer
buyer

CC

00 Stock
StockPrice
Price
XX atatexpiration
expiration
-C
-C
Payoff for call
Payoff
Payoff writer
loss
loss
Profit Diagrams for Put Options

Payoff
Payoff
profit
profit Payoff for put
writer
PP

00 Stock
StockPrice
Price
XX atatexpiration
expiration
-P
-P Payoff for put
buyer
Payoff
Payoff
loss
loss
Options

 The
TheBlack-Scholes
Black-Scholesoption
optionpricing
pricingmodel
model(the
(themodel
modelmost
mostcommonly
commonlyused
usedto
to
price and value options) is a function of:
price and value options) is a function of:
 the spot price of the underlying asset
the spot price of the underlying asset
 the exercise price on the option
the exercise price on the option
 the option’s exercise date
the option’s exercise date
 the price volatility of the underlying asset
the price volatility of the underlying asset
 the risk-free rate of interest
the risk-free rate of interest
 The
Theintrinsic
intrinsicvalue
valueof
ofan
anoption
optionisisthe
thedifference
differencebetween
betweenan
anoption’s
option’sexercise
exercise
price
priceand
andthe
theunderlying
underlyingasset
assetprice
price
 the intrinsic value of a call option = max{S – X, 0}
the intrinsic value of a call option = max{S – X, 0}
 the intrinsic value of a put option = max{X – S, 0}
the intrinsic value of a put option = max{X – S, 0}
 Where;
 Where;
 XXisisthe
 theExercise
Exerciseprice
priceororStrike
StrikePrice
Price
 S is the current price of the stock
 S is the current price of the stock
Option Price Quotes
AMR Underlying stock price $8.79
Call Put
OPEN
OPEN
INTEREST
Expiration STRIKE LAST VOLUME INTEREST LAST VOLUME
May 6.00 3.30 12 578 0.45 20 4175
Jan 7.50 1.30 60 17062 0.15 138 58909

•• The
TheMay
Maycall
callisisininthe
themoney
money(positive
(positiveintrinsic
intrinsicvalue)
value)and
andthe
thecall
call
premium
premiumisis$3.30
$3.30**100 100==$330
$330 (contracts
(contractsare arefor
for100
100shares)
shares)
•• The
Theintrinsic
intrinsicvalue
valueof ofthe
thecall
call(S-X)
(S-X)isis($8.79
($8.79--$6.00)
$6.00)**100
100==$279
$279
•• The
Thetime
timevalue
valueof ofthethecall
callisis$330
$330--$279
$279==$51 $51
•• The
TheMay
Mayputputisisout
outof ofthe
themoney
moneyand andthetheput’s
put’sintrinsic
intrinsicvalue
valueisisthe
the
maximum
maximumof ofX-S,
X-S,whichwhichininthis
thiscase
caseisis6.00-8.79=-2.79
6.00-8.79=-2.79and [Link]
The
option’s
option’sintrinsic
intrinsicvalue
valueis,is,hence,
hence,0.0.
Option Markets


 The
TheChicago
ChicagoBoard
Boardof
ofOptions
OptionsExchange
Exchange(CBOE)
(CBOE) opened
openedin
in
1973
1973as
asthe
thefirst
firstexchange
exchangedevoted
devotedsolely
solelyto
tothe
thetrading
tradingof
of
stock
stockoptions
options

 An
AnAmerican
Americanoption
option can
canbe
beexercised
exercisedat atany
anytime
timebefore
before
(and
(andon)
on)the
theexpiration
expirationdate
date

 AAEuropean
Europeanoption
option can
canbebeexercised
exercisedonlyonlyon
onthe
theexpiration
expiration
date
date

 The
Thetrading
tradingprocess
processfor
foroptions
optionsisissimilar
similarto
tothat
thatfor
forfutures
futures
contracts
contracts
More on Options

 The
 Theunderlying
underlyingasset
asseton
onaa stock
stockoption
optionisisthe
thestock
stockof
ofaa
publicly
publiclytraded
tradedcompany
company

 The
Theunderlying
underlyingasset
asseton
onaa stock
stockindex
indexoption
optionisisthe
thevalue
valueof
ofaa
major
majorstock
stockmarket
marketindex
index(e.g.,
(e.g.,DJIA
DJIAor
orS&P
S&P500)
500)

 The
Theunderlying
underlyingasset
asseton
onaa futures
futuresoption
optionisisaafutures
futurescontract
contract
Swaps


 AAswap
swapisisan
anagreement
agreementbetween
betweentwotwoparties
partiestotoexchange
exchange
assets
assetsor
oraaseries
seriesof
ofcash
cashflows
flowsfor
foraaspecific
specificperiod
periodof
oftime
timeat
at
aaspecified
specifiedinterval
interval
 An

Aninterest
interestrate
rateswap
swapisisan
anexchange
exchangeofoffixed-interest
fixed-interest
payments
paymentsforforfloating-interest
floating-interestpayments
paymentsbybytwo
twocounterparties
counterparties
 the

theswap
swapbuyer
buyermakes
makesaaperiodic
periodicfixed
fixedinterest
interestrate
ratepayment
paymenton
onaa
stated
statednotional
notionalprincipal
principalamount
amount
 the

theswap
swapseller
sellermakes
makesaaperiodic
periodicfloating-rate
floating-rateinterest
interestpayments
payments
on
onthe
thesame
samestated
statednotional
notionalprincipal
principalamount
amount
 no

noprincipal
principalisisexchanged
exchanged
Swaps


 AAcurrency
currencyswap
swapisisaaperiodic
periodicexchange
exchangeof
ofone
onecurrency
currencyfor
for
another
anotherbetween
betweenthe
theparties
parties
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