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1.1.1.1.1Chapter Ten
Derivative Securities Markets
1.1.1.2 I. Chapter Outline
1. Derivative Securities: Chapter Overview
2. Forwards and Futures
a. Spot Markets
b. Forward Markets
c. Futures Markets
3. Options
a. Call Options
b. Put Options
c. Option Values
d. Option Markets
4. Regulation of Futures and Options Markets
5. Swaps
a. Interest Rate Swaps
b. Currency Swaps
c. Credit Swaps
d. Swap Markets
6. Caps, Floors, and Collars
7. International Aspects of Derivative Securities Markets
Appendix 10A: Black-Scholes Option Pricing Model (available on Connect or from your
McGraw-Hill representative)
1.1.1.3 II. Learning Goals
1. Distinguish between forward and future contracts.
2. Understand how a futures transaction is conducted.
3. Identify information that can be found in a futures quote.
4. Understand what option contracts are.
5. Examine information found in an options quote.
6. Know the main regulators of futures and options markets.
7. Describe an interest rate swap.
8. Understand caps, floors, and collars.
9. Identify the biggest derivative securities markets globally.
1.1.1.4 III. Chapter in Perspective
This is the final chapter that introduces securities markets. Derivatives are contracts whose value
is linked to and derived from something else. The ‘something else’ is usually a security, a
portfolio or an index. Derivatives may be used for different purposes. For instance, mortgage
backed derivatives are often created to improve the marketability of existing loans, thereby
improving a FI’s liquidity. The primary purpose of most derivative markets is to reallocate risk
from parties who do not wish to bear some or all of the risk arising from their underlying lines of
business (hedgers) to other parties who are willing to bear the risk (speculators). Most
derivatives involve significant amounts of leverage; this allows hedgers to reduce risk on large
spot positions without incurring large hedging costs. The leverage also allows speculators to
potentially earn large rates of return (or generate large losses). In this chapter, readers are
introduced to the characteristics and uses of forward contracts, futures markets, options, swaps
and interest rate options. The Black-Scholes option pricing model is relegated to the appendix,
which may be omitted without loss of continuity in the text. The focus of the chapter is on
terminology, the participants and the functioning of the markets, rather than on hedging.
Hedging with derivatives is covered in Chapter 23.
1.1.1.5 IV. Key Concepts and Definitions to Communicate to Students
Derivative security Open interest
Derivative security markets Option
Spot contract American option
Forward contract European option
Futures contract Call option
Marked to market Put option
Initial margin Intrinsic value of an option
Maintenance margin Time value of an option
Open-outcry auction Electronic Trading
Globex Swap
Floor broker Interest rate swap
Professional traders Swap buyer
Position traders Notional principal
Day traders Swap seller
Scalpers Currency swap
Long position Cap
Short position Floor
Clearinghouse Collar
1.1.1.6 V. Teaching Notes
1. Derivative Securities: Chapter Overview
Derivatives have a long and somewhat checkered history. For instance, options were banned in
Europe after the tulip bulb crisis of yore.1 Although commodity futures have a long history in
the U.S., options were not widely traded until the development of the Black-Scholes Option
Pricing Model in the early 1970s. In modern times derivatives have developed as the need to
manage the risk of a given commodity or exposure grew. For instance, currency futures were
introduced by the International Monetary Market (IMM), a subsidiary of the Chicago Mercantile
Exchange (CME), as the collapse of the Bretton Woods Agreement led to higher currency
volatility. Interest rate derivatives were created after the Fed stopped targeting interest rates in
1979. As stock trading grew, stock index derivatives were introduced in the early 1980s and
listed option contracts were eventually added for additional stocks. With the extreme increases
in short term interest rates in the early 1980s, institutions became interested in swaps to manage
interest rate risk. In the 1990s, credit risk derivatives were created that pay the holder if the
credit risk on an underlying asset increases. Enron was a major trader in credit risk derivatives.
Trading gains from these derivatives were used to help mask losses on other business lines at
Enron.2
Banks are major players in derivative markets, particularly in certain OTC derivatives and in
mortgage backed securities. Derivatives usage among banks however is limited to the largest
1,390 banks and 93% of derivatives held by banks are written by just 4 banks.
Derivatives are now traded on electronic exchanges. Eurex (a European exchange) launched a
fully electronic exchange in Chicago (no less) offering futures and options on U.S. T-notes and
T-bonds as well as contracts on Euro interest rates. The CME’s electronic trading platform,
Globex, allows extended hours of trading. Electronic trading now dominates traditional pit
trading by a wide margin.
Derivatives share part of the blame for problems in the financial crisis, particularly credit
derivatives. Since 2000 the FASB has required derivatives gains and losses be marked to market
to increase transparency. Huge losses on derivatives during the crisis will lead to additional
regulations but the details of the regulations are not yet fully known.
2. Forwards and Futures
a. Spot Markets
A spot contract is a contract for immediate payment and delivery. Settlement is usually within
two to three business days.
1 In the 1500s speculation in tulip bulbs led to a severe crash in the Netherlands, which caused
an equally severe depression; options were commonly used as speculative instruments at the
time.
2 For a detailed look at the use of various types of derivatives at Enron see, “Thoughts on Enron:
What Happened, Why and How it Can Be Avoided Again,” Financial Engineering News,
June/July 2002, #26.
b. Forward Markets
A forward contract is a contract for future payment and delivery (beyond two or three days) but
the terms of the future transaction are determined when the contract is initiated. Hedgers enter
into forward agreements to lay off risks created by their existing spot positions or future
commitments. FIs agree to take the opposite side of the contract as the customer for a fee and to
earn the bid-ask spread. Forward contracts can specify interest rates on future borrowings as
well as prices on specified assets. A forward rate agreement (FRA) is a forward contract for
loans that fixes the interest rate today on a loan that will be originated in the future.
Forward contracts are custom arrangements negotiated by the buyer and seller. Both parties are
at risk if the counterparty fails to perform as promised; hence, both parties should evaluate the
creditworthiness of the counterparty. If the counterparty is not known to the bank, collateral may
be required.
A credit forward is a new type of forward agreement that allows the buyer to hedge against an
increase in default risk on a loan or other credit contract. Banks are common buyers of credit
forwards and insurance companies have been the major sellers.
c. Futures Markets
Futures contracts are exchange traded. The CME and the New York Futures Exchange are
examples of futures markets. Membership seat prices on the CME as of June 2014 were offered
at $625,000, although leases were appreciably less (www.cmegroup.com). Note that the CME
and the CBOT have merged to form the CME Group.3 According to the FIA Annual Volume
Survey, $12.2 trillion in futures contracts were traded worldwide in 2013.
A buyer of a futures contract (long position) incurs the obligation to pay the extant futures price
at the time the contract is purchased. Payment is made at contract maturity in exchange for
receipt of the underlying commodity. A seller of a futures contract (short position) incurs the
obligation to deliver the underlying commodity at contract maturity in exchange for receiving the
futures price that was outstanding at the time the contract was enacted. Most futures contracts
do not result in delivery; indeed some contracts do not even allow delivery. The long position
is eliminated by selling the same contract. The clearinghouse nets the position (1 long and 1
short) to zero. Likewise, the short seller simply purchases the same contract and the
clearinghouse nets their position to zero.
Teaching Tip: Because of the lack of delivery futures contracts are really bets on the price
movements of the underlying commodity. The purchaser (seller) of a futures contract agrees to
receive (pay) any increase in the value of the underlying commodity and agrees to pay (receive)
any decrease in value between contract origination and termination.
The amount of open interest on a contract is the amount of long (short) positions that have not
executed offsetting trades. Open interest is useful as a measure of liquidity on the contract.
On a forward contract, no cash is paid or received until contract maturity. Buyers and sellers of
3 The CME Group includes the CME, the CBOT, NYMEX and COMEX.
futures contracts however must post an initial margin requirement (IMR) to enter into a futures
deal. The IMR is usually set at about 3%-5% of the face value of the contract, depending on the
volatility of the underlying commodity and whether there are daily price limits on the futures
contracts. Participants must also maintain minimum margin requirements called the
maintenance margin requirement (usually about 75% of the IMR). Futures contracts are
marked to market daily, which means that gains or losses on the contracts are realized daily.
This may require additional cash outlays if the customer’s margin falls below the minimum
required.
For example:
Suppose an investor purchases the June CBOT 30 year T-bond contract when it is priced at
98’16. The investor is technically agreeing to purchase $100,000 face value T-bonds (the
contract size) at contract maturity in June and is agreeing to pay 98 16/32% of $100,000 or
$98,500. As of 2014 the initial margin requirement (for speculators) was $2,530 and the
maintenance margin requirement was $2,300 (Source www.cmegroup.com).
Margin account transactions resulting from marking to market (long position):4
Long in contract
Marking to Market
Sele
Underlying
Value
Price
Change
Margin
Acct
OPEN $98,500.00 $2,530.00
Mon. 98’10 $98,312.50 ($187.50) $2,342.50
Tues. 97’00 $97,000.00 ($1,312.50) $1,030.00
MARGIN CALL (beneath $2,300) add cash = $1,500.00
$2,530.00
Teaching Tip: Marking to market may require the hedger to pay additional cash into their
margin account even though offsetting spot gains have not yet been realized. Banks are willing
to make short term loans to hedgers, such as farmers hedging a crop, to provide the necessary
liquidity. Nevertheless, the requirement to mark to market daily can be onerous and may require
the hedger to exhibit both financial and psychological staying power as futures losses may have
to be realized before spot gains.
The exchange (clearing corporation) guarantees payment for both parties in a futures contract
so that counterparty default risk is not a concern and principles will not normally know the
opposing party in the contract. Margin requirements, price limits, position limits and daily
marking to market limit the risk to the exchange. If the underlying spot volatility increases,
exchanges are quick to impose stricter requirements.
Teaching Tip: Why delivery is not an issue on futures contracts:
An investor goes long in a futures contract with a $100,000 face value (F = futures price, S =
spot price at time = 0 (today) or time = T at expiration)
4 The example ignores any minimum margin requirements brokers may require beyond those for
the individual contract, a simplification.
Suppose F0 = $110,000 but at contract expiration ST = $108,000. The seller of the pounds could
sell the pound spot and receive $108,000 and the seller has already gained $2,000 from the daily
marking to market. The invoice price is adjusted to $108,000 and the net proceeds to the seller
are $110,000, the same as if no delivery occurred.
Suppose an investor goes short in a futures contract at F0 = $110,000, but at contract expiration
ST = $112,000. The buyer of the pounds (the long side of the contract) could buy the pound spot
and pay $112,000 and the (buyer) has already gained $2,000 from the daily marking to market so
the net cost to the buyer is $110,000.
Futures contracts are highly standardized in terms of contract size, maturity, price quotations and
specifications of the deliverable security if any. Interest rate contracts with the highest amount of
open interest include the Eurodollar, Eurolibor, Short Sterling, T-note and T-bond contracts. The
euro, yen and the S&P500 contracts are among the highest in open interest for currency and
stocks respectively.
Traditional futures trading uses an open outcry auction where traders communicate with each
other via oral communications (usually shouted) and a variety of hand signals. As of 2013 about
90% or more of CME derivative trading was conducted electronically rather than via pit trading.
In fact as of 2008, futures contracts on the Intercontinental Exchange (ICE Futures U.S.) are
only traded electronically. Electronic trading is cheaper, allows more rapid order execution,
global access to trading and extended trading hours.
Types of traders include:
Professional traders:
Position traders that maintain positions in a contract for longer than a day,
Day traders that liquidate their positions by the end of the day,
Scalpers who hold positions only a matter of minutes and attempt to profit from either very
small price changes or the bid-ask spread. Scalpers who hold their positions for more than 3
minutes typically lose.
Teaching Tip: Day traders and position traders often use proprietary models to estimate which
way they believe prices will move. They normally will not disclose their trading models.
Similar to the NYSE, floor brokers process public orders to buy and sell.
Example futures quote:
30 year T-bond contract quote sheet on the CBOT website in June 2014 was:
Last Change
Prev
Settle Open High Low Volume
Jun 2014 136’18 -0’01 136’19 136’16 136’30 136’00 3,244
Sep 2014 135’25 0 135’25 135’23 136’06 135’05 342,159
June is the near term contract. The contract size is for $100,000 face value T-bonds and the price
quotes (Last, Open, High, Low, Close and Previous Settle) are percentages of face value where
the price quotes are in 32nds, although the minimum price quote is now ½ of a 32nd. For
example 136’18 is 136 18/32% of $100,000 or $ $136,562.50. Typically only the nearer term
contracts in most futures are actively traded.
