978-0077861667 Chapter 10 Lecture Note Part 1

Unlock access to all the studying documents.

View Full Document

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

Sele

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

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.