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Chapter 7
Derivatives and Derivate Markets
Brief Chapter Summary and Learning Objectives
7.1 Derivatives, Hedging, and Speculating (pages 191–192)
Explain what derivatives are and distinguish between using them to hedge and using them to
speculate.
Derivatives are financial securities that derive their value from an underlying asset.
An important use of derivatives is to hedge or reduce risk.
Derivatives can also be used to speculate, which means placing financial bets on movements in
asset prices.
7.2 Forward Contracts (pages 193–194)
Define forward contracts.
Forward contracts give firms and investors an opportunity to hedge the risk on transactions that
depend on future prices.
7.3 Futures Contracts (pages 194–202)
Discuss how futures contracts can be used to hedge and to speculate.
Hedging involves taking a short (long) position in the futures market to offset a long (short)
position in the spot market.
Investors can use commodity futures to speculate on the price of a commodity.
7.4 Options (pages 203–212)
Distinguish between call options and put options and explain how they are used.
A call option gives the buyer the right to buy the underlying asset at the strike price (or exercise
price), at any time up to the option’s expiration date.
A put option gives the buyer the right to sell the underlying asset at the strike price.
Firms, banks, or individual investors can use options to hedge the risk from fluctuations in
commodity or stock prices, interest rates, and foreign currency exchange rates.
7.5 Swaps (pages 212–216)
Define swaps and explain how they can be used to reduce risk.
A swap is an agreement between two or more counterparties to exchange sets of cash flows over
some future period.
Firms engage in swaps to transfer risk to parties that are more willing to bear it.
Key Terms
Call option A type of derivative contract that
gives the buyer the right to buy the underlying
asset at a set price during a set period of time.
Counterparty risk The risk that the counter
party—the person or firm on the other side of the
transaction—will default.
Credit swap A contract in which interest-rate
payments are exchanged, with the intention of
reducing default risk.
Currency swap A contract in which counter
Credit default swap A derivative that requires
the seller to make payments to the buyer if the
price of the underlying security declines in value;
in effect, a type of insurance.
Marking to market In the futures market, a daily
settlement in which the exchange transfers funds
from a buyer’s account to a seller’s account or
vice versa, depending on changes in the price of
the contract.
Option A type of derivative contract in which the
parties agree to exchange principal amounts
denominated in different currencies.
Derivative An asset, such as a futures contract
or an option contract, that derives its economic
value from an underlying asset, such as a stock
or a bond.
Forward contract An agreement to buy or sell
an asset at an agreed upon price at a future time.
Futures contract A standardized contract to buy
or sell a specified amount of a commodity or
financial asset on a specific future date.
Hedge To take action to reduce risk by, for
example, purchasing a derivative contract that
will increase in value when another asset in an
investor’s portfolio decreases in value.
Interest-rate swap A contract under which
counterparties agree to swap interest payments
over a specified period on a fixed dollar amount,
called the notional principal.
Long position In a futures contract, the right and
obligation of the buyer to receive or buy the
underlying asset on the specified future date.
Margin requirement In the futures market, the
minimum deposit that an exchange requires from
the buyer or the seller of a financial asset;
reduces default risk.
buyer has the right to buy or sell the underlying
asset at a set price during a set period of time.
Options premium The price of an option.
Put option A type of derivative contract that
gives the buyer the right to sell the underlying
asset at a set price during a set period of time.
Settlement date The date on which the delivery
of a commodity or financial asset specified in a
forward contract must take place.
Short position In a futures contract, the right and
obligation of the seller to deliver the underlying
asset on the specified future date.
Speculate To place financial bets, as in buying or
selling futures or option contracts, in an attempt to
profit from movements in asset prices.
Spot price The price at which a commodity or
financial asset can be sold at the current date.
Strike price (or exercise price) The price at
which the buyer of an option has the right to buy
or sell the underlying asset.
Swap An agreement between two or more
counterparties to exchange sets of cash flows over
some future period.
Chapter Outline
Teaching Tips
In the past, the material in this chapter was frequently omitted from money and banking courses,
particularly from courses that focus on policy. The events of the 2007-2009 financial crisis,
however, showed the importance of students having some basic understanding of derivatives.
The discussion in this chapter focuses on forward contracts, futures contracts, and options, with a
brief concluding section on swaps. The risk-sharing, liquidity, and information services provided
by derivative securities are analyzed. Here, as elsewhere in the text, student interest can be
stimulated by spending time on the financial listings (see the Making the Connection, “How to
Follow the Futures Market,” that begins on page 199 of the text and the Making the Connection,
“How to Follow the Options Market,” which begins on page 207 of the text).
Students often struggle to understand derivatives. One point to emphasize is the essentially financial
nature of derivatives. Derivatives are intended to give investors and firms a way of hedging by
giving them a mechanism to profit if there is an adverse price movement in an underlying asset.
(Or to give speculators an opportunity to profit from their ability to forecast future price
movements in the underlying asset.) The derivatives markets are ordinarily separate from the
markets for the underlying assets. Grasping this essential point usually improves students’
understanding.
Using Financial Derivatives to Reduce Risk
Warren Buffett, nicknamed the “Oracle of Omaha,” remarked in 2002 that financial derivates were
“financial weapons of mass destruction.” Just as Buffet had warned, financial derivatives played an
important role in the financial crisis of 2007-2009. Despite Buffet’s denunciations, derivatives play a
useful role in the economy, providing investors with
risk-sharing, liquidity, and information services that
they would not be able to obtain elsewhere.
7.1 Derivatives, Hedging and Speculating (pages 191–192)
Learning Objective: Explain what derivatives are and distinguish between using them to hedge and
using them to speculate.
Derivatives are financial securities that derive their value from an underlying asset. Most
derivatives are intended to allow investors and firms to profit from price movements in the underlying
asset. An important use of derivatives is to hedge, or reduce risk. Typically, hedging involves the
purchase of a derivative that increases in value if there is an adverse price change in the underlying
asset in the derivatives contract. Investors can also use derivatives to speculate, or place financial
bets on movements in asset prices. Speculators serve two useful purposes: First, hedgers are able to
transfer risk to speculators. Second, studies of derivatives markets have shown that speculators provide
essential liquidity.
7.2 Forward Contracts (pages 193–194)
Learning Objective: Define forward contracts.
Forward contracts give firms and investors an opportunity to hedge the risk on transactions that
depend on future prices. Forward contracts make possible forward transactions, which are
transactions agreed to in the present, but settled in the future. Forward contracts typically involve
an agreement in the present to exchange a specific amount of a commodity or financial asset in the
future. Although forward contracts provide risk sharing, they have liquidity and information
problems.
7.3 Futures Contracts (pages 194–202)
Learning Objective: Discuss how futures contracts can be used to hedge and to speculate.
Futures contracts share the benefits of forward contracts, while having greater liquidity, less risk,
and lower information costs due to being traded on exchanges. The market determines the prices
of futures contracts, and futures contracts are standardized in terms of the quantity of the
underlying asset to be delivered and the settlement date.
A. Hedging with Commodity Futures
Hedging involves taking a short position in the futures market to offset a long position in the
spot market, or taking a long position in the futures market to offset a short position in the spot
market. Someone has a short position if he or she has promised to sell or deliver the underlying
asset, while the person who buys the contract is taking the long position.
B. Speculating with Commodity Futures
Some investors who are not connected with a commodity market can use commodity futures to
speculate on the price of a commodity. Without speculators, most futures markets would not
have enough buyers or sellers to operate, thereby reducing the risk sharing available to hedgers.
C. Hedging and Speculating with Financial Futures
The process of hedging risk using financial futures is very similar to the process of hedging risk
using commodity futures. An investor who believes that he or she has superior insight into the
likely path of future interest rates can use the futures market to speculate.
Teaching Tips
Students can enhance their understanding of using futures contracts to hedge risk by completing Solved
Problem 7.3, How can You Hedge an Investment in Treasury Notes When Interest Rates are Low, on page
201 of the text. How to hedge against possible changes in interest rates is an issue that students may face
in the future, either personally, for instance when planning to buy a house, or professionally, for instance
when considering how to finance capital purchases at the companies they work for.
D. Trading in the Futures Market
To reduce default risk, the exchange requires both the buyer and seller to make an initial
deposit called a margin requirement into a margin account. At the end of each trading day, the
exchange carries out a daily settlement known as marking to market in which, depending on the
closing price of the contract, funds are transferred from the buyer’s account to the seller’s
account or vice versa.
7.4 Options (pages 203–212)
Learning Objective: Distinguish between call options and put options and explain how they are
used.
The buyer of an option has the right to buy or sell the underlying asset at a set price during a set
period of time. A call option gives the buyer the right to buy the underlying asset at the strike price
(or exercise price), at any time up to the option’s expiration date. A put option gives the buyer the
right to sell the underlying asset at the strike price. With options contracts, the buyer has rights,
while the seller has obligations.
A. Why Would You Buy or Sell an Option?
If you expect the price of a stock to rise, you can purchase call options that would allow you to
buy the stock at a strike price above the existing price. If the price of the stock never reaches
the strike price, you can allow the options to expire without exercising them, which limits your
loss to the price of the options. Similarly, you can buy a put option if you expect the price of a
stock to decline, while limiting your loss to the price of the option.
B. Option Pricing and the Rise of the “Quants”
The price of an option is called an option premium. The size of the option premium reflects the
probability that the option will be exercised and can be divided into two parts—the option’s
intrinsic value and its time value. The intrinsic value of an option equals the net gain to the
buyer of the option from exercising it immediately. The time value is affected by how far away
the expiration date is and by how volatile the stock price has been in the past. The further away
the expiration date, the greater the chance that the intrinsic value of the option will increase.
Similarly, if the volatility in the price of the underlying asset is small, the chance that the
intrinsic value of the option may increase substantially because of a large price swing is small.
The Black-Scholes formula developed in 1973 uses sophisticated mathematics to price options.
As a result of the success of the Black-Scholes formula, financial firms began hiring people
with advanced degrees in economics, finance, and mathematics to build models that can be
used to price new securities. These people have come to be known as quants.
Teaching Tips
Many students have read information about stocks, but few have interpreted data about options. Having
students complete Solved Problem 7.4, Interpreting the Options Listings for Amazon.com, on pages
208–209 will help them to interpret information about options and therefore strengthen their
understanding.
C. Using Options to Manage Risk
Non-financial firms, banks, or individual investors can use options, as well as futures, to hedge
the risk from fluctuations in commodity or stock prices, interest rates, and foreign currency
exchange rates. Though options are more expensive than futures contracts, they have the
important advantage that an investor who buys options will not suffer a loss if prices should
move in the opposite direction being hedged against.
7.5 Swaps (pages 212–216)
Learning Objective: Define swaps and explain how they can be used to reduce risk.
A swap is an agreement between two or more counterparties to exchange sets of cash flows over
some future period.
A. Interest-Rate Swaps
With an interest-rate swap, the counterparties agree to swap interest payments on a
fixed dollar amount, called the notional principal. One motivation for firms to engage
in interest-rate swaps is to transfer interest-rate risk to parties that are more willing to
bear it. Swaps are more flexible than futures or options because they can be
custom-tailored to meet the needs of counterparties. Swaps also involve more privacy,
less regulation, and can be written for longer periods of time. Unlike with futures and
exchange-traded options, with swaps counterparties must be sure of the
creditworthiness of their partners.
B. Currency Swaps and Credit Swaps
In a currency swap, counterparties exchange principal amounts denominated in
different currencies. Firms may engage in currency swaps when some firms have a
comparative advantage in borrowing in their domestic currency. In a credit swap,
interest rate payments are swapped with the intention of reducing default or credit
risk.
C. Credit Default Swaps
Developed in the mid-1990s, a credit default swap is a derivative that requires the seller to
make payments to the buyer if the price of the underlying security declines in value; in effect, a
credit default swap is a type of insurance. By 2005, some investors began to speculate on credit
default swaps on mortgage-backed securities and collateralized debt obligations while
companies, such as insurance giant AIG, issued an increasing number of credit default swaps,
eventually resulting in huge losses for the companies involved.
