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Chapter 09 – Derivatives: Futures, Options, and Swaps

Chapter 9

Derivatives: Futures, Options, and Swaps

Chapter Overview

This chapter provides an introduction to derivatives, and examines both their uses and

abuses.

Learning Objectives: Establish an understanding of:

1. How derivatives transfer risk

2. Forward versus futures contracts

3. Options and their pricing

4. Use and abuse of swaps

Important Points of the Chapter

Recent history has shown that derivatives are open to abuse; they were at the bottom of

the scandal that engulfed Enron and were also linked to the collapse of Long Term

Capital Management (the hedge fund). But when used properly, derivatives are

extremely helpful instruments that can be used to reduce risk, or as a form of insurance.

Application of Core Principles

Principle #2: Risk. Derivatives allow people to transfer risk, and this encourages them

to do things they would not otherwise do because in effect they provide a kind of

insurance.

Principle #1: Time. The longer the time to expiration, the more valuable an option.

Principle #2: Risk. The option premium increases with the volatility of the price of the

underlying asset.

Principle #2: Risk. The difference between the benchmark rate for a swap (the market

interest rate on a U.S. Treasury bond of the same maturity as the swap) and the swap rate

(the rate to be paid) is called the swap spread, and is a measure of risk. In recent years it

has attracted substantial attention as a measure of the overall risk in the economy

(systematic risk).

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Chapter 09 – Derivatives: Futures, Options, and Swaps

Teaching Tips/Student Stumbling Blocks

Derivatives were first introduced back in Chapter 3; you may wish to review that

material.

The material on hedging and speculation was introduced in Chapter 5; you may

wish to review that material before beginning section II.

Give students a brief look at the action at the Chicago Board of Trade; part of the

movie Ferris Bueller’s Day Off (1986) was filmed there and showing that very

brief clip of the movie (it’s probably less than a minute) can really give them a

feel for the action in the pits.

Features in this Chapter

Lessons from the Crisis: Centralized Counterparties and Systemic Risk

Both a loss of liquidity and transparencies can threaten the financial system. One way to

keep markets functioning is to shift trading from over-the-counter transactions (OTC),

which occur between a single buy and a single seller, to a centralized counterparty, which

is an intermediary between buyers and sellers. When trading OTC, a firm can build up

significant risk without the other parties to the transactions knowing of the risk. A CCP

has the ability and incentive to monitor the riskiness of its counterparties. The CCP can

also standardize contracts and refuse to trade with a counterparty that may not be able to

pay. Further, a CCP limits its own risk through economies of scale.

Your Financial World: Should You Believe Corporate Financial Statements?

While financial statements must meet exacting accounting standards, that does not mean

they accurately reflect a company’s true financial position. Unfortunately, the standards

are so specific that they provide a roadmap for the creation of misleading statements.

Investors should never trust an accounting statement that doesn’t meet the standards set

forth by financial regulators and should look for companies that are open in their

financial accounting. Finally, investors should remember that diversification reduces

risk.

Your Financial World: Should You Accept Options as Part of Your Pay?

Many firms that offer options on their own stock to employees view options as a

substitute for wages. But while the options may have substantial value, there is a catch:

employees generally are not allowed to sell them, and may need to remain with the firm

to exercise them. Employees should think hard before trading salary for options;

investing in the same company that pays your salary is a risky business.

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Chapter 09 – Derivatives: Futures, Options, and Swaps

Applying the Concept: What Was Long-Term Capital Management Doing?

Long-Term Capital Management, a Connecticut-based hedge fund, engaged in a large

number of complex speculative transactions, including interest rate swaps and options

writing. In the late 1990s its erroneous bet that interest rate spreads would shrink resulted

in losses of over $2.5 billion. The Federal Reserve Bank of New York formed a group of

banks and investment companies to purchase the company for fear that its collapse would

jeopardize the entire financial system.

In the News: No Insurance Pay-out on Greek Debt

Credit default insurance will not pay out on Greek sovereign bonds despite the

restructuring of €186bn of the country’s debt. The International Swaps and Derivatives

Association decided that the bonds had not suffered a credit event. Some argue that this

decision sets a dangerous precedent, undermining the credit default market.

Additional Teaching Tools

In “AIG’s Rescue Had ‘Poisonous’ Effect, U.S. Panel Says (Update1),” June 10, 2010,

Business Week reports that the government takeover of AIG has poisoned the

marketplace because now investors believe that the American taxpayer will fix whatever

problems come about.

http://online.wsj.com/video/german-ban-stirs-suspicions/F0C8E8D5-56CA-4EA7-9D16-

82643A3A5D2F.html?KEYWORDS=credit+default+swaps, a Wall Street Journal video

discusses Germany’s ban on the naked short selling of euro-zone bonds, credit default

swaps and certain equities that will keep market suspicions about Europe aroused for a

few days yet.

Virtual Tools

Visit the Chicago Board of Trade on the web at: http://www.cbot.com/

The Commodity Futures Trading Commission oversees the futures industry and issues a

weekly report on the positions of both speculative and commercial market participants.

Visit them on the web at: http://www.cftc.gov/About/index.htm.

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Lessons of the Article: Derivatives allow investors to transfer risk to those who can

best bear it. But a financial contract, like a sovereign CDS, whose execution and

settlement are uncertain and subject to unpredictable interpretation, may provide no

hedge at all. When investors cannot reliably hedge unwanted risks, they accept less

risk overall. In this instance, that means holding less debt of risky sovereigns like the

government of Greece.

Chapter 09 – Derivatives: Futures, Options, and Swaps

In response to the accounting scandals of recent years, Congress approved the

Sarbanes-Oxley Act of 2002. Learn more about the Act at http://www.soxlaw.com/.

Learn more about the Stock Option Accounting Reform Bill (H.R. 3574) introduced by

Rep. Baker on Nov. 21 and referenced in The Wall Street Journal story above on this

page from the web site of the House Committee on Financial Services:

http://financialservices.house.gov/news.asp?FormMode=release&id=510&NewsType=1

You can visit FASB on the web at: http://www.fasb.org/

For More Discussion

Many consumers who shop on line prefer to use a service like PayPal instead of entering

their credit card information. Does PayPal provide a service similar to the clearinghouse

described in the chapter? Discuss.

Chapter Outline

I. The Basics: Defining Derivatives

A. Derivatives are financial instruments whose value depends on (i.e., is derived

from) the value of some other underlying financial instrument or asset (these

include stocks or bonds as well as other assets).

B. A simple example is an interest rate futures contract, which is an agreement

between two investors that obligates one to make a payment to the other

depending on the movement in interest rates over the next year.

C. Such an arrangement is very different from the purchase of a bond for two

reasons:

1. Derivatives provide an easy way for investors to profit from price declines, as

opposed to the purchase of a bond, which is a bet that its price will increase.

2. In a derivatives transaction, one person’s loss is always the other person’s

gain.

D. Derivatives can be used to speculate on future price movements, but because they

allow investors to manage and reduce risk, they are indispensable to a modern

economy.

E. The purpose of derivatives is to transfer risk from one person or firm to another,

providing a kind of insurance.

F. Derivatives increase the risk-carrying capacity of the economy as a whole,

improving the allocation of resources and increasing the level of output.

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Chapter 09 – Derivatives: Futures, Options, and Swaps

G. Derivatives also can be used to conceal the true nature of certain financial

transactions because they can be used to unbundle virtually any group of future

payments and risks.

H. Derivatives may be divided into three major categories: forwards and futures,

options, and swaps.

II. Forwards and Futures

A. Of all derivative financial instruments, forwards and futures are the simplest to

understand and the easiest to use.

B. A forward or forward contract is an agreement between a buyer and seller to

exchange a commodity or financial instrument for a specified amount of cash on a

prearranged future date.

1. They are very difficult to resell to someone else because they are

customized.

C. A future or futures contract is a forward contract that has been standardize and

sold through an organized exchange.

1. A futures contract specifies that the seller (the short position) will deliver

some quantity of a commodity or financial instrument to the buyer (the

long position) for a predetermined price.

2. No payments are made initially when the contract is agreed to.

3. The seller benefits from price declines in the price of the underlying asset,

while the buyer gains from increases.

D. Before anyone will buy or sell futures contracts there must be assurance that the

buyer and seller will meet their obligations; this is done through a clearing

corporation.

E. Margin Accounts and Marking to Market

1. To reduce the risk it faces, the clearing corporation requires both parties to a

futures contract to place a deposit with the corporation itself.

2. This is called posting margin in a margin account and the deposits (called the

initial margin) serve as a guarantee that when the contract comes due the

parties will be able to meet their obligations.

3. The clearing corporation also posts daily gains and losses on the contract to

the margin accounts of the parties involved; this is called marking to market.

4. This ensures that both sides can meet their obligations; if the margin account

falls below a minimum the clearing corporation will sell the contracts and end

the person’s participation in the market.

F. Hedging and Speculating with Futures

1. Futures contracts allow risk to be transferred between buyer and seller.

2. This transfer can be accomplished through hedging or speculation.

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Chapter 09 – Derivatives: Futures, Options, and Swaps

3. A futures contract fixes the price for both the seller and the buyer and so both

can use it as a hedge against unfavorable price movements.

4. Speculators are trying to make a profit by betting on price movements.

5. Futures contracts are popular tools for speculation because they are cheap.

6. An investor needs only a relatively small amount of funds (the margin, which

can be as low as 10 percent) to purchase a futures contract that is worth a great

deal.

7. For example, if the margin is $1,485 to purchase a $100,000 U.S. Treasury

bond, then the investment of $1,485 gives the investor the same returns as the

purchase of the bond; it is as if the buyer borrowed the balance ($98,515) at a

zero rate of interest.

8. Speculators can use futures to obtain very large amounts of leverage at a very

low cost.

G. Arbitrage and the Determinants of Futures Prices

1. On the settlement or delivery date the price of the futures contract must equal

the price of the underlying asset, otherwise there would be a risk-free profit.

2. Arbitragers simultaneously buy and sell financial instruments in order to

benefit from temporary price differences.

3. As a result of arbitrage, two financial instruments with the same risk and

promised future payments will sell for the same price.

4. If that were not true, arbitragers would buy and sell, changing demand and

forcing the prices to equality.

5. So long as there are arbitragers, on the day when a futures contract is settled,

the price of a bond futures contract will be the same as the market price of the

bond.

6. Before the settlement date, the futures price moves in lock step with the

market price of the bond.

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