CHAPTER SEVENTEEN

THE ROLE OF
DERIVATIVE ASSETS

Practical Investment Management

Robert A. Strong
 Outline

 Background
 The Rationale for Derivative Assets
 Uses of Derivatives
 The Options Market
 Options Terminology
 The Financial Page Listing
 The Origin of an Option
 The Role of the Options Clearing Corporation
 Standardized Option Characteristics

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 Outline

 The Futures Market

 Futures vs. Options
 Market Participants
 Keeping the Promise
 Categories of Futures Contracts
 Financial Futures
 Stock Index Futures
 Interest Rate Futures
 Foreign Currency Futures

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 Outline

 Derivative Assets and the News

 Current Events
 Risk of Derivative Assets
 Listed vs. Over-the-Counter Derivatives

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 Introduction

 Derivative assets get their name from the

fact that their value derives from some
other asset.
 The best-known derivative assets are
futures and options contracts.
 Derivatives are not all the same. Some are
inherently speculative, while some are
highly conservative.

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 Background :
The Rationale for Derivative Assets

 The first organized derivatives

exchange in the United States
was developed in order to bring
stability to agricultural prices, by
enabling farmers to eliminate or
reduce their price risk.

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 Background : Uses of Derivatives

 Risk management : The equity manager’s

market risk or the bond manager’s interest
rate risk is analogous to the farmer’s price
risk.
 Risk transfer : Derivatives provide a means
for risk to be transferred from one person
to some other market participant who, for a
price, is willing to bear it.
 Derivatives may provide financial leverage.

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 Background : Uses of Derivatives

 Income generation : Some people use

derivatives as a means of generating
additional income from their investment
portfolio.
 Financial engineering : Derivatives can be
stable or volatile depending on how they
are combined with other assets.
 What’s next?

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 Background : Uses of Derivatives

Insert Figure 17-1 here.

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 Options Terminology
 A call option gives its owner the right to
buy a specified quantity of the underlying
asset at a set price within a set time period.
 A put option gives its owner the right to
sell a specified quantity of the underlying
asset at a set price within a set time period.
 The set price is called the striking price or
exercise price, and the last day the option
is valid is called the expiration date.
 The price of the option is the premium.

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 Options Terminology
 Options trade in units called contracts, each of
which normally covers 100 shares.
 An option’s volume indicates how many option
contracts changed hands over some period of
time. It measures trading activity.
 An option’s open interest indicates how many
option contracts exist.
 Open interest goes up when someone creates an
option and does down when two people trade and
each close out an options position.

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 Options Terminology

 The owner of an option will ultimately do

one of three things with it:
 sell it to someone else;
 let it expire; or
 exercise it.

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 The Origin of an Option
 Options can be created, or destroyed. The
quantity of options in existence changes
everyday.
 The first trade someone makes in a
particular option is called an opening
transaction. If an investor sells an option
as an opening transaction, it is called
writing the option.
 Options are fungible, meaning that, for a
given company, all options of the same
type with the same expiration and striking
price are identical.

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 The Role of the Options Clearing Corporation
 The Options Clearing Corporation positions
itself between every buyer and seller and acts
as a guarantor of all option trades.
OCC

Buyer Trading Floor Seller

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 Standardized Option Characteristics

 Options have standardized expiration dates,

striking prices, and lot size.
 option premium = intrinsic value + time value
 If an option has no intrinsic value, it is out-of-
the-money. Otherwise, it is either in-the-
money or at-the-money.

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 Standardized Option Characteristics

Components of an Option Premium

Intrinsic Time Value Option

Value + = Premium

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 Standardized Option Characteristics

 An American option can be exercised

anytime prior to the expiration of the option.
A European option, on the other hand, can
only be exercised at expiration.
 The option holder decides if and when to
exercise.
 Valuable options are usually sold rather than
exercised.

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 Standardized Option Characteristics

Fig 17-4 here

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 The Futures Market
 A futures contract is a promise.

 The initial seller of the contract promises to

deliver a quantity of a standardized commodity to
a designated delivery point during a certain
delivery month.
 The other party to the trade promises to pay a
predetermined price for the goods upon delivery.
 The person who promises to buy is said to be
long, while the person who promises to deliver is
said to be short.

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 The Futures Market

 Futures vs. options : Futures contracts do

not expire unexercised. Note that the
contract obligation may be satisfied by
making an offsetting trade.
 Market participants :
 Hedgers use futures to reduce price risk.
 Speculators assume risk in the hope of
making a profit.
 Marketmakers provide liquidity for the
marketplace.

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 The Futures Market

Insert Figure 17-5 here.

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 The Futures Market
 Keeping the promise : Each exchange has a
Clearing Corporation which ensures the
integrity of the futures contract when a
member is in financial distress.
 Categories of futures contracts :
 Agricultural e.g. wheat, cotton, cattle.
 Metals and petroleum e.g. platinum,
copper, natural gas, crude oil.
 Financial e.g. foreign currency, stock
index, interest rate.
 Others e.g. electricity, catastrophe, swap.

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 Financial Futures : Stock Index Futures

 A stock index future is a promise to buy or

sell the standardized units of a specific
index at a fixed price at a predetermined
future date.
 Unlike most other commodity contracts,
there is no actual delivery mechanism
when the contract expires. For practicality,
all settlements are in cash.

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 Financial Futures : Stock Index Futures

Insert Table 17-2 here.

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 Financial Futures : Interest Rate Futures

 Interest rate futures contracts are

customarily grouped into short-term,
intermediate-term, and long-term
categories.
 The two principal short-term contracts are
Eurodollars and U.S. Treasury bills.
 The Treasury bill futures contract calls for
the delivery of $1 million par value of 90-
day T-bills on the delivery date of the
futures contract.

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 Financial Futures : Interest Rate Futures

Insert Table 17-3 here.

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 Financial Futures : Interest Rate Futures
 The contract on U.S. Treasury notes is the
only intermediate-term contract, while
Treasury bonds are the principal long-term
contracts.
 The Treasury bond futures contract calls
for the delivery of $100,000 face value of
U.S. Treasury bonds with a minimum of 15
years until maturity (and, if callable, with a
minimum of 15 years of call protection).
Bonds that meet these criteria are said to
be deliverable.

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 Financial Futures : Interest Rate Futures

Insert Table 17-4 here.

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 Financial Futures : Interest Rate Futures

 Bonds are standardized as follows:

invoice settlement conversion accrued

price = [ price x factor ] + interest

 T-bonds are not all fungible. At any given time,

several dozen bonds are usually eligible for
delivery on a T-bond futures contract.
Normally, only one of these bonds will be
cheapest to deliver.

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 Financial Futures : Interest Rate Futures

Insert Table 17-5 here.

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 Financial Futures : Foreign Currency Futures

 Foreign currency futures contracts call for

delivery of the foreign currency in the
country of issuance to a bank of the
clearing house’s choosing.
 Most major corporations face at least some
foreign exchange risk and quickly
discovered the convenience of these
futures as a hedging vehicle, while
speculators saw the contracts as easy to
understand and use.

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 Derivative Assets and the News

 Newspapers in recent months have

been full of reports on various
businesses that have lost billions
“investing in derivatives.”
 Derivatives are neutral products. Their risk
depends on what an investor does with
them.
 Exchange-traded derivative assets and
over-the-counter derivatives are markedly
different.

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 Review

 Background
 The Rationale for Derivative Assets
 Uses of Derivatives

 The Options Market

 Options Terminology
 The Financial Page Listing

 The Origin of an Option

 The Role of the Options Clearing Corporation

 Standardized Option Characteristics

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 Review

 The Futures Market

 Futures vs. Options
 Market Participants

 Keeping the Promise

 Categories of Futures Contracts

 Financial Futures
 Stock Index Futures
 Interest Rate Futures

 Foreign Currency Futures

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 Review

 Derivative Assets and the News

 Current Events
 Risk of Derivative Assets

 Listed vs. Over-the-Counter Derivatives

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 Appendix: Option Pricing

Fig. 17A-1

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 Appendix: Option Pricing

 Black-Scholes Options Pricing Model

Insert table 17A-1

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 Appendix: Option Pricing

Insert fig. 17A2

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 Appendix: Option Pricing

Delta: the change in option premium

expected from a small change in the stock
price, all other things being equal

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