Chapter Ten

Derivative Securities
Markets

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 Derivatives
• A derivative security is a financial security that derives its value from an
underlying asset
• A derivative itself is an agreement between two parties to exchange a standard
quantity of an asset at a predetermined price at a specific date in the future
• The most common underlying assets for derivatives are stocks, bonds,
commodities, currencies, interest rates, and market indexes. These assets are
commonly purchased through brokerages.
• Common derivatives include futures contracts, forwards, options, and swaps

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 Derivatives

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 Derivatives’ Uses
• Derivatives are leveraged instruments where participants put up a small amount
of money and obtain the gain or loss on a much larger position
• Derivatives are used to hedging (to hedge a position) and for speculation
(speculate on the directional movement of an underlying asset)
• Hedging: Entering into a derivatives contract to reduce the risk associated
with positions or commitments in their line of business
• Speculation: Buying or selling a derivative contract in order to earn a leveraged
rate of return

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 Participants in a Derivative Market
• The derivatives market is similar to any other financial market and has following
three broad categories of participants:

HEDGERS:
• These are investors with a present or anticipated exposure to the underlying asset
which is subject to price risks. Hedgers use the derivatives markets primarily for
price risk management of assets and portfolios.

SPECULATORS:
• These are individuals who take a view on the future direction of the markets.
They take a view whether prices would rise or fall in future and accordingly buy
or sell futures and options to try and make a profit from the future price
movements of the underlying asset.

ARBITRAGEURS:
• They take positions in financial markets to earn riskless profits. The arbitrageurs
take short and long positions in the same or different contracts at the same time
to create a position which can generate a riskless profit.
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 Derivatives Securities Markets
• Derivative securities markets are the markets in which derivative securities trade
• While derivative securities have been in existence for centuries, the growth in
derivative securities markets has occurred mainly since the 1970s.
• The first wave of modern derivatives were foreign currency futures introduced by
the International Monetary Market (IMM) following the Smithsonian
Agreements of 1971 and 1973
• The second wave of modern derivatives were interest rate futures introduced by
the Chicago Board of Trade (CBT) in response to increases in the volatility of
interest rates in the late 1970s
• The third wave of modern derivatives occurred in the 1980s with the advent of stock
derivatives
• The fourth wave occurred in the 1990s with credit derivatives

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 Forwards and Futures
• Spot contract – an agreement made between a buyer and a seller at time 0 for the
seller to deliver the asset immediately and the buyer to pay for the asset
immediately.

• Forward contract - agreement between a buyer and a seller at time 0 to exchange a

nonstandardized asset for cash at some future date. The details of the asset and the
price to be paid at the forward contract expiration date are set at time 0. The price of
the forward contract is fixed over the life of the contract

• Futures contract - agreement between a buyer and a seller at time 0 to exchange a

standardized asset for cash at some future date. Each contract has a standardized
expiration and transactions occur in a centralized market. The price of the futures
contract changes daily as the market value of the asset underlying the futures
fluctuates.

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 Timelines for each of the three contracts using a bond as
the underlying financial security to the derivative contract

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 Differences between Forwards and Futures
• Trading:
– Forward contracts are traded by telephone or telex.
– Futures contracts are traded in a competive arena.
• Regulation:
– The forward market is self-regulating.
– The IMM is regulated by the Commodity Futures Trading Commission.
• Frequency of Delivery:
– More than 90% of all forward contracts are settled by actual delivery.
– Less than 1% of the IMM futures contracts are settled by delivery.
• Size of Contract:
– Forward contracts are individually tailored and tend to be much larger than the standardized
contracts on the futures market.
– Futures contracts are standardized in terms of currency amount.
• Delivery Date:
– Banks offer forward contracts for delivery on any date.
– IMM futures contracts are available for delivery on only a few specified dates a year.

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 Differences between Forwards and Futures
• Settlement:
– Forward contract settlement occurs on the date agreed on between the bank and the customer.
– Futures contract settlement are made daily via the Exchange’s Clearing House; gains on position
values may be withdrawn and losses are collected daily. This practice is known as marking to
market.
• Quotes:
– Forward prices generally are quoted in European terms (units of local currency per U.S. dollar).
– Futures contracts are quoted in American terms (dollars per one foreign currency unit).
• Transaction Costs:
– Costs of forward contracts are based on bid-ask spread.
– Futures contracts entail brokerage fees for buy and sell orders.
• Margins:
– Margins are not required in the forward market.
– Margins are required of all participants in the futures market.
• Credit Risk:
– The credit risk is borne by each party to a forward contract. Credit limits must therefore be set for
each customer.
– The Exchange’s Clearing House becomes the opposite side to each futures contract, thereby
reducing credit risk substantially.

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 Futures Markets
• Futures contracts are usually traded on organized exchanges
• Exchanges indemnify counterparties against credit (i.e.,
default) risk
• Futures are marked to market daily
– marked to market describes the prices on outstanding futures
contracts that are adjusted each day to reflect current futures
market conditions
• The five major U.S. exchanges are the CBOT, CME,
NYFE, MACE, and KCBOT
• The principal regulator of futures markets is the
Commodity Futures Trading Commission (CFTC)
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 Futures Markets

• Futures contract trading occurs in trading “pits” using an

open-outcry auction among exchange members
– floor brokers place trades for the public
– professional traders trade for their own accounts
– position traders take a position in the futures market based on
their expectations about the future direction of the prices of the
underlying assets
– day traders take a position within a day and liquidate it before
day’s end
– scalpers take positions for very short periods of time, sometimes
only minutes, in an attempt to profit from active trading

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 Futures Contract Terms

• Trading unit • Last delivery day

• Deliverable grades
• Tick size
• Price quote
• Contract months
• Last trading day
• Delivery method
• Trading hours
• Ticker symbols
• Daily price limit

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 Futures Contracts

• A long position is the purchase of a futures

contract
• A short position is the sale of a futures contract
• A clearinghouse is the unit that oversees trading
on the exchange and guarantees all trades made
by the exchange
• Open interest is the total number of the futures,
put options, or call options outstanding at the
beginning of the day

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 Futures Contracts

• An initial margin is a deposit required on futures trades

to ensure that the terms of the contracts will be met
• The maintenance margin is the margin a futures trader
must maintain once a futures position is taken
– if losses occur such that margin account funds fall below the
maintenance margin, the customer is required to deposit additional
funds in the margin account
• Futures trades are leveraged investments as traders post
and maintain only a small portion of the value of their
futures position and “borrow” the rest from brokers

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 Options

• An option is a contract that gives the holder the right, but

not the obligation, to buy or sell the underlying asset at a
specified price within a specified period of time
• A call option is an option that gives the purchaser the
right, but not the obligation, to buy the underlying
security from the writer of the option at a specified
exercise price on (or up to) a specified date
• A put option is an option that gives the purchaser the
right, but not the obligation, to sell the underlying security
to the writer of the option at a specified exercise price on
(or up to) a specified date
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 Payoff Functions
Options
for Call Options

Payoff Payoff function

profit for buyer

0 Stock Price
X at expiration
-C

Payoff Payoff function

loss for writer
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 Payoff Functions
Options
for Put Options

Payoff Payoff function

profit for buyer

0 Stock Price
X at expiration
-P

Payoff Payoff function

loss for writer
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 Options

• The Black-Scholes option pricing model (the model

most commonly used to price and value options) is a
function of
– the spot price of the underlying asset
– the exercise price on the option
– the option’s exercise date
– the price volatility of the underlying asset
– the risk-free rate of interest
• The intrinsic value of an option is the difference between
an option’s exercise price and the underlying asset price
– the intrinsic value of a call option = max{S – X, 0}
– the intrinsic value of 10-19
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= max{X – S, Companies,
The McGraw-Hill 0} All Rights Reserved
 Please insert Figure 10-8 here.

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 Option Markets

• The Chicago Board of Options Exchange (CBOE)

opened in 1973 as the first exchange devoted solely to the
trading of stock options
• Options on futures contracts began trading in 1982
• An American option can be exercised at any time before
(and on) the expiration date
• A European option can be exercised only on the
expiration date
• The trading process for options is similar to that for
futures contracts

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 Options

• The underlying asset on a stock option is the stock of a

publicly traded company
• The underlying asset on a stock index option is the value
of a major stock market index (e.g., DJIA or S&P 500)
• The underlying asset on a futures option is a futures
contract
• Credit swaps
– the value of a credit spread call option increases as the
default (risk) premium or yield spread on a specified
benchmark bond of the borrower increases above some
exercise spread
– a digital default option pays a stated amount in the event
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 Options

• The primary regulator of futures markets is the

Commodity Futures Trading Commission
(CFTC)
• The Securities Exchange Commission (SEC) is
the primary regulator of stock options and stock
index options
• The CFTC is the regulator of options on futures
contracts

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 Swaps

• A swap is an agreement between two parties to

exchange assets or a series of cash flows for a specific
period of time at a specified interval
• An interest rate swap is an exchange of fixed-
interest payments for floating-interest payments by
two counterparties
– the swap buyer makes the fixed-rate payments
– the swap seller makes the floating-rate payments
– the principal amount involved in a swap is called the
notional principal
• A currency swap is a swap used to hedge against
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exchange rate risk from mismatched
10-24 currencies on
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 Swap Markets

• Swaps are not standardized contracts

• Swap dealers (usually financial institutions) keep
markets liquid by matching counterparties or by
taking positions themselves
• The International Swaps and Derivatives
Association (ISDA) is a 815 member association
among 56 countries that sets codes of standards
for swap documentation

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 Caps, Floors, and Collars

• Financial institutions use options on interest rates

to hedge interest rate risk
– a cap is a call option on interest rates, often with
multiple exercise dates
– a floor is a put option on interest rates, often with
multiple exercise dates
– a collar is a position taken simultaneously in a cap and
a floor (usually buying a cap and selling a floor)

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 International Derivative Markets

• The U.S. dominates the global derivative

securities markets
– North America accounted for $57.94 trillion of the
$96.67 trillion contracts outstanding on organized
exchanges in 2007
• The euro and European exchanges are expanding
– Europe accounted for $32.28 trillion of the $96.67
trillion contracts outstanding on organized exchanges
in 2007

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 Black-Sholes Call Option Model

 rT
C  N (d1 ) S  E (e ) N (d 2 )

ln( S / E )  (r   2 / 2)T
d1 
 T
d 2  d1  T

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