Chapter Ten

Derivative Securities
Markets

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Derivatives
AAderivative
derivativesecurity
securityisisan
anagreement
agreementbetween
betweentwo
two
parties
partiesto
toexchange
exchangeaastandard
standardquantity
quantityof
ofan
anasset
assetatataa
predetermined
predeterminedprice
priceatataaspecific
specificdate
datein
inthe
thefuture
future
Derivative
Derivativesecurities
securitiesmarkets
marketsare
arethe
themarkets
marketsin
inwhich
which
derivative
derivativesecurities
securitiestrade
trade
Derivatives
Derivativesinvolve
involvethe
thebuying
buyingand
andselling
selling(i.e.,
(i.e.,the
the
transfer
transferof)
of)risk,
risk,which
whichresults
resultsin
inaapositive
positiveimpact
impacton
onthe
the
economic
economicsystem
system
Derivatives
Derivativesare
areused
usedfor
forhedging
hedgingand
andfor
forspeculation
speculation

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Derivatives
The
Thefirst
firstwave
waveof
ofmodern
modernderivatives
derivativeswere
wereforeign
foreign
currency
currencyfutures
futuresintroduced
introducedby
bythe
theInternational
International
Monetary
MonetaryMarket
Market(IMM)
(IMM)following
followingthe
theSmithsonian
Smithsonian
Agreements
Agreementsof
of1971
1971and
and1973
1973
The
Thesecond
secondwave
waveof
ofmodern
modernderivatives
derivativeswere
wereinterest
interest
rate
ratefutures
futuresintroduced
introducedby
bythe
theChicago
ChicagoBoard
Boardof
ofTrade
Trade
(CBT)
(CBT)after
afterthe
theFed
Fedstarted
startedto
totarget
targetnonborrowed
nonborrowed
reserves
reservesin
inthe
thelate
late1970s
1970s
The
Thethird
thirdwave
waveof
ofmodern
modernderivatives
derivativesoccurred
occurredin
inthe
the
1990s
1990swith
withthe
theadvent
adventof
ofcredit
creditderivatives
derivatives
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Forwards and Futures

A
Aspot
spotcontract
contract isisan
anagreement
agreement to
to transact
transact
involving
involvingthe
the immediate
immediate exchange
exchange of
of assets
assetsand
and
funds
funds
A
Aforward
forwardcontract
contract isisaa nonstandardized
nonstandardized
agreement
agreement to
to transact
transact involving
involving the
thefuture
future
exchange
exchangeof
ofaa set
set amount
amountof
ofassets
assetsatataaset
setprice
price
A
Afutures
futurescontract
contract isisaa standardized
standardizedexchange
exchange
traded
tradedagreement
agreement to
to transact
transact involving
involving the
thefuture
future
exchange
exchangeof
ofaa set
set amount
amountof
ofassets
assetsfor
foraaprice
pricethat
that
isissettled
settled daily
daily
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Futures Markets
Futures
Futurescontracts
contractsare
areusually
usuallytraded
tradedon
onorganized
organized
exchanges
exchanges
Exchanges
Exchangesindemnify
indemnifycounterparties
counterpartiesagainst
againstcredit
credit(i.e.,
(i.e.,
default)
default)risk
risk
Futures
Futuresare
aremarket
marketto
tomarket
marketdaily
daily
marked
markedtotomarket
marketdescribes
describesthe
theprices
priceson
onoutstanding
outstandingfutures
futures
contracts
contractsthat
thatare
areadjusted
adjustedeach
eachday
daytotoreflect
reflectcurrent
currentfutures
futures
market
marketconditions
conditions

The
Thefive
fivemajor
majorU.S.
U.S.exchanges
exchangesare
arethe
theCBOT,
CBOT,CME,
CME,
NYFE,
NYFE,MACE,
MACE,and
andKCBOT
KCBOT
The
Theprincipal
principalregulator
regulatorof
offutures
futuresmarkets
marketsisisthe
the
Commodity
CommodityFutures
FuturesTrading
TradingCommission
Commission(CFTC)
(CFTC)
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Futures Markets
Futures
Futurescontract
contracttrading
tradingoccurs
occursin
intrading
tradingpits
pitsusing
using
an
anopen-outcry
open-outcryauction
auctionamong
amongexchange
exchangemembers
members
floor
floorbrokers
brokersplace
placetrades
tradesfor
forthe
thepublic
public
professional
professionaltraders
traderstrade
tradefor
fortheir
theirown
ownaccounts
accounts
position
positiontraders
traderstake
takeaaposition
positionin
inthe
thefutures
futuresmarket
marketbased
based
on
ontheir
theirexpectations
expectationsabout
aboutthe
thefuture
futuredirection
directionof
ofthe
theprices
prices
of
ofthe
theunderlying
underlyingassets
assets
day
daytraders
traderstake
takeaaposition
positionwithin
withinaaday
dayand
andliquidate
liquidateitit
before
beforedays
daysend
end
scalpers
scalperstake
takepositions
positionsfor
forvery
veryshort
shortperiods
periodsof
oftime,
time,
sometimes
sometimesonly
onlyminutes,
minutes,in
inan
anattempt
attemptto
toprofit
profitfrom
fromactive
active
trading
trading

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Futures Contract Terms

Trading
Trading unit
unit
Deliverable
Deliverable grades
grades
Tick
Tick size
size
Price
Price quote
quote
Contract
Contract months
months
Last
Last trading
trading day
day

McGraw-Hill/Irwin

10-7

Last
Last delivery
delivery day
day
Delivery
Delivery method
method
Trading
Trading hours
hours
Ticker
Ticker symbols
symbols
Daily
Daily price
price limit
limit

2009, The McGraw-Hill Companies, All Rights

Futures Contracts
A
Along
long position
position isis the
the purchase
purchase of
of aa futures
futures
contract
contract
A
Ashort
short position
position isis the
the sale
sale of
of aa futures
futures contract
contract
A
Aclearinghouse
clearinghouse isis the
the unit
unit that
that oversees
oversees trading
trading
on
on the
the exchange
exchange and
and guarantees
guarantees all
all trades
trades made
made
by
by the
the exchange
exchange
Open
Open interest
interest isis the
the total
total number
number of
of the
the futures,
futures,
put
put options,
options, or
or call
call options
options outstanding
outstanding at
at the
the
beginning
beginning of
of the
the day
day
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Futures Contracts
An
Aninitial
initialmargin
marginisisaadeposit
depositrequired
requiredon
onfutures
futurestrades
trades
to
toensure
ensurethat
thatthe
theterms
termsof
ofthe
thecontracts
contractswill
willbe
bemet
met
The
Themaintenance
maintenancemargin
marginisisthe
themargin
marginaafutures
futurestrader
trader
must
mustmaintain
maintainonce
onceaafutures
futuresposition
positionisistaken
taken
ififlosses
lossesoccur
occursuch
suchthat
thatmargin
marginaccount
accountfunds
fundsfall
fallbelow
belowthe
the
maintenance
maintenancemargin,
margin,the
thecustomer
customerisisrequired
requiredtotodeposit
deposit
additional
additionalfunds
fundsininthe
themargin
marginaccount
account

Futures
Futurestrades
tradesare
areleveraged
leveragedinvestments
investmentsas
astraders
traderspost
post
and
andmaintain
maintainonly
onlyaasmall
smallportion
portionof
ofthe
thevalue
valueof
oftheir
their
futures
futuresposition
positionand
andborrow
borrowthe
therest
restfrom
frombrokers
brokers

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Options
An
Anoption
optionisisaacontract
contractthat
thatgives
givesthe
theholder
holderthe
theright,
right,but
but
not
notthe
theobligation,
obligation,to
tobuy
buyor
orsell
sellthe
theunderlying
underlyingasset
assetatataa
specified
specifiedprice
pricewithin
withinaaspecified
specifiedperiod
periodof
oftime
time
AAcall
calloption
optionisisan
anoption
optionthat
thatgives
givesthe
thepurchaser
purchaserthe
the
right,
right,but
butnot
notthe
theobligation,
obligation,to
tobuy
buythe
theunderlying
underlying
security
securityfrom
fromthe
thewriter
writerof
ofthe
theoption
optionatataaspecified
specified
exercise
exerciseprice
priceon
on(or
(orup
upto)
to)aaspecified
specifieddate
date
AAput
putoption
optionisisan
anoption
optionthat
thatgives
givesthe
thepurchaser
purchaserthe
the
right,
right,but
butnot
notthe
theobligation,
obligation,to
tosell
sellthe
theunderlying
underlyingsecurity
security
to
tothe
thewriter
writerof
ofthe
theoption
optionatataaspecified
specifiedexercise
exerciseprice
priceon
on
(or
(orup
upto)
to)aaspecified
specifieddate
date
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2009, The McGraw-Hill Companies, All Rights

Payoff Functions
Options
for Call Options
Payoff
Payoff
profit
profit

Payoff
Payofffunction
function
for
forbuyer
buyer

CC
00

Stock
StockPrice
Price
atatexpiration
expiration

XX

-C
-C
Payoff
Payoff
loss
loss
McGraw-Hill/Irwin

Payoff
Payofffunction
function
for
forwriter
writer
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2009, The McGraw-Hill Companies, All Rights

Payoff Functions
Options
for Put Options
Payoff
Payoff
profit
profit

Payoff
Payofffunction
function
for
forbuyer
buyer

PP
00

XX

Stock
StockPrice
Price
atatexpiration
expiration

-P
-P
Payoff
Payoff
loss
loss
McGraw-Hill/Irwin

Payoff
Payofffunction
function
for
forwriter
writer
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2009, The McGraw-Hill Companies, All Rights

Options
The
TheBlack-Scholes
Black-Scholesoption
optionpricing
pricingmodel
model(the
(themodel
modelmost
most
commonly
commonlyused
usedto
toprice
priceand
andvalue
valueoptions)
options)isisaafunction
functionof
of

the
thespot
spotprice
priceof
ofthe
theunderlying
underlyingasset
asset
the
theexercise
exerciseprice
priceon
onthe
theoption
option
the
theoptions
optionsexercise
exercisedate
date
the
theprice
pricevolatility
volatilityof
ofthe
theunderlying
underlyingasset
asset
the
therisk-free
risk-freerate
rateof
ofinterest
interest

The
Theintrinsic
intrinsicvalue
valueof
ofan
anoption
optionisisthe
thedifference
differencebetween
betweenan
an
options
optionsexercise
exerciseprice
priceand
andthe
theunderlying
underlyingasset
assetprice
price

the
theintrinsic
intrinsicvalue
valueof
ofaacall
calloption
option==max{S
max{SX,
X,0}
0}
the
theintrinsic
intrinsicvalue
valueof
ofaaput
putoption
option==max{X
max{XS,
S,0}
0}

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Please insert Figure 10-8 here.

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2009, The McGraw-Hill Companies, All Rights

Option Markets
The
TheChicago
ChicagoBoard
Boardof
ofOptions
OptionsExchange
Exchange(CBOE)
(CBOE)
opened
openedin
in1973
1973as
asthe
thefirst
firstexchange
exchangedevoted
devotedsolely
solelyto
tothe
the
trading
tradingof
ofstock
stockoptions
options
Options
Optionson
onfutures
futurescontracts
contractsbegan
begantrading
tradingin
in1982
1982
An
AnAmerican
Americanoption
optioncan
canbe
beexercised
exercisedatatany
anytime
timebefore
before
(and
(andon)
on)the
theexpiration
expirationdate
date
AAEuropean
Europeanoption
optioncan
canbe
beexercised
exercisedonly
onlyon
onthe
the
expiration
expirationdate
date
The
Thetrading
tradingprocess
processfor
foroptions
optionsisissimilar
similarto
tothat
thatfor
for
futures
futurescontracts
contracts
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Options
The
Theunderlying
underlyingasset
asseton
onaastock
stockoption
optionisisthe
thestock
stockof
ofaa
publicly
publiclytraded
tradedcompany
company
The
Theunderlying
underlyingasset
asseton
onaastock
stockindex
indexoption
optionisisthe
thevalue
valueof
ofaa
major
majorstock
stockmarket
marketindex
index(e.g.,
(e.g.,DJIA
DJIAor
orS&P
S&P500)
500)
The
Theunderlying
underlyingasset
asseton
onaafutures
futuresoption
optionisisaafutures
futurescontract
contract
Credit
Creditswaps
swaps

the
thevalue
valueof
ofaacredit
creditspread
spreadcall
calloption
optionincreases
increasesas
asthe
thedefault
default
(risk)
(risk)premium
premiumor
oryield
yieldspread
spreadon
onaaspecified
specifiedbenchmark
benchmarkbond
bondof
of
the
theborrower
borrowerincreases
increasesabove
abovesome
someexercise
exercisespread
spread
aadigital
digitaldefault
defaultoption
optionpays
paysaastated
statedamount
amountininthe
theevent
eventof
ofaa
loan
loandefault
default

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Options
The
The primary
primary regulator
regulator of
of futures
futures markets
markets isis the
the
Commodity
Commodity Futures
FuturesTrading
Trading Commission
Commission
(CFTC)
(CFTC)
The
The Securities
Securities Exchange
Exchange Commission
Commission (SEC)
(SEC) isis
the
the primary
primary regulator
regulator of
ofstock
stock options
options and
and stock
stock
index
index options
options
The
The CFTC
CFTC isis the
the regulator
regulator of
of options
options on
on futures
futures
contracts
contracts
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Swaps
AAswap
swapisisan
anagreement
agreementbetween
betweentwo
twoparties
partiesto
toexchange
exchangeassets
assets
or
oraaseries
seriesof
ofcash
cashflows
flowsfor
foraaspecific
specificperiod
periodof
oftime
timeatataa
specified
specifiedinterval
interval
An
Aninterest
interestrate
rateswap
swapisisan
anexchange
exchangeof
offixed-interest
fixed-interest
payments
paymentsfor
forfloating-interest
floating-interestpayments
paymentsby
bytwo
twocounterparties
counterparties

the
theswap
swapbuyer
buyermakes
makesthe
thefixed-rate
fixed-ratepayments
payments
the
theswap
swapseller
sellermakes
makesthe
thefloating-rate
floating-ratepayments
payments
the
theprincipal
principalamount
amountinvolved
involvedininaaswap
swapisiscalled
calledthe
thenotional
notional
principal
principal

AAcurrency
currencyswap
swapisisaaswap
swapused
usedto
tohedge
hedgeagainst
againstexchange
exchangerate
rate
risk
riskfrom
frommismatched
mismatchedcurrencies
currencieson
onassets
assetsand
andliabilities
liabilities
Credit
Creditswaps
swapsallow
allowfinancial
financialinstitutions
institutionsto
tohedge
hedgecredit
creditrisk
risk
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Swap Markets

Swaps
Swaps are
are not
not standardized
standardized contracts
contracts
Swap
Swap dealers
dealers (usually
(usually financial
financial institutions)
institutions) keep
keep
markets
markets liquid
liquid by
by matching
matching counterparties
counterpartiesor
or by
by
taking
taking positions
positions themselves
themselves
The
The International
International Swaps
Swaps and
and Derivatives
Derivatives
Association
Association (ISDA)
(ISDA) isis aa 815
815 member
member association
association
among
among 56
56 countries
countries that
that sets
sets codes
codes of
ofstandards
standards
for
for swap
swap documentation
documentation
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Caps, Floors, and Collars

Financial
Financial institutions
institutions use
use options
options on
on interest
interest rates
rates
to
to hedge
hedge interest
interest rate
rate risk
risk
aacap
capisisaacall
calloption
optionon
oninterest
interestrates,
rates,often
oftenwith
with
multiple
multipleexercise
exercisedates
dates
aafloor
floorisisaaput
putoption
optionon
oninterest
interestrates,
rates,often
oftenwith
with
multiple
multipleexercise
exercisedates
dates
aacollar
collarisisaaposition
positiontaken
takensimultaneously
simultaneouslyin
inaacap
capand
and
aafloor
floor(usually
(usuallybuying
buyingaacap
capand
andselling
sellingaafloor)
floor)

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International Derivative Markets

The
The U.S.
U.S. dominates
dominates the
the global
global derivative
derivative
securities
securities markets
markets
North
NorthAmerica
Americaaccounted
accountedfor
for$57.94
$57.94trillion
trillionof
ofthe
the
$96.67
$96.67trillion
trillioncontracts
contractsoutstanding
outstandingon
onorganized
organized
exchanges
exchangesin
in2007
2007

The
The euro
euro and
and European
European exchanges
exchanges are
areexpanding
expanding
Europe
Europeaccounted
accountedfor
for$32.28
$32.28trillion
trillionof
ofthe
the$96.67
$96.67
trillion
trillioncontracts
contractsoutstanding
outstandingon
onorganized
organizedexchanges
exchanges
in
in2007
2007
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Black-Sholes Call Option Model

C N (d1 ) S E (e

rT

) N (d 2 )

ln(S / E ) (r 2 / 2)T
d1
T
d 2 d1 T

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