Financial Derivatives

Chapter Objectives

■ provide a background on financial forward and futures

contracts, options
■ explain how futures contracts are used to speculate or
hedge based on anticipated bond price movements

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Opening case: Commodity Price Risk
•  Many furniture manufacturers must buy wood, for example, so higher wood
prices increase the cost of making furniture and negatively impact furniture
makers' profit margins.
• Lower commodity prices are a risk for commodity producers. If crop prices
are high this year, a farmer may plant more of that crop on less productive
land. If prices fall next year, the farmer may lose money on the additional
harvest planted on less fertile soil.
• Automobile manufacturers face commodity price risk because they use
commodities like steel and rubber to produce cars.
• Oil-producing companies face the risk that commodity prices will fall
unexpectedly, which can lead to lower profits or even losses for producers.
Derivatives
• Definition: a type of financial contract whose value is dependent on
an underlying asset, group of assets, or benchmark.
• Prices for derivatives derive from fluctuations in the underlying
asset.
• The most common underlying assets for derivatives are stocks,
bonds, commodities, currencies, interest rates, and market indexes.
Contract values depend on changes in the prices of the underlying
asset.
• Common derivatives include futures contracts, forwards, options,
and swaps.
Hedging
• to engage in a financial transaction that reduces or eliminates risk.
• Long position/ Short position
• Hedging risk involves engaging in a financial transaction that offsets a
long position by taking an additional short position, or offsets a short
position by taking an additional long position.
Example

■ an agreement that the First National Bank will sell to the Rock
Solid Insurance Company, one year from today, $5 million
face value of the 6s of 2035 Treasury bonds (that is, coupon
bonds with a 6% coupon rate that mature in 2035) at a price
that yields the same interest rate on these bonds as today’s rate
— 6%.
■ Because Rock Solid will buy the securities at a future date, it is
said to have taken a long position
■ The First National Bank, which will sell the securities on that
date, has taken a short position.

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Interest-Rate Forward Contracts

■ A forward contract is an agreement between two parties to engage in a

financial transaction at a future (forward) point in time.
■ forward contracts that are linked to debt instruments, called interest-rate
forward contracts

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■ Interest-rate forward contracts involve the future sale (or purchase) of a
debt instrument and have several dimensions:
■ (1) specification of the actual debt instrument that will be delivered at a future
date,
■ (2) the amount of the debt instrument to be delivered,
■ (3) the price (or interest rate) to be paid on the debt instrument when it is
delivered, and
■ (4) the date on which delivery will take place.

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Exhibit 13.5 Potential Payoffs from Speculating in Financial Futures

Long position Short position

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Interest-Rate Forward Markets
Hedges by reducing price risk from change in interest rates if
holding bonds
Pros
1. Flexible
Cons
1. Lack of liquidity: hard to find counterparty
2. Subject to default risk: Requires info to screen good
from
bad risk
Example

■ an agreement that the First National Bank will sell to the Rock
Solid Insurance Company, one year from today, $5 million
face value of the 6s of 2035 Treasury bonds (that is, coupon
bonds with a 6% coupon rate that mature in 2035) at a price
that yields the same interest rate on these bonds as today’s rate
— 6%.
■ Because Rock Solid will buy the securities at a future date, it is
said to have taken a long position
■ The First National Bank, which will sell the securities on that
date, has taken a short position.

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Background on Financial Futures

 A financial futures contract is a standardized agreement to

deliver or receive a specified amount of a specified financial
instrument at a specified price and date.
 Financial futures contracts are traded on organized exchanges,
which establish and enforce rules for such trading.
 The operations of financial futures exchanges are regulated by
the Commodity Futures Trading Commission (CFTC).

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Background on Financial Futures

Purpose of Trading Financial Futures

■ Financial futures are traded to speculate on prices of securities or to hedge existing
exposure.
■ Speculators in financial futures markets take positions to profit from expected changes
in the futures prices.
■ Day traders attempt to capitalize on price movements during a single day.
■ Position traders maintain their futures positions for longer periods of time.
■ Hedgers take positions in financial futures to reduce their exposure to future
movements in interest rates or stock prices.

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Example of future contract

■ On Feb. 1, sell one $100.000 June contract at 115

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Exhibit 13.5 Potential Payoffs from Speculating in Financial Futures

Long position Short position

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Why do I need a future contract?

■ Suppose that your company expects to receive 1 million USD income in

one year from operations and you do not have plan to use it and you also
expect that interest rate will be lower next year. How to protect your
expected interest from this money NOW?

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 ■ Buy one year from today, $1 million face value of the 6s of 2035
Treasury bonds (that is, coupon bonds with a 6% coupon rate that mature
in 2035) at a price that yields the same interest rate on these bonds as
today’s rate—say, 6%.

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Application Hedging with financial futures

■ In march 2016, Holding of 5 million 6s of 2035

■ Number of contracts to sell: 50
■

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Background on Options

Call Option: right to buy underlying financial instrument at exercise price (or strike
price) within a specified period of time.
■ In the money when market price > exercise price
■ At the money when market price = exercise price
■ Out of the money when market price < exercise price
Put Option: right to sell underlying financial instrument at exercise price (or strike price)
within a specified period of time.
■ In the money when market price < exercise price
■ At the money when market price = exercise price
■ Out of the money when market price > exercise price

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 ■ American options can be exercised at any time up to the expiration date
of the contract
■ European options can be exercised only on the expiration date.
■ Option contracts are written on a number of financial instruments.
■ Options on individual stocks are called stock options
■ Option contracts on financial futures, called financial futures options or,
more commonly, futures options,

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Background on Options

Comparison of Options and Futures

■ To obtain an option, a premium must be paid in addition to the
price of the financial instrument.
■ The owner of an option can choose to let the option expire on
the expiration date without exercising it.
Institutional Use of Options
■ Although options positions are sometimes taken by financial
institutions for speculative purposes, they are more commonly
used for hedging.

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Background on Options

Markets Used to Trade Options

The Chicago Board Options Exchange (CBOE), created in 1973, is the most important
exchange for trading options.
Options are also traded at the CME Group.
As the popularity of stock options increased, various stock exchanges began to list
options.
■ Listing Requirements - One key requirement is a minimum trading volume of the
underlying stock.
■ Role of the Options Clearing Corporation - serves as a guarantor on option contracts
traded in the United States.
■ Regulation of Options Trading – SEC and others.

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Profits and Losses: Options vs. Futures
$100,000 T-bond contract,
1. Exercise price of 115,
$115,000.
2. Premium = $2,000