CHAPTER FIFTEEN

THE ROLE OFDERIVATIVE ASSETS

© 2001 South-Western College Publishing

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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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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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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.

The Options Market : The Financial Page ListingMicrosoft Option Prices, November 16, 1999

Microsoft Stock Price = 87 5/16

StrikingPrice

Expiration Volume LastPrice

OpenInterest

7070707075757575

77 8080

1380548

8158429248740512

9857224169144

12724

NovDecJanAprNovDecJanAprJanNovDec

100…6…

20627

103221

1325248

17 …

17 …

12 12

14 17

11 7 9

CallsVolume Last

PriceOpen

Interest

267488408

78678485962098812464

111656116045173656556

…3

20310…

29974

1361221

1121

…

2 …

1 3 2

Puts

21

85

87

21

43

85

85

81

83

1613

83

1611

21

83

81

161

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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

OCC

Buyer SellerTrading Floor

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

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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.

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.

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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.

The Futures Market

A futures contract is a promise.

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The Futures Market

Futures vs. options : Futures contracts donot expire unexercised.

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

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, eggs.Metals and petroleum e.g. platinum,

copper, natural gas, crude oil. Financial e.g. foreign currency, stock

index, interest rate.

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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 : 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

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

invoiceprice

settlementprice

conversion factor

accruedinterest= [ x ] +

Bonds are standardized as follows:

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 : 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

Derivatives are neutral products. Their riskdepends on what an investor does with them.

Exchange-traded derivative assets and over-the-counter derivatives are markedly different.

Newspapers in recent months havebeen full of reports on various businesses that have lost billions “investing in derivatives.”

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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

24

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