Chapter Ten

Derivative
Securities
Markets

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Derivative Securities: Overview

 A derivative security is an agreement between two

parties to exchange a standard quantity of an asset at
a predetermined price at a specified date in the future
 Payoff is linked to another, previously issued security
 As the value of the underlying security to be exchanged
changes, the value of the derivative security changes
 Involves the transference of risk
 Traders can experience large losses if the price of the
underlying asset moves against them significantly
 At the heart of the recent financial crisis were losses
associated with off-balance-sheet derivative securities
created and held by FIs

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Derivative Securities: Overview
(Continued)
 Derivative securities markets are those in which
derivative securities trade
 Growth in derivative securities markets has occurred
mainly since the 1970s
 First of the modern wave of derivatives to trade were foreign
currency futures contracts
 Second wave of derivative security growth was with interest
rate derivative securities
 Third wave of innovations occurred in the 1990s and 2000s
with credit derivatives (e.g., credit forwards, credit risk
options, and credit swaps)
 Rapid growth of derivatives has been controversial
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Spot Markets

 A spot contract is an agreement to transact involving

the immediate exchange of assets and funds
 Unique feature of a spot market is the immediate and
simultaneous exchange of cash for securities, or what is
often called delivery versus payment

 Spot transactions occur because the buyer of the

assets believes its value will increase in the
immediate future (over the investor’s holding period)
 If the value of the asset increases as expected, the investor
can sell the asset at its higher price for a profit

© 2022 McGraw-Hill Education. 10-4

Forward Markets:
Forward Contracts
 A forward contract is an agreement to transact
involving the future exchange of a set amount of
assets at a set price
 Market participants take a position in forward contracts
because the future (spot) price or interest rate on an asset is
uncertain
 Can be based on a specified interest rate (e.g., LIBOR)
rather than a specified asset (called forward rate
agreements)
 Often involve underlying assets that are nonstandardized,
because the terms of the contract are negotiated individually
between the buyer and seller

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Forward Markets

 Commercial banks, investment banks, and broker-

dealers are the major forward market participants,
acting as both principals and agents
 In September 2019, U.S. commercial banks held over $43.1
trillion of forward contracts that were listed in OTC markets
 Each forward contract is originally negotiated between
the FI and the customer
 A risk of default (by either party) exists
 Recently, credit derivative instruments have been developed
to better allow FIs to hedge credit risk
 Advent of secondary market trading has resulted in an
increase in the standardization of forward contracts
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Futures Markets:
Futures Contracts
 A futures contract is an agreement to transact involving
the future exchange of a set amount of assets for a price
that is settled daily
 Traded on an organized exchange
 Very similar to a forward contract
 One difference is that the default risk on futures is significantly
reduce by the futures exchange guaranteeing to indemnity
counterparties against credit or default risk
 Another difference relates to the contract’s price, which in a
future is marked to market daily
 Unless a systematic financial market collapse threatens
an exchange itself, futures are essentially risk-free
© 2022 McGraw-Hill Education. 10-7
Contract Terms for 10-Year
Treasury Note Futures

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Futures Markets

 Futures trading occurs on organized exchanges

 Chicago Board of Trade (CBOT) and the New York Mercantile
Exchange (NYMEX), both of which are part of the CME Group
 Financial futures market trading was introduced in 1972
 Most trading takes place in trading “pits” using an open-
outcry auction method among exchange members
 Floor brokers place trades from the public, while professional
traders trade for their own account
 Position traders take a position based on their expectations
about the future direction of the prices of the underlying assets
 Day traders generally take a position within a day and liquidate
it before day’s end, while scalpers take positions for very short
periods of time (e.g., minutes)
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Futures Markets (Continued)

 Futures trades may be placed as market or limit orders

 Order may be for long position (the purchase of a futures
contract) or short position (the sale of a futures contract)
 Clearinghouse is the unit that oversees trading on the
exchange and guarantees all trades made by the
exchange traders
 Holder of a futures contract has two choices for
liquidating his or her position:
1. Liquidate position before the futures contract expires
2. Hold the futures contract to expiration
 Traders in futures (as well as option) markets can be
either speculators, hedgers, or arbitrageurs
© 2022 McGraw-Hill Education. 10-10
Clearinghouse Function in Futures
Markets

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Profit and Loss on a Futures
Transaction: Example
 Table 10-4 (below) shows a June 2020 T-bond futures contract
could be bought (long) or sold (short) on March 13, 2020, for
176’15 (or 176.469% of the face value of the T-bond)

 Minimum contract size is $100,000, so a position in one contract

can be taken at a price of $176,469
 If the T-bond futures price falls to 175.87% of the face value
between March 13, 2020 and the June expiration, the long
position incurs a loss of $599 [(176.469% - 175.870%) x
100,000], while the short position incurs a gain of $599
© 2022 McGraw-Hill Education. 10-12
Margin Requirements on Futures
Contracts
 Brokerage firms require customers to post only a portion
of the value of the futures (and options) contracts, called
an initial margin, any time they request a trade
 Amount of the margin varies according to type of contract traded
and quantity of futures contracts traded
 If losses on the customer’s futures position occur and the level
of the funds in the margin account drops below a stated level
(i.e., maintenance margin), the customer receives a margin call

 Futures are leveraged instruments, meaning traders

post and maintain only a small portion of the value of
their futures position in their accounts
© 2022 McGraw-Hill Education. 10-13
Impact of Marking to Market and Margin
Requirements on Futures Investments

© 2022 McGraw-Hill Education. 10-14

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
 Call option gives the purchaser (or buyer) the right to buy an
underlying security (e.g., a stock) at a prespecified price
called the exercise or strike price (X)
 In return, buyer of call option must pay the writer (or seller) an
up-front fee known as a call premium (C)
 Put option gives the option buyer the right to sell an
underlying security (e.g., a stock) at a prespecified price to
the writer of the put option
 In return, the buyer of the put option must pay the writer (or
seller) the put premium (P)
© 2022 McGraw-Hill Education. 10-15
Buying a Call Option

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Writing a Call Option

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Buying a Put Option

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Writing a Put Option

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Option Values

 Model most commonly used to price and value options is

the Black-Scholes pricing model
 Black-Scholes model examines five factors that affect
the price of an option:
1. The spot price of the underlying asset
2. The exercise price on the option
3. The option’s exercise date
4. Price volatility of the underlying asset
5. The risk-free rate of interest
 Time value of an option is the difference between an
option’s price (or premium) and its intrinsic value

© 2022 McGraw-Hill Education. 10-20

Option Markets

 The Chicago Board of Options Exchange (CBOE)

opened in 1973
 First exchange devoted solely to the trading of stock
options
 In 1982, financial futures options contracts started trading
 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
© 2022 McGraw-Hill Education. 10-21
Characteristics of Actively Traded Options

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 Options Concluded

 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
 Two alternative credit option derivatives exist to hedge credit
risk on a balance sheet:
1. A credit spread call option’s payoff increases as the (default)
risk premium or yield spread on a specified benchmark bond
of the borrower increases above some exercise spread
2. A digital default option pays a stated amount in the event of a
loan default
© 2022 McGraw-Hill Education. 10-23
 Regulation of Futures and Options
Markets
 Derivative securities are subject to thee levels of
institutional regulation
1. Regulators of derivatives specify “permissible activities” that
institutions may engage in
2. Once permissible activities have been specified, institutions
engaging in those activities are subjected to supervisory
oversight
3. Regulators attempt to judge the overall integrity of each
institution engaging in derivative activities by assessing the
capital adequacy of the institutions and by enforcing regulations
to ensure compliance with those capital requirements

© 2022 McGraw-Hill Education. 10-24

 Swaps

 A swap is an agreement between two parties to exchange a

series of cash flows for a specific period of time at a
specified interval
 First developed in 1981 when IBM and the World Bank entered
into a currency swap agreement
 An interest rate swap is an exchange of fixed-interest
payments for floating-interest payments by two
counterparties
 Allows the swap parties to put in place long-term protection
against interest rate risk
 The swap buyer makes the fixed-rate payments in an interest
rate swap transaction
 The swap seller makes the floating-rate payments in an
interest rate swap transaction
© 2022 McGraw-Hill Education. 10-25
Swaps (Continued)

 A currency swap is a swap used to hedge against

exchange rate risk from mismatched currencies on
assets and liabilities
 Credit swaps (i.e., credit default swaps) were
developed to better allow FIs to hedge their credit risk
 Total return swap involves swapping an obligation to pay
interest at a specified fixed or floating rate for payments
representing the total return on a loan of a specified
amount
 Pure credit swaps remove the “interest rate”-sensitive
element of total return swaps, and are similar to buying
credit insurance and/or a multi-period credit option

© 2022 McGraw-Hill Education. 10-26

Swap Markets

 Swaps are not standardized contracts

 Generally heterogeneous in terms of maturities, indexes
used to determine payments, and timing of payments
 Swap dealers (usually FIs) keep markets liquid by
matching counterparties or by taking positions
themselves
 Unlike futures and options markets, swap markets
were historically governed by very little regulation
 Because of the role credit swaps played in the financial
crisis, the call for stricter regulation over these securities
was strong in late 2008 and early 2009

© 2022 McGraw-Hill Education. 10-27

Caps, Floors, and Collars

 Caps, floors, and collars are derivative securities that

have many uses, especially in helping an FI to hedge
interest rate risk
 A cap is a call option on interest rates, often with
multiple exercise dates
 Equivalent to buying a call option on interest rates
 A floor is a put option on interest rates, often with
multiple exercise dates
 Similar to buying a put option on interest rates
 A collar is a position taken simultaneously in a cap
and a floor (e.g., buying a cap and selling a floor)
© 2022 McGraw-Hill Education. 10-28
 Hypothetical Path of Interest Rates

Cap Agreement

Floor Agreement

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International Aspects of Derivative
Securities Markets
 Between 1999 – 2018, global OTC trading far
outweighed exchange trading
 In both markets, interest rate contracts dominated
 Markets were heavily impacted as a result of the
financial crisis of 2008
 U.S. markets and currencies dominate global
derivative securities markets
 The euro and European derivative securities markets are
a strong second (and, in some areas, exceed that of the
U.S.)

© 2022 McGraw-Hill Education. 10-30

The Keller Fund

 Compute net profits and losses per share (actual dollar profits and losses, not rates of
return) at expiration (February 19, 1994) for the following investment strategies:
• Buying a call option on Lotus's stock;
• Writing a call option on Lotus's common stock;
• Buying a put option on Lotus's common stock;
• Writing a put option on Lotus's common stock.
Hint: Start by calculating the profit or loss per share assuming that, by
February 19, 1994, Lotus's common stock is selling at, say, $60 per share.
Repeat this calculation for several other possible stock prices at the time of
expiration that span a wide range above, below and at the exercise price of
$55 per share (e.g., $45, $50, $55, $65, and so on).

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The Keller Fund

 For each of the option investment strategies listed above, draw a graph relating
possible profits and losses per share to Lotus's stock price at the time of expiration.
Put profits and losses per share on the vertical axis of your graph and stock prices on
the horizontal axis.
 
 Compute profits and losses per share, and graph them against stock prices for the
strategy of buying a share of Lotus's common stock at $55 per share and holding it
until February 19, 1994.

© 2022 McGraw-Hill Education. 10-32