Chapter 9

Derivatives: Futures, Options, and Swaps

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 Learning Objectives
1. Explain what derivatives are and how they
transfer risk.
2. Distinguish between forward and futures
contracts.
3. Define put and call options and describe how
to use them.
4. Show how swaps can be used to manage risk
or to conceal it.

© 2021 McGraw-Hill. All Rights Reserved. 9-2

 Introduction
• Although open to abuse, derivatives can be
extremely helpful financial instruments.
• They can reduce risk, allowing firms and
individual to enter into agreements that they
could not have otherwise.
• Derivatives can also be used an insurance
against future events.

© 2021 McGraw-Hill. All Rights Reserved. 9-3

 The Basics: Defining Derivatives
• A derivative is a financial instrument whose value
depends on, is derived from, the value of some
other financial instrument, call the underlying
asset.
– Examples of assets include stocks, bonds, wheat,
snowfall, and stock market indexes like S&P 500.
• For example:
– A contractual agreement between two investors that
obligates one to make a payment to the other,
depending on the movement of interest rates over the
next year.
• An interest-rate futures contract

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The Basics: Defining Derivatives
Derivatives are different from outright
purchases because:
1. Derivatives provide an easy way for
investors to profit from price declines.
2. In a derivatives transaction, one person’s
loss is always another person’s gain.

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The Basics: Defining Derivatives
• While derivatives can be used to speculate, or
gamble on future price movements, they
allow investors to manage and reduce risk.
– Farmers use derivatives regularly to insure
themselves against fluctuations in the price of
their crops.
• The purpose of derivatives is to transfer risk
from one person or firm to another.

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 The Basics: Defining Derivatives
• By shifting risk to those willing and able to
bear it, derivatives increase the risk-carrying
capacity of the economy as a whole.
– This improves the allocation of resources and
increase the level of output.
• The downside is that derivatives also allow
individuals and firms to conceal the true
nature of certain financial transactions.

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 Forward and Futures
• A forward, or forward contract, is an
agreement between a buyer and a seller to
exchange a commodity or financial instrument
for a specified amount of cash on a
prearranged future date.
• Because they are customized, forward
contracts are very difficult to resell.

© 2021 McGraw-Hill. All Rights Reserved. 9-8

 Forward and Futures
• A future, or futures contract, is a forward
contract that has been standardized and sold
through an organized exchange.
– The contract specifies that the seller (short position)
will deliver some quantity of a commodity or
financial instrument to the buyer (long position) on a
specific date, called the settlement or delivery date,
for a predetermined price.

© 2021 McGraw-Hill. All Rights Reserved. 9-9

 Forward and Futures
• No payments are made when the contract is
agreed to.
• The seller/short position benefits from
declines in the price of the underlying asset.
• The buyer/long position benefits from
increases in the price of the underlying asset.

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 Forward and Futures
• For example: a U.S. Treasury bond future
contract trades on the Chicago Board of Trade.
– The contract specifies the delivery of $100,000
face value worth of 10-year, 6% coupon U.S.
Treasury bonds at any time during a given month,
called the delivery month.
• Table 9.1 show the prices and trading activity
for this contract on March 15, 2019.

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 9-12
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 Forward and Futures
• The two parties to a futures contract each make
an agreement with a clearing corporation.
• The clearing corporation operates like a large
insurance company and is the counter party to
both sides of the transaction.
– They guarantee that the parties will meet their
obligations.
• This lowers the risk buyers and sellers face.
• The clearing corporation has the ability to
monitor traders and the incentive to limit their
risk taking.
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Margin Accounts and Marking to
Market
• The clearing corporation requires both parties
to a futures contract to place a deposit with
the corporation.
– This is called posting margin in a margin account.
– This guarantees when the contract comes due, the
parties will be able to meet their obligations.

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Margin Accounts and Marking to
Market
• The clearing corporation posts daily gains and losses
on the contract to the margin account of the parties
involved.
– This is called marking to market.
• Doing this each day ensures that sellers always have
the resources to make delivery and buyers can always
pay.
• If someone’s margin account falls below the minimum,
the clearing corporation will sell the contracts, ending
the person’s participation in the market.

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Hedging and Speculating with Futures
• Futures contracts allow the transfer of risk
between buyer and seller through hedging or
speculation.
– For example of the sale of a U.S. Treasury bond
future contract, the seller/short position benefits
from the price declines.
• The seller of the futures contract can guarantee the
price at which the bonds are sold.
– The purchaser wishes to insure against possible
price increases.

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 Hedging and Speculating with
Futures
• Buying a futures contract fixes the price that the
fund will need to pay.
– In this example, both sides use the futures contract
as a hedge - they are both hedgers.
• Producers and users of commodities employ
futures markets to hedge their risks as well:
farmers, mining companies, oil drillers, etc.
– They own the commodity outright, so they want to
stabilize revenue streams.
– Those buying want to reduce risk of fluctuations in
input costs.

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 Hedging and Speculating with
Futures
• Speculators are trying to make a profit.
– They bet on price movements.
• Sellers of futures are betting that prices will fall.
• Buyers of futures are betting that prices will risk.
• Futures contracts are popular tools for
speculation because they are cheap.
• An investor needs only a small amount to invest
- the margin - to purchase the future contract.
– Margin requirements of 10% or less are common.

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 Hedging and Speculating with
Futures
• For our example of U.S. Treasury bonds futures
contracts, The Chicago Board of Trade requires
an initial margin of only $1,050 per contract.
– This investment gives the investor the same returns
as the purchase of $100,000 worth of bonds.
– It is as if the investor borrowed the remaining
$98,950 without having to pay any interest.
• Speculators can use futures to obtain very large
amounts of leverage at a very low cost.

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• We can make markets more robust by shifting
trading from over-the-counter (OTC) markets
to transactions with a centralized
counterparty (CCP).
• When trading OTC with many partners, a firm
can build up excessively large positions
without other parties being aware of the risk.
• A CCP has the ability, as well as the incentive,
to monitor the riskiness of its counterparties.
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• Standardization of contracts also facilitates CPP
monitoring.
• A CCP can refuse to trade with a risky client or
insist on a risk premium.
• A CCP also limits its own risk through
economies of scale.
– Most trades are offset against one another.
• CCPs have helped markets function well even
when traders cannot pay.

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Arbitrage and the Determinants of
Futures Prices
• On the settlement or delivery date, the price of the
futures contract must equal the price of the
underlying asset the seller is obligated to deliver.
– If not, then it would be possible to make a risk-free
profit by engaging in offsetting cash and futures
transactions.
• The practice of simultaneously buying and selling
financial instruments in order to benefit from
temporary price differences is called arbitrage the
people who engage in it are called arbitrageurs.
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 Arbitrage and the Determinants
of Futures Prices
• If the price of a specific bond is higher in one
market than in another:
– The arbitrageur can buy at the low price and sell at the
high price.
– This increases demand in one market and supply in
another.
– The increase in demand raises price in that market.
– The increase in supply lowers price in the other market.
– This continues until the prices are equal in both
markets.

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Arbitrage and the Determinants of Futures
Prices
• As long as there are arbitrageurs, on the day when a
futures contract is settled, the price of a bond futures
contract will be the same as the market price - or spot
price - of the bond.
• How is this done?
– The arbitrageur borrows at the current market interest rate.
– These funds are used to buy a bond and sell a bond futures
contract.
– The interest owed on the loan and received from the bond
cancel out.
– The futures price must move in lockstep with the market price
of the bond.
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Arbitrage and the Determinants of
Futures Prices

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 Calls, Puts, and All That:
Definitions
• Options are agreements between two parties.
– The seller is an option writer.
– A buyer is an option holder.
• A call option is the right to buy, “call away”, a given
quantity of an underlying asset at a predetermined
price, called the strike price (or exercise price), on or
before a specific date.
– A July 2019 call option on 100 shares of Apple stock at a
strike price of 100 gives the option holder the right to
buy 100 shares of Apple for $100 each prior to the 3rd
Friday of July 2019.
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Calls, Puts, and All That: Definitions
• The writer of the call option must sell the
share if and when the holder choose to use the
call option.
• The holder of the call is not required to buy the
shares - they have the option if it is beneficial.
– When the Apple stock price exceeds the option
strike price of 100, the option holder can either call
away the 100 shares by exercising the option or sell
the option at a profit.

© 2021 McGraw-Hill. All Rights Reserved. 9-27

 Calls, Puts, and All That:
Definitions
• When the price of the stock is above the strike
price of the call option, exercising the option is
profitable and the option is said to be in the
money.
• If the price of the stock exactly equals the
strike price, the option is said to be at the
money.
• If the strike price exceeds the market price of
the stock, it is termed out of the money.

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 Calls, Puts, and All That: Definitions
• A put option gives the holder the right but not the
obligation to sell the underlying asset at a
predetermined price on or before a fixed date
• The writer of the option is obliged to buy the shares
should the holder choose to exercise the option.
• The same terminology that is used to describe calls,
is also used to describe puts:
– In the money - profitable
– At the money - same price
– Out of the money - not profitable

© 2021 McGraw-Hill. All Rights Reserved. 9-29

Calls, Puts, and All That: Definitions
• Although options can be customized, most
are standardized and traded on exchanges.
• A clearing corporation guarantees the
obligations embodied in the option -- those
of the option writer.
– The options writer is required to post margin.
– The option holder incurs no obligation, so no
margin is needed.

© 2021 McGraw-Hill. All Rights Reserved. 9-30

 Calls, Puts, and All That:
Definitions
• There are two types of calls and puts:
• American options can be exercised on any
date from the time they are written to the
expiration date.
• European options can be exercised only on the
day they expire.

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 Using Options
• Options transfer risk from the buyer to the
seller, so can be used for both hedging and
speculation.
• For someone who wants to purchase an asset
in the future, a call option ensure that the cost
of buying the asset will not rise.
• For someone who plans to sell the asset in the
future, a put option ensures that the price at
which the asset can be sold will not go down.

9-32
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 Using Options
Say you think interest rates are going to fall.
• You can:
– Buy a bond but that’s expensive as you need
money.
– Buy a futures contract taking the long position -
low investment but high risk.
– Buy a call option that pays off only if the interest
rate falls - if you are wrong, only cost is the price
of the option.

© 2021 McGraw-Hill. All Rights Reserved. 9-33

 Using Options
The option writer can take a large loss, so who
does this?
1. Speculators willing to take the risk and bet
that prices will not move against them.
2. Dealers called market makers who engage in
the regular purchase and sale of the
underlying asset.

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 Using Options
• Market makers both
– Own the underlying asset so they can deliver it, and
– Are willing to buy the underlying asset so they have it
read to sell to someone else.
• If you own the underlying asset, writing a call
option that obligates you to sell it at a fixed price is
not that risky.
• Market makers write options to get the fees from
the buyer.

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 Using Options
• Options are very versatile and can be bought
and sold in many combinations.
• Allow investors to get rid of risks they do not
want and keep the ones they do.
• Options allow investors to bet that prices will
be volatile.
• Table 9.3 summarizes options.

© 2021 McGraw-Hill. All Rights Reserved. 9-36

 9-37
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• Corporations work hard to appear profitable.
• Financial statements can be misleading.
• Never trust a statement unless it meets
regulatory standards.
• The more open a company is in its financial
accounting, the more likely that it is honest.
• Diversification reduces risk.

© 2021 McGraw-Hill. All Rights Reserved. 9-38

 Pricing Options: Intrinsic Value
and the Time Value of the Option
An option has two parts:
1. Intrinsic value - the value of the option if it is
exercised immediately, and
2. Time value of the option - the fee paid for the
option's potential benefits.
Option price = Intrinsic value + time value of the option

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 Pricing Options: Intrinsic Value
and the Time Value of the Option
• We can calculate the time value of the option by
calculating the expected present value of the
payoff.
– For a call option, we take the probability of a
favorable outcome (a higher price), times the payoff.
– Increasing the standard deviation of the stock price,
an increase in volatility, increases the option’s time
value.

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 General Considerations
• Calculating the price of an option and how it
might change means developing some rules for
figuring out its intrinsic value and time value.
• The most important thing to remember is that
a buyer is not bound to exercise the option.
• Because the options can either be exercised or
expire worthless, we can conclude that the
intrinsic value depends only on what the
holder receives if the option is exercised.

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 General Considerations
• For an in-the-money call, or the option to buy, the
intrinsic value to the holder is the market price of
the underlying asset minus the strike price.
• If the call is at the money or out of the money, it
has no intrinsic value.
• Similarly, the intrinsic value of a put, or the option
to sell, equals the strike price minus the market
price of the underlying asset, or zero - which ever
is greater.

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 General Considerations
• Prior to expiration, there is always the chance
that the price of the underlying asset will
move making the option valuable.
• The longer the time to expiration, the bigger
the likely payoff when the option does expire
and, thus, the more valuable it is.

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 General Considerations
• The likelihood that an option will pay off
depends on the volatility, or standard
deviation, of the price of the underlying asset.
– The more variability there is in the asset’s price,
the more chance it has to move into the money.
– Therefore the option’s time value increases with
volatility in the price of the underlying asset.
– Increased volatility has no cost to the option
holder - only benefits.

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 General Considerations
• The bigger the risk being insured, the more
valuable the insurance, and the higher the
price investors will pay.
• The circumstances under which the payment is
made have an important impact on the
option’s time value.
• Table 9.4 summarizes the factors affecting the
value of options.

© 2021 McGraw-Hill. All Rights Reserved. 9-45

General Considerations

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• The price of a company’s stock could skyrocket
or the company could go bankrupt.
• Generally employees are not allowed to sell
their stock options for a set period of time and
may need to stay with the firm to exercise them.
• If taking stock options means a lower salary,
then you are paying for them and should think
hard about that offer.
• Investing in the same company that pays your
salary is risky.

© 2021 McGraw-Hill. All Rights Reserved. 9-47

 The Value of Options: Some Examples

Table 9.5 shows the prices of

Apple puts and calls on March
21, 2019, reported on the
Wall Street Journal’s website.
• Panel A shows the prices of
options with different strike
prices but the same
expiration date, June 21,
2019.
• Panel B shows the prices of
options with different
expiration dates but with
the same strike price.

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 The Value of Options: Some
Examples
What can we discover?
• At a given price of the underlying asset and
time to expiration, the higher the strike price
of a call option, the lower its intrinsic value
and the less expensive the option.
• At a given price of the underlying asset and
time to expiration, the higher the strike price
of a put option, the higher the intrinsic value
and the more expensive the option.
© 2021 McGraw-Hill. All Rights Reserved. 9-49
The Value of Options: Some Examples
What can we discover (cont.)?
• The closer the strike price is to the current
price of the underlying asset, the larger the
option's time value.
• Deep in-the-money options have lower time
value.
• The longer the time to expiration at a given
strike price, the higher the option price.

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 Swaps
• Swaps are contracts that allow traders to
transfer risk just like other derivatives.
– Interest-rate swaps which allow one swap party,
for a fee, to alter the stream of payments it
makes or receives.
– Credit-default swaps (CDS) which are a form of
insurance that allow a buyer to own a bond or
mortgage without bearing its full default risk.

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 Understanding Interest-Rate
Swaps
• Interest-rate swaps are agreements between
two counterparties to exchange periodic
interest-rate payments over some future
period, based on an agreed-upon amount of
principal, called the notional principal.
• The term notional is used because the
principal of a swap is not borrowed, lent, or
exchanged.

© 2021 McGraw-Hill. All Rights Reserved. 9-52

 Understanding Interest-Rate
Swaps
• In the simplest type of interest-rate swap, one
party agrees to make payments based on a
fixed interest rate, and in exchange the
counterparty agrees to make payments based
on a floating interest rate.
– This turns fixed rates in to floating rates and vice
versa.

© 2021 McGraw-Hill. All Rights Reserved. 9-53

Understanding Interest-Rate
Swaps

9-54
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• LTCM had engaged in a large number of complex
speculative transactions, including interest rate
swaps and options writing, which all failed
simultaneously.
• Large banks, insurance companies, pension funds,
and mutual-fund companies with whom LTCM did
business were at risk of being bankrupted
themselves.
• The Federal Reserve had no choice but to step in and
ensure that the financial system remained sound.

55
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Pricing and Using Interest Rate Swaps
• Pricing interest-rate swaps means figuring out
the fixed interest rate to be paid.
• Financial firms begin by noting the market
interest rate on a U.S. Treasury bond of the
same maturity as the swap, called a
benchmark.
• The rate to be paid by the fixed-rate payer,
the swap rate, is the benchmark rate plus a
premium.
© 2021 McGraw-Hill. All Rights Reserved. 9-56
Pricing and Using Interest Rate Swaps

• The difference between the benchmark rate

and the swap rate is called the swap spread
and is a measure of risk.
– The swap spread has become a measure of overall
risk in the economy.
– When the swap spread widens, it signals that
general economic conditions are deteriorating.

© 2021 McGraw-Hill. All Rights Reserved. 9-57

Pricing and Using Interest Rate Swaps
• Who uses interest-rate swaps?
– Banks
• Deposits are short-term liabilities
• Loans are long-term assets
• Swaps help control risk
– Government debt managers
• Issue long-term debt relatively cheaply
• Tax revenue matches up better with short-term
interest rate

© 2021 McGraw-Hill. All Rights Reserved. 9-58

Pricing and Using Interest Rate Swaps
• The primary risk in a swap is the risk that one
of the parties will default.
– The risk is not very high because the other side
can enter into another agreement to replace the
one that failed.
• Unlike futures and options, swaps are not
traded on organized exchanges.
– Swaps are very difficult to resell.

© 2021 McGraw-Hill. All Rights Reserved. 9-59

• The VIX (fear index) is a measure of the
uncertainty and risk that investors see over
the future, specifically the next 30 days
– Gauge of implied volatility
• When low, stock market liquidity and valuations are
usually high (confidence)
• When high, stock trading is more difficult and
valuations suffer (cautious about uncertainty)
• Low volatility breeds risk and complacency

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 Credit-Default Swaps
• A credit-default swap (CDS) is a credit derivative that
allows lenders to insure themselves against the risk that
a borrower will default.
• The buyer of a CDS makes payments, like insurance
premiums, to the seller, and the seller agrees to pay the
buyer if an underlying loan or security defaults.
• The CDS buyer pays a fee to transfer the risk of default,
the credit risk, to the CDS seller.
• A CDS agreement often lasts several years and requires
that collateral be posted to protect against the inability
to pay of either the seller or the buyer of the insurance.

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 Credit-Default Swaps
CDS contributed to the financial crisis in three
important ways:
1. Fostering uncertainty about who bears the
credit risk on a given loan or security,
2. Making the leading CDS sellers mutually
vulnerable, and
3. Making it easier for sellers of insurance to
assume and conceal risk.

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 Credit-Default Swaps
• Because CDS contracts are traded over the
counter (OTC), even traders cannot identify
others who take on concentrated positions on
one side of a trade.
• So long as CDS trading lacks transparency, the
lingering worry is that a failure of one
institution could bring down the financial
system as a whole.

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