chapter 9 derivative securities and derivative...

186

Derivative Securities andDerivative Markets

CHAPTER

9Many commentators called it the year of the derivative. The period from spring 1994through spring 1995 brought exotic financial instruments called derivatives to the frontpage of newspapers and to television screens all over the world. There were casualties:A prosperous California county sought bankruptcy protection. A distinguished Britishinvestment firm older than the United States of America failed. The chairman of theAmerican Stock Exchange termed derivatives “the 11-letter four-letter-word.” At thesame time, many economists and market participants praised derivatives as financialinstruments that allow investors to manage and transfer risk. What should an investorbelieve? Do derivatives offer investors a way to gamble with their funds, or can deriv-atives be used to reduce risk? As you learn more about derivative securities in this chap-ter, you will see that derivative markets offer investors risk-sharing, liquidity, andinformation services.

The derivative securities that we describe in this chapter—futures contracts andoptions contracts—derive their value from an underlying asset. These assets may becommodities, such as pork bellies or oil, or financial assets, such as stocks or bonds.To understand why investors include derivatives among their investments, we describethe situations in which derivatives benefit the parties in a transaction, the obligationsand benefits of each type of derivative, and the strategies investors use in buying andselling derivatives. One reason for the popularity of futures and options is the existenceof organized exchanges where they can be traded. These derivative markets generateliquidity and information and provide common arrangements for clearing and settlingtransactions. The appendix to the chapter describes the use of a third type of deriva-tive: swaps.

Forward Transactions and DerivativesThe financial markets described in earlier chapters matched borrowers and lendersthrough the trading of such financial instruments as stocks and bonds. An increasingamount of activity takes place in markets where the actual instruments for borrowingand lending are not traded. Rather, trading occurs in derivative markets, in which par-ticipants buy and sell securities that derive their economic value from underlying assets.Such assets, principally futures and options contracts, are called derivative instruments.Derivative securities offer benefits to borrowers, lenders, and traders that are not avail-able in other types of securities.

Many lenders and borrowers want to lock in the rate of return or the interest costson funds borrowed rather than risk the fluctuations that might occur over time. Thatis, they want to negotiate today their returns or their costs on trades to be executed inthe future. For example, the financial manager of a corporation would like to know inadvance how much the interest costs will be on funds needed to finance future capitalprojects.

In contrast to spot transactions, in which settlement is immediate, forward trans-actions give savers and borrowers the ability to conduct a transaction now and settleit in the future. Historically, forward transactions took place in agricultural and othercommodity markets to reduce price fluctuation problems. Such fluctuations imposedsignificant risks on sellers, for whom the revenue from the sale of the commodity wastheir sole source of income.

Consider the situation facing a wheat farmer who planted wheat in the spring butreceived no payment for the crop until it was harvested. The farmer expected to receive$10,000 for the crop. But suppose that between planting time and harvest time, the priceof wheat dropped to $7500 for the crop; the farmer would lose $2500 of the expectedreturn. Similarly, suppose a miller needed wheat to grind into flour. If the price of wheatfluctuates, the miller faces uncertain input prices. Therefore the miller might agree topay, at planting time, $10,000 for the farmer’s wheat at harvest time. By engaging in aforward transaction, the farmer reduces the risk of a loss and the miller reduces the riskof a price fluctuation. In general, by agreeing on the price in advance, buyers and sellersuse forward transactions to reduce risks associated with price fluctuations. But whathappens if prices change between the time of the agreement and the time of settlement?Fluctuations in prices over the life of the forward transaction confer capital gains andlosses on the contracting parties, much as movements in market interest rates affect thevalues of lenders’ assets and borrowers’ obligations over time.

Although forward transactions provide risk sharing, they have liquidity and infor-mation problems. Because forward contracts generally contain terms specific to theparticular buyer and seller in the exchange, convincing other traders to take over thecontract and accept the same terms may be difficult. Therefore the contracts are likelyto be illiquid. In addition, forward contracts are subject to default risk, or the possi-bility that the buyer or seller may be unable or unwilling to fulfill the contractual obli-gation. As a result, buyers and sellers of the contract will incur information costs whenanalyzing the creditworthiness of potential trading partners. Derivative marketsevolved to reduce both liquidity and information problems. To show how they do so,we first trace the development of two categories of derivative market instruments:futures and options.

FuturesFutures contracts evolved in markets for agricultural and mineral commodities to main-tain the risk-sharing features of forward transactions while increasing liquidity and low-ering information costs. A futures contract is an agreement that specifies the delivery ofa commodity or financial instrument at an agreed-upon future date at a currently agreed-upon price. Most futures traded today are financial futures rather than commodityfutures. That is, the underlying asset is not a crop or mineral, but a financial asset. Youmight, for example, buy a futures contract requiring you to buy a Treasury bill six monthsfrom now at a price you agree to today. Trading of futures contracts on agricultural andmineral commodities declined from 70% of total futures transactions in 1981 to less thanone-third in the new century. Therefore we use financial futures as examples in thisdescription of futures contracts and their use in risk sharing.

Futures contracts specify the rights and obligations of the buyer and seller withregard to the underlying asset. Buyers and sellers of futures contracts have symmetricrights. The buyer of a futures contract assumes the long position, or the right and obli-gation to receive the underlying financial instrument (say, Treasury bonds) at the specified

CHAPTER 9 Derivative Securities and Derivative Markets 187

future date. The seller assumes the short position, or the right and obligation to deliverthe instrument at that time.

The principal financial futures contracts traded in the United States include those forinterest rates (Eurodollars; Treasury bills, notes, and bonds; and the municipal bondindex), stock indexes (S&P 500, NYSE Composite, and Value Line indexes), and curren-cies (such as U.S. dollars, Japanese yen, euros, British pounds, and Australian dollars).

Futures trading traditionally has been dominated by markets in Chicago (theChicago Board of Trade and the Chicago Mercantile Exchange), although markets inNew York, London, Paris, Tokyo, Sydney, and Singapore have become strong com-petitors. Significant computer and telecommunications improvements have strength-ened trading links among exchanges.

Financial futures contracts are regulated by exchange rules approved by the Com-modity Futures Trading Commission (CFTC). The CFTC monitors potential pricemanipulation and conduct of exchanges. Since 1981, the National Futures Associationhas complemented the CFTC’s efforts as a self-regulatory organization.

Futures Pricing

Unlike other obligations such as the amount of the commodity or financial asset andtime horizon of the contract or delivery location, the futures price is not specified in thefutures contract. Instead it is set by the futures market and reflects traders’ expectationsof the spot price, or the price of the underlying asset on the date of delivery. The spotprice and the futures price are determined by supply and demand. If market partici-pants expect bumper crops in the next harvest, they probably believe that agriculturalcommodity prices will fall. In this case, the futures price may be below the current spotprice. As the time to deliver approaches, the futures price comes closer to the spot price,eventually equaling the spot price on the date of delivery. Why? At the date of delivery,no investor or trader is willing to pay more or less for the underlying asset than its cur-rent market value, which is the spot price.

Suppose that you buy in March a $1 million futures contract in three-month U.S.Treasury bills (T-bills) to be delivered in June. T-bills are discount obligations. Hencethe futures price, say $980,000, which represents the futures price you pay today forT-bills to be delivered in June, is less than the face amount of the T-bills.

The futures price of $980,000 implies an expected future three-month interest rateof just over 2%, or an annualized rate of 8.42%. If the current annual interest rate onT-bills is 10.4%, the current spot price of $1 million in T-bills (that is, for immediatedelivery) will be $975,610. Of course, you don’t know what the actual spot price of thethree-month T-bills will be in June; it will depend on the market interest rate at thattime. If that interest rate turns out to be 10.4% as well, you will have lost money onyour long position and the seller will have gained on his or her short position.

In the futures market on any particular day, either the buyer or the seller may gainwith respect to his or her initial position. Because buyer and seller trade with each otheranonymously through an exchange, the exchange requires collateral from traders bymandating that gains and losses be settled each day.✝ This daily settlement of positions iscalled marking to market the accounts of the buyer and seller, whose account values areset at that day’s market value. If the price of your $1 million, three-month T-bill contractrises from $975,610 to $985,610, the value of your long position has increased by

188 PART 3 Financial Markets

Web Site Suggestions:http://www.cbot.comhttp://www.liffe.comOffer informationabout futures marketsin the United Statesand elsewhere.

✝ In a forward contract, movements in current and expected future prices do not require transfers among buy-ers and sellers. The transaction is settled at the agreed-upon date at the agreed-upon price.

web_links188.html

$10,000, and the holder of the short position correspondingly loses. In this case, theexchange would collect $10,000 from the holder of the short position and transfer it toyour account. Ultimately, the contract is settled in cash. (Even in the case of commodities,actual delivery rarely takes place and contracts are settled in cash.)

Using Futures to Manage Risks

Futures contracts offer risk-sharing and profit opportunities to participants in futures mar-kets. By gaining the right to buy or sell an asset (say, a Treasury bond) at a known price,buyers or sellers can reduce their exposure to risk. The practice of using futures to reducerisk is called hedging. In contrast to hedgers, other futures traders may be speculators.They seek profits by anticipating price movements. Speculators play an important role infutures markets: By betting on anticipated price movements, they assume the other side ofhedgers’ positions and provide liquidity in markets for hedgers.

Hedgers taking either long or short positions in financial futures include lenders,borrowers, suppliers, or customers concerned about the risk of fluctuations in interestrates and firms and financial services companies exposed to fluctuations in the value offoreign currencies. Hedgers can benefit by participating in financial futures markets inthree key ways. First, they can spread the risk of price fluctuations by locking in afuture price today. Second, they can access liquid markets. Third, their information


U S I N G T H E N E W S . . .

Reading Financial Futures ListingsThe Wall Street Journal reports infor-mation on futures contracts each busi-ness day. An example of interest ratefutures on U.S. Treasury securitiesappears here. The uppermost set ofquotations refers to Treasury bondfutures traded on the Chicago Board ofTrade (CBT). The heading shows thatthe size of a contract is $100,000; indi-vidual quotations represent percent-ages of $100 of face value. Fractionalvalues are reported in thirty-seconds ofa percent.

The leftmost column states the contractmonth for delivery (from September toDecember 2003). The next fourcolumns present price information fromthe previous trading day: the opening(Open) price, the high and low for theday, and the closing (Settle) price. TheChg column reports the change in theprice of the futures contract from theprevious day’s closing price. The Sep-tember 2003 contract closed at 1074/32, down from the previous day. Theprice calculations are based on an 8%

coupon, 15-year Treasury bond. Notethat the price of the September 2003contract, 107 2/32, is higher than theface value of 100. Therefore the yieldto maturity is less than the coupon rateof 8%. The next two columns tell youlifetime high and low prices for the con-tract. The last column, Open Interest,reports the volume of contracts out-standing: 516,720 for the September2003 contract.

You can get free information fromthese quotes. The interest rate futurescontracts tell you market participants’expectations of future interest rates.

Note that futures prices are lower forDecember 2003 than for September2003, telling you that futures marketinvestors expected long-term Treasuryinterest rates to rise.

Although not shown, you can also findinterest rate futures quotations forTreasury notes and bills and foreigncurrencies. The financial futures pagealso gives you quotes on stock indexfutures, such as contracts on Stan-dard & Poor’s 500 stocks (known asthe S&P 500). Investors use stockindex futures to anticipate broadstock market movements.

Est vol 383,338; vol Mon 257,569; open int 555,426, +8.

Treasury Bonds (CBT)-$100,000; Pts. 32nds Of 100%

Closing price.OPEN HIGH LOW SETTLE CHG HIGH LOW

LIFETIMEINTEREST

OPEN

Source: The Wall Street Journal, July 30, 2003. Republished by permission of Dow Jones, Inc. via Copyright Clearance Center, Inc. © 2000 Dow Jones and Company, Inc. All Rights Reserved Worldwide. (Quotes are for July 30, 2003.)

Interest Rate Futures

SeptDec

108-05106-19

109-05107-21

106-51105-05

107-02105-19

–40–41

123-03121-18

106-02105-05

516,72038,519


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costs are reduced by the introduction of organized exchanges. At the same time, deriv-ative markets offer buyers and sellers opportunities to profit from disagreementsamong traders about future prices of a commodity or financial instrument by specula-tion or from anticipating changes in prices.

Fluctuations in market interest rates can change the value of fixed-rate financialinstruments that have long maturities. As interest rates became more volatile in the 1980s,savers and borrowers seeking to hedge their investments dramatically expanded deriva-tive markets. That growth has continued unabated in the 1990s and the new century.

How does hedging actually work? Suppose that Bigtime Financial Services wants toextend a $10 million, two-year loan to Smokestack Industries. After analyzing the com-pany’s creditworthiness, Bigtime charges an interest rate of 10% per year for each of thetwo years. Bigtime can raise funds for the first year at a cost of 8%, but it will have to goto the market to raise the funds for the second year. Borrowing at an interest rate differ-ential of two percentage points offers a comfortable profit margin for the first year. How-ever, Bigtime is worried that market interest rates might rise for the second year,increasing its cost of funds and reducing (or even eliminating) the profitability of the loan.

One way for Bigtime to manage its risk and hedge the loss from possible interestrate increases in the second year is to sell Treasury bill futures contracts. Specifically, itcould agree to sell 10 contracts for one-year, $1 million T-bills when the second yearbegins. The price that Bigtime charges for the T-bills at that time will reflect the inter-est rate that is expected to prevail during the second year.

To examine this strategy, let’s suppose that the market expects the rate on one-year,$1 million T-bills to be 8% when the second year begins. The one-year futures price ofa $1 million contract will then be $926,000 (rounding to the nearest $1000). That is,Bigtime will pay $926,000 and will receive $1 million from its futures position, or aone-year yield to maturity of 8%. Therefore Bigtime will promise to sell 10 contractsat $926,000 each at the start of the second year.

Who would buy such a contract? Perhaps a speculator who believes strongly that T-bill prices will rise, say, to $930,000. Such a person would want to lock in Bigtime’s priceof $926,000 per T-bill because the speculator expects to resell the T-bills immediately for$930,000. Hence speculators’ self-interest adds liquidity to the market, allowing lendersto hedge their interest rate risk.

Suppose now that interest rates rise to 12%, or four percentage points above theexpected 8% and two percentage points above the rate that Bigtime charged SmokestackIndustries. On the one hand, Bigtime is harmed, as it loses money on its loan to Smoke-stack in the second year. The $10 million loan brings in 10%, or $1 million, but the costof funds is now 12%, or $1,200,000. Thus, instead of earning a $200,000 profit($1,000,000 – $800,000 expected cost of funds), Bigtime incurs a second-year loss of$200,000. Overall, then, the higher interest rate reduces Bigtime’s earnings by $400,000(from a $200,000 profit to a $200,000 loss).

On the other hand, Bigtime is helped by the unexpected interest rate increase,which lowers the cost of T-bills. At a one-year interest rate of 12%, the market price ofa $1 million T-bill is $1,000,000/1.12, or $893,000 (rounding to the nearest $1000).Therefore, to fulfill its futures contract, Bigtime will buy $10 million worth of T-bills for $8,930,000 (10 × $893,000 each) and sell them to the speculator for theagreed-upon futures price of $9,260,000 (10 × $926,000). Bigtime thus receives aprofit of $330,000.✝


✝ The speculator, much to his chagrin, lost money. He must buy the T-bills for $926,000 each while the mar-ket price is $893,000.


Bigtime Financial Services’ Use of Futures to Manage Risk

Profits with no futures hedge Profits with futures hedge

Year 1 (Market interest Interest income [$10,000,000 � 10%] At the end of year 1, Bigtime sells 10 rate expected to be 8% � Cost of funds [$10,000,000 � 8%] $1,000,000 T-bill futures contracts for in year 2) Year 1 profit [$200,000] $9,260,000. Bigtime must buy them

back in year 2.

Year 2 (Market interest Interest income [$10,000,000 � 10%] Bigtime buys back futures contracts forrates rise from 8% to � Cost of funds [$10,000,000 � 12%] $8,930,000.12%) Year 2 profits [–$200,000]

Relative to its expected return, Bigtime makes $330,000 ($9,260,000 Bigtime loses $400,000 – $8,930,000) on its futures position.($200,000 – (–)$200,000).

With the futures hedge, Bigtimeloses $70,000 instead of $400,000.

TABLE 9.1

On balance, if the interest rate rises to 12%, Bigtime loses $400,000 on its loan andgains $330,000 on its futures contract: −$400,000 � $330,000 � −$70,000, a net loss.If Bigtime had not sold futures, its loss would have been the full $400,000. Thefutures markets thus allowed Bigtime to reduce its potential loss. Table 9.1 summa-rizes Bigtime’s gains from using futures to hedge risks.

Of course, the hedging strategy allowed by financial futures cut both ways. Hadinterest rates fallen, Bigtime would have gained on the loan because the cost of fundswould have fallen but would have lost on the futures contract because the price of T-bills would have risen. By limiting potential gains and losses, then, futures marketsallow investors to limit the risks from unexpected interest rate changes.

Anticipated price movements. The futures hedge in the Bigtime example wassuccessful because the movement in the T-bill yield was unanticipated. If market par-ticipants had anticipated the interest rate movement, the higher expected future ratelikely would have been incorporated into the initial T-bill futures price. That price percontract would have been $893,000 ($1,000,000/1.12), rather than $926,000($1,000,000/1.08). The futures hedge is most valuable for protecting against unantici-pated changes in the price of the underlying asset.

Costs of hedging: transactions costs and basis risk. Other costs of hedgingare transactions costs and basis risk. Futures markets do not provide hedging servicesfor free; buyers and sellers pay transactions costs on futures contracts. Such costs aren’tlikely to be significant, particularly for very large transactions. The Bigtime examplealso simplified the situation facing most hedges because the spread between the rate onthe hedged instrument (cost of funds) and the rate on the instrument actually traded inthe futures market (T-bills) remained constant. We assumed that both rose by four per-centage points. However, correlation between the changes in the two rates isn’t neces-sarily one to one. This imperfect correlation is known as basis risk. If the cost of fundsmoves imperfectly (that is, other than in a one-to-one manner) with the yield on T-bills,Bigtime will experience a significant net loss on the combination of its lending andfutures positions. For instance, suppose that the T-bill rate rose only two percentagepoints, to 10%. The market price would be $909,000 (rounded to the nearest $1000),or $9,090,000 for $10 million of T-bills. Bigtime would buy the T-bills and sell themat the contract price of $9,260,000 for a gain of $170,000. However, when the

$400,000 loss on the loan in the second year was subtracted, Bigtime’s profit would fallby $230,000. That loss is considerably more than the $70,000 lost when T-bill rateschanged point for point with Bigtime’s cost of funds.

OptionsA second type of derivative instrument is the options contract, which confers the rightsto buy or sell an asset at a predetermined price by a predetermined time. For example,you might purchase the option to buy 100 shares of Boomco for $50 per share some-time during the next six months.

In contrast to symmetric rights and obligations under futures contracts, the buyerand seller in an options contract have asymmetric rights. The seller has obligations, andthe buyer has rights. Options represent the right to buy or sell an underlying asset—shares of a stock or a basket of stocks, for example. If an investor buys a call option,he or she acquires the right to buy the underlying asset. Sellers of call options have theobligation to sell the asset. Investors also may purchase a put option, or the right to sellthe underlying asset. Sellers of put options have the obligation to buy the asset. Theprice at which the asset is bought or sold is called the strike price, or exercise price. Theperiod over which a call or put option exists is determined by its expiration date, thedate at which the rights under the options contract end. Essentially, a person providingcall or put options is extending rights to another person. Those rights (to buy or sell ata specified price) are potentially valuable and so are not simply given away. Instead, theseller of the option charges a fee, called the option premium.✝

Options on individual stock issues have been traded in over-the-counter marketsand exchanges for decades. Since the 1970s, traders have reduced the risk of fluctua-tions in security returns with option contracts traded on the Chicago Board OptionsExchange, the New York Stock Exchange, and the American Stock Exchange. In addi-tion, the popularity of options on futures such as Treasury or Eurodollar interest ratefutures or foreign currency futures has grown. The principal options contracts tradedin the United States include options on individual stocks, stock index options (S&P 500or NYSE Composite indexes), options on stock index futures contracts (S&P 500 orNYSE Composite indexes), interest rate options on futures (Eurodollar rates, U.S. Trea-sury notes and bonds, and the Municipal Bond index) and currency options and cur-rency futures options (Japanese yen, Swiss francs, Canadian dollars, British pounds,Mexican pesos, and Brazilian reals).


Assuming no basis risk, what would happen to Bigtime’s profits if interest ratesfell to 6% during the second year? Instead of earning $200,000 on the loan, Big-time would net $400,000 ($1,000,000 income minus $600,000 funding costs). How-ever, Bigtime would lose money on the futures contract. At 6%, the market price of aone-year, $1 million T-bill is about $943,000 ($1,000,000/1.06). Thus Bigtime wouldhave to spend $9,430,000 to obtain $10 million in T-bills but could sell them only for$9,260,000, losing $170,000. On balance, Bigtime gains $30,000 ($200,000 gain onthe loan minus $170,000 lost in the futures contract). Had it not sold the futures con-tract, it would have gained the full $200,000. ♦

C H E C K P O I N T

Web Site Suggestions:http://biz.yahoo.com/opt/Offers quotes fromand information onoptions markets.

✝ Throughout this discussion, we describe American options, which may be exercised at any time until theexpiration date. European options may be exercised only on the expiration date.

web_links192.html

Options on securities (that is, stocks, stock indexes, bonds, and bills) and on for-eign currencies trading on stock exchanges are regulated by the Securities andExchange Commission (SEC). Options on futures contracts or on foreign currenciestraded on commodity markets are regulated by the CFTC.

Options Pricing

The value of the option premium is different from that of the futures price becauseoptions have asymmetric rights and obligations. The size of the option premium reflects



Reading Options ListingsReported data on options contractscontain many of the same measures asfutures listings. However, there aresome differences for individual options,according to whether the underlyingasset is a direct claim (for example, abond or shares of stock) or a futurescontract (for example, a stock indexfutures contract).

The quotations shown here foroptions contracts are for options onTreasury bond and note futures (suchas those discussed earlier) traded onthe Chicago Board of Trade. Again,the size of the underlying futures con-tract is $100,000, but the prices aregiven in percentage points per $100of face value; fractional values arereported in 64ths of a percent.

Open interest in Treasury bond calls is484,175 contracts, with a trading vol-ume the previous day of 61,779 con-tracts. Open interest in the Treasurybond puts is 339,733 contracts, witha trading volume of 45,671 contracts.Because calls and puts are differenttypes of options, the open interest forthe two types of options need not bethe same.

The first column conveys the strikeprice, which ranges from 105 in thefirst line to 110 in the last line. The sec-ond, third, and fourth columns list theclosing (Settle) prices for call optionsexpiring in September, October, andNovember 2003, respectively. The 105calls with a September expiration datehave a closing price of 2 61/64. Each

percentage point of the $100,000Treasury bond contract is worth$1000, so these calls cost 2 61/64($1000) � $2953.13. For some con-tracts (for example, the 105 calls with aNovember expiration date), no price isgiven because the contract did nottrade that day. The last three columnsgive the closing price for put optionswith expiration dates of September,October, and November 2001, respec-tively.

As with futures price quotations,options price quotations tell youabout expectations. Note that theprice of 107 calls is higher in theOctober contract than in the Septem-

ber contract, indicating that tradersand investors expected the option tobuy the Treasury bond futures at 107to be worth more in October. Thusinvestors expected the bond price torise and the yield to fall. The closingprices for the 109 and 110 calls arelow, indicating that investors believedthat Treasury bond prices are unlikelyto be so high or yields so low.

Although not shown, quotations foroptions on individual stocks containinformation on the closing price of theoption (the premium) and the closingprice of the individual stock. Volumestatistics (such as trading volume oropen interest) are usually not reported.

Source: The Wall Street Journal, July 30, 2003. Republished by permission of Dow Jones, Inc. via Copyright Clearance Center, Inc. © 2003 Dow Jones and Company, Inc. All Rights Reserved Worldwide. (Quotes are for July 30, 2003)

FUTURES OPTIONS PRICES

Interest Rate

Est. vol. 115,298; Mn vol. 61,779 calls 45,671 putsOp. int. Mon 485,175 calls 339,733 puts

T-Bonds (CBT)$100,000; points and 64ths of 100%

Oct NovSepPrice

Est. vol. 380,820 Mn 157,565 calls 81,518 putsOp. int. Mon 941,148 calls 797,430 puts

Oct NovSep2-472-141-501-261-070-55

...

...

...

...

...

...

2-612-181-451-150-550-36

105106107108109110

2-102-403-123-524-325-16

...

...

...

...

...

...

0-571-141-412-112-513-32

T-Notes (CBT)$100,000; points and 64ths of 100%

Oct NovSepPrice Oct NovSep1-441-140-550-380-260-17

...1-30

...

...

...

...

2-111-330-630-380-210-12

110111112113114115

1-512-212-623-454-325-23

...2-37

...

...

...

...

0-410-621-292-042-513-32

Entries under datesare theoption price,or premium.

STRIKES CALLS-SETTLE PUTS-SETTLE Tuesday, July 29, 2003Final or settlement prices of selectedcontacts. Volume and open interest aretotals in all contract months.


the chance that the option will be exercised, in the same way that a car insurance pre-mium reflects the risk of an accident. Just as a driver with a history of car accidentspays higher insurance rates, anything that increases the chance of the option’s beingexercised increases the size of the option premium.

Four factors influence the size of the option premium for put and call options.First, greater volatility in the price of the underlying asset increases the premiumbecause the asset price is more likely to rise above the strike price, increasing the valueof the options contract.

Second, as the option nears its expiration date, the size of the premium approachesits intrinsic value. The intrinsic value, or the amount the option actually is worth if itis immediately exercised, is the current price of the asset less the strike price of theunderlying asset. Suppose, for example, that you are considering investing in a calloption to buy common stock in Consolidated Instruments at $60 per share in June; thecurrent share price is 621⁄8, and the option premium is 41⁄2. A portion of that premium(21⁄8 of the 41⁄2) equals the intrinsic value of 21⁄8 per share you would earn from exer-cising the option immediately (that is, from buying a share for 60 and selling it for621⁄8). That portion is said to be in the money. A put option is in the money when themarket price of the underlying asset is less than the strike price.

Third, the fact that buyers of call options in effect are buying the underlying asseton credit also helps to determine the option premium. You pay the option premiumtoday but do not pay the strike price until you exercise the option. A longer time untilexpiration increases the value of the right conferred by the call option and henceincreases the option premium. For put options as well, the further from expiration, thehigher the option premium.

Fourth, the default-risk-free interest rate affects the value of the option premium.A higher interest rate reduces the present value of the exercise price, increasing thevalue of a call option and decreasing the value of a put option.

Market participants try to estimate these effects not just qualitatively but as pre-cisely as possible, using mathematical models. Indeed, Wall Street firms have luredmathematicians, physicists, engineers, and economists—“rocket scientists”—todevelop models for pricing more complex derivatives. This influx of talent includesthree pioneers in the pricing of options: the late Fischer Black, Robert Merton of Har-vard University, and Myron Scholes of Stanford University. Empirical testing of theo-retical pricing models has demonstrated their usefulness. Improving the models insearch of greater precision (and profit!) is a topic of active research in academia andamong financial practitioners.

Using Options to Manage Risk

As with futures, hedgers can use options to reduce the risk of adverse fluctuations incommodity or stock prices, interest rates, and foreign currency exchange rates. Theextent to which an options hedge is satisfactory depends on basis risk—that is, howclosely movements in the value of the asset underlying the option mirror those of thehedged asset. Unlike futures contracts, options allow hedgers to keep profits on theirpositions in the presence of favorable shifts in the price of the underlying asset.

An options contract is more like insurance (hence the use of the term premium) thanis a futures contract. In a futures hedge, a hedger can sell Treasury futures at any time,reducing potential net losses should market interest rates increase. If rates decrease,however, the hedger cannot earn an additional net profit. With options, a hedger can


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buy Treasury puts to protect against an increase in rates while still earning an extrareturn if market rates fall. In the Bigtime Financial Services example earlier, Bigtimecould buy put options on $10 million of Treasury bills. The benefit to the options buyermust be measured against the cost of the option premium, however. If the option pre-mium is high, the transactions costs of using options may well exceed those for futures.Hence the choice between futures and options reflects a trade-off between the generallyhigher cost of using options and the extra insurance benefit that options provide. As anoption buyer, you assume less risk than with a futures contract because the maximumloss is the option premium. The option seller bears the risk of unfavorable price move-ments in the underlying asset.✝

Benefits of Derivative Markets for the Financial SystemDerivative markets generate important risk-sharing benefits for hedgers and informa-tion about expectations of future prices for all market participants. These markets alsoprovide a means for speculation. As a group, speculators play important roles in deriv-ative markets because their presence facilitates risk sharing with hedgers. Active mar-ket participation by speculators generates liquidity, thereby improving marketefficiency and the information content of prices. This increased efficiency benefits notonly the derivative markets, but also the markets for underlying assets (Treasury instru-ments, stocks, foreign exchange, and so on), because price changes in the derivatives


Futures Trading, IndexArbitrage, and the StockMarket Crash of 1987Some market analysts blame a formof trading known as index arbitragefor the stock market crash of October19, 1987. Index arbitrage is thesimultaneous trading in stock indexfutures and the underlying stocks toexploit price differences. Such pricedifferences would arise if an investorcould buy a portfolio of the stocksused in the S&P 500 index at a pricethat was slightly lower or higher (netof transactions costs) than the priceof the index futures. Suppose, forexample, that the futures index for delivery one year from now sellsfor $1.1 million, while the stocks are

selling for $1 million and the interestrate on a one-year Treasury instru-ment is 81⁄2%. Let’s say that you buythe stocks now and sell the indexfutures at the same time. At the endof the futures contract, you sell thestocks to close your futures position.You have received $1.1 million for thestocks, so you earned $100,000, or10%, on your $1 million investment,regardless of stock price fluctuationsin the interim. That return is greaterthan the return on the default-risk-free Treasury instrument (81⁄2%).Index arbitrage is facilitated by com-puter monitoring of price margins.

This activity can contribute to marketefficiency by eliminating price differ-entials among markets. Why, then,

the controversy? The reason is thatlarge trading volume can be gener-ated by index arbitrage, particularlyon days on which index futures con-tracts expire. On October 19, 1987,large sell orders on the New YorkStock Exchange were placed as aresult of S&P 500 index arbitrage,which some claimed worsened stockprice fluctuations. However, there islittle formal evidence to support theclaim. Indeed, the presidential com-mission that was appointed to assessthe origins of the stock market crashdid not place much blame on indexarbitrage. A decade later, index arbi-trage trading accounted for about 4%of overall trading volume on the NewYork Stock Exchange.

O T H E R T I M E S , O T H E R P L A C E S . . .

✝ In the conventional covered option, the seller owns the underlying asset. In a naked option, the seller doesnot have an interest in the underlying asset.

market provide information about the value of underlying assets. Hence derivativemarkets contribute positively to the three key services of risk sharing, liquidity, andinformation provided by the financial system.

Nonetheless, some observers are critical of derivative markets. The multibillion-dollar speculative losses in derivatives by Orange County, California, in 1994 and Bar-ings P.L.C. in 1995 have led to further calls for regulatory review. During 1994 and1995, the General Accounting Office, the Congress, and the futures industry itself sug-gested new regulations of market participants. While derivatives played a role in thespectacular collapse of Long Term Capital Management in 1998, most analysts blamethe firm’s risk management system, not derivatives per se. Federal Reserve ChairmanAlan Greenspan has highlighted the positive role derivatives play in risk managementand in helping financial markets and institutions withstand shocks.

Standardization and Liquidity

For financial markets in derivative instruments to be liquid, futures and options contractsmust apply to standardized products. Here, standardization means that contracts contain


C A S E S T U D Y

Citron Pressed— The Orange County Fiasco

In April 1995, former Orange County (California) Treasurer Robert L. Citron, who was responsible forthe biggest municipal bankruptcy ever, pleaded guilty to six felony charges of misleading investors andmisrepresenting interest earnings from the county’s doomed investment fund. While Citron blamed hard-to-understand derivatives and bad advice from Merrill Lynch for the losses, Orange County taxpayerslooked on in shock at losses of $2 billion. While the headlines focused on derivatives, the culprits in theOrange County disaster were more likely bad decisions and bad supervision. Let’s see what happened.

The Orange County Investment Pool, a repository for local and county tax receipts, bought largeamounts of “stepped inverse floaters,” notes with derivative features whose value is linked to the levelof short-term interest rates. If short-term rates fall, the floaters’ rate does the inverse. This increasebrings about above-market returns for the noteholders. On the other hand, if short-term rates rise, rateson the notes fall. At the same time, the market value of the notes falls because their rates are belowother rates in the market.

Citron’s assumption throughout the 1990s was that short-term rates would fall, thereby makinginvestments in the somewhat exotic inverse floaters a good bet. Orange County—rather than using deriv-atives to hedge risks—became a major speculator. As short-term rates fell from 1991 through 1993, theOrange County pool earned returns significantly greater than those earned by bond mutual funds. Begin-ning in February 1994, however, the Federal Reserve pursued a strategy of steadily increasing short-term interest rates, producing huge losses for the Orange County fund. As losses mounted, Citron tookriskier positions to try to break even. In November 1994, the Irvine Ranch Water District presidentbecame suspicious. His request to redeem $400 million would have taken almost all of the pool’s cash.On December 6, 1994, the pool filed for bankruptcy protection.

What went wrong? Although derivatives were present in the Orange County investments, the losseswere caused not by the instruments themselves but by the erroneous assumption that interest rateswould continue to fall in 1994. This bad decision was matched by poor supervision. Citron averted a runon the fund during 1994 because California law required disclosure of the pool’s positions only onceeach year. Many commentators (and taxpayers) were left wondering how a single individual with rela-tively little experience in managing sophisticated financial instruments was allowed to manage the multi-billion-dollar pool with so little oversight. Another casualty was Orange County’s broker, Merrill Lynch,which paid a settlement of $400 million in June 1998.

C A S E S T U D Y

exact specifications—for example, the weight, quality, and grade of a commodity. Stan-dardization increases liquidity and results in increased trading volume for the market as awhole, because traders do not have to spend time and money to determine the exact spec-ifications of the financial instrument or good being traded. The terms of a futures contractspecify the type of financial instrument or commodity, the amount or value of the finan-cial instrument or commodity, and the location and time of delivery.

The specifications of financial assets—particularly government debt, foreignexchange, and groups of stocks—can be standardized easily. In the case of financialfutures, the assets underlying the contracts are specific instruments, such as Treasury billsor bonds, or the cash value of the S&P 500 stocks. Sponsoring exchanges specify the termsof futures contracts, and, as we noted earlier, trading practices in the United States are reg-ulated by the CFTC. The National Futures Association also exercises self-regulation.

Standardization also is important for options. An options contract is defined withrespect to an underlying asset, traditionally 100 shares of a particular stock. For indexoptions, the underlying asset is a group of equities represented by the index, say, theS&P 500. For options on futures contracts, the underlying obligations are futures; thebuyer receives a T-bill futures contract rather than the underlying T-bill itself.

Rules for standardizing options contracts are developed by the exchange on whichthey are traded. An options contract specifies different strike prices and expiration


C A S E S T U D Y

Barings Lost—The Queen’sBanker Goes Bust

Peter Baring, chairman of Barings P.L.C., the investment firm his family founded in 1763, thought thatFebruary 24, 1995, would be a good day. After all, he would tell the firm’s employees that the com-pany’s profits during 1994—and their bonuses—were high. At 7:00 a.m. in London, however, Baring dis-covered a disastrous loss of about $1 billion, enough to wipe out the firm. Indeed, two days later, thefirm was placed in bankruptcy proceedings. On March 5, ING, a Dutch banking and insurance firm, pur-chased Barings for £1, and assumed its assets and liabilities.

In 1818, the Duc de Richelieu declared that “there are six great powers in Europe: England, France,Russia, Austria, Prussia, and the Baring brothers.” In 1995, the firm was investment advisor to noneother than Queen Elizabeth II. In the wake of its collapse, Barings blamed derivatives and the tradingbets of 27-year-old Barings trader Nick Leeson. Other commentators pointed to the need for closer topmanagement scrutiny.

Leeson’s job at Barings was in principle a low-risk form of arbitrage, riskless trading that takes advan-tage of price differentials between markets (in his case, Japan and Singapore). He was supposed to buya futures contract in one market and sell it for slightly more in the other, profiting from the difference.Leeson soon departed from arbitrage and risk management. Itchy for a higher profile, Leeson beganengaging in a risky investment strategy known as a “straddle.” His straddle was a bet that the Tokyostock market would remain in a narrow trading range. To execute the strategy, Leeson sold an equalnumber of call options and put options. As long as stock prices did not get out of the trading range setby the calls and puts, Barings and Leeson would profit. However, if the market moved out of the trad-ing range, Barings would quickly sustain large losses. Leeson’s positions were in trouble after the earth-quake in Kobe, Japan, in January 1995. Through the first three weeks of February, he bought futurescontracts on the Nikkei 225 stock index, betting that Japanese stock prices would rise. They fell instead.

As investigators probed the details of the Barings collapse, it became clear that top management had paidinsufficient attention to Leeson’s trading activities—in part because of the high profits he seemed to be gen-erating. In the summer of 1994, Barings P.L.C. rejected the idea of buying software that continuously trackstraders’ positions to calculate potential risk. It seems that, at $50,000, the software was too expensive.

C A S E S T U D Y

dates, as determined by the exchange. As with futures contracts, the intent of stan-dardization is to interest the greatest possible number of potential traders in order toprovide liquidity.

Anonymous Trading and Information

Derivative markets also promote risk sharing by reducing information costs for hedgersand speculators. Exchanges permit buyers and sellers of futures contracts to trade atarm’s length through an exchange, instead of trading with each other personally. Thisapproach overcomes certain information problems: The exchange provides a clearing-house to clear the trades of market participants. In so doing, the exchange, whose cap-ital is provided by its members, guarantees that contracts will be honored. Thus tradecan be anonymous; that is, buyers and sellers do not have to search for each other anddo not have to assess the creditworthiness of trading partners. Organized exchangesmatch buyers and sellers as part of the exchange mechanism, through which prices aredetermined in an auction market by demand and supply. In the United States, only acommodity broker can trade futures on exchanges. Options contracts also are tradedanonymously through exchanges by any broker who is registered to trade stocks.✝

Figure 9.1 summarizes the value that financial futures and options add in pro-viding risk-sharing, liquidity, and information services in the financial system.


Some futures and options contracts have failed after their introduction becausethere was insufficient demand for them. What factors do you think determinewhether a particular futures or options contract will be demanded by hedgers orspeculators? The underlying asset or commodity should exhibit significant price fluc-tuations to create a demand for hedging and speculation. In addition, the underlying

C H E C K P O I N T

Information

Standardization ofcontracts increasesliquidity.

Hedgers usefutures and optionsto transfer risks tospeculators.

Funds

Returns

Funds

ReturnsSavers Borrowers

Risk

SharingLiquidity

Exchanges reduce information costs byguaranteeing that contracts will be honored.

Derivative

Markets

Derivative Markets Add Value in the Financial SystemDerivative markets for financial futures and options provide valuable risk-sharing, liquidity, and information services for savers and borrowers.

FIGURE 9.1

✝ Some options contracts are traded over the counter, but most are listed on an exchange (though, in the caseof stock options, not necessarily on the same exchange as the underlying stocks). Just as exchanges do notset futures prices, exchanges do not contractually specify or regulate the prices of options contracts.

SUMMARY

1. An increasingly significant amount of activity infinancial markets takes place not in actual instru-ments for borrowing and lending, but in derivativeinstruments. A derivative instrument’s economicvalue comes from the value of some underlying asset.Futures and options contracts, the two most widelyused derivative instruments, facilitate risk sharing bybringing together individuals who want to reducetheir exposure to fluctuations in the price of theunderlying asset (hedgers) and individuals who hopeto profit from anticipated fluctuations in the price ofthe underlying asset (speculators).

2. Derivative instruments specify rights and obliga-tions regarding the underlying asset. The buyer ofa futures contract, who assumes the long position, hasboth the right and the obligation to receive the underlying asset (say, Treasury bonds) at the agreed-upon future date. The seller, who assumes the shortposition, has the obligation to deliver the asset at thattime. With an options contract, the seller has obliga-tions, and the buyer has rights. Buyers of call optionshave the right to buy the underlying asset. Buyers of putoptions have the right to sell the underlying asset.Because of the asymmetry of rights and obligations

between the buyer and seller, the buyer of a call or putoption pays an option premium to the seller. The buyerof the option has the right to pay an agreed-upon price(called the strike, or exercise, price) by a certain time(the expiration date).

3. Costs of using futures contracts include transactionscosts and basis risk (movements in the spread betweenthe price of the hedged instrument and the instrumentactually traded in the futures market). In addition, thehedging strategy cuts two ways. The hedger’s potentiallosses are reduced by holding an offsetting futures posi-tion, but so are the gains if there is a favorable pricemovement in the underlying asset. With an options con-tract, a hedger is protected against adverse movementsin the price of the underlying asset while benefitingfrom favorable price movements.

4. Speculation in derivative markets is beneficial for thefinancial system because it increases liquidity andhelps to incorporate information into market prices.This increased efficiency benefits not only the deriva-tive markets, but also the markets for underlyingfinancial claims, which gain from the integration ofprice information.


KEY TERMS AND CONCEPTS

Derivative instruments

Derivative markets

Forward transactions

Futures contract

Basis risk

Futures price

Hedging

Long position

Marking to market

Short position

Speculators

Spot price

Options contract

Call option

Exercise price

Expiration date

Intrinsic value

Option premium

Put option

Strike price

Spot transactions

Standardization

REVIEW QUESTIONS

1. What is the difference between a spot transaction anda forward transaction? What advantages does afutures contract have over a forward transaction?

2. What is an options contract? What are the rights andobligations of buyer and seller? How does a calloption differ from a put option?

3. What is the difference between using options to hedgeand using options to speculate?

4. What are the main costs of using futures as a hedge?

5. What type of financial contract can be used likeinsurance to protect the value of other assets? Howdoes the insurance aspect of this approach work?

6. Why is standardization important in futures andoptions markets?

7. What is important about anonymity in the trading offutures and options?

8. Why do the futures exchanges require marking tomarket every day?

QUIZ

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When Richard Sandor talkedabout trading financial futuresin the 1970s, his colleagues atthe Chicago Board of Tradescratched their heads. Futurestrading already existed fortangible goods like corn andcattle. Why trade an interestrate change—something youcan’t see or touch? . . .

That was just the begin-ning. Sandor came to believethat any problem, from moviefinancing to water scarcity, canbe solved by figuring out howto commoditize the product. . . .In the late 1980s he helped per-suade the federal governmentto add a trading element to theClean Air Act that places a capon the amount of sulphur diox-ide a factory can belch into theair—and gives companies cred-its that they can buy and sell—if they go below the cap. Thetrading proved to be the key tothe act’s success. In 2001 cor-porate polluters traded $2 bil-lion in rights for 12 milliontons of pollution emissions.Trades are up seventeenfold insix years. . . .

Sandor now wants to putone particular kind of pollu-tion trade—for carbon dioxide,the gas suspected to causeglobal warming—on an ex-change, the Chicago ClimateExchange. Sandor is chairmanand an equity holder.

Starting with a four-yearpilot program, Sandor has

signed up 17 big companies,including Ford, DuPont andAmerican Electric Power, aswell as the city of Chicago andTufts University. They haveagreed to reduce, voluntarily,their rate of carbon dioxideemissions by 4% below whattheir average level was from1998 to 2001. Reduce emis-sions by more than 4% andyou earn an allowance for eachadditional ton of carbon diox-ide taken out of the air. Thoseallowances can then be sold toother companies over the Inter-net, offering an upside ratherthan a regulatory fiat.

It’s a big idea with biggerimplications. If Sandor’s modelworks, it could encourage mas-sive greenhouse-gas reductionsin the U.S. without onerous leg-islation. Instead of leaving it tothe government to set rigidcaps on carbon dioxide emis-sions, business could controlpollution on its own throughcredit trades. . . .

Sandor has been watchingthe growing world market incarbon dioxide emissions trad-ing since 1992, when he gavea speech on the value of trad-

ing pollution rights at the RioEarth Summit. The WorldBank estimates pollution rightsto 65 million tons of carbondioxide were exchanged glob-ally in 2002, five times theamount traded in the previousyear. The vast majority of those

trades were through privatebrokers arranging one projectat a time. . . .

But Sandor felt a bettersolution would be a publicmarket. The price of getting amarginal ton of carbon dioxideout of the air, either by buildingmore efficient factories or get-ting Montanans to plant trees,could fluctuate with marketdemand; all trades would bemade using one standard. So inMay 2000, with help from a$400,000 grant from the JoyceFoundation, a Chicago outfitfocused on the environment inthe Great Lakes region, he setout to establish the ChicagoClimate Exchange. . . .

“I think [the climateexchange] is Richard’s best ideayet,” says Leslie Rosenthal, for-mer chairman of the ChicagoBoard of Trade and vice chair-man of the climate exchange.“Not only is there a financialand societal need, but it’s alsosomething that people aregoing to take to in an emo-tional way.”

And Richard Sandorwould be the pioneer of yetanother form of trading that atone point seemed unthinkable.“I’m more excited about thenext 20 years in the environ-mental and social arena than Iwas about financial futures,”he says. “While it seems com-plicated to a lot of people, tome it’s really simple.”

FORBES AUGUST 11, 2003

Futures for Emissions?

a

b

c

M O V I N G F R O M T H E O R Y T O P R A C T I C E . . .M O V I N G F R O M T H E O R Y T O P R A C T I C E . . .


Futures contracts evolve to providerisk-sharing, liquidity, and informationservices for investors in the financialsystem. As part of a market-orientedapproach to reducing air pollution, theU.S. Clean Air Act of 1990 allowedpolluters to buy and sell rights to sul-fur dioxide. Economists argue that theprice established in such a market willsend important signals for investment.That is, a higher price for pollutionrights will make firms more willing toinvest in pollution abatement equip-ment or new technologies to controlemissions. Speculators will provide theliquidity for the market in pollutionrights. With some trading in emissionscontracts in the United States, thequestion arises as to whether tradingin pollution contracts could play a rolein international coordination to reduceemissions—a goal of greenhouse-gaspolicies to reduce global warming.Richard Sandor, a pioneer in financial

futures and pollution futures believesthe answer is a resounding “yes.”

Who might participate in afutures market for emissions?

Hedgers likely include businesses thatproduce emissions or use pollutants intheir production processes; such firmscould use futures contracts to mitigatethe effects of fluctuating prices ofemissions quotas on profits. Specula-tors would include investors who seekto profit from their belief that prices ofemissions permits may rise or fall inthe near future.

For emissions futures markets tobe successful, market partici-

pants must agree on the emissions orpollutants to be traded, just as theymust agree on the choice of copper,wheat, or Treasury bills. The standard-ization required for exchange tradingwill make the market more liquid.

The creation of a market for trad-ing greenhouse-gas emissions

permits encourages the developmentof low-cost technologies for reducingemissions. A futures market aids plan-ning by providing information on theexpected future value of the permits.The liquidity provided by the futuresmarket improves the information con-tent of permit prices.

For further thought . . .

The Kyoto Protocol supports a sub-stantial role for a global market fortrading emissions permits. How mightsuch a market be used to offer incen-tives to less developed countries toreduce their pollution?

Source: Excerpted from “Can This Man Save the World?”, Forbes,August 11, 2003. Copyright © 2003 Forbes. Reprinted withpermission.

a

b

c

A N A L Y Z I N G T H E N E W S . . .A N A L Y Z I N G T H E N E W S . . .


9. Consider options on Bigmove Corporation stock.Suppose that there are call options with a strike priceof $75 and put options with a strike price of $65.Which, if any, of the options are in the money if thecurrent price of Bigmove’s stock is (a) $60, (b) $70,and (c) $80?

10. Why are option premiums generally greater thanintrinsic value before the expiration date?

11. Suppose that a presidential candidate planned toinclude in her platform a plan to abolish options andfutures markets, arguing that they are simply a “casino

for the rich.” As her economic advisor, would you agreewith her position or try to change her mind?

12. If speculators were not present in derivatives markets,would these markets work more efficiently or lessefficiently?

13. Suppose you become convinced that an Internet stockis greatly overvalued at its current stock price. Howmight you use the derivatives market to profit?

14. Explain index arbitrage (see the “Other times, otherplaces . . .” box). How can you obtain a greater risk-free return by using index arbitrage than by buyingTreasury bills?

15. In early 2000, the Dow Jones Industrial Average roseabove the 11,000 level. If the Dow were to fall to7000, who would gain the most: investors who hadbought call options, investors who had sold calloptions, investors who had bought put options, orinvestors who had sold put options? Who would behurt the most?

16. Suppose that a court decision will have a majorimpact on a firm’s profits. If the court decision isfavorable, you estimate that the firm’s stock will beworth $100 per share. If the court ruling is unfavor-able, you estimate that the stock will be worth only$60 per share. Currently, the price is $80 per share,as half the market participants are betting on eachpossibility. Is there any way to use options contractsto profit from this situation?

17. In the fall of 1998, an article in The Wall Street Jour-nal stated: “The risk of gyrating orange pricesprompted some analysts to question PepsiCo’s $3.3billion purchase of Tropicana [which is a brand oforange juice] from Seagram Co. when the deal wasannounced in July. Orange juice is a notoriouslytough business that is subject to the vagaries ofweather. . . . ‘These are exactly some of the negativecomponents that came up at the time of the acquisi-tion—you’re adding agricultural commodity risk toPepsiCo,’ said Skip Carpenter, an analyst at Donald-son, Lufkin & Jenrette.” Would Tropicana be betteroff if orange prices were high or if they were low?Explain how Tropicana might go about hedging therisk of an adverse price movement in oranges.

18. Suppose that a U.S. firm signs a contract to buy fac-tory equipment from a Japanese firm at a cost of ¥250million. The equipment is to be delivered to the UnitedStates and paid for in one year. The current exchange

rate is ¥250/$1. The current interest rate is 6% in theUnited States and 4% in Japan.

a. If the U.S. firm trades dollars for yen today andinvests the yen in Japan for one year, how manydollars does it need today?

b. If the U.S. firm enters a futures contract, agreeing tobuy ¥250 million in one year at an exchange rate of¥245/$1, how many dollars does it need today toinvest at the U.S. interest rate of 6%?

c. If the U.S. firm invests in the United States at 6%today, without entering into any other type of con-tract, does the firm know how many dollars itneeds today to fulfill its equipment contract in oneyear?

d. Which method(s) described in (a)–(c) provide(s) ahedge against exchange rate risk? Which do(es) not?Which method is the U.S. firm likely to prefer?

e. Bonus: What does the futures contract exchangerate have to be in (b) for the results in (a) and (b)to be equivalent?

19. Suppose that you own Treasury bonds with a face valueof $1 million. You believe that the economy is growingstrongly and that interest rates are about to rise. Youwant to protect the value of your assets without incur-ring the transactions costs of selling them. How couldyou use options to protect their value?

20. Suppose that you believe the fundamental value of Wal-Grey stock is about to rise from $50 to $100 because ofits new management team. You have $20,000 that youcan risk in the market, and you can think of four possi-ble ways to profit: (a) use your $20,000 to buy sharesof Wal-Grey; (b) borrow (at a 6% interest rate) an addi-tional $20,000 on margin to buy a total of $40,000worth of Wal-Grey stock; (c) enter into a futures con-

ANALYTICAL PROBLEMSQUIZ

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tract to buy 400 shares of Wal-Grey in one year for$21,200 (you can invest safely for a year at a 6% inter-est rate); and (d) buy a call option (for every $1000 youspend on call options, you have the right to buy 100shares of Wal-Grey at the current price of $50 pershare). Calculate how much you earn or lose by eachmethod if:

(i) Wal-Grey stock rises to $100 per share in one year.

(ii) Wal-Grey stock stays at $50.

21. Suppose that you manage a bank that has made manyloans to people at a fixed interest rate. You are wor-ried because you believe that inflation might rise andyour bank will suffer a capital loss on its loans. Howmight you use options to protect your bank’s portfo-lio, which includes many Treasury securities?

DATA QUESTIONS

22. In the library, look in the latest Economic Report ofthe President for annual data on the rise in the con-sumer price index (CPI). Suppose that options existon the CPI. Call options on the CPI pay off wheneverthe CPI rises by 5% or more during the year. Putoptions pay off whenever the CPI rises by 2% or lessduring the year. In what years would CPI call optionspay off? In what years would CPI put options payoff? How could a bank or other financial intermedi-ary use these types of options to protect its portfolio?How expensive do you think these options were inthe early 1960s? In the 1970s?

23. Examples of agricultural products sold on futuresmarkets can be found at Euronext’s LIFFE web site,at www.liffe.com. Locate the site “Delayed Com-modity Pricing Service” and compare futures marketdata for both sugar and corn (free registrationrequired). Are the three-month futures for both sugarand corn selling today at prices higher or lower thantoday’s actual settlement price? What do youranswers tell you about the expectations of the marketprices for these goods three months from now?

A P P E N D I X

SwapsAlthough the standardization of futures and options contracts promotes liquidity, theyoften cannot be tailored to meet the needs of market participants. This problem hasspurred the growth of swap contracts (“swaps”). A swap is an agreement between twoor more parties (known as “counterparties”) to exchange sets of cash flows over somefuture period. For example, Company A may consent to pay a fixed rate of interest on$10 million each year for five years to Bank B. Bank B, in return, may pay a floating rateof interest on $10 million each year for five years. The cash flows are generally relatedto the value of the underlying financial instruments, typically debt instruments or for-eign currencies. Hence swaps are generally interest rate swaps or currency swaps. Anindustry of swap facilitators has emerged to identify and bring together prospectivecounterparties. Recent swap innovation has encompassed “credit derivatives,” swaps inwhich credit risk can be separated from interest rate risk.

From a negligible presence in the early 1980s, the swap market has grown rapidly,with contract values exceeding $50 trillion in mid-2003. This growth in part reflectsthe flexibility of swaps, which, unlike exchange-traded derivatives, can be custom-tailored to meet the needs of the counterparties. In addition, swaps offer more privacythan exchange trading, and swaps are subject to almost no government regulation.However, unlike exchange-traded instruments, counterparties must be sure of thecreditworthiness of their partners. This problem has led to the participation of largefirms and financial institutions that can assess creditworthiness; these firms and insti-tutions dominate the market.

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In this appendix, we explain the execution of interest rate swaps and currencyswaps (and introduce the recent development of credit derivatives). We discuss addi-tional uses of interest rates swaps in Chapter 13 and of currency swaps in Chapter 16.

Interest Rate Swaps

In a basic (or “plain vanilla”) interest rate swap, one counterparty has an initial posi-tion in a floating-rate obligation, while the other has an initial position in a fixed-rateobligation. The first counterparty can reduce its exposure to interest rate risk by swap-ping with the second counterparty. The second counterparty is exposed to more inter-est rate risk after the swap occurs and bears the risk in anticipation of a return.

Let’s consider an example, in which the swap covers a five-year period and incor-porates annual payments on a principal amount of $10 million. This principal is calleda notional principal, because it is an amount used as a base for calculations but is notan amount actually transferred between the counterparties. Bigco agrees to pay a fixedinterest rate of 10% to Bankco. Bankco in return agrees to pay to Bigco a floating rateequal to 3% above the London Interbank Offered Rate. This rate, known as LIBOR,is the rate at which large international banks lend to each other. Figure 9A.1 summa-rizes the payments in the swap transaction.

If LIBOR is 8% when the first payment is made, Bigco must pay $1 million (10%� 10 million) to Bankco; Bankco owes $1.1 million ((8 � 3)% � $10 million) to Bigco.Netting the two payments, Bankco pays $100,000 to Bigco. Generally, only the netpayment is exchanged.

Why might firms and financial institutions participate in interest rate swaps? Onemotivation is to transfer interest rate risk to parties that are more willing to bear it. Sec-ond, one party may have better access to long-term fixed-rate capital markets thananother. For example, in an early U.S. swap transaction in 1982, the Student LoanMarketing Association (Sallie Mae) and ITT Financial were counterparties. Sallie Maehad a portfolio consisting mostly of floating-rate assets, while ITT Financial had aportfolio consisting mostly of fixed-rate assets. Before the swap, Sallie Mae used its sta-tus to borrow in an intermediate-term fixed-rate debt market, while ITT Financial bor-rowed using commercial paper. After the swap, Sallie Mae paid ITT Financial’s floatingrate, while ITT Financial paid Sallie Mae’s fixed rate. The swap gave both counterpar-ties a better match with their assets.

Pays (3% � LIBOR) � $10 million

each year for 5 years

Pays (10% � $10 million) each

year for 5 years

Bankco Bigco

Payments in a SwapTransactionIn a swap transaction, counterpar-ties exchange fixed-rate andfloating-rate payments on thenotional principal in the transac-tion. On a notional principal of$10 million, Bigco agrees to payBankco a fixed payment of $1million (10% � $10 million)each year for five years. In return,Bankco agrees to pay Bigco avariable payment of (3% �LIBOR) � $10 million each yearfor five years.

FIGURE 9A.1

Currency Swaps

In interest rate swaps, counterparties exchange payments on fixed-rate and floating-rate debt. In currency swaps, counterparties exchange principal amounts denominatedin different currencies. For example, Le Taste Company might have French francs andwant to swap the francs (or equivalent in euros) for U.S. dollars. Big Steel Companymight have U.S. dollars and be willing to exchange those dollars for francs.

A basic (“plain vanilla”) currency swap has three steps. First, the two partiesexchange the principal amount in the two currencies. (Note the difference from theinterest rate swap, in which the counterparties deal in the same currency and can payonly the net interest amount.) Second, the parties exchange periodic interest paymentsover the life of the agreement. Third, the parties exchange the principal amount againat the conclusion of the swap.

Suppose, for example, that the current spot exchange rate between euros and U.S.dollars is 1 per dollar, or €1 � $1.00. Le Taste has €10 million and would like toexchange the amount for dollars. In return, Big Steel would pay $10 million to Le Tasteat the beginning of the swap. Let’s assume that the swap is for a five-year period andthat the parties make annual interest payments. The U.S. interest rate is 8%, and theFrench interest rate is 10%. Hence Big Steel will pay 10% interest on the €10 millionit received, for an annual payment of €1 million. Le Taste will pay 8% interest on the$10 million it received, for an annual payment of $800,000. (In practice, the two firmswill make net payments.) At the end of five years, Le Taste and Big Steel again exchangeprincipal amounts. Le Taste pays $10 million, and Big Steel pays €10 million, endingthe swap.

Why might firms and financial institutions participate in currency swaps? One rea-son is that firms may have a comparative advantage in borrowing in their domestic cur-rency. They can then swap the proceeds with a foreign counterparty to obtain foreigncurrency for, say, investment projects. In this way, both parties may be able to borrowmore cheaply than if they had borrowed directly in the currency they needed.

Over the past decade, interest rate swaps and currency swaps have become morecomplex. On the one hand, this complexity serves the commercial and financial inter-ests of transacting parties. On the other hand, many policymakers worry that defaultsby some key participants could precipitate a crisis in swap markets.

Credit Derivatives

Swap contracts designed to transfer credit risk (as opposed to just interest rate risk orexchange rate risk) are a rapidly growing segment of derivative markets. In a defaultswap, two parties enter into a contract in which the hedger pays a periodic fee in returnfor a contingent payment by the speculator following a default or bankruptcy by a ref-erence entity (such as a company that fails to pay its supplier). In a more complicatedtransaction known as a total return swap, the two parties transfer both interest raterisk and credit risk. This transaction exchanges the total economic performance of aspecified asset for another cash flow. Although credit derivatives are increasingly usedby a range of financial institutions—including banks, pension funds, insurance compa-nies, and hedge funds (largely unregulated money managers for very wealthy individu-als)—some analysts fear that not all market participants understand the risks involved.


chapter 9 derivative securities and derivative...

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