Derivatives Markets
Purpose: Discuss the structure and
function of derivatives
markets
Background

Derivatives


A derivative is a financial instrument whose return is
derived from the return on another instrument.
The Underlying Asset
Called the underlying
  A derivative derives its value from the underlying


Size of the derivatives market at mid-year 2009

$604 trillion underlying value of all OTC derivatives
  With
notional principal of all other contracts added, total
would exceed a quadrillion US dollars
OTC Notional Principal
in US $ trillion
(Source: Bank of International Settlements)
CBOE VIX
Daily Close 1/2/2004-1/25/2010
Background
  The
Storage Mechanism: Spreading
Consumption across Time
  Delivery and Settlement
Placing an Order
  pit
  open
outcry
  electronic systems
Role of Derivatives Markets

Risk Management
Hedging vs. speculation
  Setting risk to an acceptable level

Price Discovery
  Operational Advantages

Transaction costs
Liquidity
  Ease of short selling


Market Efficiency
  Market
Efficiency and Theoretical Fair
Value
  Definition
of an efficient market
  The concept of theoretical fair value
  Arbitrage
and the Law of One Price
Criticism of Derivatives
Markets
  Speculation
  Comparison
to gambling
  High leverage
  Inappropriate use
Forward Market
  Forward
Contracts
  Definition:
a contract between two parties for
one party to buy something from the other at a
later date at a price agreed upon today
  Exclusively over-the-counter
Futures Markets
  Futures
Contracts
  Definition:
a contract between two parties for
one party to buy something from the other at a
later date at a price agreed upon today; subject
to a daily settlement of gains and losses and
guaranteed against the risk that either party
might default
  Exclusively traded on a futures exchange
Swap Market
  Swaps
  Definition
of a swap: a contract in which two
parties agree to exchange a series of cash
flows
  Exclusively over-the-counter
  Other types of derivatives include swaptions
and hybrids. Their creation is a process
called financial engineering
The futures game has a long
history
  In
Europe
  Futures
  In
trading since the 1600s
North America
  Commodity
trading mechanisms originated
in colonial times
  Today’s organized futures exchanges trace
their roots back to the early 1800s
Large variety of futures
contracts now being traded
fungible agricultural commodities
  petroleum products
  metals (precious and otherwise)
  T-bills, T-bonds, and other financial contracts
  currencies
  Equity indices
  inflation indices
  bulk freight rates

Other possibilities in the next
twenty years:
  more
stock market indices
  GNP series, real estate indices, and other
economic indicators
  perhaps even electronic components
The basics of futures trading
warehouse receipts
  spot price
  futures contract
terms
  futures price
  basis
  basis risk

Basis & Basis Risk
Basis
Futures
Spot
The “basis” is the difference between the
futures price and the spot price
  “Basis risk” refers to the risk that the basis
may fluctuate
  Hedging gets rid of price risk, replacing it with
basis risk

The basics of futures trading






warehouse receipts
spot price
futures contract terms
futures price
basis
basis risk
Marking to Market

10:00 AM
Smith buys @ $1
  Jones sells @ $1

Closing price = $1.05
Settlement:

Smith makes 5¢
  Jones loses 5¢

Margins and Limits



Margin equals the maximum that can be lost in one
day’s trading
Upper and lower limits define margin
Margins normally established by vote among the
traders on the exchange



What are incentives for keeping margins small?
What are incentives for increasing margins?
Exchanges and regulators can change margin in
emergency
Clearinghouse
  Clearinghouse
holds all margin deposits
  This amount equals twice the amount that
is exposed to risk
  Ancestors of modern clearinghouses are
also the ancestors of central banks
Summary, Mechanics of
Futures Trading
daily settlement
  initial margin
  maintenance margin
  concept of “margin” vs. performance bond
  settlement price
  variation margin
  open interest

The cast of characters in the
futures game
  Hedgers
  Speculators
  Arbitrageurs
Hedgers:
  They
want to reduce their business risks
  They trade risks with one another
  There is a long history
Speculators:
  People
with valuable information are
naturally attracted to futures trading
  What good do they do?
  Informed
speculators enhance pricing
efficiency
  Uninformed speculators contribute liquidity
Arbitrageurs:
  People
with access to several
marketplaces
  Look for imbalances
  profit
  What
from them as they arise
good do they do?
  quickly
eliminate imbalances
Some trading examples to
illustrate arbitrage
  “crush”
  live
spread
hogs and pork bellies
  any
pair of commodities for which the first is
directly convertible into the second
  soy
beans into soy bean meal and soy bean
oil
  any
set of commodities for which the raw
material is directly convertible into a standard
package of refined commodities
The Cast of Characters

Classification by Trading Style
scalpers
  day traders
  position traders


Off-Floor Futures Traders
individuals
  institutions
  Others: Introducing Broker (IB), Commodity
Trading Advisor (CTA), Commodity Pool Operator
(CPO), Associated Person (AP)

What are options?


Options are financial contracts whose value is
contingent upon the value of some underlying asset
Such arrangements are also known as contingent
claims


because equilibrium market value of an option moves in direct
association with the market value of its underlying asset.
OPT measures this linkage
Everyday examples of options
  rain
check
  discount coupon
  airline ticket with cancellation right
  right to drop a course
The basics of options
Calls and puts defined
  Call: privilege of buying the underlying
asset at a specified price and time
  Put: privilege of selling the underlying
asset at a specified price and time
The basics of options
Regional differences
  American options can be exercised
anytime before expiration date
  European options can be exercised only
on the expiration date
  Asian options are settled based on
average price of underlying asset
The basics of options
  Options
may be allowed to expire without
exercising them
  Options game has a long history
  at
least as old as the “premium game” of
17th century Amsterdam
  developed from an even older “time game”
  which
evolved into modern futures markets
  and spawned modern central banks
The Development of Options
Markets
  Early
origins
  Put and Call Brokers and Dealers
Association
  Chicago Board Options Exchange, 1973
  Resurgence of over-the-counter market
Moneyness concepts
  In-the-money
  Out-of-the-money
  At-the-money
The Over-the-Counter Options
Market
  Worldwide
scope
  Credit risk is present
  Customized terms
  Private transactions
  Unregulated
  Options on stocks and stock indices,
bonds, interest rates, commodities, swaps
& currencies
Organized Option Exchanges
  Listing
Requirements
  Contract Size
  Exercise Prices
  Expiration Dates
  Position and Exercise Limits
Option Traders

The Market Maker
Bid, ask, and bid-ask spread
  Scalpers, position traders, spreaders


The Floor Broker
Designated primary market makers
  Dual trading


The Order Book Official
Limit orders
  Electronic order processing

Option Price Quotations
  See
web sites of newspapers and options
exchanges
  Problems
  Delayed
information
  Nonsynchronized prices
Types of Options
Stock Options
  Index Options
  Currency Options
  Other Types of Traded Options

interest rate options
  currency options
  options attached to bonds
  exotic options
  warrants, callable bonds, convertible bonds
  executive options

Put-Call Parity
Consider two portfolios
•  Portfolio A contains a
call and a bond:
C(S,X,t) + B(X,t)
•  Portfolio B contains
stock plus put:
S + P(S,X,t)
Put-Call Parity
Consider two
portfolios
•  Portfolio A contains
a call and a bond:
C(S,X,t) + B(X,t)
•  Portfolio B contains
stock plus put:
S + P(S,X,t)
VA
VB
S*<X
0
+X
=X
X-S
+S
=X
S*>X
S-X
+X
=S
0
+S
=S
Put-Call Parity
C(S,X,t) + B(X,t) = S + P(S,X,t)
News leaks about negative event
  Informed traders sell calls and buy puts

Put-Call Parity
,X,t)
S
(
P
+
,t) = S
(X
)+B
t
,
X
,
S
(
C
News leaks about negative event
  Informed traders sell calls and buy puts
  Arbitrage traders buy the low side and sell the
high side

Put-Call Parity
C(S,X,t) + B(X,t) = S + P(S,X,t)
News leaks about negative event
  Informed traders sell calls and buy puts
  Arbitrage traders buy the low side and sell the
high side
  Stock price falls — “the tail wags the dog”
