Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
and
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
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CHAPTER 11
DERIVATIVES
MARKETS
The Nature of Derivative Securities
Derivative securities are used to minimize or
eliminate an investor’s or a firm’s exposure to
various types of risk that they may be exposed to.
Derivatives are financial securities which are
based upon or derived from existing securities.
Risk to an investor or a firm can be caused by
interest rate changes or foreign exchange rate
changes, commodity prices or stock prices
The purpose is to eliminate the price risk inherent
in transactions that call for future delivery of
money, a security, or a commodity.
Copyright© 2006 John Wiley & Sons, Inc.
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Spot versus Forward Market
Trading for immediate or very-near-term
delivery is called the spot market.
Trading for future delivery - forward
market.
Copyright© 2006 John Wiley & Sons, Inc.
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Forward Markets
Buying/selling of a specified amount, price, and future
delivery date of foreign currency.
Direct relationship between buyer and seller.
Foreign exchange dealers earn revenues on the spread
between buying and selling.
Seller delivers at the specified date called the settlement
date.
Buyer of the forward contract has the long position; seller
of the forward contract has the short position.
Banks and foreign exchange dealers are the primary
counter-parties to most transactions in the forward market.
Copyright© 2006 John Wiley & Sons, Inc.
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Futures Markets
Buying/selling of standardized contracts
specifying the amount, price, and future delivery
date of a currency, security, or commodity.
Buyers/sellers deal with the futures exchange, not
with each other.
A specific trade (buy/sell) involves a hedger and a
speculator.
Delivery seldom made - buyer/seller offsets
previous position before maturity.
Futures contracts expire on specific dates.
Margin requirements exist – varies by contract
type.
Copyright© 2006 John Wiley & Sons, Inc.
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Margin Requirements
Initial margin - small percentage deposit
required to trade a futures contract.
Daily settlements - reflect gains/losses
daily and cash payments.
Maintenance margin - minimum deposit
requirements on futures contracts.
Copyright© 2006 John Wiley & Sons, Inc.
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Futures Markets Participants
Hedgers attempt to reduce or eliminate
price risk.
Speculators accept the price risk in turn for
expected return.
Traders speculate on very-short-term
changes in future contract prices.
Copyright© 2006 John Wiley & Sons, Inc.
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Risks in the Futures Markets (concluded)
Manipulation risk - risk of price losses due
to a person or group trading (buying or
selling) to affect price.
Margin risk - the liquidity risk that added
maintenance margin calls will be made by
the exchange.
Copyright© 2006 John Wiley & Sons, Inc.
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Options
An option gives the holder the right, (but not the
obligation) to buy/sell a round lot (100 shares) of the
underlying security or commodity on or before a specified
date at a specified price.
An American option gives the buyer the right to exercise
the option at any time between the date of writing and the
expiration or maturity date. A European option can be
exercised only on its expiration date, not before.
An option that would be profitable if exercised
immediately is said to be in the money.
The seller of the option is called the writer, and the buyer
of the option, holder.
The holder or buyer of the option will pay the writer of the
option a premium to secure the option.
With options the buyer can lose only the premium and the
commission paid.
Copyright© 2006 John Wiley & Sons, Inc.
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Calls and Puts
Call option - buyer has the option to buy an
item at the strike price.
Put option - buyer has the option to sell an
item at the strike price.
Copyright© 2006 John Wiley & Sons, Inc.
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Covered and Naked Options
Covered option - writer either owns the
security involved in the contract or has
limited his or her risk with other contracts.
Naked option - writer does not have or has
not made provision to limit the extent of
risk.
Copyright© 2006 John Wiley & Sons, Inc.
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The Value of Options
The size of the option premium varies:
directly with the price variance of the
underlying commodity or security.
directly with the time to its expiration.
directly with the level of interest rates, and
for options based on stocks, with the
dividends of the underlying stocks.
Copyright© 2006 John Wiley & Sons, Inc.
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