Chapter 13, 14, 15
Derivative Markets
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
A financial futures contract is a standardized agreement to
deliver or receive a specified amount of a specified financial
instrument at a specified price and date.

Financial futures contracts are traded on organized
exchanges, which establish and enforce rules for such
trading.

The operations of financial futures exchanges are regulated
by the Commodity Futures Trading Commission (CFTC).
Source: Republished with permission of Dow Jones & Company, Inc., from The Wall Street
Journal, January 7, 2009, C9; permission conveyed through the Copyright Clearance Center, Inc.
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Purpose of Trading Financial Futures
■ Financial futures are traded to speculate on prices of
securities or to hedge existing exposure.
■ Speculators in financial futures markets take positions to
profit from expected changes in the futures prices.
■ Day traders attempt to capitalize on price movements during a
single day.
■ Position traders maintain their futures positions for longer
periods of time.
■ Hedgers take positions in financial futures to reduce their
exposure to future movements in interest rates or stock
prices.
Trading Futures
Customers open accounts at brokerage firms and establish
margin deposits with the brokers
■ Type of Orders
■ With a market order, the trade is executed at the
prevailing price.
■ With a limit order, the trade is executed if the price is
within the limit specified by the customer.
■ How Orders Are Executed
■ Although most trading now takes place electronically,
some trades are still conducted on the trading floor.
■ Floor brokers receive transaction fees in the form of a
bid–ask spread.
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Hedging with Interest Rate Futures
In the short run, an institution may consider using financial
futures to hedge its exposure to interest rate movements.
■ Using Interest Rate Futures to Create a Short Hedge Financial institutions commonly take a position in interest
rate futures to create a short hedge, which represents the
sale of a futures contract.
■ Cross-Hedging
■ The use of a futures contract on one financial instrument
to hedge a position in a different financial instrument.
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■ The effectiveness of a crosshedge depends on the
correlation between the changes in market values of the
two instruments.
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
The purchase of an S&P 500 futures contract obligates the
purchaser to purchase the S&P 500 index at a specified
settlement date for a specified amount.

Stock index futures contracts have settlement dates on the
third Friday in March, June, September, and December.

The securities underlying the stock index futures contracts
are not actually deliverable, so settlement occurs through a
cash payment.

Like other financial futures contracts, stock index futures
can be closed out before the settlement date by taking an
offsetting position.
Market Risk
■ Refers to fluctuations in the value of the instrument as a
result of market conditions.
Basis Risk
■ The risk that the position being hedged by the futures
contracts is not affected in the same manner as the
instrument underlying the futures contract.
■ Applies only to those firms or individuals who are using
futures contracts to hedge.
Liquidity Risk
■ Refers to potential price distortions due to a lack of liquidity.
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Credit Risk
■ The risk that a loss will occur because a counterparty
defaults on the contract.
■ This type of risk exists for over-the-counter transactions in
which a firm or individual relies on the creditworthiness of a
counterparty.
Prepayment Risk
■ Refers to the possibility that the assets to be hedged may be
prepaid earlier than their designated maturity.
Operational Risk
■ The risk of losses as a result of inadequate management or
controls.
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Currency Futures Contracts
■ A standardized agreement to deliver or receive a specified
amount of a specified foreign currency at a specified price
(exchange rate) and date.
■ The settlement months are March, June, September, and
December.
■ Purchasers of currency futures contracts can hold the
contract until the settlement date and accept delivery of the
foreign currency at that time, or they can close out their long
position prior to the settlement date by selling the identical
type and number of contracts before then.
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■ explain how stock index futures contracts are used to speculate or hedge
based on anticipated stock price movements
■ explain how single stock futures are used to speculate on anticipated stock
price movements
■ describe the different types of risk to which traders in financial futures
contracts are exposed
■
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explain how interest rate futures contracts are used to speculate or hedge
based on anticipated interest rate movements
Call Option: right to buy underlying financial instrument at
exercise price (or strike price) within a specified period of time.
■ In the money when market price > exercise price
■ At the money when market price = exercise price
■ Out of the money when market price < exercise price
Put Option: right to sell underlying financial instrument at
exercise price (or strike price) within a specified period of time.
■ In the money when market price < exercise price
■ At the money when market price = exercise price
■ Out of the money when market price > exercise price
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Comparison of Options and Futures
■ To obtain an option, a premium must be paid in addition to
the price of the financial instrument.
■ The owner of an option can choose to let the option expire
on the expiration date without exercising it.
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Hedging with Covered Call Options
■ Call options on a stock can be used to hedge a position in that
stock.
■ When the stock declines in value, the premium received from
selling the call partially offsets the losses incurred on the
stock.
■ When the stock increases in value, the call will be exercised
and the stock will be sold to the purchaser of the call option.
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Hedging with Put Options
■ Put options are used to hedge when portfolio managers are
concerned about a temporary decline in a stock’s value.
■ Hedging with LEAPs
■ Long-term equity anticipations (LEAPs) are options that
have longer terms to expiration, usually between two and
three years from the initial listing date.
■ These options are available for some large capitalization
stocks, and they may be a more effective hedge over a
longer term period than using options with shorter terms
to expiration.
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Hedging with Stock Index Options
Financial institutions and other firms commonly take
positions in options on ETFs or indexes to hedge against
market or sector conditions that would adversely affect their
asset portfolio or cash flows.
Dynamic Asset Allocation with Stock Index Options
Dynamic asset allocation involves switching between risky
and low-risk investment positions in response to changing
expectations. Some portfolio managers use stock index
options as a tool for dynamic asset allocation.
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■ An option on a particular futures contract gives its owner
the right (but not an obligation) to purchase or sell that
futures contract for a specified price within a specified
period of time.
■ Options are available on stock index futures.
■ Options on indexes have become popular for speculating on
general movements in the stock market.
■ Options are also available on interest rate futures, such as
Treasury note futures or Treasury bond futures.
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explain why stock option premiums vary
■ explain how stock options are used to speculate
■ explain how stock options are used to hedge
■ explain the use of stock index options
■ explain the use of options on futures
■ Q&A: 1, 3, 4, 9, 11, 14 Interp: a, c
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An interest rate swap is an arrangement whereby one
party exchanges one set of interest payments for
another.
The provisions of an interest rate swap include:
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■ The notional principal value to which the interest rates are
applied to determine the interest payments involved.
■ The fixed interest rate.
■ The formula and type of index used to determine the
floating rate.
■ The frequency of payments, such as every six months or
every year.
■ The lifetime of the swap.
■ An example of a swap is an agreement to exchange 11
percent fixed-rate payments for floating payments at the
prevailing one-year Treasury bill plus 1 percent based on $30
million notional principal.
■ Swap payments are usually netted.
■ The market for swaps is facilitated by over-the-counter
trading rather than trading on an organized exchange.
■ Interest rate swaps became popular in the early 1980s when
corporations were experiencing large fluctuations in interest
rates.
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Use of Swaps for Hedging
■ Financial institutions in the U.S. with more interest
rate sensitive liabilities than assets were adversely
affected by increasing interest rates.
■ Financial institutions in Europe had more access to
long-term fixed rate funding and used the funds for
floating-rate loans and were adversely affected by
declining interest rates.
■ Interest rate swaps allowed both types of financial
institutions to reduce exposure to interest rate risk.
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Plain Vanilla Swaps (fixed-for-floating swap)
■ Fixed-rate payments are periodically exchanged for
floating-rate payments.
Forward Swaps
■ Involves an exchange of interest payments that does
not begin until a specified future time.
■ Useful for financial institutions or other firms that
expect to be exposed to interest rate risk at some
time in the future.
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Callable Swaps
■ Gives the party making the fixed payments the right
to terminate the swap prior to its maturity.
■ It allows the fixed-rate payer to avoid exchanging
future interest payments if it desires.
Putable Swaps
■ Gives the party making the floating-rate payments
the right to terminate the swap.
■ A putable swap allows the institution to terminate
the swap in the event that interest rates rise (see
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Equity Swaps
■ Involves the exchange of interest payments for
payments linked to the degree of change in a stock
index.
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Basis Risk
■ The interest rate of the index used for an interest rate swap
will not necessarily move perfectly in tandem with the
floating-rate instruments of the parties involved in the swap.
■ When this happens, the higher payments received do not
offset the increase in the cost of funds.
■ Basis risk prevents the interest rate swap from completely
eliminating the financial institutions exposure to interest rate
risk.
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Credit Risk
■ There is risk that a firm involved in an interest rate swap will
not meet its payment obligations.
■ Concerns about a Swap Credit Crisis - The willingness of large
banks and securities firms to provide guarantees has
increased the popularity of interest rate swaps, but it has also
raised concerns that widespread adverse effects might occur
if any of these intermediaries cannot meet their obligations.
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Sovereign Risk
■ Reflects potential adverse effects resulting from a
country’s political conditions.
■ Sovereign risk differs from credit risk because it
depends on the financial status of the government
rather than on the counterparty itself.
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Interest Rate Caps
■ Offers payments in periods when a specified interest rate
index exceeds a specified ceiling (cap) interest rate.
■ The payments are based on the amount by which the interest
rate exceeds the ceiling, multiplied as usual by the notional
principal specified in the agreement.
■ The buyer of a cap is a financial institution that would be
adversely affected by rising interest rates.
■ The seller of a cap receives the fee and is obligated to
provide payments when rates exceed the ceiling rate.
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Interest Rate Floors
■ Offers payments in periods when a specified interest rate
index falls below a specified floor rate.
■ The payments are based on the amount by which the interest
rate falls below the floor rate, which is multiplied by the
notional principal specified in the agreement.
■ The buyer of an interest rate floor will receive payments
when interest rates decline below the floor.
■ The seller of an interest rate floor receives a fee and is
obligated to provide periodic payments when the interest
rate falls below the floor rate specified in the agreement.
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Interest Rate Collars
■ Involves the purchase of an interest rate cap and the
simultaneous sale of an interest rate floor.
■ Because the collar also involves the sale of an
interest rate floor, the financial institution is
obligated to make payments if interest rates decline
below the floor.
■ Q&A: 2, 5, 7, 10, 13, 15, 16
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