CHAPTER FIFTEEN
THE ROLE OF
DERIVATIVE ASSETS
© 2001 South-Western College Publishing
Outline

Background



The Rationale for Derivative Assets
Uses of Derivatives
The Options Market





Options Terminology
The Financial Page Listing
The Origin of an Option
The Role of the Options Clearing Corporation
Standardized Option Characteristics
2
Outline

The Futures Market





Futures vs. Options
Market Participants
Keeping the Promise
Categories of Futures Contracts
Financial Futures



Stock Index Futures
Interest Rate Futures
Foreign Currency Futures
3
Outline

Derivative Assets and the News



Current Events
Risk of Derivative Assets
Listed vs. Over-the-Counter Derivatives
4
Background :
The Rationale for Derivative Assets

The first organized derivatives
exchange in the United States
was developed in order to bring
stability to agricultural prices, by
enabling farmers to eliminate or
reduce their price risk.
5
Background : Uses of Derivatives

Risk management : The equity manager’s
market risk or the bond manager’s interest
rate risk is analogous to the farmer’s price
risk.

Risk transfer : Derivatives provide a means
for risk to be transferred from one person to
some other market participant who, for a
price, is willing to bear it.

Derivatives may provide financial leverage.
6
Background : Uses of Derivatives

Income generation : Some people use
derivatives as a means of generating
additional income from their investment
portfolio.

Financial engineering : Derivatives can be
stable or volatile depending on how they are
combined with other assets.

What’s next?
7
Options Terminology

A call option gives its owner the right to buy a
specified quantity of the underlying asset at a
set price within a set time period.

A put option gives its owner the right to sell a
specified quantity of the underlying asset at a
set price within a set time period.

The set price is called the striking price or
exercise price, and the last day the option is
valid is called the expiration date.

The price of the option is the premium.
8
Options Terminology

Options trade in units called contracts, each
of which normally covers 100 shares.

An option’s volume indicates how many
option contracts changed hands over some
period of time. It measures trading activity.

An option’s open interest indicates how many
option contracts exist.

Open interest goes up when someone creates an
option and does down when two people trade and
each close out an options position.
9
The Options Market : The Financial Page Listing
Microsoft Option Prices, November 16, 1999
Microsoft Stock Price = 87 5/16
Calls
Puts
Striking Expiration Volume Last
Open Volume Last
Open
Price
Price Interest
Price Interest
70
70
70
70
75
75
75
75
77 1 2
80
80
Nov
Dec
Jan
Apr
Nov
Dec
Jan
Apr
Jan
Nov
Dec
100
…
6
…
206
27
103
22
1
1325
248
17 5 8
…
17 7 8
…
12 1 2
12
14 3 4
17
11 5 8
7 58
9 18
1380
548
81584
2924
8740
512
98572
2416
9144
12724
…
3
203
10
…
299
74
1361
221
1121
…
3
13
8
16
3
2 8
…
11
1
3
2
1
16
1
3
1
16
2
8
8
26748
8408
78678
48596
20988
12464
111656
11604
51736
56556
10
The Origin of an Option

Options can be created, or destroyed. The
quantity of options in existence changes
everyday.

The first trade someone makes in a particular
option is called an opening transaction. If an
investor sells an option as an opening
transaction, it is called writing the option.

Options are fungible, meaning that, for a
given company, all options of the same type
with the same expiration and striking
price are identical.
11
The Role of the Options Clearing Corporation

The Options Clearing Corporation positions
itself between every buyer and seller and acts
as a guarantor of all option trades.
OCC
Buyer
Trading Floor
Seller
12
Standardized Option Characteristics

Options have standardized expiration dates,
striking prices, and lot size.

option premium = intrinsic value + time value
If an option has no intrinsic value, it is out-ofthe-money. Otherwise, it is either in-themoney or at-the-money.

An American option can be exercised
anytime prior to the expiration of the option.
A European option, on the other hand, can
only be exercised at expiration.
13
The Futures Market

A futures contract is a promise.
The initial seller of the contract promises to
deliver a quantity of a standardized
commodity to a designated delivery point
during a certain delivery month.
 The other party to the trade promises to pay a
predetermined price for the goods upon
delivery.
 The person who promises to buy is said to be
long, while the person who promises to
deliver is said to be short.

14
The Futures Market

Futures vs. options : Futures contracts do
not expire unexercised.

Market participants :
 Hedgers use futures to reduce price risk.
 Speculators assume risk in the hope of
making a profit.
 Marketmakers provide liquidity for the
marketplace.
15
The Futures Market

Keeping the promise : Each exchange has a
clearing corporation which ensures the
integrity of the futures contract when a
member is in financial distress.

Categories of futures contracts :
 Agricultural e.g. wheat, cotton, cattle, eggs.
 Metals and petroleum e.g. platinum, copper,
natural gas, crude oil.
 Financial e.g. foreign currency, stock index,
interest rate.
16
Financial Futures : Stock Index Futures

A stock index future is a promise to buy or sell
the standardized units of a specific index at a
fixed price at a predetermined future date.

Unlike most other commodity contracts, there
is no actual delivery mechanism when the
contract expires. For practicality, all
settlements are in cash.
17
Financial Futures : Interest Rate Futures

Interest rate futures contracts are customarily
grouped into short-term, intermediate-term,
and long-term categories.

The two principal short-term contracts are
Eurodollars and U.S. Treasury bills.

The Treasury bill futures contract calls for the
delivery of $1 million par value of 90-day Tbills on the delivery date of the futures
contract.
18
Financial Futures : Interest Rate Futures

The contract on U.S. Treasury notes is the
only intermediate-term contract, while
Treasury bonds are the principal long-term
contracts.

The Treasury bond futures contract calls for
the delivery of $100,000 face value of U.S.
Treasury bonds with a minimum of 15 years
until maturity (and, if callable, with a minimum
of 15 years of call protection). Bonds that
meet these criteria are said to be deliverable.
19
Financial Futures : Interest Rate Futures

T-bonds are not all fungible. At any given time,
several dozen bonds are usually eligible for
delivery on a T-bond futures contract. Normally,
only one of these bonds will be cheapest to
deliver.

Bonds are standardized as follows:
invoice
settlement conversion
accrued
x factor
] + interest
price = [
price
20
Financial Futures : Foreign Currency Futures

Foreign currency futures contracts call for
delivery of the foreign currency in the country
of issuance to a bank of the clearing house’s
choosing.

Most major corporations face at least some
foreign exchange risk and quickly discovered
the convenience of these futures as a hedging
vehicle, while speculators saw the contracts
as easy to understand and use.
21
Derivative Assets and the News

Newspapers in recent months have
been full of reports on various
businesses that have lost billions
“investing in derivatives.”

Derivatives are neutral products. Their risk
depends on what an investor does with them.

Exchange-traded derivative assets and overthe-counter derivatives are markedly different.
22
Review

Background
The Rationale for Derivative Assets
 Uses of Derivatives


The Options Market
Options Terminology
 The Financial Page Listing
 The Origin of an Option
 The Role of the Options Clearing Corporation
 Standardized Option Characteristics

23
Review

The Futures Market
Futures vs. Options
 Market Participants
 Keeping the Promise
 Categories of Futures Contracts


Financial Futures
Stock Index Futures
 Interest Rate Futures
 Foreign Currency Futures

24
Review

Derivative Assets and the News
Current Events
 Risk of Derivative Assets
 Listed vs. Over-the-Counter Derivatives

25