SM Money Banking And Financial Markets 4Th Edition By Stephen G. Cecchetti

SM Money Banking And Financial Markets 4Th Edition By Stephen G. Cecchetti

Chapter 9
Derivatives: Futures, Options, and Swaps

Chapter Overview

This chapter provides an introduction to derivatives, and examines both their uses and abuses.

Learning Objectives: Establish an understanding of:
1. How derivatives transfer risk
2. Forward versus futures contracts
3. Options and their pricing
4. Use and abuse of swaps

Important Points of the Chapter

Recent history has shown that derivatives are open to abuse; they were at the bottom of the scandal that engulfed Enron and were also linked to the collapse of Long Term Capital Management (the hedge fund). But when used properly, derivatives are extremely helpful instruments that can be used to reduce risk, or as a form of insurance.

Application of Core Principles

Principle #2: Risk. Derivatives allow people to transfer risk, and this encourages them to do things they would not otherwise do because in effect they provide a kind of insurance.

Principle #1: Time. The longer the time to expiration, the more valuable an option.

Principle #2: Risk. The option premium increases with the volatility of the price of the underlying asset.

Principle #2: Risk. The difference between the benchmark rate for a swap (the market interest rate on a U.S. Treasury bond of the same maturity as the swap) and the swap rate (the rate to be paid) is called the swap spread, and is a measure of risk. In recent years it has attracted substantial attention as a measure of the overall risk in the economy (systematic risk).

Teaching Tips/Student Stumbling Blocks

• Derivatives were first introduced back in Chapter 3; you may wish to review that material.
• The material on hedging and speculation was introduced in Chapter 5; you may wish to review that material before beginning section II.
• Give students a brief look at the action at the Chicago Board of Trade; part of the movie Ferris Bueller’s Day Off (1986) was filmed there and showing that very brief clip of the movie (it’s probably less than a minute) can really give them a feel for the action in the pits.

Features in this Chapter

Lessons from the Crisis: Centralized Counterparties and Systemic Risk

Both a loss of liquidity and transparencies can threaten the financial system. One way to keep markets functioning is to shift trading from over-the-counter transactions (OTC), which occur between a single buy and a single seller, to a centralized counterparty, which is an intermediary between buyers and sellers. When trading OTC, a firm can build up significant risk without the other parties to the transactions knowing of the risk. A CCP has the ability and incentive to monitor the riskiness of its counterparties. The CCP can also standardize contracts and refuse to trade with a counterparty that may not be able to pay. Further, a CCP limits its own risk through economies of scale.

Your Financial World: Should You Believe Corporate Financial Statements?

While financial statements must meet exacting accounting standards, that does not mean they accurately reflect a company’s true financial position. Unfortunately, the standards are so specific that they provide a roadmap for the creation of misleading statements. Investors should never trust an accounting statement that doesn’t meet the standards set forth by financial regulators and should look for companies that are open in their financial accounting. Finally, investors should remember that diversification reduces risk.

Your Financial World: Should You Accept Options as Part of Your Pay?

Many firms that offer options on their own stock to employees view options as a substitute for wages. But while the options may have substantial value, there is a catch: employees generally are not allowed to sell them, and may need to remain with the firm to exercise them. Employees should think hard before trading salary for options; investing in the same company that pays your salary is a risky business.

Applying the Concept: What Was Long-Term Capital Management Doing?

Long-Term Capital Management, a Connecticut-based hedge fund, engaged in a large number of complex speculative transactions, including interest rate swaps and options writing. In the late 1990s its erroneous bet that interest rate spreads would shrink resulted in losses of over $2.5 billion. The Federal Reserve Bank of New York formed a group of banks and investment companies to purchase the company for fear that its collapse would jeopardize the entire financial system.

In the News: No Insurance Pay-out on Greek Debt

Credit default insurance will not pay out on Greek sovereign bonds despite the restructuring of €186bn of the country’s debt. The International Swaps and Derivatives Association decided that the bonds had not suffered a credit event. Some argue that this decision sets a dangerous precedent, undermining the credit default market.

Additional Teaching Tools
In “AIG’s Rescue Had ‘Poisonous’ Effect, U.S. Panel Says (Update1),” June 10, 2010, Business Week reports that the government takeover of AIG has poisoned the marketplace because now investors believe that the American taxpayer will fix whatever problems come about.

At http://online.wsj.com/video/german-ban-stirs-suspicions/F0C8E8D5-56CA-4EA7-9D16-82643A3A5D2F.html?KEYWORDS=credit+default+swaps, a Wall Street Journal video discusses Germany’s ban on the naked short selling of euro-zone bonds, credit default swaps and certain equities that will keep market suspicions about Europe aroused for a few days yet.

Virtual Tools

Visit the Chicago Board of Trade on the web at: http://www.cbot.com/

The Commodity Futures Trading Commission oversees the futures industry and issues a weekly report on the positions of both speculative and commercial market participants. Visit them on the web at: http://www.cftc.gov/About/index.htm.

In response to the accounting scandals of recent years, Congress approved the Sarbanes-Oxley Act of 2002. Learn more about the Act at http://www.soxlaw.com/.

Learn more about the Stock Option Accounting Reform Bill (H.R. 3574) introduced by Rep. Baker on Nov. 21 and referenced in The Wall Street Journal story above on this page from the web site of the House Committee on Financial Services:
http://financialservices.house.gov/news.asp?FormMode=release&id=510&NewsType=1

You can visit FASB on the web at: http://www.fasb.org/

For More Discussion

Many consumers who shop on line prefer to use a service like PayPal instead of entering their credit card information. Does PayPal provide a service similar to the clearinghouse described in the chapter? Discuss.

Chapter Outline
I. The Basics: Defining Derivatives
A. Derivatives are financial instruments whose value depends on (i.e., is derived from) the value of some other underlying financial instrument or asset (these include stocks or bonds as well as other assets).
A simple example is an interest rate futures contract, which is an agreement between two investors that obligates one to make a payment to the other depending on the movement in interest rates over the next year.
B. Such an arrangement is very different from the purchase of a bond for two reasons:
1. Derivatives provide an easy way for investors to profit from price declines, as opposed to the purchase of a bond, which is a bet that its price will increase.
In a derivatives transaction, one person’s loss is always the other person’s gain.
C. Derivatives can be used to speculate on future price movements, but because they allow investors to manage and reduce risk, they are indispensable to a modern economy.
The purpose of derivatives is to transfer risk from one person or firm to another, providing a kind of insurance.
D. Derivatives increase the risk-carrying capacity of the economy as a whole, improving the allocation of resources and increasing the level of output.

E. Derivatives also can be used to conceal the true nature of certain financial transactions because they can be used to unbundle virtually any group of future payments and risks.
Derivatives may be divided into three major categories: forwards and futures, options, and swaps.
II. Forwards and Futures
A. Of all derivative financial instruments, forwards and futures are the simplest to understand and the easiest to use.
B. A forward or forward contract is an agreement between a buyer and seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date.
1. They are very difficult to resell to someone else because they are customized.
C. A future or futures contract is a forward contract that has been standardize and sold through an organized exchange.
1. A futures contract specifies that the seller (the short position) will deliver some quantity of a commodity or financial instrument to the buyer (the long position) for a predetermined price.
2. No payments are made initially when the contract is agreed to.
3. The seller benefits from price declines in the price of the underlying asset, while the buyer gains from increases.
D. Before anyone will buy or sell futures contracts there must be assurance that the buyer and seller will meet their obligations; this is done through a clearing corporation.
E. Margin Accounts and Marking to Market
1. To reduce the risk it faces, the clearing corporation requires both parties to a futures contract to place a deposit with the corporation itself.
2. This is called posting margin in a margin account and the deposits (called the initial margin) serve as a guarantee that when the contract comes due the parties will be able to meet their obligations.
3. The clearing corporation also posts daily gains and losses on the contract to the margin accounts of the parties involved; this is called marking to market.
4. This ensures that both sides can meet their obligations; if the margin account falls below a minimum the clearing corporation will sell the contracts and end the person’s participation in the market.
F. Hedging and Speculating with Futures
1. Futures contracts allow risk to be transferred between buyer and seller.
2. This transfer can be accomplished through hedging or speculation.
3. A futures contract fixes the price for both the seller and the buyer and so both can use it as a hedge against unfavorable price movements.
4. Speculators are trying to make a profit by betting on price movements.
5. Futures contracts are popular tools for speculation because they are cheap.
6. An investor needs only a relatively small amount of funds (the margin, which can be as low as 10 percent) to purchase a futures contract that is worth a great deal.
7. For example, if the margin is $1,485 to purchase a $100,000 U.S. Treasury bond, then the investment of $1,485 gives the investor the same returns as the purchase of the bond; it is as if the buyer borrowed the balance ($98,515) at a zero rate of interest.
8. Speculators can use futures to obtain very large amounts of leverage at a very low cost.
G. Arbitrage and the Determinants of Futures Prices
1. On the settlement or delivery date the price of the futures contract must equal the price of the underlying asset, otherwise there would be a risk-free profit.
2. Arbitragers simultaneously buy and sell financial instruments in order to benefit from temporary price differences.
3. As a result of arbitrage, two financial instruments with the same risk and promised future payments will sell for the same price.
4. If that were not true, arbitragers would buy and sell, changing demand and forcing the prices to equality.
5. So long as there are arbitragers, on the day when a futures contract is settled, the price of a bond futures contract will be the same as the market price of the bond.
6. Before the settlement date, the futures price moves in lock step with the market price of the bond.
III. Options
A. Puts, Calls, and All That: Definitions
1. Like futures, options are agreements between two parties, a seller (option writer) and a buyer (option holder).
2. Option writers incur obligations, while option holders obtain rights.
3. There are two basic options, calls (the right to buy) and puts (the right to sell).
4. A call option has a predetermined price (the strike price) and a specific date.
a) The writer of the call option must sell the shares if and when the holder chooses to use the call option, but the holder is not obligated to buy the shares.
b) The holder will buy (exercise the option) only if doing so is beneficial.
c) The holder could also sell the option to someone else at a profit.
B. Whenever the price of the stock is above the strike price of the call option, the option is “in the money”. (If the prices are equal it is “at the money” and if the price is less than the stock price it is “out of the money”.)
1. A put option gives the holder the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date.
a) The writer of the option is obliged to buy the shares if the holder chooses to exercise the option.
b) Puts are “in the money” when the option’s strike price is above the market price of the stock; they are “out of the money” when the strike price is below the market price, and “at the money” when the two prices are equal
2. Many options are standardized and traded on exchanges just like futures contracts, and the mechanics of trading are the same.
3. There is a clearing corporation, but only writers of options are required to post margin.
a) There are two types of options: American options can be exercised on any date from the time they are written until the day they expire; European options can only be used on the day they expire
b) The vast majority of options traded in the United States are American.
C. Using Options
1. Options transfer risk from the buyer to the seller so they can be used for both hedging and speculation.
2. When used for hedging, a call option ensures that the cost of buying the asset will not rise and a put option ensures that the price at which the asset can be sold will not go down.
a) Car insurance is like an American call option, sold by the insurance company to the car’s owner.
3. How options are used for speculation: if you believed that interest rates were going to fall, you could bet on this by buying a bond (expensive), buying a futures contract (cheap but risky), or by buying a call option on a U.S. Treasury bond. If you are right, its value will increase; if you are wrong all you lose is the price paid for the call option.
4. Purchasing a put option allows an investor to speculate on a decrease in the price of an asset.
5. Sellers of options are speculators or are insured against any loss that may arise because they own the underlying asset (market makers).
6. Options are versatile and can be bought and sold in many combinations.
7. Options can be used to construct synthetic instruments that mimic the payoffs of virtually any other financial instrument.
8. Options allow investors to bet that prices will be volatile.
D. Pricing Options: Intrinsic Value and the Option Premium
1. An option price is the sum of two parts: the value of the option if it is exercised (the intrinsic value) and the fee paid for the option’s potential benefits (the time value of the option).
2. As the volatility of the stock price rises, the time value of the option rises with it.
3. In general, calculating the price of an option and how it might change means developing some rules for figuring out its intrinsic value and the time value of the option.
4. Since the buyer is not obligated to exercise it, the intrinsic value of the option depends only on what the holder receives if it is exercised.
5. The intrinsic value is the difference between the price of the underlying asset and the strike price of the option, or the size of the payment, and it must be greater than or equal to zero.
6. At expiration, the value of an option equals its intrinsic value, but prior to expiration there is always the chance that the price will move.
7. The longer the time to expiration, the bigger the likely payoff when the option does expire and thus the more valuable it is.
8. The likelihood that an option will pay off depends on the volatility of the price of the underlying asset; the time value of the option increases with that volatility.