Chapter 9 Demystifying Derivatives v 27
Chapter 9
Money and Capital Markets
n CHAPTER OUTLINE
I. An Overview of Financial Futures
A. Using financial futures contracts
B. Pricing financial futures contracts
II. An Overview of Options Contracts
A. Using and valuing options
B. What determines option premiums
III. An Overview of Swaps
A. Why swap?
B. Valuing a swap
n CHAPTER SUMMARY
The name derivative comes from the fact that a derivative contract derives its value from the value of an underlying security. This chapter describes some of the basic characteristics of the main categories of derivative contracts (futures, options, and swaps) and explains how these derivatives are priced and used. Futures contracts are used by financial institutions to reduce the risk of price changes in the underlying security. Long hedgers buy futures, while short hedgers sell futures. For example, a bank that wishes to protect against the possible loss in value of its assets if interest rates rise and prices fall should short hedge (i.e., sell futures contracts on those assets). If prices fall, these contracts will rise in value to offset the losses on the bank’s balance sheet.
Options contracts provide the right, but not the obligation, to sell (put option) or buy (call option) the underlying security at a stated price (strike or exercise price) on or before the contract’s expiration date. Options are essentially an insurance policy against an adverse price movement and option writers (sellers) charge a premium to provide this insurance. Financial institutions can use options to hedge balance sheet risk, much as described above for futures contracts. Option prices rise when the price of the underlying security is more volatile or when the expiration date is further in the future, because these factors increase the risk to the seller that the option will be exercised.
Interest rate swaps are contractual agreements between two parties to exchange interest payments over a specified time period. Financial institutions like swaps because they provide a low transactions cost method for reducing the risk associated with a mismatch of maturities on their assets and liabilities.
n TEACHING
This chapter explores the options and futures markets in detail, and a final section discusses interest‑rate swaps. Emphasize the use of these instruments in portfolio composition and risk reduction. Point out the differences between options and futures. Material from financial news sources can readily be included in class discussions. A common sticking point for students is distinguishing between changes in the value or premium of an option contract and the value of the underlying security. Also emphasizing the difference between selling an option and exercising a put option is usually well worth the time. Comparing put options to auto insurance is a useful way of making the connection between options and insurance. More volatile drivers pay higher insurance premiums, just as more volatile stock prices cause underlie options with higher premiums.
If pressed for time, the final section on swaps can be cut.
Useful Internet sites
1. http://www.numa.com/ — for links to lots of basic information about derivatives and their markets.
2. http://www.ex.ac.uk/~RDavies/arian/scandals/derivatives.html — for the cynic, a list of links to sites concerning economic scandals including some related to derivative trading.
n DISCUSSION QUESTIONS
1. What are speculators? Do they have a destabilizing effect on the financial system?
They take open positions in derivative markets in the hope of making a profit. While they could conceivably have a destabilizing effect, they are more likely to have a stabilizing effect as they are likely to position themselves to profit when prices are away from long-run equilibrium. They also add depth to the markets, which makes hedging much easier.
2. Under what conditions would you be a long hedger in financial futures? A short hedger?
A long hedger wishes to protect against a rise in the price of the underlying asset. A short hedger wishes to protect against a fall in the price of an asset.
3. Would you buy stock index futures at this time based on the S&P 500?
Yes, if I were extremely confident that the S&P 500 index would rise above the price of the futures contract.
4. What are financial futures used for?
Hedgers use them to offset other positions so that a price movement that causes losses on these positions will cause gains on their financial futures position. Speculators use financial futures to “bet” on certain price movements. That is, a speculator who believe prices on an asset will rise can take a long position in a futures contract that will payoff if prices actually do rise. Though these same positions could be taken by buying the underlying security, futures contracts allow the investor greater leverage.
5. Aren’t financial futures and options markets just serving a speculative buildup of asset prices fueled by greed?
No, it is much more like insurance against an undesirable outcome. Though it is essentially gambling for speculators, but it actually reduces risks for hedgers. Moreover, speculators could actually serve to reduce “speculative buildup.”
n ANSWERS TO QUESTIONS IN TEXT
1. Legitimate hedgers use the futures market do not normally make or take delivery when using futures contracts to offset risk. The profits or losses from the contract are what is important to the hedger, and these can be settled between the two parties without delivery of the underlying security.
2. During the delivery period, rights and obligations force the price of the futures contract and the price of the underlying security to be equal. If the price of the futures contract is higher, arbitragers would sell them, then buy the securities at a lower price, pocket the difference, and deliver the securities in satisfaction of their obligation as shorts. And vice versa, if the price is lower, arbitragers would buy them and sell the actual security.
3. Unlike futures contracts, the rights and obligations of options buyers and sellers are not symmetrical. The buyer of a call has the right to buy the underlying asset at a future time and the seller has an obligation to sell it. The buyer pays the seller an option premium for that right.
4. The main difference between the two hedging strategies occurs when bond prices rise. Because of the asymmetrical payoff on puts, the option buyer is protected from downside risk but retains upside potential. Selling futures as a hedge gives downside protection but also eliminates upside potential. The decision on which strategy is optimal depends on the option premium. Zero price movement will cause zero profit or loss on the futures contract but loss of the premium on the options contract.
5. The greater the volatility of a stock price, the more likely the price is to move such that the option moves into the money. Therefore, given the current stock price, call option buyers are willing to pay more for a call option on a volatile stock. Large declines are not a major concern to the option buyer, due to asymmetrical payoff to the call.
6. Because the fixed‑rate payer receives a higher variable rate on the notional principal, while continuing to pay the same fixed rate.
7. There would be benefits and costs associated with such laws. Most participants in these markets are well‑informed; many are institutional investors. Currently, information about options and futures is sent to those private citizens who wish to take advantage of those instruments. The costs would be in thinner markets; the laws might lead to larger spreads. The benefit might be the disqualification of high‑pressure operators who may be recruiting unsophisticated investors.
n ESSAY QUESTIONS
1. Distinguish between financial futures and options contracts.
Futures are standardized agreements to buy or sell a particular asset at a future date for a currently agreed‑upon price. Options are divided into two parts: buyers of puts have the right to sell the underlying security at a fixed price, and buyers of calls have the right to buy the underlying security at a fixed price. Options contracts do not impose an obligation on the buyer.
2. How are financial futures contracts standardized? What is benefit of this?
Standardized contracts are bought and sold on the organized futures markets. Terms are established by the exchange that sponsors the contracts. Only the price is open for negotiation. Standardization increases liquidity and lowers transaction costs. Perhaps most importantly, all traders pay or receive payment from the exchange rather from the other party in the transactions. This removes the need to know with whom one is trading or their credit rating.
3. What is the role of arbitragers in futures markets? What impact do they have on futures prices?
Arbitragers buy and sell futures contracts when there is a difference between the futures price and the prices of the underlying asset. This activity tends to close that difference. They improve market efficiency.
4. Suppose you are advising a relatively risk‑averse person. Would you recommend futures or options to him?
Options are probably more attractive. The asymmetric payoff to puts and calls means that unlimited gains are possible, while losses are limited to the premium paid for the option. But my recommendation would also depend on the other assets the person had in his or her portfolio.
5. What are the primary determinants of the price of an option on an individual asset?
Included are the price volatility of the underlying asset and the length of time before the option expires. Puts and calls are influenced (in opposite directions) by the price of the underlying asset.