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Financial Markets & Institutions Ch10
 

Financial Markets & Institutions Ch10

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Financial Markets & Institutions

Financial Markets & Institutions

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    Financial Markets & Institutions Ch10 Financial Markets & Institutions Ch10 Presentation Transcript

    • 8- McGraw-Hill/Irwin Chapter Ten Derivative Securities Markets
    • Derivatives
      • A derivative security is an agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specific date in the future
      • Derivative securities markets are the markets in which derivative securities trade
      • Derivatives involve the buying and selling (i.e., the transfer of) risk , which results in a positive impact on the economic system
      • Derivatives are used for hedging and for speculation
      10- McGraw-Hill/Irwin
    • Derivatives
      • The first wave of modern derivatives were foreign currency futures introduced by the International Monetary Market (IMM) following the Smithsonian Agreements of 1971 and 1973
      • The second wave of modern derivatives were interest rate futures introduced by the Chicago Board of Trade (CBT) after the Fed started to target nonborrowed reserves in the late 1970s
      • The third wave of modern derivatives occurred in the 1990s with the advent of credit derivatives
      10- McGraw-Hill/Irwin
    • Forwards and Futures
      • A spot contract is an agreement to transact involving the immediate exchange of assets and funds
      • A forward contract is a nonstandardized agreement to transact involving the future exchange of a set amount of assets at a set price
      • A futures contract is a standardized exchange traded agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily
      10- McGraw-Hill/Irwin
    • Futures Markets
      • Futures contracts are usually traded on organized exchanges
      • Exchanges indemnify counterparties against credit (i.e., default) risk
      • Futures are market to market daily
        • marked to market describes the prices on outstanding futures contracts that are adjusted each day to reflect current futures market conditions
      • The five major U.S. exchanges are the CBOT, CME, NYFE, MACE, and KCBOT
      • The principal regulator of futures markets is the Commodity Futures Trading Commission (CFTC)
      10- McGraw-Hill/Irwin
    • Futures Markets
      • Futures contract trading occurs in trading “pits” using an open-outcry auction among exchange members
        • floor brokers place trades for the public
        • professional traders trade for their own accounts
        • position traders take a position in the futures market based on their expectations about the future direction of the prices of the underlying assets
        • day traders take a position within a day and liquidate it before day’s end
        • scalpers take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading
      10- McGraw-Hill/Irwin
    • Futures Contract Terms
      • Trading unit
      • Deliverable grades
      • Tick size
      • Price quote
      • Contract months
      • Last trading day
      • Last delivery day
      • Delivery method
      • Trading hours
      • Ticker symbols
      • Daily price limit
      10- McGraw-Hill/Irwin
    • Futures Contracts
      • A long position is the purchase of a futures contract
      • A short position is the sale of a futures contract
      • A clearinghouse is the unit that oversees trading on the exchange and guarantees all trades made by the exchange
      • Open interest is the total number of the futures, put options, or call options outstanding at the beginning of the day
      10- McGraw-Hill/Irwin
    • Futures Contracts
      • An initial margin is a deposit required on futures trades to ensure that the terms of the contracts will be met
      • The maintenance margin is the margin a futures trader must maintain once a futures position is taken
        • if losses occur such that margin account funds fall below the maintenance margin, the customer is required to deposit additional funds in the margin account
      • Futures trades are leveraged investments as traders post and maintain only a small portion of the value of their futures position and “borrow” the rest from brokers
      10- McGraw-Hill/Irwin
    • Options
      • An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price within a specified period of time
      • A call option is an option that gives the purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a specified exercise price on (or up to) a specified date
      • A put option is an option that gives the purchaser the right, but not the obligation, to sell the underlying security to the writer of the option at a specified exercise price on (or up to) a specified date
      10- McGraw-Hill/Irwin
    • Payoff Functions for Call Options 10- McGraw-Hill/Irwin Payoff Payoff function profit for buyer C 0 Stock Price X at expiration -C Payoff Payoff function loss for writer Options
    • Payoff Functions for Put Options 10- McGraw-Hill/Irwin Payoff Payoff function profit for buyer P 0 Stock Price X at expiration -P Payoff Payoff function loss for writer Options
    • Options
      • The Black-Scholes option pricing model (the model most commonly used to price and value options) is a function of
        • the spot price of the underlying asset
        • the exercise price on the option
        • the option’s exercise date
        • the price volatility of the underlying asset
        • the risk-free rate of interest
      • The intrinsic value of an option is the difference between an option’s exercise price and the underlying asset price
        • the intrinsic value of a call option = max{S – X, 0}
        • the intrinsic value of a put option = max{X – S, 0}
      10- McGraw-Hill/Irwin
    • Please insert Figure 10-8 here. 10- McGraw-Hill/Irwin
    • Option Markets
      • The Chicago Board of Options Exchange (CBOE) opened in 1973 as the first exchange devoted solely to the trading of stock options
      • Options on futures contracts began trading in 1982
      • An American option can be exercised at any time before (and on) the expiration date
      • A European option can be exercised only on the expiration date
      • The trading process for options is similar to that for futures contracts
      10- McGraw-Hill/Irwin
    • Options
      • The underlying asset on a stock option is the stock of a publicly traded company
      • The underlying asset on a stock index option is the value of a major stock market index (e.g., DJIA or S&P 500)
      • The underlying asset on a futures option is a futures contract
      • Credit swaps
        • the value of a credit spread call option increases as the default (risk) premium or yield spread on a specified benchmark bond of the borrower increases above some exercise spread
        • a digital default option pays a stated amount in the event of a loan default
      10- McGraw-Hill/Irwin
    • Options
      • The primary regulator of futures markets is the Commodity Futures Trading Commission (CFTC)
      • The Securities Exchange Commission (SEC) is the primary regulator of stock options and stock index options
      • The CFTC is the regulator of options on futures contracts
      10- McGraw-Hill/Irwin
    • Swaps
      • A swap is an agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval
      • An interest rate swap is an exchange of fixed-interest payments for floating-interest payments by two counterparties
        • the swap buyer makes the fixed-rate payments
        • the swap seller makes the floating-rate payments
        • the principal amount involved in a swap is called the notional principal
      • A currency swap is a swap used to hedge against exchange rate risk from mismatched currencies on assets and liabilities
      • Credit swaps allow financial institutions to hedge credit risk
      10- McGraw-Hill/Irwin
    • Swap Markets
      • Swaps are not standardized contracts
      • Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves
      • The International Swaps and Derivatives Association (ISDA) is a 815 member association among 56 countries that sets codes of standards for swap documentation
      10- McGraw-Hill/Irwin
    • Caps, Floors, and Collars
      • Financial institutions use options on interest rates to hedge interest rate risk
        • a cap is a call option on interest rates, often with multiple exercise dates
        • a floor is a put option on interest rates, often with multiple exercise dates
        • a collar is a position taken simultaneously in a cap and a floor (usually buying a cap and selling a floor)
      10- McGraw-Hill/Irwin
    • International Derivative Markets
      • The U.S. dominates the global derivative securities markets
        • North America accounted for $57.94 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 2007
      • The euro and European exchanges are expanding
        • Europe accounted for $32.28 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 2007
      10- McGraw-Hill/Irwin
    • Black-Sholes Call Option Model 10- McGraw-Hill/Irwin