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8- McGraw-Hill/Irwin Chapter Ten Derivative Securities Markets
Derivatives <ul><li>A  derivative security  is an agreement between two parties to exchange a standard quantity of an asse...
Derivatives <ul><li>The first wave of modern derivatives were  foreign currency futures  introduced by the  International ...
Forwards and Futures <ul><li>A  spot contract  is an agreement to transact involving the immediate exchange of assets and ...
Futures Markets <ul><li>Futures contracts are usually traded on organized exchanges </li></ul><ul><li>Exchanges indemnify ...
Futures Markets <ul><li>Futures contract trading occurs in trading “pits” using an  open-outcry auction  among  exchange m...
Futures Contract Terms <ul><li>Trading unit </li></ul><ul><li>Deliverable grades </li></ul><ul><li>Tick size </li></ul><ul...
Futures Contracts <ul><li>A  long position  is the purchase of a futures contract </li></ul><ul><li>A  short position  is ...
Futures Contracts <ul><li>An  initial margin  is a deposit required on futures trades to ensure that the terms of the cont...
Options <ul><li>An  option  is a contract that gives the holder the right, but not the obligation, to buy or sell the unde...
Payoff Functions for Call Options 10- McGraw-Hill/Irwin Payoff   Payoff function  profit for buyer C 0  Stock Price X at e...
Payoff Functions for Put Options 10- McGraw-Hill/Irwin Payoff Payoff function  profit for buyer P 0  Stock Price X at expi...
Options <ul><li>The  Black-Scholes option pricing model  (the model most commonly used to price and value options) is a fu...
Please insert Figure 10-8 here. 10- McGraw-Hill/Irwin
Option Markets <ul><li>The  Chicago Board of Options Exchange (CBOE)  opened in 1973 as the first exchange devoted solely ...
Options <ul><li>The underlying asset on a  stock option  is the stock of a publicly traded company </li></ul><ul><li>The u...
Options <ul><li>The primary regulator of futures markets is the  Commodity Futures Trading Commission (CFTC) </li></ul><ul...
Swaps <ul><li>A  swap  is an agreement between two parties to exchange assets or a series of cash flows for a specific per...
Swap Markets <ul><li>Swaps are  not standardized  contracts </li></ul><ul><li>Swap dealers  (usually financial institution...
Caps, Floors, and Collars <ul><li>Financial institutions use options on interest rates to hedge interest rate risk </li></...
International Derivative Markets <ul><li>The U.S. dominates the global derivative securities markets </li></ul><ul><ul><li...
Black-Sholes Call Option Model 10- McGraw-Hill/Irwin
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Financial Markets & Institutions Ch10

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Transcript of "Financial Markets & Institutions Ch10"

  1. 1. 8- McGraw-Hill/Irwin Chapter Ten Derivative Securities Markets
  2. 2. Derivatives <ul><li>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 </li></ul><ul><li>Derivative securities markets are the markets in which derivative securities trade </li></ul><ul><li>Derivatives involve the buying and selling (i.e., the transfer of) risk , which results in a positive impact on the economic system </li></ul><ul><li>Derivatives are used for hedging and for speculation </li></ul>10- McGraw-Hill/Irwin
  3. 3. Derivatives <ul><li>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 </li></ul><ul><li>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 </li></ul><ul><li>The third wave of modern derivatives occurred in the 1990s with the advent of credit derivatives </li></ul>10- McGraw-Hill/Irwin
  4. 4. Forwards and Futures <ul><li>A spot contract is an agreement to transact involving the immediate exchange of assets and funds </li></ul><ul><li>A forward contract is a nonstandardized agreement to transact involving the future exchange of a set amount of assets at a set price </li></ul><ul><li>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 </li></ul>10- McGraw-Hill/Irwin
  5. 5. Futures Markets <ul><li>Futures contracts are usually traded on organized exchanges </li></ul><ul><li>Exchanges indemnify counterparties against credit (i.e., default) risk </li></ul><ul><li>Futures are market to market daily </li></ul><ul><ul><li>marked to market describes the prices on outstanding futures contracts that are adjusted each day to reflect current futures market conditions </li></ul></ul><ul><li>The five major U.S. exchanges are the CBOT, CME, NYFE, MACE, and KCBOT </li></ul><ul><li>The principal regulator of futures markets is the Commodity Futures Trading Commission (CFTC) </li></ul>10- McGraw-Hill/Irwin
  6. 6. Futures Markets <ul><li>Futures contract trading occurs in trading “pits” using an open-outcry auction among exchange members </li></ul><ul><ul><li>floor brokers place trades for the public </li></ul></ul><ul><ul><li>professional traders trade for their own accounts </li></ul></ul><ul><ul><li>position traders take a position in the futures market based on their expectations about the future direction of the prices of the underlying assets </li></ul></ul><ul><ul><li>day traders take a position within a day and liquidate it before day’s end </li></ul></ul><ul><ul><li>scalpers take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading </li></ul></ul>10- McGraw-Hill/Irwin
  7. 7. Futures Contract Terms <ul><li>Trading unit </li></ul><ul><li>Deliverable grades </li></ul><ul><li>Tick size </li></ul><ul><li>Price quote </li></ul><ul><li>Contract months </li></ul><ul><li>Last trading day </li></ul><ul><li>Last delivery day </li></ul><ul><li>Delivery method </li></ul><ul><li>Trading hours </li></ul><ul><li>Ticker symbols </li></ul><ul><li>Daily price limit </li></ul>10- McGraw-Hill/Irwin
  8. 8. Futures Contracts <ul><li>A long position is the purchase of a futures contract </li></ul><ul><li>A short position is the sale of a futures contract </li></ul><ul><li>A clearinghouse is the unit that oversees trading on the exchange and guarantees all trades made by the exchange </li></ul><ul><li>Open interest is the total number of the futures, put options, or call options outstanding at the beginning of the day </li></ul>10- McGraw-Hill/Irwin
  9. 9. Futures Contracts <ul><li>An initial margin is a deposit required on futures trades to ensure that the terms of the contracts will be met </li></ul><ul><li>The maintenance margin is the margin a futures trader must maintain once a futures position is taken </li></ul><ul><ul><li>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 </li></ul></ul><ul><li>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 </li></ul>10- McGraw-Hill/Irwin
  10. 10. Options <ul><li>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 </li></ul><ul><li>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 </li></ul><ul><li>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 </li></ul>10- McGraw-Hill/Irwin
  11. 11. 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
  12. 12. 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
  13. 13. Options <ul><li>The Black-Scholes option pricing model (the model most commonly used to price and value options) is a function of </li></ul><ul><ul><li>the spot price of the underlying asset </li></ul></ul><ul><ul><li>the exercise price on the option </li></ul></ul><ul><ul><li>the option’s exercise date </li></ul></ul><ul><ul><li>the price volatility of the underlying asset </li></ul></ul><ul><ul><li>the risk-free rate of interest </li></ul></ul><ul><li>The intrinsic value of an option is the difference between an option’s exercise price and the underlying asset price </li></ul><ul><ul><li>the intrinsic value of a call option = max{S – X, 0} </li></ul></ul><ul><ul><li>the intrinsic value of a put option = max{X – S, 0} </li></ul></ul>10- McGraw-Hill/Irwin
  14. 14. Please insert Figure 10-8 here. 10- McGraw-Hill/Irwin
  15. 15. Option Markets <ul><li>The Chicago Board of Options Exchange (CBOE) opened in 1973 as the first exchange devoted solely to the trading of stock options </li></ul><ul><li>Options on futures contracts began trading in 1982 </li></ul><ul><li>An American option can be exercised at any time before (and on) the expiration date </li></ul><ul><li>A European option can be exercised only on the expiration date </li></ul><ul><li>The trading process for options is similar to that for futures contracts </li></ul>10- McGraw-Hill/Irwin
  16. 16. Options <ul><li>The underlying asset on a stock option is the stock of a publicly traded company </li></ul><ul><li>The underlying asset on a stock index option is the value of a major stock market index (e.g., DJIA or S&P 500) </li></ul><ul><li>The underlying asset on a futures option is a futures contract </li></ul><ul><li>Credit swaps </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>a digital default option pays a stated amount in the event of a loan default </li></ul></ul>10- McGraw-Hill/Irwin
  17. 17. Options <ul><li>The primary regulator of futures markets is the Commodity Futures Trading Commission (CFTC) </li></ul><ul><li>The Securities Exchange Commission (SEC) is the primary regulator of stock options and stock index options </li></ul><ul><li>The CFTC is the regulator of options on futures contracts </li></ul>10- McGraw-Hill/Irwin
  18. 18. Swaps <ul><li>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 </li></ul><ul><li>An interest rate swap is an exchange of fixed-interest payments for floating-interest payments by two counterparties </li></ul><ul><ul><li>the swap buyer makes the fixed-rate payments </li></ul></ul><ul><ul><li>the swap seller makes the floating-rate payments </li></ul></ul><ul><ul><li>the principal amount involved in a swap is called the notional principal </li></ul></ul><ul><li>A currency swap is a swap used to hedge against exchange rate risk from mismatched currencies on assets and liabilities </li></ul><ul><li>Credit swaps allow financial institutions to hedge credit risk </li></ul>10- McGraw-Hill/Irwin
  19. 19. Swap Markets <ul><li>Swaps are not standardized contracts </li></ul><ul><li>Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves </li></ul><ul><li>The International Swaps and Derivatives Association (ISDA) is a 815 member association among 56 countries that sets codes of standards for swap documentation </li></ul>10- McGraw-Hill/Irwin
  20. 20. Caps, Floors, and Collars <ul><li>Financial institutions use options on interest rates to hedge interest rate risk </li></ul><ul><ul><li>a cap is a call option on interest rates, often with multiple exercise dates </li></ul></ul><ul><ul><li>a floor is a put option on interest rates, often with multiple exercise dates </li></ul></ul><ul><ul><li>a collar is a position taken simultaneously in a cap and a floor (usually buying a cap and selling a floor) </li></ul></ul>10- McGraw-Hill/Irwin
  21. 21. International Derivative Markets <ul><li>The U.S. dominates the global derivative securities markets </li></ul><ul><ul><li>North America accounted for $57.94 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 2007 </li></ul></ul><ul><li>The euro and European exchanges are expanding </li></ul><ul><ul><li>Europe accounted for $32.28 trillion of the $96.67 trillion contracts outstanding on organized exchanges in 2007 </li></ul></ul>10- McGraw-Hill/Irwin
  22. 22. Black-Sholes Call Option Model 10- McGraw-Hill/Irwin
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