DERIVATIVES MARKET NOTES

1. Derivatives - The Futures Trade Process
Most U.S. futures exchanges offer two ways to enact a trade - the traditional floor-
trading process (also called "open outcry") and electronic trading. The basic steps are
essentially the same in either format: Customers submit orders that are executed - filled
- by other traders who take equal but opposite positions, selling at prices at which other
customers buy or buying at prices at which other customers sell. The differences are
described below.
Open outcry trading is the more traditional form of trading in the U.S. Brokers take
orders (either bids to buy or offers to sell) by telephone or computer from traders (their
customers). Those orders are then communicated orally to brokers in a trading pit. The
pits are octagonal, multi-tiered areas on the floor of the exchange where traders conduct
business. The traders wear different colored jackets and badges that indicate who they
work for and what type of traders they are (FCM or local). It's called "open outcry"
because traders shout and use various hand signals to relay information and the price at
which they are willing to trade. Trades are executed (matches are made) when the
traders agree on a price and the number of contracts either through verbal
communication or simply some sort of motion such as a nod. The traders then turn their
trade tickets over to their clerks who enter the transaction into the system. Customers
are then notified of their trades and pertinent information about each trade is sent to the
clearing house and brokerages.
In electronic trading, customers (who have been pre-approved by a brokerage for
electronic trading) send buy or sell orders directly from their computers to an electronic
marketplace offered by the relevant exchange. There are no brokers involved in the
process. Traders see the various bids and offers on their computers. The trade is
executed by the traders lifting bids or hitting offers on their computer screens. The
trading pit is, in essence, the trading screen and the electronic market participants
replace the brokers standing in the pit. Electronic trading offers much greater insight into
pricing because the top five current bids and offers are posted on the trading screen for
all market participants to see. Computers handle all trading activity - the software
identifies matches of bids and offers and generally fills orders according to a first-in,
first-out (FIFO) process. Dissemination of information is also faster on electronic trades.
Trades made on CME® Globex®, for example, happen in milliseconds and are
instantaneously broadcast to the public. In open outcry trading, however, it can take
from a few seconds to minutes to execute a trade.
Price Limit
This is the amount a futures contract's price can move in one day. Price limits are
usually set in absolute dollar amounts - the limit could be $5, for example. This would
mean that the price of the contract could not increase or decrease by more than $5 in a
single day.
Limit Move
A limit move occurs when a transaction takes place that would exceed the price limit.
This freezes the price at the price limit.

2. Limit Up
The maximum amount by which the price of a futures contract may advance in one
trading day. Some markets close trading of these contracts when the limit up is reached,
others allow trading to resume if the price moves away from the day's limit. If there is a
major event affecting the market's sentiment toward a particular commodity, it may take
several trading days before the contract price fully reflects this change. On each trading
day, the trading limit will be reached before the market's equilibrium contract price is
met.
Limit Down
This is when the price decreases and is stuck at the lower price limit. The maximum
amount by which the price of a commodity futures contract may decline in one trading
day. Some markets close trading of contracts when the limit down is reached, others
allow trading to resume if the price moves away from the day's limit. If there is a major
event affecting the market's sentiment toward a particular commodity, it may take
several trading days before the contract price fully reflects this change. On each trading
day, the trading limit will be reached before the market's equilibrium contract price is
met.
Locked Limit
Occurs when the trading price of a futures contract arrives at the exchange's
predetermined limit price. At the lock limit, trades above or below the lock price are not
executed. For example, if a futures contract has a lock limit of $5, as soon as the
contract trades at $5 the contract would no longer be permitted to trade above this price
if the market is on an uptrend, and the contract would no longer be permitted to trade
below this price if the market is on a downtrend. The main reason for these limits is to
prevent investors from substantial losses that can occur as a result of the volatility found
in futures markets.
The Marking to Market Process
At the initiation of the trade, a price is set and money is deposited in the account.
At the end of the day, a settlement price is determined by the clearing house. The
account is then adjusted accordingly, either in a positive or negative manner,
with funds either being drawn from or added to the account based on the
difference in the initial price and the settlement price.
The next day, the settlement price is used as the base price.
As the market prices change through the next day, a new settlement price will be
determined at the end of the day. Again, the account will be adjusted by the
difference in the new settlement price and the previous night's price in the
appropriate manner.
If the account falls below the maintenance margin, the investor will be required to add
additional funds into the account to keep the position open or allow it to be closed out. If

3. the position is closed out the investor is still responsible for paying for his losses. This
process continues until the position is closed out.
OPTIONS
Derivatives - Options: Calls and Puts
An option is common form of a derivative. It's a contract, or a provision of a contract,
that gives one party (the option holder) the right, but not the obligation to perform a
specified transaction with another party (the option issuer or option writer) according to
specified terms. Options can be embedded into many kinds of contracts. For example, a
corporation might issue a bond with an option that will allow the company to buy the
bonds back in ten years at a set price. Standalone options trade on exchanges or OTC.
They are linked to a variety of underlying assets. Most exchange-traded options have
stocks as their underlying asset but OTC-traded options have a huge variety of
underlying assets (bonds, currencies, commodities, swaps, or baskets of assets).
There are two main types of options: calls and puts:
Call options provide the holder the right (but not the obligation) to purchase an
underlying asset at a specified price (the strike price), for a certain period of
time. If the stock fails to meet the strike price before the expiration date, the
option expires and becomes worthless. Investors buy calls when they think the
share price of the underlying security will rise or sell a call if they think it will fall.
Selling an option is also referred to as ''writing'' an option.
Put options give the holder the right to sell an underlying asset at a specified
price (the strike price). The seller (or writer) of the put option is obligated to buy
the stock at the strike price. Put options can be exercised at any time before the
option expires. Investors buy puts if they think the share price of the underlying
stock will fall, or sell one if they think it will rise. Put buyers - those who hold a
"long" - put are either speculative buyers looking for leverage or "insurance"
buyers who want to protect their long positions in a stock for the period of time
covered by the option. Put sellers hold a "short" expecting the market to move
upward (or at least stay stable) A worst-case scenario for a put seller is a
downward market turn. The maximum profit is limited to the put premium
received and is achieved when the price of the underlyer is at or above the
option's strike price at expiration. The maximum loss is unlimited for an
uncovered put writer.
To obtain these rights, the buyer must pay an option premium (price). This is the
amount of cash the buyer pays the seller to obtain the right that the option is granting
them. The premium is paid when the contract is initiated.
In Level 1, the candidate is expected to know exactly what role short and long positions
take, how price movements affect those positions and how to calculate the value of the
options for both short and long positions given different market scenarios. For example:

4. Q. Which of the following statements about the value of a call option at expiration is
FALSE?
A. The short position in the same call option can result in a loss if the stock price
exceeds the exercise price.
B. The value of the long position equals zero or the stock price minus the exercise price,
whichever is higher.
C. The value of the long position equals zero or the exercise price minus the stock price,
whichever is higher.
D. The short position in the same call option has a zero value for all stock prices equal to
or less than the exercise price.
A. The correct answer is "C". The value of a long position is calculated as exercise price
minus stock price. The maximum loss in a long put is limited to the price of the premium
(the cost of buying the put option). Answer "A" is incorrect because it describes a gain.
Answer "D" is incorrect because the value can be less than zero (i.e. an uncovered put
writer can experience huge losses).
Derivatives - Options: Basic Characteristics
Both put and call options have three basic characteristics: exercise price, expiration date
and time to expiration.
The buyer has the right to buy or sell the asset.
To acquire the right of an option, the buyer of the option must pay a price to the
seller. This is called the option price or the premium.
The exercise price is also called the fixed price, strike price or just the strike and
is determined at the beginning of the transaction. It is the fixed price at which the
holder of the call or put can buy or sell the underlying asset.
Exercising is using this right the option grants you to buy or sell the underlying
asset. The seller may have a potential commitment to buy or sell the asset if the
buyer exercises his right on the option.
The expiration date is the final date that the option holder has to exercise her
right to buy or sell the underlying asset.
Time to expiration is the amount of time from the purchase of the option until the
expiration date. At expiration, the call holder will pay the exercise price and
receive the underlying securities (or an equivalent cash settlement) if the option
expires in the money. (We will discuss the degrees of moneyness later in this
session.) The call seller will deliver the securities at the exercise price and receive
the cash value of those securities or receive equivalent cash settlement in lieu of
delivering the securities.
Defaults on options work the same way as they do with forward contracts.
Defaults on over-the counter option transactions are based on counterparties,
while exchange-traded options use a clearing house.

5. Example: Call Option
IBM is trading at 100 today. (June 1, 2005)
The call option is as follows:Strike price = 120, Date = August 1, 2005,Premium on the
call = $3
In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for
the right to purchase IBM at $125 on or before August 1, 2005. If the buyer decides to
exercise the option on or before August 1, 2005, the seller will have to deliver IBM
shares at a price of $125 to the buyer.
Example: Put Option
IBM is trading at 100 today (June 1, 2005)
Put option is as follows:Strike price = 90, Date = August 1, 2005, Premium on the put =
$3.00
In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the
right to sell IBM at $90 on or before August 1, 2005. If the buyer of the put decides to
exercise the option on or before August 1, 2005, the seller will have to purchase IBM
shares at a price of $90.
Example: Interpreting Diagrams
For the exam, you may be asked interpret diagrams such as the following, which shows
the value of a put option at expiration.
A typical question about this diagram might be:

6. Q: Ignoring transaction costs, which of the following statements about the value of the
put option at expiration is TRUE?
A. The value of the short position in the put is $4 if the stock price is $76.
B. The value of the long position in the put is $4 if the stock price is $76.
C. The long put has value when the stock price is below the $80 exercise price.
D. The value of the short position in the put is zero for stock prices equaling or
exceeding $76.
The correct answer is "C". A put option has positive monetary value when the underlying
instrument has a current price ($76) below the exercise price ($80).
SWAP
Derivatives - Swaps
A swap is one of the most simple and successful forms of OTC-traded derivatives. It is a
cash-settled contract between two parties to exchange (or "swap") cash flow streams. As
long as the present value of the streams is equal, swaps can entail almost any type of
future cash flow. They are most often used to change the character of an asset or
liability without actually having to liquidate that asset or liability. For example, an
investor holding common stock can exchange the returns from that investment for lower
risk fixed income cash flows - without having to liquidate his equity position.
The difference between a forward contract and a swap is that a
swap involves a series of payments in the future, whereas a
forward has a single future payment.
Two of the most basic swaps are:
Interest Rate Swap - This is a contract to exchange cash flow streams that might be
associated with some fixed income obligations. The most popular interest rate swaps
are fixed-for-floating swaps, under which cash flows of a fixed rate loan are exchanged
for those of a floating rate loan.
Currency Swap - This is similar to an interest rate swap except that the cash flows are
in different currencies. Currency swaps can be used to exploit inefficiencies in
international debt markets. For example, assume that a corporation needs to borrow
$1O million euros and the best rate it can negotiate is a fixed 6.7%. In the U.S., lenders
are offering 6.45% on a comparable loan. The corporation could take the U.S. loan and

7. then find a third party willing to swap it into an equivalent euro loan. By doing so, the
firm would obtain its euros at more favorable terms.
Cash flow streams are often structured so that payments are synchronized, or occur on
the same dates. This allows cash flows to be netted against each other (so long as the
cash flows are in the same currency). Typically, the principal (or notional) amounts of
the loans are netted to zero and the periodic interest payments are scheduled to occur
on that same dates so they can also be netted against one another.
As is obvious from the above example, swaps are private, negotiated and mostly
unregulated transactions (although FASB 133 has begun to impose some regulations).
Purpose and benefits of derivatives
Derivatives - Purposes and Benefits of Derivatives
Today's sophisticated international markets have helped foster the rapid growth in
derivative instruments. In the hands of knowledgeable investors, derivatives can derive
profit from:
Changes in interest rates and equity markets around the world
Currency exchange rate shifts
Changes in global supply and demand for commodities such as
agricultural products, precious and industrial metals, and energy products such as
oil and natural gas
Adding some of the wide variety of derivative instruments available to a traditional
portfolio of investments can provide global diversification in financial instruments and
currencies, help hedge against inflation and deflation, and generate returns that are not
correlated with more traditional investments. The two most widely recognized benefits
attributed to derivative instruments are price discovery and risk management.
1. Price Discovery
Futures market prices depend on a continuous flow of information from around the world
and require a high degree of transparency. A broad range of factors (climatic conditions,
political situations, debt default, refugee displacement, land reclamation and
environmental health, for example) impact supply and demand of assets (commodities in
particular) - and thus the current and future prices of the underlying asset on which the
derivative contract is based.This kind of information and the way people absorb it
constantly changes the price of a commodity. This process is known as price discovery.
o With some futures markets, the underlying assets can be geographically
dispersed, having many spot (or current) prices in existence. The price of

8. the contract with the shortest time to expiration often serves as a proxy
for the underlying asset.
o Second, the price of all future contracts serve as prices that can be
accepted by those who trade the contracts in lieu of facing the risk of
uncertain future prices.
o Options also aid in price discovery, not in absolute price terms, but in the
way the market participants view the volatility of the markets. This is
because options are a different form of hedging in that they protect
investors against losses while allowing them to participate in the asset's
gains.
As we will see later, if investors think that the markets will be volatile, the prices of
options contracts will increase. This concept will be explained later.
2. Risk Management
This could be the most important purpose of the derivatives market. Risk management is
the process of identifying the desired level of risk, identifying the actual level of risk and
altering the latter to equal the former. This process can fall into the categories of
hedging and speculation.
Hedging has traditionally been defined as a strategy for reducing the risk in holding a
market position while speculation referred to taking a position in the way the markets
will move. Today, hedging and speculation strategies, along with derivatives, are useful
tools or techniques that enable companies to more effectively manage risk.
3. They Improve Market Efficiency for the Underlying Asset
For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock
index fund or replicate the fund by buying S&P 500 futures and investing in risk-free
bonds. Either of these methods will give them exposure to the index without the expense
of purchasing all the underlying assets in the S&P 500.
If the cost of implementing these two strategies is the same, investors will be neutral as
to which they choose. If there is a discrepancy between the prices, investors will sell the
richer asset and buy the cheaper one until prices reach equilibrium. In this context,
derivatives create market efficiency.
4. Derivatives Also Help Reduce Market Transaction Costs
Because derivatives are a form of insurance or risk management, the cost of trading in
them has to be low or investors will not find it economically sound to purchase such
"insurance" for their positions
Derivatives - Criticisms of Derivatives

9. Options offer the potential for huge gains and huge losses. While the potential for gain is
alluring, their complexity makes them appropriate for only sophisticated investors with a
high tolerance for risk.
1. When a derivative fails to help investors achieve their objectives, the derivative
itself is blamed for the ensuing losses when, in fact, it's often the investor who
did not fully understand how it should be used, its inherent risk, etc.
2. Some view derivatives as a form of legalized gambling enabling users to make
bets on the market. However, derivatives offer benefits that extend beyond those
of gambling by making markets more efficient, helping to manage risk and
helping investors to discover asset prices.
While professional traders and money managers can use derivatives effectively, the odds
that a casual investor will be able to generate profits by trading in derivatives are
mitigated by the fundamental characteristics of the instrument:
Lifespan - Derivatives are "time-wasting" assets. As each day passes and the expiration
date approaches, you lose more and more "time" premium and the option's value
decreases.
Direction and Market Timing - In order to make money with many derivatives,
investors must accurately predict the direction in which the market or index will move
(up or down) and the minimum magnitude of the move during a set period of time. A
mistake here almost guarantees a substantial investment loss.
Costs - The bid/ask spreads of more common derivatives such as options can be
daunting. An option with a bid of 5.25 and an ask of 5.875 means an investor could buy
a round lot (100 units) for $587.50 but could only sell them for $525, resulting in an
immediate loss of $61.50 before factoring in commissions.
Derivatives - Arbitrage
Arbitrage opportunities exist when the prices of similar assets are set at different levels.
This opportunity allows an investor to achieve a profit with zero risk and limited funds by
simply selling the asset in the overpriced market and simultaneously buying it in the
cheaper market.
This buying and selling of the asset will push the cheaper asset's price up and the higher
asset price down. This process will continue until the asset price is equal in both
markets.
Achieving this equilibrium through buying and selling is referred to as the law of one
price. This law may look like it has been violated at times, but this usually is usually not
the case once you factor in financing or delivery costs associated with the different
markets.

10. For example, on exchange A IBN is trading at $25 and on exchange B IBN is
trading at $30 dollars. If you buy IBN on exchange A and simultaneously sell it on
exchange B, you can net a profit of $5 with out any risk or any outlay of cash.
As people continue to buy on exchange A, the price of IBN will increase and all of
the selling of IBN on exchange B will force the price down until equilibrium has
been reached. This is how arbitrage works to make the marketplace efficient.
Additional information about arbitrage and its theories:
Theoretically, the large number of market participants combined with real-time
price-setting mechanisms eliminates the opportunity to generate risk-free
profits.
This leads to an important question: If there are no arbitrage opportunities (i.e.
opportunities to earn a risk-free profit), why does the industry survive? One
reason is that individual investors may have different views on how, why and to
what degree market prices are off kilter. Also, investors are reluctant to believe
that there are no arbitrage opportunities and so they spend a good deal of time
watching price movements, ferreting out inconsistencies and trading on those
they perceive to exist. The process itself ensures that any potential arbitrage
opportunities will be quickly discovered and eliminated. If investors believed there
were no arbitrage opportunities and were no longer vigilant about identifying and
exploiting price differentials, the lack of continuous oversight might, in itself, lead
to arbitrage opportunities In other words, disbelief concerning the absence of
arbitrage opportunities is required to maintain its legitimacy as a principle.
Relatively efficient markets have either no arbitrage opportunities or the market
participants quickly remove them. The opportunity can occur, but only through
chance and it would be considered an abnormal return
Derivatives - Common Characteristics of Futures and Forwards
Forward Commitments
A forward commitment is a contract between two (or more) parties who agree to engage
in a transaction at a later date and at a specific price, which is given at the start of the
contract. It is acustomized, privately negotiated agreement to exchange an asset or cash
flows at a specified future date at a price agreed on at the trade date. In its simplest
form, it is a trade that is agreed to at one point in time but will take place at some later
time. For example, two parties might agree today to exchange 500,000 barrels of crude
oil for $42.08 a barrel three months from today. Entering a forward contract typically
does not require the payment of a fee.
There are two major types of forward commitments:
Forward contracts, or forwards, are OTC-traded derivatives with customized
terms and features.

11. Futures contract, or futures, are exchange-traded derivatives with standardized
terms.
Futures and forwards share some common characteristics:
Both futures and forwards are firm and binding agreements to act at a later date.
In most cases this means exchanging an asset at a specific price sometime in the
future.
Both types of derivatives obligate the parties to make a contract to complete the
transaction or offset the transaction by engaging in anther transaction that settles
each party's obligation to the other. Physical settlement occurs when the actual
underlying asset is delivered in exchange for the agreed-upon price. In cases
where the contracts are entered into for purely financial reasons (i.e. the engaged
parties have no interest in taking possession of the underlying asset), the
derivative may be cash settled with a single payment equal to the market value
of the derivative at its maturity or expiration.
Both types of derivatives are considered leveraged instruments because for little
or no cash outlay, an investor can profit from price movements in the underlying
asset without having to immediately pay for, hold or warehouse that asset.
They offer a convenient means of hedging or speculating. For example, a rancher
can conveniently hedge his grain costs by purchasing corn several months
forward. The hedge eliminates price exposure, and it doesn't require an initial
outlay of funds to purchase the grain. The rancher is hedged without having to
take delivery of or store the grain until it is needed. The rancher doesn't even
have to enter into the forward with the ultimate supplier of the grain and there is
little or no initial cash outlay.
Both physical settlement and cash settlement options can be keyed to a wide
variety of underlying assets including commodities, short-term debt, Eurodollar
deposits, gold, foreign exchange, the S&P 500 stock index, etc.