9- Derivative Securities Markets

a financial security whose payoff is linked to another previously issued security it involves the buying, selling or transfer of risk

1. Forwards
2. Futures
3. Options
4. Swaps

agreement to exchange a set quantity of an asset at predetermined price on specific date in the future
- as the value of the underlying security to be exhcnage changes, the value of the derivative security changes

1. Speculation
2. Hedging
3. Leveraged

buying/selling derivative contract with risk of loosing value but expectation of a significant gain

enter into derivative contract to reduce risk of price movements by offsetting positions in derivatives that correspond to an existing position

put small amount of money and obtain a gain or loss on a much larger position

derivative market introduced in response to floating exchange rates between currencies
- 1st wave

derivative market in response to increased volatility of interest rates
- 2nd wave

derivative market
- 3rd wave

1. using derivative contracts for heding, dealers act as counterparts in trades with customers for a fee
2. arbitrageurs, buying in one market and simultaneously selling in another maarket to make risk free profit when there is a mismatch between the prices

agreement for immediate exchange of cash for security
- occurs because the buyer believes the assets value will increase in immediate future

agreement to exchange a non standardized asset at some future date
- asset details, price and contract expiration date are set at time 0 and the price remains fixed over life of the contract
- forward traders pay financial institutions a fee to arrange a contract to hedge the risk
terms to each contract are negotiated individually because they involve nonstandardized assets

agreement to exchange a standardized asset at some future date, each contract has a standardized expiration and transactions occur in a centralized market
- the price of a futures contract changes daily (marked to market daily) so it is adjusted each day to reflect current futures market conditions

the purchase of a futures contract

the selling of a futures contract

unit that oversees trading and guarantees all trades made by the exchange traders

total number of futures or options contracts outstanding at the beginning of the day

forwards are the future exchange of a set amount of non standardized asset for a price that is fixed
(example) buying 10 gallons of oil every month for 50$ a gallon for a year (no matter if price of gallon increases or decreases) futures are the future exchange of a set amount of a standardized asset for a price that is settled dailey (example) options contract to buy stocks

1. marking to market means theres no buildup of losses or gains
2. margin requirements (deposit) acts as a security bond should a counterparty default
3. price movement limits that spread extreme price fluctuations over time
4. default guarantee by the futures exchange itself

position in futures market based on their expectations about direction of prices of underlying assets (they trade for their own account)

take a position within a day and liquidate it before days end

take positions for short periods of time (even minutes) in attemp to profit from active trading

PROFIT - when the valye of the underlying t bond increases (interest rate decreases)
LOSS - if interest rates increases, the future price drops

"buy something in future, at price defined today" if price increases, profit if it decreases i loss

PROFIT - when the value of t bond decreases, interest rates rise
LOSS - when interest rates fall, t bond price rises

"sell something in future, at price defined today" if price increases, loss if it decreases i profit

a deposit required on futures trades to ensure the terms of contract will be met
- amount depends on type of contract and quantity of futures traded
- minimum margin set by each exchange

margin a futures trader myst maintain once a futures position is taken
- if this is not maintained then the broker closes out (sells) the futures position

if losses occur so that the margin account funds are below the maintenence magrin the customer is required to deposit additional funds to keep position open

a contract that gives the holder the right but not the obligation to buy or sell an underlying asset at a prespecified price for a set time period

option that gives purchaser the right to buy the underlying security ffrom the writer of the option at the preset price on or before the prescribed date

option that gives purchaser the right to sell the underlying security to the writer of the option at a prescribed price on or before the set date

called the exercise/strike price

gives the buyer the right to buy an underlying security at the exercise price in exchange the buyer of the call must pay the call premium (immediate negative cash flow for the buyer)
- if the price of the underlying stock is greater than the exercise price the buyer would excercise the option, buy the stock and sell for profit
- if the price of the underlying stock is less than the exercise price the buyer would not excercise the option (the option matures and expires unexercised) in this case the buyer incurs a cost of the call premium

BUYER - has unlimited profit (stock price can increase) and limited loss (call premium)
WRITER - has limited profit (call premium) and unlimited loss

therefore, buy a call option when the asset's price is expected to rise and write a call option when the price is expected to fall

gives the buyer the right to sell an underlying security at a exercise price and in return the buyer myst pay the writer the put premium
- if the stocks price is less than the exercise price the buyer will buy the stock in the stock market and sell it at exercise price (exercising the put option)
- if the price of the stock is greater than the exercise price the buyer would not exercise the option (would rather sell on market) therefore the option matures and expires unexercised so the buyer incurs a cost of put premium for the option

BUYER - unlimited profit (depends how low stock price goes) and limited losses (put premium)
SELLER - limited profit (put premium) and unlimited losses

buy a put option when asset price is expected to fall
write a put option when asset price is expected to rise

Most commonly used to price and value options, based on the 5 factors that affect the price of an option
1. spot price of underlying option
2. exercise price on the option
3. options exercise date
4. price volatility of the underlying asset
5. risk free rate of interest

the difference between options excercise price and underlying asset (spot) price
- call option = maximum(stock price - execrise price,0)
- put option = maximum(exercise price - stock price,0)

if stock price is greater than exercise price "option is in the money" thus stock price - exercise price = intrinsic value

if stock price is equal to or less than exercise price "option is out of the money" thus intrinsic value = 0

if stock price is less than exercise price "option is in the money" thus exercise price - stock price = intrinsic value

if stock price is equal to or more than exercise price "option is out of the money" so intrinsic value = 0

the higher the exercise price - the higher the value of a put, the lower the value of a call

the higher the stock price - the higher the value of a call, the lower value of a put

equal to options market price (premium) - instrisic value
- associated with probability the instrisic value could increase between the options purchase and expiration date
- function of price volatility of the underlying asset and the time until the option matures (expiration date)

all else consistnet, if risk free rate of interest increases the growth rate of stock prices increases hwoever the present value of any future cash flpws recieved decreases

for a call option - the price of a call option always increases as the risk free rate increases
for a put option - the price of a put option decreases as the risk free rate increases

agreement between two parties to exchange a series of cash flows for a specific period of time at specified intervals
- can be seen as a series of forward contracts

1. interest rate swaps
2. currency swaps
3. credit risk swaps
4. commodity swaps
5. equity swaps

an exchange of fixed interest payments for floating interesting payments by two counterparties
- used to hedge interest rate risk on mismatched rates on assets and liabilities

BUYER - makes fixed rate payments based on a principal contractual amount
SELLER - makes floating rate payments
- no principal is exchanged, only cash flows from interet payments

two companies with same problem exchange thier interest rate to their preffered interest mode
- banks support companies building a swap by finding a company to be the counterparty in return they get an agent fee
- most heavily traded financial contract in the world

assets or liabilities wgose income or cost will change if interest rates changes and fixed rate accounts will not
- in an interest rate swap contract there will be a "winner" depending on who has the right expectations as swaps are based on expectations

financial institution that facilitates swaps
- internaitonal commerical bank, investment bank, independent operator
BROKER - matches counterparties but assumes no risk, recieves = commision for service
MARKET MAKER - accepts a side of currency swap and then sells/matches it with a counterparty, assumes some risk and therefore recieves = portion of cash flow

exchange of principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency
- used to hedge against exchange rate risk from mismatched currencies on assets and liabilities
- fixed or variable rate of interest, but occur at known currency exchange rate

principal and interest at fixed rate of exchange

used to hedge both currency and interest rate exposure simultaneously

allow financial institutions to hedge credit risk (aka risk of default)

swapping an obligation to pay interest at specified fixed/floating rate for payments representing the total return on a loan (interest and principal changes) of a specified amount

financial institution lender will send each swap period a fixed fee/payment to counterparty
- if the financial institutions loan or loans do not default it recieves nothing back from the counterparty

1. credit risk is more likely to cause a financial institution to fail than interest rate risk or exchange risk
2. credit swaps allow financial instituitions to maintain long term customer lending relationships without bearing full credit risk exposure from those relationships

options on interest rates

call option on interest rates (often have multiple exercise dates)

if they are exposed to losses when interest rates rise

a put option on interest rates, often have multiple exercise dates

when they have fixed costs of debt and have floating rates returns on assets

a position taken simultaneously in a cap and a floor
- usually buying a cap and selling a floor

to finance cap or floor positions or when they are concerned about excessive interest rate volatility