Chapter 4-4

Derivatives: Futures, Options, and Swaps

 Learning Objectives
1. Explain what derivatives are and how they
transfer risk.
2. Distinguish between forward and futures
contracts.
3. Define put and call options and describe how
to use them.
4. Show how swaps can be used to manage risk
or to conceal it.
 The Basics: Defining Derivatives
• A derivative is a financial instrument whose value
depends on, is derived from, the value of some
other financial instrument, call the underlying
asset.
– Examples of assets include stocks, bonds, wheat,
snowfall, and stock market indexes like S&P 500.
• For example:
– A contractual agreement between two investors that
obligates one to make a payment to the other, depending
on the movement of interest rates over the next year.
• An interest-rate futures contract
 The Basics: Defining Derivatives
Derivatives are different from outright
purchases because:
1. Derivatives provide an easy way for
investors to profit from price declines.
2. In a derivatives transaction, one person’s
loss is always another person’s gain.
 The Basics: Defining Derivatives
• While derivatives can be used to speculate, or
gamble on future price movements, they allow
investors to manage and reduce risk.
– Farmers use derivatives regularly to insure
themselves against fluctuations in the price of their
crops.
• The purpose of derivatives is to transfer risk
from one person or firm to another.
 The Basics: Defining Derivatives
• By shifting risk to those willing and able to
bear it, derivatives increase the risk-carrying
capacity of the economy as a whole.
– This improves the allocation of resources and
increase the level of output.
• The downside is that derivatives also allow
individuals and firms to conceal the true
nature of certain financial transactions.
 Forward and Futures
• A forward, or forward contract, is an
agreement between a buyer and a seller to
exchange a commodity or financial instrument
for a specified amount of cash on a
prearranged future date.
• Because they are customized, forward
contracts are very difficult to resell.
 Forward and Futures
• A future, or futures contract, is a forward
contract that has been standardized and sold
through an organized exchange.
– The contract specifies that the seller (short position)
will deliver some quantity of a commodity or financial
instrument to the buyer (long position) on a specific
date, called the settlement or delivery date, for a
predetermined price.
 Forward and Futures
• No payments are made when the contract is
agreed to.
• The seller/short position benefits from declines
in the price of the underlying asset.
• The buyer/long position benefits from increases
in the price of the underlying asset.
 Forward and Futures
• The two parties to a futures contract each make
an agreement with a clearing corporation.
• The clearing corporation operates like a large
insurance company and is the counter party to
both sides of the transaction.
– They guarantee that the parties will meet their
obligations.
• This lowers the risk buyers and sellers face.
• The clearing corporation has the ability to monitor
traders and the incentive to limit their risk taking.
Margin Accounts and Marking to
Market
• The clearing corporation requires both parties
to a futures contract to place a deposit with the
corporation.
– This is called posting margin in a margin account.
– This guarantees when the contract comes due, the
parties will be able to meet their obligations.
Margin Accounts and Marking to
Market
• The clearing corporation posts daily gains and losses on
the contract to the margin account of the parties
involved.
– This is called marking to market.
• Doing this each day ensures that sellers always have
the resources to make delivery and buyers can always
pay.
• If someone’s margin account falls below the minimum,
the clearing corporation will sell the contracts, ending
the person’s participation in the market.
Hedging and Speculating with Futures
• Futures contracts allow the transfer of risk
between buyer and seller through hedging or
speculation.
– For example of the sale of a U.S. Treasury bond
future contract, the seller/short position benefits
from the price declines.
• The seller of the futures contract can guarantee the
price at which the bonds are sold.
– The purchaser wishes to insure against possible
price increases.
Arbitrage and the Determinants of
Futures Prices
• On the settlement or delivery date, the price of the
futures contract must equal the price of the
underlying asset the seller is obligated to deliver.
– If not, then it would be possible to make a risk-free profit
by engaging in offsetting cash and futures transactions.
• The practice of simultaneously buying and selling
financial instruments in order to benefit from
temporary price differences is called arbitrage the
people who engage in it are called arbitrageurs.
Arbitrage and the Determinants of
Futures Prices
• If the price of a specific bond is higher in one
market than in another:
– The arbitrageur can buy at the low price and sell at the
high price.
– This increases demand in one market and supply in
another.
– The increase in demand raises price in that market.
– The increase in supply lowers price in the other market.
– This continues until the prices are equal in both
markets.
Arbitrage and the Determinants of
Futures Prices

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 Calls, Puts, and All That:
Definitions
• Options are agreements between two parties.
– The seller is an option writer.
– A buyer is an option holder.
• A call option is the right to buy, “call away”, a given
quantity of an underlying asset at a predetermined
price, called the strike price (or exercise price), on or
before a specific date.
– A July 2016 call option on 100 shares of Apple stock at a
strike price of 100 gives the option holder the right to buy
100 shares of Apple for $100 each prior to the 3rd Friday of
July 2016.
Calls, Puts, and All That: Definitions
• When the price of the stock is above the strike
price of the call option, exercising the option is
profitable and the option is said to be in the
money.
• If the price of the stock exactly equals the strike
price, the option is said to be at the money.
• If the strike price exceeds the market price of
the stock, it is termed out of the money.
Calls, Puts, and All That: Definitions
• A put option gives the holder the right but not the
obligation to sell the underlying asset at a
predetermined price on or before a fixed date
• The writer of the option is obliged to buy the shares
should the holder choose to exercise the option.
• The same terminology that is used to describe calls,
is also used to describe puts:
– In the money - profitable
– At the money - same price
– Out of the money - not profitable
 Using Options
• Options transfer risk from the buyer to the seller,
so can be used for both hedging and speculation.
• For someone who wants to purchase an asset in
the future, a call option ensure that the cost of
buying the asset will not rise.
• For someone who plans to sell the asset in the
future, a put option ensures that the price at
which the asset can be sold will not go down.
 Using Options
Say you think interest rates are going to fall.
• You can:
– Buy a bond but that’s expensive as you need
money.
– Buy a futures contract taking the long position -
low investment but high risk.
– Buy a call option that pays off only if the interest
rate falls - if you are wrong, only cost is the price
of the option.
 Using Options
• Options are very versatile and can be bought
and sold in many combinations.
• Allow investors to get rid of risks they do not
want and keep the ones they do.
• Options allow investors to bet that prices will be
volatile.
• Table 9.3 summarizes options.
 Pricing Options: Intrinsic Value
and the Time Value of the Option
An option has two parts:
1. Intrinsic value - the value of the option if it is
exercised immediately, and
2. Time value of the option - the fee paid for the
option's potential benefits.
Option price = Intrinsic value + time value of the option
 Pricing Options: Intrinsic Value
and the Time Value of the Option
• We can calculate the time value of the option
by calculating the expected present value of
the payoff.
– For a call option, we take the probability of a
favorable outcome (a higher price), times the payoff.
– Increasing the standard deviation of the stock price,
an increase in volatility, increases the option’s time
value.
General Considerations

© 2017 McGraw-Hill Education. All Rights Reserved.

 The Value of Options: Some Examples

Table 9.5 shows the prices of

Apple puts and calls on Jan
15, 2016, reported on the
Wall Street Journal’s website.
• Panel A shows the prices of
options with different strike
prices but the same
expiration date, Mar 18,
2016.
• Panel B shows the prices of
options with different
expiration dates but with
the same strike price.
 Swaps
• Swaps are contracts that allow traders to
transfer risk just like other derivatives.
– Interest-rate swaps which allow one swap party,
for a fee, to alter the stream of payments it makes
or receives.
– Credit-default swaps (CDS) which are a form of
insurance that allow a buyer to own a bond or
mortgage without bearing its full default risk.
 Understanding Interest-Rate
Swaps
• Interest-rate swaps are agreements between
two counterparties to exchange periodic
interest-rate payments over some future period,
based on an agreed-upon amount of principal,
called the notional principal.
• The term notional is used because the principal
of a swap is not borrowed, lent, or exchanged.
 Understanding Interest-Rate
Swaps
• In the simplest type of interest-rate swap, one
party agrees to make payments based on a fixed
interest rate, and in exchange the counterparty
agrees to make payments based on a floating
interest rate.
– This turns fixed rates in to floating rates and vice
versa.
Understanding Interest-Rate
Swaps
 Pricing and Using Interest Rate Swaps
• Pricing interest-rate swaps means figuring out
the fixed interest rate to be paid.
• Financial firms begin by noting the market
interest rate on a U.S. Treasury bond of the
same maturity as the swap, called a
benchmark.
• The rate to be paid by the fixed-rate payer,
the swap rate, is the benchmark rate plus a
premium.
 Pricing and Using Interest Rate Swaps

• The difference between the benchmark rate and

the swap rate is called the swap spread and is a
measure of risk.
– The swap spread has become a measure of overall
risk in the economy.
– When the swap spread widens, it signals that general
economic conditions are deteriorating.
 Pricing and Using Interest Rate Swaps
• Who uses interest-rate swaps?
– Banks
• Deposits are short-term liabilities
• Loans are long-term assets
• Swaps help control risk
– Government debt managers
• Issue long-term debt relatively cheaply
• Tax revenue matches up better with short-term interest
rate
 Pricing and Using Interest Rate Swaps
• The primary risk in a swap is the risk that one
of the parties will default.
– The risk is not very high because the other side
can enter into another agreement to replace the
one that failed.
• Unlike futures and options, swaps are not
traded on organized exchanges.
– Swaps are very difficult to resell.
 Credit-Default Swaps
• A credit-default swap (CDS) is a credit derivative that
allows lenders to insure themselves against the risk that
a borrower will default.
• The buyer of a CDS makes payments, like insurance
premiums, to the seller, and the seller agrees to pay the
buyer if an underlying loan or security defaults.
• The CDS buyer pays a fee to transfer the risk of default,
the credit risk, to the CDS seller.
• A CDS agreement often lasts several years and requires
that collateral be posted to protect against the inability
to pay of either the seller or the buyer of the insurance.
 Credit-Default Swaps
CDS contributed to the financial crisis in three
important ways:
1. Fostering uncertainty about who bears the
credit risk on a given loan or security,
2. Making the leading CDS sellers mutually
vulnerable, and
3. Making it easier for sellers of insurance to
assume and conceal risk.
 Credit-Default Swaps
• Because CDS contracts are traded over the
counter (OTC), even traders cannot identify
others who take on concentrated positions on
one side of a trade.
• So long as CDS trading lacks transparency, the
lingering worry is that a failure of one institution
could bring down the financial system as a
whole.