C H APT E R

7
Derivatives and Derivative Markets

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

7.
Explain what derivatives are and distinguish between using them to
1
hedge and using them to speculate
7.
2 Define forward contracts
7.
3
Discuss how futures contracts can be used to hedge and to speculate
7.
4
Distinguish between call options and put options and
explain how they are used
7.
5 Define swaps and explain how they can be used to reduce risk

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 C H APT E R
7
Derivatives and Derivative Markets
HOW DANGEROUS ARE FINANCIAL DERIVATIVES?
In 2002, Berkshire Hathaway CEO Warren Buffet called financial
derivatives time bombs, both for the parties that deal in them and for the
economic system.derivatives are financial weapons of mass destruction.
All derivatives derive their value from an underlying asset. These assets
may be commodities, such as wheat or oil, or financial assets, such as
stocks or bonds.
Despite Buffetts denunciations, derivatives play a useful role in the
financial system.
An Inside Look at Policy on page 214 discusses how legislation in 2010
made significant changes to the market for financial derivatives.

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 Key Issue and Question

Issue: During the 20072009 financial crisis, some investors,

economists, and policymakers argued that financial derivatives had
contributed to the severity of the crisis.
Question: Are financial derivatives weapons of financial mass
destruction?

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 Learning
7.1
Objective
Explain what derivatives are and distinguish between using them to hedge and
using them to speculate.

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 Derivative An asset, such as a futures contract or an option contract, that
derives its economic value from an underlying asset, such as a stock or a bond.

Hedge To take action to reduce risk by, for example, purchasing a derivative
contract that will increase in value when another asset in an investors portfolio
decreases in value.

Derivatives can serve as a type of insurance against price changes in

underlying assets. Insurance plays an important role in the economic
system: If insurance is available on an economic activity, more of that activity
will occur.

Derivatives can also be used to speculate.

Speculate To place financial bets, as in buying futures or option contracts, in

an attempt to profit from movements in asset prices.

Derivatives, Hedging, and Speculating

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 Some investors and policymakers believe that speculation and
speculators provide no benefit to financial markets, but they provide two
useful functions:
1. When a hedger sells a derivative to a speculator, they transfer risk to the
speculator.
2. Speculators provide essential liquidity. Without speculators, there would
not be a sufficient number of buyers and sellers for the market to operate
efficiently.

Derivatives, Hedging, and Speculating

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 Learning
7.2
Objective
Define forward contracts

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 Forward contract An agreement to buy or sell an asset at an agreed upon
price at a future time.

Forward contracts give firms and investors an opportunity to hedge the risk
on transactions that depend on future prices.
Generally, forward contracts involve an agreement in the present to
exchange a given amount of a commodity, such as oil, gold, or wheat, or a
financial asset, such as Treasury bills, at a particular date in the future for a
set price.

Forward Contracts
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 Spot price The price at which a commodity or financial asset can be sold at the
current date.

Settlement date The date on which the delivery of a commodity or financial

asset specified in a forward contract must take place.

Because forward contracts are specific in terms, they tend to be illiquid. They
are also subject to default risk.

Counterparty risk The risk that the counterpartythe person or firm on the
other side of the transactionwill default.

Forward Contracts
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 Learning
7.3
Objective
Discuss how futures contracts can be used to hedge and to speculate.

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 Futures contract A standardized contract to buy or sell a specified amount of a
commodity or financial asset on a specific future date.

Futures contracts differ from forward contracts in several ways:

1. Futures contracts are traded on exchanges, such as the Chicago Board
of Trade (CBOT) and the New York Mercantile Exchange (NYMEX).
2. Futures contracts typically specify a quantity of the underlying asset to
be delivered but do not fix the price.
3. Futures contracts are standardized in terms of the quantity of the
underlying asset to be delivered and the settlement dates for the
available contracts.

Futures Contracts
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 Hedging with Commodity Futures

Short position In a futures contract, the right and obligation of the seller to sell
or deliver the underlying asset on the specified future date.

Long position In a futures contract, the right and obligation of the buyer to
receive or buy the underlying asset on the specified
future date.

Futures Contracts
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 Hedging with Commodity Futures
Consider the case of a farmer who in March sows seed with the expectation
that it will yield 10,000 bushels of wheat. The farmer is concerned that when
she harvests the wheat in July, the price will have fallen below $2.00, so she
will receive less than $20,000 for her wheat.
A manager who buys wheat at General Mills is concerned that in July the
price of wheat will have risen above $2.00, thereby raising his cost of
producing cereal. The farmer and the General Mills manager can hedge
against an adverse movement in the price of wheat.
Hedging involves taking a short position in the futures market to offset a long
position in the spot market, or taking a long position in the futures market to
offset a short position in the spot market.

Futures Contracts
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 Hedging with Commodity Futures
As the time to deliver approaches, the futures price comes closer to the spot
price, eventually equaling the spot price on the settlement date.
To fulfill her futures market obligation, the farmer can engage in either
settlement by delivery or settlement by offset.
We can summarize the profits and losses of buyers and sellers of futures
contracts:
Profit (or loss) to the buyer = Spot price at settlement - Futures price at
purchase
Profit (or loss) to seller = Futures price at purchase - Spot price at settlement

Futures Contracts
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 Hedging with Commodity Futures

Futures Contracts
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 Speculating with Commodity Futures
Some investors who are not connected with the wheat market can use wheat
futures to speculate on the price of wheat.
If you were convinced that the spot price of wheat was going to be lower in July
than current futures price, you could sell wheat futures with the intention of
buying them back at the lower price on or before the settlement date.
Notice, though, that because you lack an offsetting position in the spot market,
an adverse movement in wheat prices will cause you to take losses.

Futures Contracts
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 Hedging and Speculating with Financial Futures

Today most futures traded are financial futures. Widely traded financial
futures contracts include those for Treasury bills, notes, and bonds; stock
indexes; and currencies.
An investor who believes that he or she has superior insight into the likely
path of future interest rates can use the futures market to speculate.
For example, if you wanted to speculate that future interest rates will be
lower (or higher) than expected, you could buy (or sell) Treasury futures
contracts.

Futures Contracts
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 Hedging and Speculating with Financial Futures

Futures Contracts
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 Solved Problem 7.3
Hedging When Interest Rates Are Low
During the financial crisis of 20072009, interest rates on Treasury bills,
notes, and bonds and on many corporate and municipal bonds fell to very
low levels. Jane Williams is a financial adviser and chief executive officer
of Sand Hill Advisors in Palo Alto, California. In early 2010, an article in the
Wall Street Journal quoted Williams as arguing that bonds could be
among the worst-performing investments this year. . . .
a. What would make bonds a bad investment?
b. How might it be possible to hedge the risk of investing in bonds?

Futures Contracts
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 Solved Problem 7.3
Hedging When Interest Rates Are Low
Solving the Problem
Step 1 Review the chapter material.

Step 2 Answer part (a) by explaining when bonds make a bad investment.

Bonds are a bad investment when interest rates rise because higher market interest rates
cause the prices of existing bonds to decline.

Step 3 Answer part (b) by explaining how it is possible to hedge the risk of
investing in bonds.

Investors who own bonds are long in the spot market for bonds, so the appropriate hedge
calls for them to go short in the futures market for bonds by selling futures
contracts.

Futures Contracts
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 Trading in the Futures Market

Margin requirement In the futures market, the minimum deposit that an

exchange requires from the buyer or seller of a financial asset; reduces default
risk.

For instance, on the CBOT, futures contracts for U.S. Treasury notes are
standardized at a face value of $100,000 of notes, or the equivalent of 100
notes of $1,000 face value each. The CBOT requires that buyers and sellers
of these contracts deposit a minimum of $1,100 for each contract into a
margin account.

Marking to market In the futures market, a daily settlement in which the

exchange transfers funds from a buyers account to a sellers account or vice
versa, depending on changes in the price of the contract.

Futures Contracts
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 Trading in the Futures Market

Futures Contracts
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 Learning
7.4
Objective
Distinguish between call options and put options and explain how they are used.

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 Option A type of derivative contract in which the buyer has the right to buy or
sell the underlying asset at a set price during a set period of time.

Call option A type of derivative contract that gives the buyer the right to buy
the underlying asset at a set price during a set period of time.

Strike price (or exercise price) The price at which the buyer of an option has
the right to buy or sell the underlying asset.

Put option A type of derivative contract that gives the buyer the right to sell the
underlying asset at a set price during a set period of time.

Options
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 Why Might You Buy or Sell an Option?

Suppose that Apple stock has a current price of $200 per share, but you
believe the price will rise to $250 in the coming year.
You could buy call options that would allow you to buy Apple at a strike price
of, say, $210. The price of the options will be much lower than the price of
the underlying stock. In addition, if the price of Apple never rises above
$210, you can allow the options to expire, which limits your loss to the price
of the options.
If Apples stock is selling for $200 per share and you are convinced it will
decline in price, you could engage in a short sale. With a short sale, you
borrow the stock from your broker and sell it now, with the plan of buying it
backand repaying your brokerafter the stock declines in price.
If, however, the price of Apple rises rather than falls, you will lose money by
having to buy back the stockwhich is called covering a shortat a price
that is higher than you sold it for.

Options
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 Why Might You Buy or Sell an Option?
Figure 7.1 (1 of 2)
Payoffs to Owning Options
on Apple Stock Payoff
In panel (a),we illustrate the
profit from buying a call option
with a strike price of $210.
When the price of Apple stock
is between zero and $210, the
owner of the option will not
exercise it and will suffer a loss
equal to the $10 price of the
option.
As the price of Apple rises
above $210 per share, the
owner of the option will earn a
positive amount from exercising
it. For prices above $220, the
owner earns a profit.
Options
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 Why Might You Buy or Sell an Option?
Options
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Figure 7.1 (2 of 2)
Payoffs to Owning Options
on Apple Stock Payoff
In panel (b),we illustrate the
profit from buying a put option
with a strike price of $190.
The owner of a put option earns
a maximum profit when the
price of Apple is zero. As the
price of Apple stock rises, the
payoff from owning the put
option falls.
At a price of $180, the owner of
the put would just break even.
For prices above the $190
strike price, the owner of the
put option would not exercise it
and would suffer a loss equal to
the option price of $10.
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 Why Might You Buy or Sell an Option?

Options
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 Option Pricing and the Rise of the Quants
The price of an option is called an option premium.
Sellers of options lose if the option is exercised. The size of the option
premium reflects the probability that the option will be exercised. The option
premium is divided into two parts:
1. Intrinsic value, or the payoff to the buyer of the option from exercising it
immediately.
An option that has a positive intrinsic value is said to be in the money. A call
option is in the money if the market price of the underlying asset is greater
than the strike price, and a put option is in the money if the market price is
less than the strike price.
If the market price of the underlying asset is below the strike price, a call option
is out of the money, or underwater. If the market price of the underlying
asset is above the strike price, a put option is out of the money. If the market
price equals the strike price, a call option or a put option is at the money.

Options
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 Option Pricing and the Rise of the Quants

2. The option premium has a time value, which is determined by how far
away the expiration date is and by how volatile the stock price has been
in the past.
. The further away the expiration date, the greater the chance that the
intrinsic value of the option will increase.
. All else being equal, the further away in time an options expiration
date, the larger the option premium.
. Similarly, all else being equal, the greater the volatility in the price of the
underlying asset, the larger the option premium.
. In 1973, the Black-Scholes formula provided a better tool for the
optimal pricing of options and led to an explosive growth in options
trading. People who evaluate and price new securities came to be
known in Wall Street as rocket scientists, or quants.

Options
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 Making the Connection
Reading the Options Listings

The August contract listed in the first row has a Last price of $1.64. The
Volume column provides information on how many contracts were traded
that day, and the Open Interest column provides information on the
number of contracts outstandingthat is, not yet exercised.
The higher prices of the call options reflect the fact that because the strike
price is below the underlying price, so the call options are all in the money,
while the put options are out of the money. For both the call options and
the put options, the further away the expiration date, the higher the price.
Options
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 Solved Problem 7.4
Interpreting the Options Listings

a. Why are the put options selling for higher prices than the call options?
b. Why does the April call sell for a higher price than the January call?
c. Suppose you buy the April put. Briefly explain whether you would exercise it
immediately.
d. Suppose you buy the November call at the price listed and exercise it when
the price of Amazon stock is $122. What will be your profit or loss?
e. Suppose you buy the April call at the price listed, and the price of Amazon
stock remains $93.60. What will be your profit or loss?
Options
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 Solved Problem 7.4
Solving the Problem
Step 1 Review the chapter material.

Step 2 Answer part (a) by explaining why the put options are selling for higher
prices than the call options.
Notice that the strike price of $105.00 is greater than the stock price of $93.60. So, the
put options are all in the moneybuy at $93.60 and sell to the put seller at
$105.00. The calls are all out of the money because you could buy a share in
the market for $93.60. Therefore, the calls have zero intrinsic value.

Step 3 Answer part (b) by explaining why the April call sells for a higher price
than the January call.
The price of an option represents the options intrinsic value plus its time value. The
further away the expiration date, the greater the chance that the intrinsic value
of the option will increase, and the higher the price of the option. Therefore,
because the two call options have the same strike price, the April call will have
a higher price than the January call.

Options
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 Solved Problem 7.4
Solving the Problem
Step 4 Answer part (c) by explaining whether you would exercise the April put
immediately.
The price of the put is $17.30, so you would not buy the put to exercise it immediately.
You would buy the put only if you expected that before the expiration date of the
put, the price of Amazon would fall sufficiently that the intrinsic value of the put
would be greater than $17.30.

Step 5 Answer part (d) by calculating your profit or loss from buying the
November call and exercising it when the price of Amazon stock is $122.
If you exercise the November call, which has a strike price of $105.00, when the price of
Amazon stock is $122, you will earn $17.00 minus the option price of $1.73, for
a profit of $15.27.

Step 6 Answer part (e) by calculating your profit or loss from buying the April call
if the price of Amazon remains at $93.60.
If the price of Amazon fails to rise and remains at $93.60, the April call will remain out of
the money. Therefore, you will not exercise it, instead taking a loss equal to the
options price of $6.70.

Options
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 Using Options to Manage Risk
Firms, banks, and individual investors can use options, as well as futures, to
hedge the risk from fluctuations in commodity or stock prices, interest rates,
and foreign currency exchange rates.
Options are more expensive than futures, but have the important advantage
that an investor who buys options will not suffer a loss if prices move in the
opposite direction to that being hedged against.
A firm or an investor has to trade off the generally higher cost of using
options against the extra insurance benefit that options provide.
As an options buyer, you assume less risk than with a futures contract
because the maximum loss you can incur is the option premium.
The options seller does not have a limit on his or her losses. The seller of a
put option is still obligated to buy at the strike price, even if it is far above the
current market price.
Many hedgers buy options, not on the underlying asset, but on a futures
contract derived from that asset.
Options
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 Learning
7.5
Objective
Define swaps and explain how they can be used to reduce risk.

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 Swap An agreement between two or more counterparties to exchange sets of
cash flows over some future period.

Unlike futures and options, the terms of swaps are flexible.

Interest-Rate Swaps

Interest-rate swap A contract under which counterparties agree to swap

interest payments over a specified period on a fixed dollar amount, called the
notional principal.

With swaps, the interest rate is often based on the rate at which international
banks lend to each other. This rate is known as LIBOR, which stands for
London Interbank Offered Rate.
Why might firms and financial institutions participate in interest-rate swaps?
One motivation is transferring interest-rate risk to parties that are more
willing to bear it.

Swaps
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 Interest-Rate Swaps

Figure 7.2
Payments in a Swap Transaction
Wells Fargo bank and IBM agree on a swap lasting five years and based on a
notional principal of $10 million.
IBM agrees to pay Wells Fargo an interest rate of 6% per year for five years on
the $10 million.
In return, Wells Fargo agrees to pay IBM a floating interest rate. In this example,
IBM owes Wells Fargo $600,000 ($10,000,000 0.06), and Wells Fargo owes IBM
$700,000 ($10,000,000 (0.03 + 0.04)). Netting the two payments, Wells Fargo
pays $100,000 to IBM. Generally, parties exchange only the net payment.
Swaps
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 Currency Swaps and Credit Swaps

Currency swap A contract in which counterparties agree to exchange principal

amounts denominated in different currencies.

A basic currency swap has three steps:

1. The two parties exchange the principal amount in the two currencies.
2. The parties exchange periodic interest payments over the life of the
agreement.
3. The parties exchange the principal amount again at the conclusion of the
swap.
Why might firms and financial institutions participate in currency swaps?
One reason is that firms may have a comparative advantage in borrowing in
their domestic currency. With a swap, both parties may be able to borrow
more cheaply than if they had borrowed directly in the currency they needed.

Swaps
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 Currency Swaps and Credit Swaps

Credit swap A contract in which interest-rate payments are exchanged, with

the intention of reducing default risk.

For example, if two banks have difficulty diversifying their portfolios, they can
reduce their risk by swapping payment streams on some of their loans.

Swaps
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 Credit Default Swaps

Credit default swap A derivative that requires the seller to make payments to
the buyer if the price of the underlying security declines in value; in effect, a
type of insurance.

During the financial crisis of 20072009, they were most widely used in
conjunction with mortgage-backed securities and collateralized debt
obligations (CDOs), which are similar to mortgage-backed securities.
The issuer of a credit default swap on a mortgage-backed security receives
payments from the buyer in exchange for promising to make payments to the
buyer if the security goes into default.
The heavy losses that American International Group (AIG) and other firms
and investors suffered on credit default swaps deepened the financial crisis
and led policymakers to consider imposing regulations on these derivatives.

Swaps
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 Making the Connection
Are Derivatives Financial Weapons of Mass Destruction?
Derivatives can play an important role in the financial system, but Warren
Buffett points to three problems, particularly with derivatives that are not
traded in exchanges:
1. These derivatives are thinly traded. In addition, dealers use prices
predicted by models that may be inaccurate.
2. Many of these derivatives are not regulated and firms may not set aside
sufficient reserves to offset potential losses.
3. The fact that these derivatives are not traded in exchanges means that
they involve substantial counterparty risk.

Swaps
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