I need help with a finance exam about the derivatives
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ch2_PowerPoints_PowerPoint_Images.pptChance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
Chapter 2: Structure of Derivatives Markets
The key to understanding derivatives is a deeper understanding of all that’s underlying.
Morgan Stanley Dean Witter
Advertisement in Derivatives Strategy, October 1997, p. 15
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
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Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
Important Concepts in Chapter 2
- Types of derivatives
- Origins and development of derivatives markets
- Exchange-listed derivatives trading
- Over-the-counter derivatives trading
- Clearing and settlement
- Market participants
- Transaction costs
- Taxes
- Regulation of derivatives markets
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
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Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
Types of Derivatives
- Options
- Forward contracts
- Futures contracts
- Swaps
- Other types of derivatives
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
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Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
Options
- Premium – price paid to buy an option
- Call – right to buy
- Put – right to sell
- Exercise or strike price – fixed price to option buyer and buy (call) or sell (put)
- Expiration date – options have finite lives
- Moneyness – in-, at-, or out-of-the-money
- European – exercise only on expiration date
- American – exercise anytime before or on expiration date
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
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Forward Contract
- Forward contract is an obligation to engage in some transaction in the future, not a right
- Forward price – analogous to exercise price
- Initial forward value is typically zero
- Forward price is the strike price where the call premium equals the put premium
- Customizable
- Counterparty default risk
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Futures Contract
- Similar to forward contract
- Standardized
- Transacted on organized exchange
- Clearinghouse acts as intermediary
- Liquidity
- Futures price – price at which the underlying can be transacted at the expiration of the futures contract
- Margin accounts required
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Swaps
- Swap is a commitment between two parties to do a series of transactions in the future
- Similar to forward contract, but involves multiple future transactions
- Swaps can involve a variety of underlyings
- Interest rates
- Equity
- Currency
- Commodities
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Other Types of Derivatives
- Embedded derivatives – when derivative is embedded in other assets
- Callable bonds
- Convertible bonds
- Other instruments
- Options on derivatives – option on swap, option on futures
- Credit derivatives
- Default option in bonds
- Real options – e.g., options embedded in projects
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Origins and Development of Derivatives Markets
- As old as stocks and bonds
- Rice futures in Japan in 17th century
- Chicago Board of Trade (CBOT) opened in 1848
- Evolution of commodity derivatives
- To arrive contracts became known as futures contracts
- Commodity futures – wheat, corn, soybeans, gold
- Chicago Butter and Egg Board opened in 1898 (now the CME Group)
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Evolution of Financial Derivatives
- 1970 – fixed currency exchange rates ended
- Foreign currency futures began trading at the CME
- Financial futures popularity rose
- 1973 – pivotal year
- Fischer Black and Myron Scholes publish option model
- Robert Merton publish rigorous foundations of model
- CBOT spun off Chicago Board Options Exchange (CBOE)
- Many more derivatives markets were subsequently launched
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Development of the OTC Market
- Allows for customization
- Over the counter (OTC) originated as investors purchased securities literally “over the counter” at broker’s offices
- Regulations stemming from financial crisis of 2008-2009 are merging OTC and exchange traded products
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
Derivatives Exchanges
- Largest derivatives exchanges (see Table 2.1)
- Derivatives exchanges span the globe
- More than 20 billion contracts traded on world derivatives exchanges. Figure 2.1 shows breakdown between options (9.4 billion) and futures (12.2 billion)
- Exchanges are often for-profit companies
- Exchange membership is often termed seats
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
*
Standardization of Contracts
- Standardization advantages
- Reduces costs
- Improves efficiency
- Derivatives standardization
- Underlying
- Expirations
- Option exercise prices
- Contract sizes
- Unit of price quotation
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Various Limits
- Position limits – maximum number of contracts held
- Exercise limits – number of options that can be exercised
- Price limits
- Limit up – maximum up move in underlying price
- Limit down – maximum down move in underlying price
- Limit move – price change that results in hitting limit
- Locked limit – market where trading has stopped due to a limit move
- Circuit breakers – automatic trading halts
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Physical versus Electronic Trading
- Physical trading was face-to-face in octagonal-shaped pits
- Location in pit had specific meaning regarding contract maturity
- Pit trading termed open outcry
- Out-trade – discrepancy between traders caught by exchange process
- GLOBEX at CME pioneering electronic trading system
- Electronic trading reduced out-trade frequency
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Mechanics of Trading
- Types of orders
- Market order
- Limit order
- Good-till-canceled order
- Stop order
- All or none order
- Opening or closing orders
- Opening order – order for derivative in which no position is currently held (increases open interest)
- Closing order – order for derivatives that is opposite of a position previously taken (decreases open interest)
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Expiration and Exercise Procedures
- Offsetting order simply passes the derivative to someone else
- With options, contracts can be exercised
- At expiration, physical delivery or cash settlement via assignment
- Exchange-for-physicals or against actuals – long and short agree on an alternative delivery procedure
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
OTC Derivatives Trading
- Dealers – makes a market, quotes bid and ask prices
- End-users – typically the one initiating the transaction
- Trading platform – electronic quotation system, such as swap execution facilities
- Bilateral contract – two parties agree, each promising to do something
- ISDA Master Agreement – standardized OTC contract
- Notional amounts and market values
- Foreign Exchange/Interest Rate Forwards (Figure 2.2)
- Foreign Exchange/Interest Rate Swaps (Figure 2.3)
- Foreign Exchange/Interest Rate/Equity Options
(Figure 2.4)
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Orders and Procedures
- OTC early termination
- Offset with original party
- Offset with another party
- Both contracts remain
- Financial risk offset
- Default risk remains
- Cash settlement common in OTC market
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Clearing and Settlement
- Role of clearinghouse
- Futures transaction on derivatives exchange
(see Figure 2.5) - Options transaction on derivatives exchange
(see Figure 2.6)
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Daily Settlement
- Clearinghouse means of credit risk management is through margin deposit (or performance bond)
- Initial margin – amount deposited on day transaction opened
- Maintenance margin – amount that must be maintained every day thereafter
- Settlement price – average of last few trades of day
- Marked to market – gains/losses charged daily, process called daily settlement
- Margin call – additional funds required
- Variation margin – additional funds deposited
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Market Participants
- Market maker – quotes bid and ask prices
- Scalpers – hold positions for very short period of time
- Floor broker (futures commission merchant) – execute orders for non-members of exchange
- Traders – execute trades for themselves or their company
- Position traders – view driven
- Arbitrageurs – seek profits for misalignment of prices
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Transaction Costs
- Floor trading and clearing fees
- Commissions
- Bid-Ask Spreads
- Delivery Costs
- Other Transaction Costs
- Taxes
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Regulation of Derivatives Markets
- Colorful history due to alignment with gambling
- SEC, created in 1934, regulates securities and options on stocks as well as currencies
- In U.S., regulations originated in Department of Agriculture
- Commodities Futures Trading Commission created in 1974
- Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010
- Transparency
- More multilateral clearing
- Disclosure
- Reduce systemic risk
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Summary
- Types of derivatives
- Origins and development of derivatives markets
- Exchange-listed derivatives trading
- Over-the-counter derivatives trading
- Clearing and settlement
- Market participants
- Transaction costs
- Taxes
- Regulation of derivatives markets
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
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© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
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© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
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An Introduction to Derivatives and Risk Management, 10th ed.
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
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© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
(Return to text slide)
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
(Return to text slide)
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
Chance/Brooks
An Introduction to Derivatives and Risk Management, 10th ed.
Ch. 2: *
(Return to text slide)
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Introduction to Derivatives and Risk Management, 10th ed.
