6 StockDerivMarkets

!
Stock and Derivatives

Markets
Chapters 8 and 10
Financial Markets and Institutions R. Sverdlove
1
Common Stock
Equity securities represent an ownership
interest in a corporation.
Common stockholders are the residual
owners.
! Right to income
! Right to assets
! Voting rights (to elect board of directors)
! Limited liability
Financial Markets and Institutions R. Sverdlove 2
#
Common Stock (2)
Some firms have more than one class of
common shares outstanding, with different
voting rights assigned to each class
! One class of shares may have more votes per
share
! One class of shares may elect a separate set of
directors larger than that elected by the others.
A proxy vote allows stockholders to vote by
absentee ballot (e.g., by mail)
Straight voting is one vote per share per seat
on the board to be elected.
Cumulative Voting
With cumulative voting, the number of
votes assigned to each stockholder equals
the number of shares held multiplied by the
number of directors to be elected
! Provides for minority representation on board
Number of shares needed to elect p
directors is:

p ! number of votes available
number of directors to be elected +1
+1
$
Preferred Stock
Hybrid security with some features of debt
and some of equity
Equity features are
! May be perpetual
! Residual claim on corporate assets
! Income taxed as dividends
Bond-like features are:
! Usually fixed dividend rate
! Senior to common stock (but junior to bonds)
! Usually no voting rights
Preferred Stock (2)
Dividends are usually cumulative: if a
payment is missed, it must be made up
later before any additional common
dividends can be paid
Tax exemption for 70% of dividend income
makes them attractive investments for
corporations
May have a sinking fund provision
Recent issues often have floating rates
%
Stock Returns
The returns on a stock over one period (R
t
)
can be divided into capital gains and
dividend returns:
! P
t
= stock price at time t
! D
t
= dividends paid over time t 1 to t
! [(P
t
P
t

1
) / P
t
] 1 = time t1 to t capital gain
! D
t
/ P
t 1
= time t 1 to t dividend return
1 1
1
! !
!
+
!
=
t
t
t
t t
t
P
D
P
P P
R
Primary and Secondary Markets
Primary stock markets allow suppliers of
funds to raise equity capital
! Initial public offering (IPO)
! One of the principal functions of investment
banks
Secondary stock markets are the most
closely watched and reported of all financial
markets
&
Secondary Trading Locations
Stock Exchanges
! trading floors
! auction system
! central auction specialist (market maker)
system
Over-The-Counter (OTC) Market
! no trading floor
! negotiated system
! multiple market maker system
Electronic Communication Networks (ECN)
U. S. Stock Exchanges
Major National Stock Exchanges
! New York Stock Exchange (NYSE or Big Board)
! American Stock Exchange (AMEX, ASE or
Curb)
Regional Stock Exchanges
! Boston, Chicago, Pacific (San Francisco),
Philadelphia
OTC Market
! NASDAQ
! NASD
'
U. S. Stock Exchanges (2)
Consolidation of exchanges
NASD owned AMEX from 1999-2004, when
it again became independent
NYSE http://www.nyse.com/
! Merged with Euronext in 2007
! NYSE Euronext merged with the American
Stock Exchange in 2008
! Acquired by Intercontinental Exchange (ICE)
2013
Categories of Traded Stocks
Defined by Securities Act of 1934
Exchange-traded (listed) stocks
! traded on national and regional exchanges
Over-the-counter (non-exchange-traded,
unlisted) stocks
! NASDAQ listed OTC stocks
" Large
" Small
! Non-NASDAQ OTC stocks
" Bulletin Board
" Pink Sheets
(
Types of Markets
First Market
! trading on exchanges of stocks listed on an
exchange
Second Market
! trading in OTC market of stocks not listed on an
exchange
Third Market (dark pools)
! trading in OTC market of stocks listed on an
exchange (usually used by institutions)
Fourth Market
! private transactions between institutional investors
(no intermediary)
Exchanges
Formal organizations approved and
regulated by the SEC
Members
! can only trade listed stocks
! must buy a seat or trading license on the
exchange
Listing requirements
! minimum capitalization, shareholder equity,
average closing share price, etc.
)
NYSE
Centralized continuous auction market
Exchange participants:
! commission brokers
! independent floor brokers
" Work for other brokers
! registered traders
" Trade for themselves
! Specialists
" one for each stock at a trading post
" Market makers: provide liquidity
NYSE (2)
SuperDot
! Electronic order system connecting member
firms to trading posts
Major roles of specialists
! Dealer: make market
! Agent: execute orders
! Catalyst: match buyers and sellers
! Auctioneer: quotes prices
Commissions
*
NYSE (3)
Before 2006, private company owned by
members who held seats, which had to be
purchased for prices as high as $4 million.
Public company since 2006.
Seat owners received cash and stock
Access to trading floor now requires
purchasing a trading license for $40,000
per person per year.
NYSE (4)
Currently about 4000 securities are traded
on the NYSE
! Common stock
! Preferred stock
! Closed-end and exchange-traded funds
! Corporate bonds
About 500 securities houses employ
stockbrokers
!+
Trading on an Exchange
19

Order Order Order

Investor
Shares
Broker
Shares
Comm.
Shares
Market
or Maker or

Cash Cash
Floor
Cash
Other Floor
Broker Broker

Stock Market Quotes
Name
Symbol
Open
High
Low
Close
Net Chg
% Chg
Volume
52 Wk High
52 Wk Low
Div
Yield
P/E
YTD % Chg
20
!!
AMEX (NYSE Alternext)
National market for smaller stocks
! About 700 companies listed
! Now includes European issues as well
Options
Exchange-traded funds
Closed-end funds
Structured products
U. S. OTC Market
Trading unlisted stocks
Listing requirements
NASDAQ market tiers
! NASDAQ National Market (3600 securities)
! Small Capitalization Market (800 securities)
NASDAQ market makers
Other OTC markets
! OTC Bulletin Board (3700 securities)
! Pink Sheets (5500 securities)
!#
Third Market
Listed stocks traded in OTC market
NYSE Rule 390
! Dealers could not be NYSE members
! Repealed in 1999
Network of broker-dealers regulated by the
NASD
Used by institutions to lower costs and
facilitate large trades
Upstairs market for block trades
Fourth Market
Direct trading of stocks between two
investors, using an electronic system
! Lower costs
Reporting through NASDAQ
Alternative trading systems (ATS)
! electronic communications networks
" Use NASDAQ to post actual orders
" Like an open limit-order book
! crossing networks
!$
Order Execution
Brokers are required to get the best deal for
their customers
Different markets may offer incentives to
brokers to route orders through them.
! Broker must get permission to do this.
Customers may instruct broker to carry out
the order in a particular market.
! Broker may charge a higher fee for this.
Brokers may fill orders themselves
! This is called internalization
Dealers vs. Specialists
Specialists are required to maintain fair
and orderly markets
! Market can be closed if this is impossible
Dealers do not have to maintain markets in
particular stocks
! News announcements may cause problems
SEC studies have found that trades are
cheaper on NYSE, but faster on NASDAQ
!%
Regulatory Issues
To make markets fair to all traders, everyone
must have access to reporting of all trades
and execution must be uniform
! Fragmentation of markets works against this.
Securities Act of 1975 directed the SEC to
establish a national market system
! Intermarket Trading System (ITS)
" Quotes for all exchanges and OTC, intermarket execution
of trades
! Consolidated Quotation System
" Reporting of all trades across markets
Regulatory Issues (2)
NASDAQ bid-ask spreads
! In 1994 Christie and Schultz showed that most
quotes were in quarters even though eighths were
possible
! This was evidence of implicit collusion or price
fixing leading to many Wall Street firms being fined
by the SEC.
! After their publication, more bid and ask quotes
moved to odd eighths, making trading cheaper for
investors.
! Regulatory functions of NASD were moved into a
new subsidiary, NASDR, in 1996
!&
Decimalization
! NYSE price quotes moved from eighths to
sixteenths (of a dollar) in 1997 and then to
pennies in 2001.
! This again benefits most investors
! In some cases it may benefit specialists, since
large trades will be broken up into a larger
number of small trades at slightly different
prices.
Regulation FD
! SEC ruled in 2000 that all information
disclosures by companies must be made
simultaneously to all interested parties
! Previously analysts and professional money
managers would have private meetings with
companies and learn about earnings and other
announcements before the general public.
!'
International Stock Trading
Global Depository Receipt (GDR)
! Bank-issued title to shares of stock traded in a
foreign country.
American Depository Receipt (ADR)
! Tradable right to a foreign share held in trust by a
U.S. financial institution that issues the ADR.
Depository Receipt
! combination of GDRs and ADRs
Euroequity
! Stock issued outside the companys home country
American Depository Receipt
Types:
! nonsponsored (created by banks)
! Sponsored (created by the company and 1 bank)
Trading Location
! NYSE
! ASE
! OTC market
Advantages
! trade stocks on U.S. exchanges
! payments made and received are in U.S. dollars
! avoid some country-specific taxes
!(
Trading Mechanisms
Types of Orders
! market order: buy now
! limit order: buy if low, sell if high
! stop order: buy if high, sell if low
Limit-order book
! List of requested transactions maintained by a
specialist
! Execution priority
" First come, first served
" Public orders ahead of member orders
Trading Mechanisms (2)
Short Selling
! Borrowing shares through a broker
! Before July, 2007, only allowed on an uptick to
reduce downward momentum
Margin Transactions
! Borrowing from a broker to buy stock
! Limit on percent borrowed set by the Federal
Reserve Board and exchanges
" initial margin (50%)
" maintenance margin (25%)
" different for different types of transactions
!)
Trade Size
Stocks are normally traded in multiples of
100 shares or round lots.
Any part of an order less than 100 shares is
an odd lot and has a higher commission
A block trade is for a large number of
shares, defined by the NYSE as at least
10,000 or $200,000.
Small orders can be sent electronically to
the floor by systems such as SuperDot.
Transaction Costs
Explicit costs
! Commission
! Transfer and other fees or taxes
! Soft dollars: higher commissions are offset by
provision of other services, such as research,
for free.
! This is a form of payment for order flow: the
broker provides the investor with incentives to
use his trading services.
!*
Transaction Costs (2)
Implicit costs
! Bid-ask spread (part of quoted price)
! Impact cost: large trade can affect price up or
down by changing supply or demand
! Timing cost: price change that results from a
delay in execution because of trade size
! Opportunity cost: trades not made because of
delays and resulting price changes
Transaction Costs (3)
Empirical facts
! Implicit costs are economically significant
! More difficult trades to carry out cost more
! Type of market and investment affects cost
! Costs vary among managers
! Trading process has too many variables for
accurate prediction of costs
What is best execution for institutional
traders?
#+
Retail Trading
Full service brokers
! Advice and research
Discount brokers
! Trading only
! Online accounts
Compared to institutional trading:
! Higher explicit costs
! Lower impact cost
! Faster execution
Institutional Trading
Most of the market: 97% of trading both by
number of trades and by volume
Block trades
Program trades
Negotiated commission arrangements
! Fees depend on success of trade
! Broker-dealer may participate in the risk of the
trade
! Brokers asked to bid on commissions may frontrun:
buy or sell ahead of the institution
" Avoid by specifying trades in general terms
#!
Block Trades
In 1961, about 9 per day
In 2007, 4000-5000 per day on the NYSE
Large trades that cannot be filled directly
may be broken up into smaller blocks to
lower price impact
Order of execution
! Upstairs market first (27% of volume)
! Brokerage firm may take a position
! Specialist and floor trading
Program (Basket) Trades
Simultaneous purchase or sale of shares in
a large number of different stocks, which is
computer-assisted.
Used by mutual funds to rebalance
portfolios for asset allocation or index
matching
Index arbitrage is a strategy involving
simultaneous trading of futures contracts
on an index and the underlying stocks of
the index
##
Program Trade Execution
Agency basis: lowest commission
Agency incentive arrangement
! Use benchmark price for each security
! If better prices are obtained, broker gets
additional compensation
Principal basis: broker buys or sells the
portfolio for its own account immediately
Controversial Trading Practices
Flash Trading
! Some traders have early access to incoming orders
Naked Access
! brokers and exchanges allow some traders to
engage in high frequency trades anonymously
using the brokers access code
Dark Pools
! trades that occur on alternative trading platforms
(such as electronic communication networks) that
do not report the details of the trade on order books
#$
Flash Trading
Flash traders see incoming orders
milliseconds ahead of other traders, then
use computerized statistical analysis to
generate high frequency trading strategies
that are executed by computer as well
Pro: Flash trading creates more liquidity
and the possibility of price improvement
Flash Trading (2)
Con:
! Creates a disadvantage for regular traders and
investors who are not allowed to view incoming
orders
! High volume of trading generated by multiple
computers can lead to events like the so called
flash crash
" On May 6, 2010, markets fell about 5% in a very brief time,
only to just as quickly recover most of the loss.
" Definitive cause unknown, but supposedly trades of $4.1
billion S&P500 futures contracts by a Kansas City based
mutual fund, Asset Strategy Fund, triggered the crash
#%
Price Change Limits
Stock Market Crash of 1987
! Market lost almost 25% in one day
New regulations to prevent recurrence
(Rule 80B)
! Levels for the S&P 500 are set at the end of
each day to restrict trading on the following day
! Levels are 7%, 13%, and 20% of the close.
! Trading can be halted if too large a drop occurs
in one day: circuit breakers.
Circuit Breakers
Levels 1 and 2 (7% and 13% declines)
result in a 15 minute trading halt, at most
once per day.
Level 3 (20% decline) results in a trading
halt for the rest of the day.
No halts after 3:25 PM.
These rules were revised in 2013.
#&
Stock Market Indexes
Exchange Indexes
! NYSE Composite
! AMEX
! NASDAQ Composite
Subjective Selection
! Dow Jones Industrial Average (DJIA)
! S&P 500
! Value Line Composite Average (VLCA)
Selection by Rule (Market Capitalization)
! Russell 1000, 2000, 3000 (large, small, all)
! Wilshire 5000, 4500 (all actively traded stocks)
Stock Market Indexes (2)
DJIA is a price-weighted average, adjusted
for stock splits and dividends
! Company size has no effect.
! Returns are those of a portfolio with one share
of each stock in the index
VLCA is an equal-weighted average
! Returns are those of a portfolio with the same
number of dollars invested in each stock.
! This portfolio must be rebalanced.
#'
Stock Market Indexes (3)
Other indexes such as the S&P 500 are
value-weighted (by market capitalization)
! Returns are those of a portfolio consisting of all
the stock of all the companies in the index.
Foreign market indexes
! Japan: Nikkei 225
! U. K.: FTSE 100
! Germany: DAX 30
Stock Market Pricing Efficiency
Forms of Efficiency
! Weak form
" Prices reflect past price and trading history
" Supported by empirical evidence
! Semistrong form
" Prices reflect all publicly available information
" Supported by some empirical evidence
! Strong form
" Prices reflect all information, public or not
" Not supported by empirical evidence
#(
Stock Market Pricing Efficiency (2)
Implications for Investing in Common Stock
! Weak form efficiency means that technical
analysis does not work
! Semistrong form efficiency means that
" no active strategy, including fundamental analysis, will
work
" Passive strategies are best (indexing)
! Strong form is not true because insider trading
is profitable
International Investing
For investors, provides more diversification
since national economies are not highly
correlated
For issuers, provides a larger market for
their securities and publicity for their
products
#)
Multiple Listings
Some company stocks are listed on
exchanges in several countries
These are usually large companies,
because of the costs involved
! Must satisfy different accounting and disclosure
rules
Companies have significant international
sales, particularly in countries where they
are listed
Multiple Listings (2)
Prices are approximately the same in all
markets
Prices vary with exchange rates
If prices were not equivalent, arbitrage
would bring them back to equality
! Buy where the price is low, sell where the price
is high
! Changing supply and demand brings the prices
into line
#*
Trading Costs
Trading costs vary significantly from one
country to another.
Costs in the highest-cost markets are about
five times the lowest-cost.
Costs are higher for small stocks.
! Liquidity premium
U. S. costs are about average.
Global Diversification
Economic policies and macroeconomic
factors are different in each country, so
markets are not highly correlated.
Closely linked countries have higher
correlations, such as U. S. and Canada or
Germany and Switzerland.
Japan is not highly correlated with any of
the other major economies.
$+
Global Diversification (2)
Low correlations allow the creation of
portfolios with higher returns and lower risk.
Increasing globalization of markets may
tend to increase correlation between
different national markets.
! A larger part of each country's economy is
related to global business.
! Correlation may increase in times of crisis:
flight to quality
Stock Exchange Ownership
Privately Owned Markets
! United States, United Kingdom, Hong Kong,
Canada, Japan, Australia
Public Institutions
! France, Spain, Italy, Belgium
! Move toward private ownership
Banks
! Switzerland, Austria, Germany
$!
Stock Market Trends
Institutionalization
! Great majority of stock is now held by
institutions, not individuals
Deregulation
! Happening in many countries
Technology
! Trading is moving more and more to electronic
media
Derivatives Markets
62
$#
Derivatives
A derivative is an instrument whose value
depends on the values of other more basic
underlying variables.
Great variety in todays market.
More being developed all the time.
The underlying asset can itself be a
derivative.
Derivative sales involve transfers of risk.
Types of Derivatives
Forwards
Futures
Swaps
Options
! Differ from the others in that the underlying
transaction may not take place
$$
Underlying Assets
Commodities
! Agricultural products
! Minerals
Interest rates
Foreign currencies
Stocks and Stock Indices
Uses of Derivatives
To hedge (insure against) risks
To speculate (take a view on the future
direction of the market)
! Create leverage
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment
without incurring the costs of selling one
portfolio and buying another
$%
Futures Contracts
A futures contract is an agreement to buy or sell
an asset at a certain time in the future for a
certain price
By contrast in a spot contract there is an
agreement to buy or sell the asset immediately
(or within a very short period of time)
The contract is guaranteed to be carried out by
the exchange and clearinghouse
Contract specifies
! Underlying Asset
! Futures Price
! Settlement Date or Delivery Date, usually quarterly
History of Futures Markets
Originally developed for agricultural
products
! Stabilize income of farmers
! Stabilize prices for users of products
Known in some form since middle ages.
Chicago Board of Trade founded 1848
! Futures contracts on grains
! Speculators began trading
! Now includes futures on Treasury securities
$&
History of Futures Markets (2)
Chicago Mercantile Exchange
! Organized from earlier exchanges in 1919
! Futures contracts on perishable agricultural
products
CME started trading in currency futures in
1972 for many major currencies.
Trading system
! Traditionally open-outcry: floor traders
! Moving toward more electronic trading
Commodity Futures
Agricultural
! Sugar
! Corn
! Soybeans
! Orange Juice
! Pork Bellies
! Wheat
! Lumber
!
$'
Commodity Futures (2)
Mineral
! Crude oil
! Natural gas
! Heating oil
! Unleaded gasoline
! Gold
! Silver
! Aluminum
!
Financial Futures
Financial Instruments
! U.S. Treasury bonds, notes, and bills
! Other government bonds:
" U.K., Japan, Germany
! LIBOR
! Eurodollar deposits
! Individual stocks
! GNMA
$(
Financial Futures (2)
Indices
! Dow Jones Industrial Average
! S&P 500
! Other country stock indices
" U.K., France, Germany, Japan, Europe
Currencies
! Euro
! Yen
!
Futures Exchanges
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)
London International Financial Futures and Options
Exchange (LIFFE)
Eurex
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
. . .
Different commodities are traded on different
exchanges.
Two exchanges may offer different contracts on the
same commodity.
$)
Futures Price
The futures price for a particular contract is
the price at which you agree to buy or sell
It is determined by supply and demand in
the same way as a spot price
Futures Contract Examples
Agreement to:
! buy 100 oz. of gold @ US$1000/oz. in
December (COMEX)
! sell 62,500 @ 1.4537 US$/ in March (CME)
! sell 1,000 bbl. of oil @ US$38/bbl. in April
(NYMEX)
$*
Futures Positions
The party that has agreed to buy (buyer)
has a long position
The party that has agreed to sell (seller)
has a short position
To close a position, enter a contract for the
opposite position
Open interest is the total number of long (=
short) positions held at a given time.
Futures Trade Example
January: an investor enters into a long
futures contract on COMEX to buy 100 oz.
of gold @ $925 in April
April: the price of gold is $935 per oz.
What is the investors profit?
%+
Role of Clearinghouse
Functions of Clearinghouse
! guarantees that both parties to futures contracts
satisfy their obligations
! simplifies the unwinding of futures positions
prior to the settlement date
When an investor takes a long (short)
position, the Clearinghouse takes the
opposite position
! Investor does not make the contract directly
with another investor
Futures Regulation
Regulation is designed to protect the public
interest
Regulators try to prevent questionable
trading practices by either individuals on
the floor of the exchange or outside groups.
! Cornering the market
! Overcharging
! Insider trading
%!
Futures Regulation (2)
Commodity Futures Trading Commission
! Independent Agency of U.S. government
! Founded 1974, role expanded several times
! Oversees derivatives markets
" Exchanges
" Clearing organizations
Exchanges enforce speculation controls
! Daily price movement limits (like stocks)
! Position limits
Mark-to-Market
Futures contracts are marked-to-market
(settled) on a daily basis
! a buyer (seller) realizes a profit if the futures
price increases (decreases)
! a buyer (seller) realizes a loss if the futures
price decreases (increases)
Daily price limits restrict the maximum daily
price moves
%#
Mark-to-Market Example
Farmer agrees to sell 100,000 bushels of
wheat for $2.80 a bushel in a specified
future month.
Next day, wheat futures price is $2.75.
Farmers profit is 100,000 x $0.05 =
$5000, credited to his account.
Farmer now has an agreement to sell
100,000 bushels of wheat at the specified
time for $2.75 a bushel.
Principle of Convergence
At the delivery date, the futures price must
equal the cash price.
As the delivery date approaches, the
futures price converges to the cash price.
! The financing cost approaches zero
! The yield approaches zero
! The cost of carry approaches zero
%$
Convergence of Futures to Spot
85
Time
(a)
Futures
Price
Spot Price
Time
(b)
Futures
Price
Spot Price
Margin
The amount (percentage) of a Futures
Contract Value that must be on deposit with
a broker in cash or marketable securities
(e.g., Treasuries).
The balance in the margin account is
adjusted to reflect daily settlement
Margins minimize the possibility of a loss
through a default on a contract
%%
Margin (2)
Since a Futures Contract is not an actual
sale, you need only pay a fraction of the
asset value to open a position. This
fraction is the margin requirement.
Minimum margin requirements are set by
the exchange. Broker may require a higher
level of margin
Margin (3)
Initial margin is required when opening a
position.
Initial margin level depends on the
particular contract.
Maintenance margin is required later,
usually about 75% of initial margin.
Variation margin is the amount necessary
to bring equity account back to initial
margin level
%&
Margin (4)
Investing on margin creates leverage.
For example, with a 30% margin
requirement, you can control $100,000 of
assets with only $30,000.
Gains and losses are magnified.
Higher risk, higher potential return.
Margin Call
If you have a margin account, and your
balance falls below the maintenance level,
you must put in enough cash to bring your
account back up to the initial margin level.
%'
Margin Call Example
An investor takes a long position in 2
December gold futures contracts on June 5
! contract size is 100 oz.
! futures price is US$400
! Initial margin requirement is US$2,000/contract
(US$4,000 in total)
! maintenance margin is US$1,500/contract (US
$3,000 in total)
Margin Call Example (2)
92
Daily Cumulative Margin
Futures Gain Gain Account Margin
Price (Loss) (Loss) Balance Call
Day (US$) (US$) (US$) (US$) (US$)
400.00 4,000
5-Jun 397.00 (600) (600) 3,400 0
. . . . . .
. . . . . .
. . . . . .
13-Jun 393.30 (420) (1,340) 2,660 1,340
. . . . . .
. . . . .
. . . . . .
19-Jun 387.00 (1,140) (2,600) 2,740 1,260
. . . . . .
. . . . . .
. . . . . .
26-Jun 392.30 260 (1,540) 5,060 0
+
=
4,000
3,000
+
=
4,000
<
%(
Market Structure
Exchange Trading (like stock exchange)
! Pit
! Seat on the exchange
Floor Traders
! Locals
" Trade for their own accounts
! Floor or pit brokers
! Futures commission merchant
" Trade for paying customers
Electronic Trading Systems
Forwards
Forwards are over-the-counter contracts
negotiated directly between the parties.
No money changes hands when the
contract is first negotiated.
! Initial contract value is zero
The contract is settled once at maturity.
! Usually no marking to market
! Delivery is made at settlement
All profit or loss occurs at settlement.
%)
Forward Price
The forward price for a contract is the
delivery price that would be applicable to
the contract if it were negotiated today (i.e.,
it is the delivery price that would make the
contract worth exactly zero)
The forward price may be different for
contracts of different maturities
Forward vs Futures Contracts
Forwards Futures
Private contract between 2 parties Exchange traded
Non-standard contract Standard contract
Usually 1 specified delivery date Range of delivery dates
Settled at maturity Settled daily
Counterparty credit risk Clearinghouse provides guarantee
Delivery or final cash settlement
usually occurs
Usually closed out prior to maturity
%*
Forward and Futures Example
Investor A enters into a long forward contract
to buy 1,000,000 @ 1.4381 US$/ in 90 days
Investor B enters into a long futures contract
to buy 1,000,000 @ 1.4381 US$/ in 90 days
The exchange rate is 1.4600 US$/ in 90 days
Both investors make a profit of $21,900
! Investor A receives all profit on day 90
! Investor B receives some profit or loss on each of
the 90 days.
Hedge Positions
Short Hedge
! protects against a decline in the cash price of a
financial asset or portfolio
! sell hedge
Long Hedge
! protects against an increase in the cash price of
a financial asset or portfolio
! buy hedge
&+
Commodity Hedge Example
In June, farmer John Smith expects to
harvest 10,000 bushels of corn during the
month of August. In June, the September
corn futures are selling for $2.94 per bushel
(1 contract = 5,000 bushels). Farmer Smith
wishes to lock in this price.
What happens if the September spot price
drops to $2.80?
In June, farmer John Smith expects to harvest 10,000
bushels of corn during the month of August. In June, the
September corn futures are selling for $2.94 per bushel (1
contract = 5,000 bushels). Farmer Smith wishes to lock in
this price.
Revenue from Crop: 10,000 x 2.80 28,000
June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 2.80 = 28,000 .
Gain on Position------------------------------- 1,400
Total Revenue $ 29,400
Commodity Hedge Example (2)
&!
Revenue from Crop: 10,000 x 3.05 30,500
June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 3.05 = 30,500 .
Loss on Position------------------------------- ( 1,100 )
Total Revenue $ 29,400
What if the spot price rises to $3.05 in
September?
Farmer John Smith has succeeded in
locking in the June price.
He gets that price whether the spot price
increases or decreases.
In fact, he gets slightly less because of
transaction costs.
&#
Cross Hedge
A cross hedge is one where the asset
underlying the futures contract is similar,
but not identical, to the asset in which the
investor holds a long or short position.
Example: to hedge a position in a
diversified stock portfolio, one could take a
futures position in the S&P 500 index.
A cross hedge is perfect when the ratio of
cash asset prices remains the same.
Futures Quotes
&$
Futures Quotes (2)
Heading
! Underlying asset
! Exchange
! Contract size
! Price quote units
Summary at end
! Estimated volume for day, actual for previous
day.
! Total open interest for all contracts and change
from previous day.
Futures Quotes (3)
Individual contracts
! Maturity date
! Opening, high, and low prices for the day
! Settlement price
" Average price of trades just before closing
" Used for marking to market
! Change in settlement price
! Lifetime high and low price
! Open interest
&%
Futures Quotes Questions
When a new trade is completed what are
the possible effects on the open interest?
Can the volume of trading in a day be
greater than the open interest?
Futures Role in Financial Markets
More efficient and liquid than asset market
Altering exposure to asset risk (hedging)
More efficient price discovery
Arbitrage process brings prices in line
Increased underlying asset price volatility
! Faster reactions to changing information
! Are markets destabilized?
&&
GAO Financial Derivatives Study
Principal Conclusions (1994)
! A legal framework is needed which will set basic
standards to effectively manage derivative risk.
! Financial reporting requirements are inadequate for
derivative instruments.
! Coordination with foreign regulators is needed.
! Policymakers and regulators should not stifle the
use of derivatives.
No action was taken but financial market
events of 2007-2008 confirm these
conclusions
Options
The right, not the obligation, to buy or sell a
specified amount of a specific asset at a
specified price within a specified time period
In a futures contract, both parties have an
obligation; in an options contract only the
seller has an obligation and then only if the
buyer asks the seller to do it.
Option buyer has a limited, known maximum
loss.
Option position risk/return profile is
asymmetric, while that of a futures position is
symmetric.
&'
Mechanics of Options Markets
Assets underlying exchange-traded options
! Stocks
! Stock indices
! Foreign currency
! Futures
! Interest rates
Specification of exchange-traded options
! Expiration date (maturity)
! Strike price (exercise price)
! European or American: exercise at maturity or any time
! Call or put (option class): option to buy or sell
! Expiration date+strike price+class = option series
Option Listings
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15.25 107 5.25
138.3 130 Jan 112 19.5 420 9.25
138.3 135 Jul 2365 4.75 2431 0.81
138.3 135 Aug 1231 9.25 94 5.5
138.3 140 Jul 1826 1.75 427 2.75
138.3 140 Aug 2193 6.5 58 7.5
--Put-- --Call--
&(
Moneyness
An option is in the money if exercising it
now would give a positive cash flow.
An option is at the money if exercising it
now would give a zero cash flow.
An option is out of the money if exercising it
now would give a negative cash flow.
Moneyness Examples
A call is in (out of) the money if the
current stock price is greater (less)
than the strike price.
A put is in (out of) the money if the
current stock price is less (greater)
than the strike price.
A call or a put is at the money if the
current stock price is equal to the
strike price.
&)
Commissions
Commissions on option trades are usually
a fixed base plus a percentage of the trade
value.
Exchanges set maximum and minimum
commissions.
Another commission must be paid to close
out a position.
If an option is exercised, the usual stock
transaction commission is paid.
Margin Requirements
Options cannot be bought on margin since
they are already highly leveraged
investments. Full payment is required.
Margins are required when options are
sold, as protection against default by the
writer, who has an obligation.
Covered options (with corresponding
positions in the underlying stock) have
lower margin requirements.
&*
Risk and Return of Options
The purchase of a call (put) is like taking a
long (short) position in the underlying asset
with a fixed maximum loss.
! Benefits the buyer if the price of the underlying
asset rises (falls).
! Benefits the seller if the price of the underlying
asset falls (rises) or is unchanged.
Profit from Options
Buying a call option produces a profit if the
stock price at maturity is more than the
strike price plus the option price.
Buying a put option produces a profit if the
stock price at maturity is less than the strike
price minus the option price.
Selling a call or put produces a profit when
these relations are reversed.
'+
Option Value at Maturity
The value of an option at expiration is a
function of the stock price and the exercise
price.

Example - Option values given an exercise price
of $55
0 0 0 5 15 25 Value Put
25 15 5 0 0 0 Value Call
80 70 60 50 40 $30 Price Stock
Long Call Option Payoff
Call option payoff to the buyer given a $55 exercise price.
Share Price
C
a
l
l

o
p
t
i
o
n

v
a
l
u
e

55 75
$20
$0
payoff
profit
option price
'!
Long Put Option Payoff
121
Put option payoff to the buyer given a $55 exercise price.
Share Price
P
u
t

o
p
t
i
o
n

v
a
l
u
e

50 55
$5
$0
option price
payoff
profit
Short Call Option Payoff
122
Call option payoff to the seller (writer) a $55 exercise price.
Share Price
C
a
l
l

o
p
t
i
o
n

$

p
a
y
o
f
f

55
$0
option price
profit
payoff
'#
Short Put Option Value
123
Put option payoff to the seller (writer) given a $55 exercise price.
Share Price
P
u
t

o
p
t
i
o
n

$

p
a
y
o
f
f

55
$0
option price
profit
payoff
Profit and Loss Limits
Long position has loss limited to option price
Short position has profit limited to option price
Long call has no theoretical limit to profit
Short call has no theoretical limit to loss
Long put has profit limited to strike price - option
price
Short put has loss limited to strike price - option
price
'$
Option Leverage
If stock price goes up, the profit from a call
option is less than the profit from buying a
share of the stock by the option price.
However, cost of investing in the option is
much lower than cost of buying a share.
Therefore, the option investment has a
much higher return.
If the stock doesnt go up and the option
expires unexercised, the loss on the
investment is 100%.
Economic Role of Options Market
Hedging With Futures
! Minimizes the risks of adverse price movements.
! Gives up the benefits of favorable price
movements.
! No initial investment required
Hedging With Options
! Limits price risk.
! May benefit from favorable price movements.
! May mold a risk/return relationship.
! Investor must pay a premium for this insurance
policy
'%
Pricing of Options
The price of an option consists of two
components: the intrinsic value and the
time premium.
Intrinsic value
! the economic value of the option if exercised
immediately, if it is positive. or else zero
Time premium
! amount by which the option price exceeds the
intrinsic value
Factors Influencing Option Price
Current price of the underlying asset
Strike price
Time to expiration of the option
Expected price volatility of the underlying
asset over the life of the option
Short-term, risk-free interest rate over the
life of the option
Anticipated cash payments on the
underlying asset over the life of the option
'&
Variable Effects on Option Values
Option Type
Variable
Eur. call Eur. put Am. call Am. put
Stock Price
+ - + -
Strike Price
- + - +
Maturity
? ? + +
Volatility
+ + + +
Interest Rate
+ - + -
Dividend
- + - +
+ (-) means when variable goes up, option value goes up (down).
Option Pricing Models
The theoretical option price is determined
on the basis of arbitrage arguments.
Option Pricing Models
! Binomial Option Pricing Model
! Black-Scholes Option Pricing Model
! Call Price:

C = N(d
1
)S ! E(e
!rT
)N(d
2
)
d
1
=
ln(S / E) + (r +"
2
/2)T
" T
d
2
= d
1
!"T
''
Exotic Options
Over the counter options created by
dealers to meet specific needs of
customers
Since they are not exchange traded, they
can have any conditions
! Different rules for exercise
" Bermuda option can be exercised on a specific set of
dates
! Different rules for payoffs
Exotic Option Examples
Compound option: option on an option
Binary option: fixed payment if price is on
the right side of the strike, zero otherwise
Lookback option: payoff based on the
maximum asset price during the term
Asian option: payoff based on the average
asset price during the term
Exchange option: option to exchange one
asset for another asset
'(
Swaps
A swap is an agreement to exchange cash
flows at specified future times according to
certain specified rules.
Most common types of swaps are those of
! Different interest rates (fixed and floating) on
the same principal (notional amount)
" Notional is not exchanged
! Cash flows in two different currencies
" Notional is exchanged at beginning and end
Other Types of Swaps
Cash flows can be based on the returns on
two different stock indexes
A fixed or floating interest rate can be
exchanged for the return on a stock index
Credit default swap: a fixed rate is
exchanged for a guarantee on the face
value of a bond.
')
Swap Markets
Swaps are not standardized contracts
Swap dealers (financial institutions) keep
markets liquid by matching counterparties
or by taking positions themselves
The International Swaps and Derivatives
Association (ISDA) is an association of
over 840 members from 58 countries that
sets codes of standards for swap
documentation
Uses of Currency Swaps
Conversion from a liability in one currency
to a liability in another currency
Conversion from an investment in one
currency to an investment in another
currency
Comparative advantage may lead a
borrower to borrow in one currency when it
needs the other one.
'*
Interest Rate Caps
Floating rate loans often have a limit on
how much the rate can be increased in
each loan period.
This limit is called a cap
It is a kind of insurance against large rate
increases.
It is common to have a per-period cap and
an overall cap on a floating-rate home
mortgage.
Floors and Collars
A floor is the opposite of a cap: a limit on
how low a floating interest rate can go
during a given period.
A floor is a put option on the interest rate,
where a cap is a call.
A collar is a combination of a cap and a
floor: the interest rate is limited to a range.
(+
Option Markets Regulation
The primary regulator of futures markets is
the Commodity Futures Trading
Commission (CFTC)
The Securities Exchange Commission
(SEC) is the primary regulator of stock
options and stock index options
The CFTC is the regulator of options on
futures contracts
International Derivative Markets
The U.S. dominates the global derivative
securities markets
! North America accounted for $57.94 trillion of
the $96.67 trillion contracts outstanding on
organized exchanges in 2007
The euro and European exchanges are
expanding
! Europe accounted for $32.28 trillion of the
$96.67 trillion contracts outstanding on
organized exchanges in 2007

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