Practice investment management pim3 ch17

 The Financial Page Listing The Origin of an Option  The Role of the Options Clearing Corporation  Standardized Option Characteristics... Options Terminology A call option gives its

THE ROLE OF DERIVATIVE ASSETS

CHAPTER SEVENTEEN

 The Financial Page Listing

 The Origin of an Option

 The Role of the Options Clearing Corporation

 Standardized Option Characteristics

 The Futures Market

 Futures vs Options

 Market Participants

 Keeping the Promise

 Categories of Futures Contracts

 Financial Futures

 Stock Index Futures

 Interest Rate Futures

 Foreign Currency Futures

 Derivative Assets and the News

 Current Events

 Risk of Derivative Assets

 Listed vs Over-the-Counter Derivatives

 Derivative assets get their name from the

fact that their value derives from some

other asset.

 The best-known derivative assets are

futures and options contracts.

 Derivatives are not all the same Some are

inherently speculative, while some are

highly conservative.

Introduction

Background : The Rationale for Derivative Assets

 The first organized derivatives

exchange in the United States was developed in order to bring stability to agricultural prices, by enabling farmers to eliminate or reduce their price risk.

Background : Uses of Derivatives

 Risk management : The equity manager’s market risk or the bond manager’s interest rate risk is analogous to the farmer’s price risk.

 Risk transfer : Derivatives provide a means for risk to be transferred from one person

to some other market participant who, for a price, is willing to bear it.

 Derivatives may provide financial leverage.

Background : Uses of Derivatives

 Income generation : Some people use

derivatives as a means of generating

additional income from their investment

portfolio.

 Financial engineering : Derivatives can be stable or volatile depending on how they are combined with other assets.

 What’s next?

Background : Uses of Derivatives

Insert Figure 17-1 here.

Options Terminology

 A call option gives its owner the right to

buy a specified quantity of the underlying asset at a set price within a set time period.

 A put option gives its owner the right to sell

a specified quantity of the underlying asset

at a set price within a set time period.

 The set price is called the striking price or

exercise price, and the last day the option

is valid is called the expiration date.

 The price of the option is the premium.

Options Terminology

 Options trade in units called contracts, each

of which normally covers 100 shares.

 An option’s volume indicates how many

option contracts changed hands over some period of time It measures trading activity.

 An option’s open interest indicates how many option contracts exist.

 Open interest goes up when someone creates an option and does down when two people trade and each close out an options position.

 The owner of an option will ultimately do

one of three things with it:

 sell it to someone else;

 let it expire; or

 exercise it.

Options Terminology

The Origin of an Option

 Options can be created, or destroyed The

quantity of options in existence changes

everyday.

 The first trade someone makes in a

particular option is called an opening

transaction If an investor sells an option as

an opening transaction, it is called writing the option.

 Options are fungible, meaning that, for a

given company, all options of the same

type with the same expiration and striking

The Role of the Options Clearing Corporation

OCC

Buyer Trading Floor Seller

 The Options Clearing Corporation positions itself between every buyer and seller and acts

as a guarantor of all option trades.

Standardized Option Characteristics

 Options have standardized expiration dates,

striking prices, and lot size.

 option premium = intrinsic value + time value

 If an option has no intrinsic value, it is the-money Otherwise, it is either in-the-

out-of-money or at-the-money.

Standardized Option Characteristics

Standardized Option Characteristics

 An American option can be exercised

anytime prior to the expiration of the option

A European option, on the other hand, can only be exercised at expiration.

 The option holder decides if and when to

exercise.

 Valuable options are usually sold rather than

exercised.

Standardized Option Characteristics

Fig 17-4 here

 The initial seller of the contract promises to

deliver a quantity of a standardized

commodity to a designated delivery point

during a certain delivery month

 The other party to the trade promises to pay a

predetermined price for the goods upon

delivery

 The person who promises to buy is said to be

long, while the person who promises to

deliver is said to be short.

The Futures Market

 A futures contract is a promise.

The Futures Market

 Futures vs options : Futures contracts do

not expire unexercised Note that the

contract obligation may be satisfied by

making an offsetting trade.

 Market participants :

 Hedgers use futures to reduce price risk.

 Speculators assume risk in the hope of making a profit.

 Marketmakers provide liquidity for the

marketplace.

The Futures Market

Insert Figure 17-5 here.

The Futures Market

 Keeping the promise : Each exchange has a

Clearing Corporation which ensures the

integrity of the futures contract when a

member is in financial distress.

 Categories of futures contracts :

 Agricultural e.g wheat, cotton, cattle.

 Metals and petroleum e.g platinum,

copper, natural gas, crude oil

 Financial e.g foreign currency, stock

index, interest rate.

 Others e.g electricity, catastrophe, swap.

Financial Futures : Stock Index Futures

 A stock index future is a promise to buy or sell the standardized units of a specific

index at a fixed price at a predetermined

future date.

 Unlike most other commodity contracts,

there is no actual delivery mechanism

when the contract expires For practicality, all settlements are in cash.

Financial Futures : Stock Index Futures

Insert Table 17-2 here.

Financial Futures : Interest Rate Futures

 Interest rate futures contracts are

customarily grouped into short-term,

intermediate-term, and long-term

categories.

 The two principal short-term contracts are

Eurodollars and U.S Treasury bills

 The Treasury bill futures contract calls for

the delivery of $1 million par value of

90-day T-bills on the delivery date of the

Financial Futures : Interest Rate Futures

Insert Table 17-3 here.

Financial Futures : Interest Rate Futures

 The contract on U.S Treasury notes is the

only intermediate-term contract, while

Treasury bonds are the principal long-term

contracts.

 The Treasury bond futures contract calls

for the delivery of $100,000 face value of

U.S Treasury bonds with a minimum of 15 years until maturity (and, if callable, with a minimum of 15 years of call protection)

Bonds that meet these criteria are said to

Financial Futures : Interest Rate Futures

Insert Table 17-4 here.

Financial Futures : Interest Rate Futures

invoice

price = [ x ] + settlement price conversion factor accrued interest

 Bonds are standardized as follows:

 T-bonds are not all fungible At any given time, several dozen bonds are usually eligible for

delivery on a T-bond futures contract

Normally, only one of these bonds will be

cheapest to deliver.

Financial Futures : Interest Rate Futures

Insert Table 17-5 here.

Financial Futures : Foreign Currency Futures

 Foreign currency futures contracts call for delivery of the foreign currency in the

country of issuance to a bank of the

clearing house’s choosing.

 Most major corporations face at least some

foreign exchange risk and quickly

discovered the convenience of these

futures as a hedging vehicle, while

speculators saw the contracts as easy to understand and use.

Derivative Assets and the News

 Newspapers in recent months have

been full of reports on various businesses that have lost billions

“investing in derivatives.”

 Derivatives are neutral products Their risk

depends on what an investor does with

them.

 Exchange-traded derivative assets and

over-the-counter derivatives are markedly different.

 The Financial Page Listing

 The Origin of an Option

 The Role of the Options Clearing Corporation

 Standardized Option Characteristics

 The Futures Market

 Futures vs Options

 Market Participants

 Keeping the Promise

 Categories of Futures Contracts

 Financial Futures

 Stock Index Futures

 Interest Rate Futures

 Foreign Currency Futures

 Derivative Assets and the News

 Current Events

 Risk of Derivative Assets

 Listed vs Over-the-Counter Derivatives

Appendix: Option Pricing

Fig 17A-1

Appendix: Option Pricing

 Black-Scholes Options Pricing Model

Insert table 17A-1

Appendix: Option Pricing

Insert fig 17A2

Appendix: Option Pricing

Delta: the change in option premium

expected from a small change in the stock

price, all other things being equal