DERIVATIVES MARKETS

OVERVIEW AND LEARNING OBJECTIVES Futures markets develop whenever and wherever there is price volatility. Buyers and sellers of the product have the risk of approaching the marketplace and finding the market price too high or too low to justify their efforts. Futures markets enable buyers and sellers to establish prices today for transactions (trading, lending, or borrowing) in the future. Today financial derivative activity is a consideration in every financial decision. Corporate financial managers, financial institutions, and investors have a need to hedge price risk, and financial futures, options on financial futures, or swaps are now a part of their decisionmaking process. It is critical for those who study finance to understand that futures, options, swaps, and other derivatives are integral to understanding the financial environment in which firms operate today.

KEY TERMS I. The Nature of Derivative Securities A. Introduction 1. 2. 3. 4. Derivatives are financial securities whose value is based upon or derived from the value of other assets (so called underlying assets). Derivative securities can be used to minimize or eliminate an investors or a firms exposure to various types of risk that they may be exposed to. Risk to an investor or a firm can be caused by interest rate changes or foreign exchange rate changes, commodity prices or stock prices. Derivatives are also used for speculation. Speculators, unlike hedgers, consciously take on risk.

B.

Forward Markets 1. 2. 3. 4. Buying/selling of a specified amount, price, and future delivery date of the underlying security or commodity. Direct relationship between buyer and seller Seller delivers at the specified date called the settlement date. Buyer of the forward contract has a long position; seller of the forward contract has a short position in the contract. The terms buyer and seller are a bit deceptive as nothing is bought or sold at the time the contract is negotiated. Banks and foreign exchange dealers are the primary counterparties to most transactions in the forward market.
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5.

6.

Forward contracts, while designed to achieve the same results as futures contracts, differ in many ways: a. They do not trade on exchanges, but only over-the-counter. b. They are customized contracts in terms of maturity dates, sizes, and grades of deliverable assets. c. Higher default risk exists because either party may default. d. Almost always settled at maturity by delivery of the underlying asset. e. No margin requirement s or other cash flows between origination and termination of contract.

C.

Futures Markets 1. 2. 3. 4. 5. Buying/selling of standardized contracts specifying the amount, price, and future delivery date of a currency, security, or commodity. Buyers/sellers deal with the futures exchange, not with each other. That is, the futures exchange clearing house is the counterparty! A specific trade (buy/sell) may involve two hedgers, a hedger and a speculator, or two speculators. Delivery seldom made buyer/seller offsets previous position before maturity. Spot vs. futures market. a. Trading for immediate or very-near-term delivery is called the spot market. b. Trading for future delivery - futures market. A position in the futures market: a. Long - an agreement to buy in the future. b. Short - an agreement to sell (deliver) in the future. Margin requirements varies by contract type. a. Initial margin - small deposit required to trade a futures contract. b. Daily settlements (marking to market) reflect gains/losses daily and cash payments. c. Maintenance margin - minimum deposit requirements on futures contracts. Futures contracts expire on specific dates.

6.

7.

8. D.

Futures Market Instruments 1. Futures exchanges tend to specialize (capture the trading market) in a type of futures contract. 2. See Exhibit 11-4 for the specific financial futures contracts traded. Futures Exchanges 1. 2. 3. 4. Competition between exchanges is keen. Contract innovation is common. Exchanges advertise and promote heavily. Exchange specifies terms of a contract. a. Dates b. Denomination c. Specific items that can be delivered
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E.

d. e. f. F.

Method of delivery Minimum daily price variance Rules for trading

Futures Market Participants. 1. Hedgers attempt to reduce or eliminate their risk exposure by using short or long positions in the futures and forward markets. a. Are hedging to protect the value of their business and financial transactions. b. Their major objective is to reduce risk by securing a future price. Speculators In contrast to hedgers, speculators seek to take risk in financial markets to make money. a. They are not involved with commodities or securities, but buy/sell in these markets to achieve profits. Traders - speculate on very-short-term changes in future contract prices. a. Traders limit (hedge) the extent of their exposure (risk). b. Traders keep bid/ask differentials very close.

2.

3.

II.

Uses of Financial Futures Markets to Hedge and/or Speculate A. Reducing Systematic Risk in Stock Portfolios 1. 2. 3. 4. Stock index futures contracts trading began in 1982. Stock index futures derive their value from the value of an underlying group of selected stocks. Stock index futures permit investors to alter the market or systematic risk of their portfolio. Investors who try to protect stock gains may hedge against a decline in the market value of their stock portfolio by selling (shorting) stock index futures.

B.

Stock Index Program Trading 1. 2. 3. Stock Index program trading is done to arbitrage the price discrepancies between a stock index future and the stocks that make up the stock index. Program trading allows to earn a risk-free return higher than a T-Bill yield for the corresponding period. Stock index program trading involves buying or selling large number of stocks in high volume which can influence stock prices dramatically over the short-term.

C.

Guaranteeing Cost of Funds 1. 2. Futures and forward contracts can be used to hedge future borrowing costs by utilizing the inverse relationship between interest rates and security prices. If interest rates are expected to rise (leading to an increased cost of funds), a borrower who executes a short hedge (sells interest rate futures) will gain in the futures market and therefore offset all or part of the increased borrowing cost.
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D. E.

Funding Fixed-Rate Loans. (See Exhibit 11-5) Hedging a Balance Sheet 1. Price sensitivity rule of hedging a. To hedge properly, a futures contract value must change by the same amount as the change in the underlying asset. b. The price sensitivity rule states that to hedge properly the relative price change or sensitivity (elasticity) of the underlying asset, PA, given a change in market interest rate, rM must be equal to the ratio of the change in the price of the futures contract, PF, divided by the change in market interest rates, rM, times the number of futures contracts, or: PA / rM = N x PF/ rM (Equation 11.1)

N is the number of contracts needed to be sold hedge the risk exposure. To solve for N, transpose the above equation:

PA / rM PF / rM

As you see, the relative volatility of the value of the underlying asset and the futures contract caused by a change in market interest rates determines the number of contracts needed to hedge properly. If the futures value and your portfolio value move in opposite directions with a change in interest rates, the resulting N will be negative. It means that you need to buy N futures contracts to hedge your risk exposure. 2. The financial institution may hedge its earnings or the market value of its net worth, not both.

III.

Risks in the Futures Markets A. Profile of Risks 1. While futures contracts can help investors and businesses hedge against certain kinds of risk, they need to be aware of their exposure to risks that are inherent in trading futures. Basis risk - risk of an imperfect hedge because the value of item being hedged may not always keep the same price relationship to the futures contracts. a. Cross hedging is hedging an asset with a derivative contract whose characteristics do not exactly match those of hedged assets. Related-contract risk risk of failure due to an unanticipated change in the business activity being hedged, such as a loan default or prepayment. Manipulation risk risk of price losses due to a person or group trading (buying or selling) to affect price.
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2.

3. 4.

5.

Margin risk the liquidity risk that added maintenance margin calls will be made by the exchange. If a hedger does not add funds to meet the margin requirement, the futures exchange will close his position in order to avoid default. The hedge will be lost.

IV.

Options Markets A. The Nature of Options 1. An option gives the holder a right (not an obligation) to buy/sell a certain amount (e.g., a round lot of 100 shares) of the underlying security or commodity on or before a specified date at a specified price (called strike or exercise price). An American option gives the buyer the right to exercise the option at any time before the expiration date. A European option can be exercised only on its expiration date, not before. An option that would be profitable if exercised immediately is said to be in the money. The seller of the option is called the writer, and the buyer of the option, holder. The buyer will pay the writer of the option a premium. With options the buyer can lose only the premium and the commission paid. If the holder decides to exercise his option, the writer is obligated to honor it.

2.

3. 4. 5. 6. 7. B.

Calls and Puts 1. 2. Call option - an option to buy an asset at the strike price. Put option - an option to sell an asset at the strike price.

C.

Potential for gains and losses differ for: (Exhibit 11.7) 1. 2. buyers and sellers of options. futures contracts versus options.

D.

Covered and Naked Options 1. 2. Covered option - writer either owns the security involved in the contract or has limited his or her risk with other contracts. Naked option - writer does not have or has not made provision to limit the extent of risk.

E.

The Value of Options 1. The size of the option premium varies: a. directly with the price variance of the underlying commodity or security. b. directly with the time to its expiration. c. directly with the level of interest rates, and for options based on stocks, with the dividends of the underlying stocks.
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F.

Options vs. Futures Contracts 1. 2. 3. 4. The option to transact at the strike price exists over a period of time, not at a given date. The buyer of an option pays the seller (writer) a premium which the writer keeps regardless of whether or not the option is ever exercised. The option does not have to be exercised by the buyer; it can be sold if it has a market value, before the expiration date. Gains and losses are unlimited with futures contracts; with options the buyer can lose only the premium and the commission paid.

V.

Regulation of the Futures Market A. The Commodity Futures Trading Commission (CFTC) 1. 2. 3. B. Federal commission formed in 1974 to centralize government regulation of the futures markets. Purpose to prevent abuse of the public through misrepresentation or market manipulation. Regulates all options that are settled with the delivery of a futures contract.

The Securities Exchange Commission (SEC) 1. 2. Regulates option contracts that have equity securities as underlying assets. Regulates stock index options markets.

C.

Exchange Regulation 1. 2. 3. Exchanges impose self-regulation with rules of conduct for members. Exchange rules determine trading procedures, contract terms, and maximum daily price movements for commodities. Position limits are also determined by the exchange to prevent market manipulation by any one investor.

VI.

Swap Markets A. Role of Swaps 1. 2. 3. Swaps are used to offset interest rate risk Fixed interest rate payments are exchanged for variable interest rate payments. Institutions with excessive GAP positions swap variable cash flows for fixed and vice versa to reduce their effective GAP.

B.

Swaps vs. Forwards/Futures

1.

2. 3. 4.

Swaps are like series of forward contracts in that they guarantee the exchange of two items at several points of time in the future, but a swap only transfers the net amount. Unlike in forwards, price changes are tied to changes in an indexed interest rate. Similar to forwards and futures, swaps can be used to hedge both interest rate and foreign exchange risks. Unlike forwards and futures, credit risk differences between the counterparties provide the impetus for swaps.

C.

Swap Transaction Characteristics 1. 2. 3. Swap dealers serve as counterparties to both sides of swap transactions. Dealers negotiate a deal with one party, then seek out other parties with opposite interests and write a separate contract with them. The two contracts hedge each other and the dealer earns a fee for serving both parties.

D.

Swaps have limited regulation. 1. 2. 3. Bank regulators require risk-based capital support for swap-risk exposure. Other swap market participants, such as investment banks and life insurance companies, have no regulatory capital costs. The market is self-regulated because of the lack of any organized regulator. The International Swap Dealers Association leads in this effort.

CAPITAL MARKETS BY FABOZZI DERIVATIVES MARKETS INTRODUCTION TO FINANCIAL FUTURES MARKETS A futures contract is an agreement that requires a party to the agreement either to buy or sell something at a designated future date at a predetermined price (futures price). Commodity futures involve agricultural and industrial commodities. Financial futures are based on financial instruments or indices. Because their value is typically derived from the value of an underlying instrument, they are often called derivatives. MECHANICS OF FUTURES TRADING Liquidating a position Most financial futures contracts have settlement dates in the months of March, June, September or December. The contract with the closest settlement date is called the nearby futures contract, and the furthest settlement date the most distant futures contract. Alternatives for closing or liquidating a futures position are: (1) prior to the settlement date, the buyer or seller can take an offsetting position in the same contract; (2) the buyer or seller can wait until the settlement date and settle the contract either through an exchange of cash or by taking (or making) delivery. The Role of the Clearinghouse Associated with every futures exchange is a clearinghouse. The functions performed by the clearinghouse are: (1) guaranteeing that the two parties to the transaction will perform as obligated; (2) making it easier for parties to a futures contract to unwind their position prior to the settlement date. Counterparty risk is the default risk of a party to a future contract or derivative. Margin Requirements There are initial margin, maintenance margin and variation margin requirements that are specified by the exchange. A futures position is opened with the investor posting an initial margin. The futures position is marked to market at the close of each trading day, and changes in the value of the contract may require a buyer or seller to post additional variation margin to ensure that the maintenance margin is met. Margin requirements vary by contract, and these reflect the volatility of contract prices. Daily Price Limits The exchange has a right to impose a limit on the daily price movement of a futures contract from the previous day's closing price. There is a good deal of debate as to the rationale for daily price limits, but it is thought that the additional time provided by daily price limits protects the market from extreme swings in prices over short periods of time. FUTURES VERSUS FORWARD CONTRACTS A futures contract is a standardized agreement as to the delivery date and quality of the deliverable, and these contracts are traded on organized exchanges. A forward contract differs in that it is usually nonstandardized (that is, the terms of each contract are individually negotiated between the buyer and the
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seller), there is no clearinghouse, and secondary markets are often non-existent or extremely thin. Unlike a futures contract, a forward contract is an over-the-counter instrument. Futures contracts are marked to market at the end of each trading day, while forward contracts are not. Parties to a forward contract are exposed to credit risk because either party may default on their obligation. In contrast, credit risk is minimal for futures contracts because the clearinghouse associated with the exchange guarantees the other side of the transaction. The main advantage of forward contracts is the ability to negotiate the quantity, price and timing of delivery. With futures contracts, there is a specific set of available contracts which are determined by the exchange, and firms with different needs may wish to obtain a forward contract for the flexibility it may offer. RISK AND RETURN CHARACTERISTICS OF FUTURES CONTRACTS An investor whose opening position is the purchase of a futures contract is said to be long the contract or to be long futures. The sale is taking the short position or short futures. The long position will realize a profit if the futures price increases; the short position will realize a profit if the futures price decreases.

Leveraging Aspect of Futures Because a position can be created with only a fraction of the cost of the underlying asset (i.e. just the initial margin), futures permit a great deal of leverage. This is one of the advantages cited by users of futures contracts. PRICING OF FUTURES CONTRACTS The pricing of futures is based on arbitrage principles. In a cash and carry trade, an investor sells an overpriced future, purchases the underlying asset at the borrowing rate, and thereby pockets an arbitrage profit. In a reverse cash and carry trade, the investor buys an underpriced future, shorts the underlying asset and invests the money, and thereby pockets an arbitrage profit. (See book for details of this trade.) The equilibrium price at which there is no arbitrage is the theoretical futures price. Theoretical Futures Price Based on Arbitrage Model Using arbitrage arguments, the equilibrium futures price can be determined based on the following information: (1) the price of the asset in the cash market; (2) the cash yield earned on the asset until the settlement date; (3) the interest rate for borrowing and lending until the settlement date. The borrowing and lending rate is referred to as the financing cost. Letting: r = the financing cost (in percent) y = the cash yield (in percent) P = the cash market price ( in dollars) F = futures price (in dollars) The theoretical futures price is: F = P + P (r y) The term (r - y) is called the net financing cost (or cost of carry, or simply carry). The theoretical futures price may sell at a premium to the cash market price or at a discount from the cash market price. Price Convergence at the Delivery Date At the delivery date, the futures price must be equal to the cash market price. As the delivery date approaches, the futures price will converge to the cash market price. A Closer Look at the Theoretical Futures Price The following common factors are some of the reasons for the deviation of the actual futures price from the theoretical futures price: (1) interim cash flows are not considered; (2) there may be a difference between borrowing and lending rates;
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(3) there are transaction costs; (4) the proceeds from short selling may not be available; (5) the deliverable asset and the settlement date may be unknown; (6) the deliverable may be a basket of securities which may be difficult to track; and (7) there are differences in the tax treatment of securities and futures contracts.

GENERAL PRINCIPLES OF HEDGING WITH FUTURES The major function of futures markets is to transfer price risk from hedgers to speculators, locking in a value for the hedgers cash position. Hedging is the employment of a futures transaction as a temporary substitute for a transaction to be made in the cash market. As long as cash and futures prices move together, any loss realized on one position (whether cash or futures) will be offset by a profit on the other position. A perfect hedge should provide a return equal to the risk-free rate if the futures contract is priced according to its theoretical price. Risks Associated with Hedging The amount of loss or profit on a hedge will be determined by the relationship between the cash price and the futures price. This relationship is known as the basis. The basis is defined as the cash price minus the futures price. Hedging involves the substitution of basis risk for price risk. Changes in the basis between the initiation of the hedge and the unwinding of the contract expose the hedger to risk. Cross-hedging is common in asset/liability and portfolio management and introduces another risk: the price movement of the underlying instrument of the futures contract may not accurately trace the price movement of the portfolio or financial instrument to be hedged. The effectiveness of a cross-hedge will be determined by the relationship between (1) the cash price of the underlying instrument and its futures price when a hedge is placed and when it is lifted (the basis); and (2) the market (cash) value of the portfolio and the cash price of the instrument underlying the futures contract when the hedge is placed and when it is lifted. Short-Hedge and Long Hedge A short hedge is used to protect against a decline in the future cash price of a financial instrument or portfolio. To execute a short hedge, the hedger sells a futures contract (agrees to make delivery). A long hedge is undertaken to protect against an increase in the price of a financial instrument or portfolio to be purchased in the cash market at some future time.

THE ROLE OF FUTURES IN FINANCIAL MARKETS The futures market provides an alternative to the cash market for changing the risk exposure of a
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financial asset. It is the preferred market because transaction costs (commissions, bid-ask spreads, market impact costs, and initial wealth invested) are lower, the execution can be accomplished faster, and there is substantial leverage available. Since market participants use the futures market to alter their risk exposure in reaction to new information, this market is said to be the price discovery market. Arbitrage ties the futures market and cash market together.

Effect of Futures on Volatility of Underlying Asset There is a debate as to whether the introduction of a futures market for an asset will increase the price volatility of the asset in the cash market. This is referred to as the destabilization hypothesis. Whether or not volatility is impacted is an empirical question, and the text reviews the empirical evidence for stock index futures in a later chapter. Is Increased Price Volatility Bad? Regardless of whether the introduction of futures contracts increases cash market price volatility, there is a question as to whether greater volatility has adverse effects, for instance, from the point of view of allocative efficiency and from that of market participation. This inference may not be justified, if, say, the introduction of new markets makes the price more promptly responsive to changes in fundamentals and the fundamentals are subject to large shocks. INTRODUCTION TO OPTIONS MARKETS

OPTION CONTRACT DEFINED An option is a contract in which the writer (or seller) of the option grants the buyer of the option the right, but not the obligation, to purchase from or sell to the writer some underlying asset at a specified price within a specified period of time (or on a specified date). For granting this right, the writer (or the seller) receives a fee called the option price or the option premium. The important elements of an option contract are: (1) whether the buyer has the right to purchase (in the case of a call option) or sell (in the case of a put option) the underlying asset; (2) the underlying financial instrument, index or commodity that can be bought or sold; (3) the exercise or strike price, which is determined when the option is purchased; (4) the expiration date or term to expiration; and (5) whether the buyer has the right to exercise the option at any time up to and including the expiration date (as in the case of an American option), or whether the option can only be exercised on the expiration date (as in the case of a European option). Margin Requirements The buyer of an option is not subject to margin requirements after the option price is paid in full. Because the option price is the maximum amount the investor can lose, no matter how adverse the price movement of the underlying asset, margin is not necessary.

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Exchange Traded versus OTC Options Options may be traded either on an organized exchange or in the over-the-counter (OTC) market. There are three advantages of exchange traded options: (1) the exercise price and expiration of the contract are standardized; (2) the clearinghouse performs the same functions in the options market as it does in the futures market; and (3) transactions costs are lower than for OTC options. An institutional investor may need a customized option. This happens more often in the case of fixed income portfolio management rather than equity portfolio management. In fact, in the fixed income area, OTC options (also called customized or dealer options) are becoming increasingly popular because of the cross-hedging risks associated with using exchange-traded products.

DIFFERENCES BETWEEN OPTIONS AND FUTURES CONTRACTS The differences between the two contracts are the following. (1) Only the seller (not the buyer) has the obligation to perform. The buyer need not perform. For a futures contract, both parties are obligated to perform. (2) The buyer of the option must pay the seller to enter into the contract (the option price). Neither party compensates the other to enter into a futures contract. (3) The buyer of an option sets a price at which the underlying can be acquired (in the case of a call) or sold (in the case of a put) but can take advantage of a more favorable price. With a futures contract, a price is locked in and the party to such a contract cannot benefit from potentially favorable price movements.

RISK AND RETURN CHARACTERISTICS OF OPTIONS The four basic option positions are reviewed in the text. These are: (1) buying call options (long call); (2) writing (selling) call options (short call); (3) buying put options (long put); (4) writing (selling) put options (short put). The book contains detailed examples of these trades. Upon exercise, the intrinsic value of the option V is calculated as: Long call: V = max [(S X P), P] where S = stock price at exercise X = exercise price P = option premium

Short call Long put Short put

V = min [(X S + P), P] V = max [(X S P), P] V = min [(S X + P), P]

The maximum loss of the holder of a call or put option is the premium. The maximum loss of a writer of a call option is unlimited, i.e., it is (X S + P). As long as S can theoretically reach infinity, there is no cap on losses. The maximum loss of a writer of a put option is (S X + P). Since S cannot go below 0 due to corporate limited liability, the maximum loss of a writer is (P X).
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PRICING OF OPTIONS Basic Components of the Option Price The option price can be decomposed into two parts. (1) The intrinsic value is the options economic value if it is exercised immediately. If there is no positive economic value that will result from exercising immediately then the intrinsic value is zero. (2) The time premium is the amount by which the option premium exceeds its intrinsic value.

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Put-Call Parity Relationship Put-call parity is the relationship between the price of a call option and the price of a put option on the same underlying instrument, with the same strike price and the same expiration date. The prices of puts and calls can be shown to follow the following relation P C = X / (1 + R)t + D / (1 + R)t S where P = put price C = call price R = borrowing rate X = exercise price D = cash distribution from asset S = underlying asset

Factors that Influence the Option Price There are six factors that influence the option price: (1) the current price of the underlying asset; (2) the strike or exercise price; (3) the time to expiration of the option; (4) the expected price volatility of the underlying asset over the life of the option; (5) the short-term risk-free interest rate over the life of the option; (6) the anticipated cash payments of the underlying asset over the life of the option (such as dividends). An increase in these factors has the following effects on the value of a call and put option. American Call Stock price Strike price Time to expiration Volatility Risk-free rate Dividends + + + + American Put + + + +

Call values are positively related to the price and expected volatility of the underlying asset, the time until expiration, and the short-term interest rate. The value of a call option is negatively related to increases in the strike price and the level of cash payments to the underlying asset. Put values are positively related to the strike price, the time to expiration, the expected price volatility of the underlying asset, and the level of anticipated cash payments to the underlying asset. Put prices are negatively related to the value or price of the underlying asset and the short-term riskless rate of interest. Option Pricing Models Theoretical boundary conditions for the price of an option can be derived based on arbitrage arguments. Boundary conditions can be tightened by using arbitrage arguments coupled with certain assumptions about the cash distributions expected for the underlying asset. The most popular option pricing model is the Black-Scholes model. The underlying principle is that the payoff of an option can be replicated with a portfolio consisting of the underlying asset and borrowed funds. Deriving the Binomial Option Pricing Model
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To derive a one-period binomial option pricing model for a call option, we begin by constructing a portfolio consisting of (1) a long position in a certain amount of the asset, and (2) a short call position in the underlying asset. The book runs through detailed examples of how the hedge is done. Below is another simplified example of a binomial option pricing scheme. It is helpful to see a simple option value calculation and how its determinants affect value, particularly as value relates to volatility. The following example can be used in class. Assume that the current stock price S = $100, strike price X = $130, time period T = 1 year, borrowing rate R = 5%, and no transaction costs. For simplicity, assume that the variance of the stock price moves 50 percent by maturity so that the spread of possible future share prices is [Su, Sd] = [$150, $50]. At the strike price of $130, the option would be in the money only if the stock goes up by 50 percent. The option payoffs are calculated as P = max *0, S X+ where S is the share price at maturity. If the payoff is negative, meaning X > S at maturity, the option would not be exercised and so the payoff would be zero. The spread of possible option payoffs at maturity is [(Pu = Su X), (Pd = Su X)] = [$20, $0]. Suppose than the issuer wants to hedge this risk of the option being called against him. He must create a portfolio of stock and borrowing that replicates the option payoff. Moreover, the hedge must be selffunding so that the purchase of the stock is funded externally by the option premium and borrowing as opposed to the issuers own funds (which would defeat the purpose of a hedge). Based on these conditions, the issuer must purchase 1/5 share of common stock at the current price of $20, which must be funded by $9.52 of borrowing, and $10.48 of option premium. These calculations assume that stock prices have a binomial distribution. Of course, stock prices typically take a distribution and the shape of this distribution is determined by the stocks volatility. The BlackScholes option pricing formula takes this into account with a partial differential equation. But the binomial assumption keeps the example simple. With this in mind, the calculation of the above values requires three steps. Step 1: How many shares of stock must be bought? This is determined by the hedge ratio, which is the spread of the possible option payoffs divided by the spread of the possible share prices:
Pu Pd $20 $0 1 . The issuer must buy 1/5 share of stock at the current price of $100. This Su Sd $150 $50 5

$20 purchase must be funded by borrowing and option premium.

Step 2: How much borrowing is required? The borrowing amount is the present value of the difference between the option payoff and the payoff from the 1/5 share at maturity:
Borrowing ( Su ) Pu ( Sd ) Pd (1 / 5 x $150) $20 (1 / 5 x $50) $0 $9.52. (1 R) (1 R) (1 5%) (1 5%)

Note that the borrowing is independent of the stock price movement.

Step 3: What is the option premium? The option premium is the value of the synthetic portfolio: Option Value = Stock Value Borrowing. Here, the option premium must be (1/5 x $100) $9.52 = $10.48. The combined amount of borrowing ($9.52) and premium ($10.48) exactly funds the issuers purchase of the 1/5 share of stock ($20).
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The value of the option equals the stock price minus borrowing. By replicating an option payoff from a synthetic portfolio of ordinary assets and liabilities, the issuer has hedged his exposure to the option risk. If this hedge is continuously maintained, the issuer has zero risk and so it is irrelevant whether the stock price goes up or down.

The synthetic portfolio value must equal the option value, lest there be a riskless arbitrage opportunity. Arbitrage is the simultaneous purchase and sale of securities that creates a riskless profit. Much of finance theory rests on the principle that market participants will ruthlessly exploit riskless arbitrage opportunities and so such opportunities are not sustainable. The possibility of arbitrage leads to the most fundamental principle of financial theory, the Principle of Absence of Arbitrage, which states that there is always a tradeoff between risk and reward because in the longterm there are no unbounded riskless gains. The moment such opportunities are discovered, they will be exploited until they cease to exist. Thus, this process drives the markets Law of One Price. Arbitrage keeps prices of the same assets consistent in spite of the different ways in these assets may be packaged.

In the option context, if the option price is mispriced, either higher or lower than the synthetic portfolio, an investor can always lock in a riskless profit by either selling the overpriced option or buying the underpriced option and hedging with the synthetic portfolio. We can prove this. Assume a call option is mispriced one dollar higher than intrinsic value, i.e., $11.48. An issuer could execute an arbitrage by selling the option at $11.48, borrowing $9.52 at a rate of 5 percent and then using the $21 in hand to buy 1/5 share of stock at $20. One dollar remains, which is invested at a risk-free 5 percent. At maturity, if the stock increases to $150, the call option is in the money and she owes the holder $20 and the lender $10. This $30 liability is matched exactly by the 1/5 share of a $150 stock. The investors profit is $1.05. Now, if the stock price decreases to $50, the option is out of the money and she owes the holder nothing but still owes $10 to the lender. This liability is matched by the 1/5 share of $50 stock. But her profit is still $1.05. By selling the mispriced option and hedging the exposure, she creates a riskless profit opportunity. Thus, the option value must equal the value of the replicating portfolio.

The variance of the stock price substantially affects option value. Assume that the stock price is less risky and moves 35 percent rather than 50 percent. At the strike price of $130 and per the above calculations, the option premium is $2.72. If the volatility is 75 percent, the option value is now $22.86. The change in variance from 35 to 50 to 75 percent results in an increase in option value from $2.72 to $10.48 to $22.86. Thus, increased volatility of the underlying asset increases option value.

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ECONOMIC ROLE OF THE OPTION MARKETS In a prior chapter, it was shown that futures contracts can be used to hedge some underlying position or portfolio. Options provide a hedging opportunity which requires a minimal investment and provides hedgers with some advantages over a futures position. In particular, options allow investors to participate in any price changes that might benefit them. For instance, in the event that market prices of the underlying asset have increased since the option was purchased, the buyer of a put contract can choose to allow her option to expire rather than exercising her right to sell at the exercise price. In a similar futures hedge, the investor would be required to follow through on her contract and her losses in one market would offset her gain in the other market. Her "loss" on the options contract would be limited to the option premium, which should be thought of as being similar to an insurance premium in this case. EXOTIC OPTIONS OTC options can be customized in any manner desired by the investor. The more complex options are called exotic options. Two examples of exotic options are alternative options and outperformance options. An alternative option (also called an either-or option) has a payoff that is the best independent payoff of two distinct assets. For example, the option holder may have the choice of two different underlying assets at expiration. An outperformance option is an option whose payoff is based on the relative payoff of two assets at the expiration date. For example, an OTC options dealer might write an option with the strike price equal to the difference between the value of two known portfolios. Such an option will expire worthless if the strike price is negative on the expiration date. In general, the ability to purchase exotic options represents a valuable hedging alternative for investors. As with forward contracts, exotic options are easily customized to meet the needs of hedgers.

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INTRODUCTION TO THE SWAPS, CAPS, AND FLOORS MARKETS SWAPS A swap is a financial contract whereby two counterparties agree to exchange periodic payments. The dollar amount of the payments exchanged is based on a pre-determined notional principal amount. In swap only the agreed-upon payments are exchanged, not the notional principal. In a swap, each party is exposed to the risk that the other party will fail to meet its payment obligations. This is referred to as counterparty risk. Types of Swaps There are five basic types of swaps: interest rate swaps, interest rate-equity swaps, equity swaps, currency swaps, and credit default swaps. In the case of an interest rate swap, the counterparties swap payments in the same currency based on an base interest rate. A common kind of interest rate swap is one where one party makes payments based on a fixed interest rate and another party makes payments based on a floating interest rate. The floating interest rate is commonly referred to as a reference rate. In an interest-rate equity swap, one party makes payments based on an interest rate, while the other party makes payments based on the return on an equity index (such as the S&P 500 index). The interest rate may be fixed or floating. Both payments are made in the same currency. In an equity swap, both parties exchange payments in the same currency based on equity indexes. In a currency swap, both parties contract to swap payments based on different currencies. In a credit default swap, counterparties can buy or sell protection against particular types of events that can adversely affect the credit quality of a debt obligation. The two parties are called protection buyer and protection seller. The protection buyer agrees to pay the protection seller a payment at specified dates to insure against the impairment of the debt of the reference entity. The specific credit-related events are identified in the contract is called the credit event. Derivative instruments in this area are called credit derivatives. Interpretation of a Swap A swap may be thought of as a package of forward contracts. Although forward contracts existed for many years before the advent of interest rate swaps, the latter are not redundant instruments for several reasons. First, the typical swap has a much longer maturity than that of forward or futures contracts. Second, a swap can replicate the payoff of a package of forward contracts at a lower transactions cost, and therefore is more efficient. Third, the liquidity of the swap market has grown to a point where swaps are much easier to trade than long-dated forward contracts. Applications Application to Asset/Liability Management

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The text gives an example of how an interest rate swap can be used to lock in an interest rate spread between borrowing and lending rates. Application to Creation of a Security The text also gives an example of how swaps can be used to create a security. For example, it is possible to create a bond whose annual interest rate is based on the performance of the S&P 500 stock index. Such a bond would be attractive to some institutional investors who are prohibited from investing in stocks (for example, a depository institution) but who would like to benefit from higher returns. Debt instruments created by using swaps are known as structured notes.

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CAP AND FLOOR AGREEMENTS It is possible to obtain financial contracts whereby one party agrees to compensate another for the difference between a designated reference and a pre-determined level, called the strike. A cap is an agreement where the seller agrees to pay the buyer if the designated reference exceeds the strike. A floor is an agreement where the seller agrees to pay the buyer if the designated reference falls below the strike. The reference could be an interest rate or a currency exchange rate, or even the return on some domestic or foreign stock market index. In the case of a cap, if the designated reference is less than or equal to the strike, then the seller pays the buyer nothing. Otherwise, the payment is given by: Notional Principal Amount x [Actual Value of Reference Strike] In the case of a floor, if the designated reference is greater than or equal to the strike, then the seller pays the buyer nothing. Otherwise, the payment is given by: Notional Principal Amount x [Strike Actual Value of Reference] Interpretation of a Cap and a Floor The payoffs to these contracts are similar to payoffs to options. In case of a cap, the buyer pays a fee which represents the maximum that the buyer can lose on the contract. The buyer gains if the reference rises above the strike because the seller must compensate the buyer. This is similar to the payoff on a call option. In case of a floor, once again, the buyer pays a fee which represents the maximum that the buyer can lose on the contract. The buyer benefits if the designated reference falls below the strike, because the seller must compensate the buyer. This is similar to the payoff on a put option. Thus, a cap or a floor can be viewed simply as a package of options.

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Application to Asset/Liability Management A bank usually borrows short-term and holds long-term assets (loans). It may be possible for the bank to purchase a cap such that the cap rate plus the cost of purchasing the cap is less than the rate it is earning on its fixed-rate loans. If short-term interest rates rise, the borrowing cost of the bank is limited to the cap rate. On the other hand, if short-term interest rates decline, the bank benefits from a lower cost of funds. Thus a cap enables the bank to impose a ceiling on the cost of funds while retaining the opportunity to benefit from a decline in interest rates.

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