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DERIVATIVE MARKETS

Call Option
- A contract that gives the holder the right, but not obligation to buy/sell
the underlying asset at a specified price called exercise/strike price
within a specified period of time
- pays an intial call premium (C ) If price at exercise date is above strike
price, then they will buy the stock and sell it immediately in stock market
at current market price; if not, they will not buy the asset, they incur a
cost C.
Put option
- contract that gives option buyer the right to sell security at specified price
to the writer of the put option.
- The buyer will pay writer the put premium (P)
- If the stock price is less than X, buyer will immediately buy asset in stock
market and sell it at X by exercising the put option
Option values
- At expiration dates, options intrinsic value = Assets spot price options
exercise price
- Time value of an option is the value associated w the probability that
intrinsic value could increase between options purchase and expiration
date
- As an option moves towards expiration date, the time value goes to zero
- Time value = Market price/premium Intrinsic value
Option market
- Also work like future contracts through an open-outcry auction method
- Trades from pulic are placed w a floor broker, professional trader or a
market maker for particular option being traded
- Once the option price is agreed upon in trading pit, two parties
electronically send details of trade to option clearinghouse.
Stock Option
- One option generally involves 100 shares of underlying companys stock
Stock Index Option
- The underlying asset is the value of a major stock market index
- One will buy call option on index if it expects index to rise in value by
expiration date
- Other than S&P 500 which is a European option, stock index options are
American options
American options options that can be exercised before and on expiration date
European options options that can be exercised only on expiration date

Options on future contract
- the underlying asset is a future contract
- Buyer of a call option has right to buy at or before expiration date
- Options can be more attractive than actual assets because it ensures that
a highly liquid asset will be delivered and that problems associated with
accrued interest and the determination of which long term bond to
deliver are avoided, and that price info about future contracts is generally
more readily available

Credit options
- options w potential use in hedging credit risk of a financial institution
- (a) credit spread call option : call option whose payoff increase as the risk
premium or yield spread on a specified benchmark bond of borrower
increases above some exercise spread
- (b) digital default option : option that pays a stated amount in event of a
loan default
Regulation of future and option markets
- Securities and exchange commission (SEC) and commodities future
trading comissions (CFTC) are the functional regulators
SWAPS
- Agreement between counterparties to exchange specified periodic cash
flow in future based on some underlying instrument or price (eg: a fixed
or floating rate on a bond or note)
- Allows firms to better manage their interest rate, foreign exchange and
credit risk
- Interest rate swaps, currency swaps, credit risk swaps, commodity swaps,
equity swaps
Interest rate swaps
- swap buyer agrees to make a number of fixed interest rate payments
based on a principal contractual amount (Notional payment) on periodic
settlement dates to swap seller
- Swap seller agrees to make floating rate payments tired to some interest
rate to swap buyers on same periodic settlemt dates
- Eg: a bank might have fixed liabilities and variable income, so theyd
prefer to get fixed income
- The counterparty can do this by direct telephone contact or by a
commercial bank or investment bank which would act as a broker or an
agent, receiving a fee.
Currency swaps
- to hedge against mistmatch of currencies of their assets/liabilities
- Fixed-fixed currency swaps: The counterparties fix exchange rate
Credit swaps
- (a) total return swap: swapping an obligation to pay interest at a
specified fixed/floating rate for payments representing the total return on
a loan of a specified amount
- (b)pure credit swap: FI lender will send a fixed fee or payment to the
counterparty, to strip out the interest rate sensitive elemnt of total return
swaps
- Eg: Bond holder will buy credit swaps, in case of default, they will be
insured the whole principal and interest payment
- Commercial banks are main seller, Insurance companies have been net
sellers of credit risk protection
Swap markets
- swap dealers serve the function of taking opposite side of each
transaction in order to keep market liquid by locating or matching
counterparties
- Without swap ddealers, the search costs is significant to find a
counterparty with exact requirements
Caps, floors and collars
- derivative securities w many uses, especially to hedge interest rate risk
- caps are purchased when expecting int rate to rise
- floors are purchased when they have fixed cost of debt and have variable
or floating rates on assets
- collars to finance cap or floor position
- Buying a cap is similar to buying a call option on interest rates,
- Buying a floor is similar to buying a put option on int rate, if it falls then
the seller of floor compensates the buyer in return for an upfront
premium
- Collar is where a firm buys a cap and sells a floor option. So, there if int
rate increases above the strike int rate, there will be gain; when int rate
fall below floor, then the firm needs to pay out.







COMMERCIAL BANKS
- largest group of depository institutions measured by asset size
- Accept deposit, make loans
- key role in mechanism of transmission of monetary policy
- Major Asset:
1. Business/commercial and industrial loans; commercial and
residential real estate loans; individual loans; consumer loans for auto
purchases and credit card loans; all other loans
2. Investment securities: federal funds sold to other banks, Repos, US
treasury, MBS etc.
3. Loans are main revenue generating assets, securities provide liquidity
- Exposed to high liquidity risk risk that arise when FI liability holders
such as depositor demand cash
- Major risk faced: credit default, liquidity, int rate, insolvency risk
- Commercial banks are highly leveraged
- To manage credit risk, they sell securitized loans
- Major Liabilities:
1. Deposits
2. Borrowed or other liability funds
- OF DEPOSITS, it is split to
1. Transaction accounts sum of noninterest-bearing demand deposits
and interest-bearing checking accounts (most commonly called
negotiable order of withdrawal accounts or NOW accounts)
2. Retail and household savings and time deposits
3. Large time deposits which are primarily negotiable CDs that can be
resold outside in secondary market
- Time deposits require a depositor to give notice 30 days before
withdrawal and they earn interest
- Major equity: common and preferred stock, retained earning, surplus
paid in capital
- Part of troubled asset relief program (TARP) of 2008/9 was the Capital
purchase program intended to encourage FI to build capital to increase
flow of financing to US businesses and consumers to support the economy
- Off balance sheet activities
1. Issuing various types of credit (Letter of credit)
2. Future, forward, options, swap
- Only when contingent event occurs, the item move onto balance sheet
- They undertake OBS activities in hope to earn additional fee income to
complement declining margins or spreads on their traditional lending
business, also can avoid regulatory costs or taxes
- OBS increase insolvency risk
- Trust services holds and manages assets for individuals or coporations
- Correspondant banking provision of banking services to other banks
that do not have the staff resources to perform services themselves
Banks Size and concentration
1. Community Banks specialize in retail/consumer banking provide
residential mortgage and consumer loans
2. Wholesale Banking commercial oriented banking provide commercial
and industrial loans funded w purchased funds
- Money center bank: Bank of NY Mellon, Deutsche Bank, Citigroup, JP
Morgan chase and HSBC North America
- Money center banks are banks that are located in major financial center
that heavily relies on both national and internatonal money market for
source of funds


Large banks Small banks
- Concentrate on wholesale - Concentrate on retail
- Operate w lower equity, more
accessible to fed funds, have fewer
core deposits
- Hold less OBS A/L
- Interest rate spread and net interest
margin is narrower, more competitive
- Sheltered from competition, spread
is wider
- Pay higher salaries; more investment
- more diversification and more non-
interest income (fees, trading acc,
derivative)



- Interest rate spread: Diff between lending and deposit rate
- Net interest margin Interest income minus interest expense divided by
earning assets
REGULATORS
1. Federal Deposit Insurance Corporation (FDIC)
- insures deposits of commercial banks
- levies insurance premiums on banks
- when a bank closes, FDIC acts as the receiver and liquidator
2. Office of the Comptroller of Currency (OCC)
- oldest US bank regulatory agency
- main fn is to charter national banks as well as to close them
- approve/disapprove merger
3. Federal Reserve System
- conduct Monetary policy, central bank and regulatory power over some
banks
- they set reserve requirements
4. State authorities
- Banks can choose to be either state chartered/nationally chartered; state
chartered regulated by state agencies
International expansion
Benefit Disadvantage
Risk Diversification not just
influenced by domestic economy
Information/Monitoring cost
language, cultural and legal issues
Economies of Scale lower AC
Innovation R&D Nationalisation/Expropriation
Fund Source cheapest
Customer relationship goodwill Fixed costs
Regulatory avoidance such as activity
restrictions and reserve requirements
impose constraints or taxes so higher
net profitability

Financial statements
- FS must be submitted end of each calendar quarter
- Federal financial institution Examination council (FFIEC) prescribes
uniform principles, standard and report forms for depository institution
- Webster Financial Corporation (WBS) is a publicly traded commercial
bank holding company. It offers produces in consumer and business
banking
- Retail banks focus on individual consumer banking relationship eg
residential mortgages and consumer loans, NOW, savings and time
deposits
- Wholesale banks focus on business side
- Bank of America (BOA) was one time the nations largest bank holding
company, it has both retail and wholesale banking
Balance Sheet structure
- Banks have higher leverage than corporations
Assets:
1. Cash and due from depository institution vault cash includes currency and
coin needed to meet legal reserve requirements
2. Investment securities fed funds, repos, US Treasury, MBS etc they hold a lot
to improve liquidity
3. Loans and leases C&I loans, loans secured by real estate, individual or
consumer loans, other loans
4. Other assets
- Short term assets: fed fund, repo, Treasury bills and agency securities
- Long term: US treasury bond, US agency securities, municipals, MBS
higher expected returns, subject to greater int rate risk
- Municipals securities interest payment is exempt from federal income tax
1. Commercial and Industrial loans
- finance firms capital needs, equipment purchase and plant expansion
- a secured loan (asset-backed loan)is backed by specific asset of borrower;
an unsecured loan(junior debt) gives lender only a general claim on asset
2. Real Estate loan
- primarily mortgage loans and some revolving home equity loans
3. Consumer Loan
- Individual loan for example personal, auto loans
4. Other Loans
- eg loans to nonbank financial institutions, state and local gov, foreign banks
and sovereign gov
Liabilities:
1. Deposits