CHAPTER SEVENTEEN THE ROLE OF DERIVATIVE ASSETS Practical Investment Management Robert A Strong Outline Background The Rationale for Derivative Assets Uses of Derivatives The Options Market Options Terminology The Financial Page Listing The Origin of an Option The Role of the Options Clearing Corporation Standardized Option Characteristics South-Western / Thomson Learning © 2004 17 - Outline 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 South-Western / Thomson Learning © 2004 17 - Outline Derivative Assets and the News Current Events Risk of Derivative Assets Listed vs Over-the-Counter Derivatives South-Western / Thomson Learning © 2004 17 - Introduction 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 South-Western / Thomson Learning © 2004 17 - 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 South-Western / Thomson Learning © 2004 17 - 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 South-Western / Thomson Learning © 2004 17 - 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? South-Western / Thomson Learning © 2004 17 - Background : Uses of Derivatives Insert Figure 17-1 here South-Western / Thomson Learning © 2004 17 - 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 South-Western / Thomson Learning © 2004 17 - 10 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 90day T-bills on the delivery date of the futures contract South-Western / Thomson Learning © 2004 17 - 25 Financial Futures : Interest Rate Futures Insert Table 17-3 here South-Western / Thomson Learning © 2004 17 - 26 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 be deliverable South-Western / Thomson Learning © 2004 17 - 27 Financial Futures : Interest Rate Futures Insert Table 17-4 here South-Western / Thomson Learning © 2004 17 - 28 Financial Futures : Interest Rate Futures Bonds are standardized as follows: invoice = [ settlement x conversion ] + accrued price price factor interest 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 South-Western / Thomson Learning © 2004 17 - 29 Financial Futures : Interest Rate Futures Insert Table 17-5 here South-Western / Thomson Learning © 2004 17 - 30 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 South-Western / Thomson Learning © 2004 17 - 31 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 South-Western / Thomson Learning © 2004 17 - 32 Review Background The Rationale for Derivative Assets Uses of Derivatives The Options Market Options Terminology The Financial Page Listing The Origin of an Option The Role of the Options Clearing Corporation Standardized Option Characteristics South-Western / Thomson Learning © 2004 17 - 33 Review 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 South-Western / Thomson Learning © 2004 17 - 34 Review Derivative Assets and the News Current Events Risk of Derivative Assets Listed vs Over-the-Counter Derivatives South-Western / Thomson Learning © 2004 17 - 35 Appendix: Option Pricing Fig 17A-1 South-Western / Thomson Learning © 2004 17 - 36 Appendix: Option Pricing Black-Scholes Options Pricing Model Insert table 17A-1 South-Western / Thomson Learning © 2004 17 - 37 Appendix: Option Pricing Insert fig 17A2 South-Western / Thomson Learning © 2004 17 - 38 Appendix: Option Pricing Delta: the change in option premium expected from a small change in the stock price, all other things being equal South-Western / Thomson Learning © 2004 17 - 39 ... price risk South-Western / Thomson Learning © 2004 17 - Background : Uses of Derivatives Risk management : The equity manager’s market risk or the bond manager’s interest rate risk is analogous... 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