Practice investment management pim3 ch17

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