Chapter 9: Derivatives: Futures, Options and Swaps, Part I

Part I: Futures

As we mentioned in chapter 3, financial instruments and markets play an important role in the transfer of risk. How is this accomplished? Among the tools available are derivative securities that derive their value from other securities traded in financial markets. Fluctuating interest rates cause the value of these securities to fluctuate, so buying or selling derivative securities can help banks control fluctuations in the value of their assets and the costs of their liabilities. The derivatives market grew rapidly in the 1970s as increased volatility in interest rates and foreign exchange rates increased the demand for risk-management tools.

Futures Contracts

Simply put, a futures contract is a contract for a trade to take place in the future. Two counterparties enter into this contract and promise to buy/sell an asset at a specified price on a specified date.

The asset to be traded is called the underlying.
The date for the trade is the settlement date or maturity date
The price to be paid/received for the asset is the futures price.
The buyer or long position in the futures contract has the obligation to buy the underlying at the futures price on the settlement date.
The seller or short position in the futures contract has the obligation to sell the underlying at the futures price on the settlement date.

The market for futures contracts originated in the 1800s as a way for farmers to lock in prices for agricultural commodities, like soybeans or beef. There is still a huge commodities futures market with contracts trading on exchanges in Chicago and New York. In the 1970s futures contracts began to trade where the underlying was a financial asset instead of a commodities.

The futures markets trade contracts for future trades, while immediate trades occur in the spot or cash market (at the spot price or the cash price). As the price of the underlying changes in the spot market, this affects the value of the futures contract, since the price of the underlying is already locked in. Therefore, firms concerned about price fluctuations of certain commodities or financial assets can lock in prices in the futures market and thus control that risk.

Example 1

Suppose Southwest Airlines is concerned about fluctuations in jet fuel prices. So in this case, rising jet fuel prices would be bad for Southwest, cutting into their profits. Falling jet fuel prices would be good, but the real problem here is the uncertainty created by fuel prices that fluctuate up and down. So Southwest could control this risk (known as hedging) by taking a long position on jet fuel future contracts. This makes them the buyer of jet fuel on a future date, at the futures price. Southwest has locked in a price for fuel. As the contract proceeds to the settlement date, fluctuations in the cash price of fuel affect the value of the futures contract. Suppose the futures price is $3 per gallon.

If the price of jet fuel rises in the spot market to, say $3.20 per gallon, Southwest's long position has just gotten more valuable, since they will buy fuel for $3 per gallon. When the spot price of the underlying rises, the buyer of a futures contract gains, while the seller loses.
If the price of jet fuel falls in the spot market to, say $2.85 per gallon, Southwest's long position has just gotten less valuable, since they must buy fuel for $3 per gallon. When the spot price of the underlying rises, the buyer of a futures contract loses, while the seller gains.

Southwest pays $3 per gallon no matter what, so they can price airline tickets accordingly. In reality, Southwest is pretty good at hedging jet fuel prices in the futures markets, which is one reason why they are one of the most profitable airlines in the industry.

In the next example, we see how interest rate risk may be hedged using financial futures. The underlying is a short-term or long-term bond. Remember: bond prices rise when interest rates fall, and bond prices fall when interest rates rise.

Example 2

Suppose A1 Savings & Loan is concerned about its interest rate risk. Most of its assets are long-term mortgages, while most of its liabilities are savings and time deposits. If short-term interest rates rise, the costs of attracting these deposits will increase. However, the income from the mortgages on the books will not increase, since most of them have a fixed rate. So for an S&L rising short-term interest rates could mean lower profits. So A1 could hedge this risk by taking a short position on a Tbill contract. Suppose the futures price of the Tbill is $98 per $100 of face value.

If short-term interest rates rise, the spot Tbill price will fall, say to $96. A1 still gets to sell their Tbill for $98 in the futures contract. This gain in their futures position helps offset the losses from the increased interest costs on their deposits.
If short-term interest rates fall, the spot Tbill price will rise, say to $99. A1 still has to sell their Tbill for $98 in the futures contract. This loss in their futures position offsets the gains from the decreased interest costs on their deposits.

So the gain/loss in the futures market offsets any gain/loss in the cost of A1's liabilities. Note that in order to protect themselves against rising short-term interest rates they give up potential gains from falling short-term interest rates. But the purpose here is to minimize the impact of ANY fluctuation in short-term interest rates.

In general,

Parties concerned about rising prices for the underlying will hedge their risk as buyers of futures contracts.
Parties concerned about falling prices for the underlying will hedge their risk as sellers of futures contracts.

Note that in both of our examples, futures contracts are a zero sum game: One counterparty's gain is the other counterparty's loss. When spot prices change, there is a winner and a loser. This means there is always an incentive for one counterparty to try and back out or default on the contract no matter which way prices move.

There are two types of players in the futures markets:

Hedgers are concerned about price fluctuations in the underlying due to their primary business (such as banks or airlines) to they are in the futures market in order to manage the risks faced in their primary business.
Speculators are essentially sophisticated gamblers, betting on future price movements and trading futures contracts in order to make money. While hedgers trade futures contracts to manage risk, speculators take on risk when trading futures contracts. Speculators are essential for liquidity in the futures markets: Without them, there would not be enough buyers and sellers to make the markets work. Derivative securities are attractive to speculators because they have a great deal of leverage. With only a small initial outlay, speculators can take a futures position that has the same returns of buying 30 times the same amount of the underlying asset.

Financial Futures Market

Whether the underlying is a financial asset or agricultural commodity these contracts are traded on an exchange. The three largest in the United States are:

Chicago Mercantile Exchange (CME)

Chicago Board of Trade (CBT)

New York Futures Exchange (NYFE)

Futures trading and exchanges are regulated by the Commodities and Futures Trading Commission (CFTC). The CFTC monitors for fraud and price manipulation, and approves new contracts.

In order to deal with the trading of millions of buyers and sellers on all types of contracts, futures contracts are standardized with respect to the underlying, the futures price, and the settlement date. This means I cannot got to a futures exchange and try to create a customized contract for the date I want and the price I want. There is only a limited choice of dates, each date has a preset future price, and the amount of the underlying is fixed. It's like going to a restaurant. Your can only order what is on the menu, you cannot create your own meal.

For example, consider the Tbill future contracts that trade on the CME.

The underlying is standardized to be Tbills with approximately 90 days to maturity (88-92 days is acceptable) and $1 million in face value. If you want to only trade $100,000 in Tbills, tough.
There are four settlement dates available: the last business day of March, June, September, December. Each settlement date has its own futures price.
As the spot price of Tbills fluctuate, the contracts may be sold and resold at prices that reflect the changing value of the Tbills.

This standardization enhances liquidity in a couple of ways. Since buyers and sellers must choose between only 4 or 5 Tbills contracts, this maximizes the number of buyers and sellers per contract so it will be easier to buy and sell. Also, buyers and sellers do not haggle over the terms of the contract--they are already set by the exchange.

A list of widely traded financial futures contracts is on table 1 (pages344-45) in your book.

In addition to enhancing the liquidity of the futures market, exchanges play a very important role in limiting default risk.

Recall that the nature of futures contracts creates an incentive to default since there is always a winner and loser as spot prices fluctuate. The futures exchange acts as a clearinghouse, so really when buyers and sellers enter into a contract, they each have a contract with the exchange, not with each other:

So buyers and sellers do not have to worry about default risk, because for each of them the other counterparty is the exchange. However, this does expose the exchange itself to a substantial amount of default risk as prices fluctuate. So the exchange takes several steps to limit its own exposure to default risk:

Buyers or sellers of future contracts must put up an initial deposit, called a margin requirement. Sort of like the security deposit you give your landlord.
Every trading day, futures contracts are marked to market. This means the change in the value of the contract (positive or negative) is credited or debited from the margin account. If the account falls too low (below the maintenance margin), the counterparty receives a margin call and must put up additional cash or the contract is canceled. This limits the losses of the exchange in case there is a default.

The global financial future markets are huge. On any given day the number of contracts outstanding (called the open interest) is in the millions.

Part II: Options and Swaps

Options

Options contracts offer another alternative for hedging interest rate and stock market risk or for speculating on changing bond and stock prices. Option contracts are a bit more one-sided that futures contracts. They allow someone to protect against a bad price movement (like Southwest and rising jet fuel prices) without giving up all the benefits of a good price movement (like Southwest and falling jet fuel prices).

Options Contracts

First we need to examine how these contracts work, including the relevant terminology.

Options contracts have 2 counterparties: the buyer and the writer.

The buyer of an option contract has the right to buy/sell the underlying at a set price (the exercise or strike price) with a certain period of time (the term to expiration).
The writer of an option contract has the obligation to buy/sell the underlying at a set price (the exercise or strike price) with a certain period of time (the term to expiration) if the buyer exercises his/her rights.

So the buyer has rights, the writer has obligations. The buyer has the choice of not using the contract if it turns out not to be profitable. In return for getting this choice, the buyer pays the writer a premium. (So option contracts involve three different prices: the price of the underlying, the strike price, and the premium.)

American options can be exercised any time up to the expiration date.

European options can be exercised only on the expiration date.

Call options give the buyer the right to buy the underlying at the strike price (the writer has the obligation to sell).

Put options give the buyer the right to sell the underlying at the strike price (the writer has the obligation to buy).

The regulation of options is split between the Securities and Exchange Commission (SEC) and the CFTC. Regulators ensure that counterparties are able to cover their losses and again monitor for fraud and price manipulation. The most common options contracts are for share of stock in a specific company, but there are also contract

Contract Payoffs

Understanding contract payoffs is easiest in the context of an example:

Example 3

Microsoft stock option contract (100 shares)

Price (P) = $53 per share

Strike price (X) = $50

call premium (Qc) = $2.50 per share or $250 for the contract

put premium (Qp) = $1.25 per share or $125 for the contract

Suppose this option contract is about to expire. We want to ask ourselves: (1) will the options be exercised by the buyer at these prices? (2) what are the payoffs to the buyer/writer at these prices?

First, the call option. The buyer has the right to buy the stock for $50, and it is worth $53. Will the buyer exercise the right? YES! If the price of the underlying is greater than the strike price, the call option is in the money. This means it will be exercised.

The buyer's payoff is the difference between the strike price and the market value of the stock, minus what the buyer paid for the option:

($53 - $50 - $2.50)(100) = $50

The writer must sell the stock for less than it is worth, but received the call premium, so the writer payoff is:

($50 - $53 + $2.50)(100) = -$50.

Note that the buyer's and writer's payoffs sum to zero. THIS IS ALWAYS THE CASE FOR ANY OPTIONS CONTRACT.

Now the put option. The buyer has the right to SELL the stock for $50, but they can sell it elsewhere for $53. Will put buyer sell the stock. NO! If the price of the underlying is greater than the strike price, the put option is out of the money. This means it will NOT be exercised and will be allowed to expire unused.

The buyer does not exercise the option, so the buyer is just out the put premium of $125.

The writer received the put premium of $125, but does not have to do anything since the option is not used.

Note that the buyer of a put or call option cannot lose more than the option premium. The buyer's losses are limited, the writer's losses are potentially huge.

It is the price, P, and strike price, X, that determined if an option is in or out of the money. However, an in the money option does not guarantee a positive payoff. Consider the next example:

Example 4

Consider again the Microsoft stock option contract. Now suppose P = $51.

P > X. The call option is still in the money. The buyer payoff is

($51 - $50 - $2.5)(100) = - $150.

The buyer payoff is negative. Why did she exercise? Well, if she didn't, she would have lost the entire call premium of $250. So losing $150 is better than losing $250.

P and X alone determine whether an option is in the money or out of the money.

Check yourself: Go through this example again by yourself where P = $48. Check yourself here.

The table below summarizes the payoffs for the buyers and writers of put and call options:

	call option	put option
P > X	in the money buyer payoff = P - X - Qc writer payoff = X - P + Qc	out of the money buyer payoff = -Qp writer payoff = +Qp

P < X	out of the money buyer payoff = -Qc writer payoff = +Qc	in the money buyer payoff = X - P - Qp writer payoff = P - X + Qp

Option Pricing

There are several factors that affect the size of the option premium. In general

anything that makes an option more likely to be in the money will increase the premium;
anything that makes an option less likely to be in the money will decrease the premium.

There are several factors that affect this likelihood.

The price of the underlying. The higher the price of the underlying, ceteris paribus, the more likely that P>X, so the call option is more likely to be in the money, the put, out of the money. So as P rises, Qc rises and Qp falls, ceteris paribus.
The strike price. The higher the strike price of the option, ceteris paribus, the more likely that P< X, so the call option is less likely to be in the money, the put, in the money. So as X rises, Qc falls and Qp rises, ceteris paribus.
The term to expiration. The greater the time until expiration, ceteris paribus, the larger the likely fluctuations in P. So the possibility of large gains with put or call options is there. So a longer time to expiration mean higher Qc and Qp, ceteris paribus.
The volatility of the price of the underlying. Again, the greater the volatility of P, ceteris paribus, the larger the likely fluctuations in P. So the possibility of large gains with put or call options is there. So the greater the volatility of P, the higher both Qc and Qp, ceteris paribus.

Using Options to Manage Risk

Looking at the examples above, it is not hard to see how options may be used to manage risk. By buying an option, the buyer essentially purchases insurance that guarantee a maximum price for buying an asset (in the case of a call option). Or a minimum price for selling an asset (in the case of a put option). One such example is a married put. In this case the other of, say, Microsoft stock also buys a put option for that stock. If the stock price falls, the put options helps offset the losses.

Options Trading

Options trade on the CME, CBT, and the NYSE. The regulation of options is split between the Securities and Exchange Commission (SEC) and the CFTC. Regulators ensure that counterparties are able to cover their losses and again monitor for fraud and price manipulation. The most common options contracts are for shares of stock in a specific company, but there are also contracts for stock indices, financial futures, Tbills and Tbonds, and foreign currency.

Options contracts are also standardized with respect to the underlying, expirations dates, and strike prices. They expire the third Friday of March, June, September, December in what is known as "triple witching day." On this day financial markets are characterized by heavy volume and price volatility as stock index futures, stock index options, and stock options all expire.

Interest Rate Swaps

While the standardization of futures and options contracts make trading easy and limit exposure to default risk, the downside to standardization is that it "one size fits all." In other words, banks cannot custom tailor those contracts to match their specific risk exposure. Its like the restaurant menu, where they have chicken marsala and veal piccata, but you really want chicken piccata.

Swap contracts are custom-tailored arrangements between financial institutional. Each party of the swap contract trades one set of payments they receive for a set of payments the other party receives. Swaps can be incredibly complicated, but we will focus on a basic interest rate swap (known as the plain vanilla swap).

The interest rate swap specifies the interest rate each party will exchange (typically one interest rate is fixed and one is variable, or both are variable), the notional principal that determines the size of the payment, the time period over which payments will be swapped. The principal never gets exchanged, only the interest payments.

Example 5

A1 Savings and Loan & Ed's Finance Co. agree to a swap with

--$1 million notional principal

--annual payments over 10 years

--A1 will pay Ed's Finance 6%

--Ed's Finance will pay A1 6-mo. Tbill rate + 1%

So A1 is paying a fixed rate and Ed's Finance is paying a variable rate.

Suppose at the end of the first year the Tbill rate is 4.5%:

A1 owes Ed's Finance (.06)($1 million) = $60,000

Ed's Finance owes A1 (.045 + .01)($1 million) = $55,000, so A1 pays Ed's Finance the $5,000 difference.

Suppose at the end of year 2 the Tbill rate is 6%:

A1 owes Ed's Finance (.06)($1 million) = $60,000

Ed's Finance owes A1 (.06 + .01)($1 million) = $70,000, so Ed's Finance pays A1 the $10,000 difference.

What's the point? Well, recall that A1, as an S&L, has many rate-sensitive liabilities (deposits) but few rate-sensitive liabilities (mostly fixed-rate mortgages). By receiving the variable rate payments from Ed's Finance company, A1 gains from rising short-term interest rates in their swap position to offset losses in their traditional activities. What's in it for Ed's Finance Co.? They may have more rate-sensitive assets than liabilities, or they may simply be speculating that interest rates will fall. By using a swap, A1 can hedge its interest rate risk and tailor the assets to its exact needs.

There are two big disadvantages to swaps. First, there is substantial default risk. There is no exchange to guarantee this transaction. If Ed's Finance Co. goes bankrupt, A1 is left without any protection against rising short-term interest rates. Second, because the swaps are custom-tailored for A1 and Ed, the swap is not liquid. If A1 wanted to get of the contract during the next ten years, it might be impossible to find a buyer. Also, A1 and Ed may have difficulty finding each other in the first place.

High profile losses from derivatives trading, including the Orange County bankruptcy in 1994 and the bailout of Long-Term Capital Management in 1999 (see the link below), have caused some to be concerned about whether derivatives are safe enough assets. However, the truth is the derivative use allows many financial institutions to reduce their risks and regulator guidelines supervise and limit trading activities.

FYI: Related Links

Multiple Choice Quiz Chapter 9 An interactive quiz from the textbook website.

The Chicago Mercantile Exchange trades futures and options contracts for currencies, interest rates, and stock indexes.

The Chicago Board of Trade is the other leading futures exchange

The Commodities and Futures Trading Commission (CFTC) regulates futures exchanges, contracts, and traders.

Lessons from the collapse of hedge fund, Long-Term Capital Management This is a case study of how an investment company got into trouble with speculative derivatives trading, especially illiquid swaps. Concerns that the default of LTCM would cause a financial panic led the Federal Reserve to organize a private bailout of the company in 1999. LTCM was a highly respected fund ran by very experienced Wall Street financiers and 2 Nobel Prize winners in economics.