Money banking and the financial system 1e by hubbard and OBrien chapter 07

R. GLENN

HUBBARD
ANTHONY PATRICK

O’BRIEN
Money,
Banking, and
the Financial
System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall


CHAPTER

7
Derivatives and Derivative Markets

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
7.1

Explain what derivatives are and distinguish between using them to
hedge and using them to speculate

7.2

Define forward contracts

7.3

Discuss how futures contracts can be used to hedge and to speculate

7.4

Distinguish between call options and put options and
explain how they are used

7.5

Define swaps and explain how they can be used to reduce risk

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CHAPTER

7
Derivatives and Derivative Markets

HOW DANGEROUS ARE FINANCIAL DERIVATIVES?
•In 2002, Berkshire Hathaway CEO Warren Buffet called financial derivatives
“time bombs, both for the parties that deal in them and for the economic
system….derivatives are financial weapons of mass destruction.”
•All derivatives derive their value from an underlying asset. These assets may
be commodities, such as wheat or oil, or financial assets, such as stocks or
bonds.
•Despite Buffett’s denunciations, derivatives play a useful role in the financial
system.
•An Inside Look at Policy on page 214 discusses how legislation in 2010
made significant changes to the market for financial derivatives.

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Key Issue and Question
Issue: During the 2007–2009 financial crisis, some investors,
economists, and policymakers argued that financial derivatives had
contributed to the severity of the crisis.
Question: Are financial derivatives “weapons of financial mass
destruction”?

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Learning
Objective
Explain what derivatives are and distinguish between using them to hedge and
using them to speculate.
7.1

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Derivative An asset, such as a futures contract or an option contract, that
derives its economic value from an underlying asset, such as a stock or a bond.
Hedge To take action to reduce risk by, for example, purchasing a derivative

contract that will increase in value when another asset in an investor’s portfolio
decreases in value.
• Derivatives can serve as a type of insurance against price changes in
underlying assets. Insurance plays an important role in the economic
system: If insurance is available on an economic activity, more of that activity
will occur.
• Derivatives can also be used to speculate.
Speculate To place financial bets, as in buying futures or option contracts, in
an attempt to profit from movements in asset prices.

Derivatives, Hedging, and Speculating
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• Some investors and policymakers believe that “speculation” and
“speculators” provide no benefit to financial markets, but they provide two
useful functions:
1. When a hedger sells a derivative to a speculator, they transfer risk to the
speculator.
2. Speculators provide essential liquidity. Without speculators, there would
not be a sufficient number of buyers and sellers for the market to operate
efficiently.

Derivatives, Hedging, and Speculating
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Learning
Objective
Define forward contracts
7.2

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Forward contract An agreement to buy or sell an asset at an agreed upon
price at a future time.
• Forward contracts give firms and investors an opportunity to hedge the risk
on transactions that depend on future prices.
• Generally, forward contracts involve an agreement in the present to
exchange a given amount of a commodity, such as oil, gold, or wheat, or a
financial asset, such as Treasury bills, at a particular date in the future for a
set price.

Forward Contracts
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Spot price The price at which a commodity or financial asset can be sold at the
current date.

Settlement date The date on which the delivery of a commodity or financial

asset specified in a forward contract must take place.

• Because forward contracts are specific in terms, they tend to be illiquid. They
are also subject to default risk.

Counterparty risk The risk that the counterparty—the person or firm on the
other side of the transaction—will default.

Forward Contracts
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Learning
Objective
Discuss how futures contracts can be used to hedge and to speculate.
7.3

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Futures contract A standardized contract to buy or sell a specified amount of a
commodity or financial asset on a specific future date.
• Futures contracts differ from forward contracts in several ways:
1. Futures contracts are traded on exchanges, such as the Chicago Board
of Trade (CBOT) and the New York Mercantile Exchange (NYMEX).
2. Futures contracts typically specify a quantity of the underlying asset to

be delivered but do not fix the price.
•

Futures contracts are standardized in terms of the quantity of the
underlying asset to be delivered and the settlement dates for the
available contracts.

Futures Contracts
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Hedging with Commodity Futures
Short position In a futures contract, the right and obligation of the seller to sell
or deliver the underlying asset on the specified future date.

Long position In a futures contract, the right and obligation of the buyer to
receive or buy the underlying asset on the specified
future date.

Futures Contracts
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Hedging with Commodity Futures
• Consider the case of a farmer who in March sows seed with the expectation
that it will yield 10,000 bushels of wheat. The farmer is concerned that when

she harvests the wheat in July, the price will have fallen below $2.00, so she
will receive less than $20,000 for her wheat.
• A manager who buys wheat at General Mills is concerned that in July the
price of wheat will have risen above $2.00, thereby raising his cost of
producing cereal. The farmer and the General Mills manager can hedge
against an adverse movement in the price of wheat.
• Hedging involves taking a short position in the futures market to offset a long
position in the spot market, or taking a long position in the futures market to
offset a short position in the spot market.

Futures Contracts
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Hedging with Commodity Futures
• As the time to deliver approaches, the futures price comes closer to the spot
price, eventually equaling the spot price on the settlement date.
• To fulfill her futures market obligation, the farmer can engage in either
settlement by delivery or settlement by offset.
• We can summarize the profits and losses of buyers and sellers of futures
contracts:
• Profit (or loss) to the buyer = Spot price at settlement - Futures price at
purchase
• Profit (or loss) to seller = Futures price at purchase - Spot price at settlement

Futures Contracts
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Hedging with Commodity Futures

Futures Contracts
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Making the Connection

Should Farmers Be Afraid of the Dodd-Frank Act?
• During the financial crisis of 2007–2009, some policymakers and economists
argued that the use of derivatives had destabilized the financial system.
• When Congress passed the Dodd-Frank Wall Street Reform and Consumer
Protection Act in July 2010, it contained some restrictions on trading in
derivatives. In particular, the act required that some derivatives that had
previously been traded over the counter be traded on exchanges instead.
• Farmers were worried that they might have to post more collateral to trade
futures. They were also worried that small community banks and special
agriculture banks may no longer be allowed to offer forward contracts.
• As of late 2010, the Commodity Futures Trading Commission (CFTC) had
not finished writing the new regulations.

Futures Contracts
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Speculating with Commodity Futures
Some investors who are not connected with the wheat market can use wheat
futures to speculate on the price of wheat.
If you were convinced that the spot price of wheat was going to be lower in July
than current futures price, you could sell wheat futures with the intention of
buying them back at the lower price on or before the settlement date.
Notice, though, that because you lack an offsetting position in the spot market,
an adverse movement in wheat prices will cause you to take losses.

Futures Contracts
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Hedging and Speculating with Financial Futures
• Today most futures traded are financial futures. Widely traded financial
futures contracts include those for Treasury bills, notes, and bonds; stock
indexes; and currencies.
• An investor who believes that he or she has superior insight into the likely
path of future interest rates can use the futures market to speculate.
• For example, if you wanted to speculate that future interest rates will be
lower (or higher) than expected, you could buy (or sell) Treasury futures
contracts.

Futures Contracts
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Hedging and Speculating with Financial Futures

Futures Contracts
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Making the Connection

Reading the Financial Futures Listings

• An example of interest-rate futures on U.S. Treasury securities appears above.
The quotation is for a standardized contract of $100,000 in face value of notes
paying a 6% coupon.
• The first column states the contract month for delivery. The next five columns
present price information.
• Futures prices are lower for December 2010 than for September 2010, telling
you that futures market investors expect long-term Treasury interest rates to
rise.
Futures Contracts
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Solved Problem

7.3

Hedging When Interest Rates Are Low
During the financial crisis of 2007–2009, interest rates on Treasury bills,
notes, and bonds and on many corporate and municipal bonds fell to very
low levels. Jane Williams is a financial adviser and chief executive officer
of Sand Hill Advisors in Palo Alto, California. In early 2010, an article in the
Wall Street Journal quoted Williams as arguing that “bonds could be
among the worst-performing investments this year. . . .”
a. What would make bonds a bad investment?
b. How might it be possible to hedge the risk of investing in bonds?

Futures Contracts
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Solved Problem

7.3

Hedging When Interest Rates Are Low
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by explaining when bonds make a bad investment.
Bonds are a bad investment when interest rates rise because higher market interest rates
cause the prices of existing bonds to decline.
Step 3 Answer part (b) by explaining how it is possible to hedge the risk of

investing in bonds.
Investors who own bonds are long in the spot market for bonds, so the appropriate hedge
calls for them to go short in the futures market for bonds by selling futures contracts.

Futures Contracts
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Trading in the Futures Market
Margin requirement In the futures market, the minimum deposit that an
exchange requires from the buyer or seller of a financial asset; reduces default
risk.
• For instance, on the CBOT, futures contracts for U.S. Treasury notes are
standardized at a face value of $100,000 of notes, or the equivalent of 100
notes of $1,000 face value each. The CBOT requires that buyers and sellers
of these contracts deposit a minimum of $1,100 for each contract into a
margin account.

Marking to market In the futures market, a daily settlement in which the
exchange transfers funds from a buyer’s account to a seller’s account or vice
versa, depending on changes in the price of the contract.

Futures Contracts
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Trading in the Futures Market

Futures Contracts
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