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
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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
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Outline
Derivative Assets and the News
Current Events
Risk of Derivative Assets
Listed vs. Over-the-Counter Derivatives
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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.
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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.
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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.
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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?
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Background : Uses of Derivatives
Insert Figure 17-1 here.
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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.
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Options Terminology
Options trade in units called contracts, each
of which normally covers 100 shares.
An option’s volume indicates how many
option contracts changed hands over some
period of time. It measures trading activity.
An option’s open interest indicates how many
option contracts exist.
Open interest goes up when someone creates an
option and does down when two people trade and
each close out an options position.
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Options Terminology
The owner of an option will ultimately do
one of three things with it:
sell it to someone else;
let it expire; or
exercise it.
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The Origin of an Option
Options can be created, or destroyed. The
quantity of options in existence changes
everyday.
The first trade someone makes in a
particular option is called an opening
transaction. If an investor sells an option as
an opening transaction, it is called writing
the option.
Options are fungible, meaning that, for a
given company, all options of the same type
with the same expiration and striking price
are identical.
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The Role of the Options Clearing Corporation
The Options Clearing Corporation positions
itself between every buyer and seller and acts
as a guarantor of all option trades.
OCC
Buyer
Trading Floor
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Seller
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Standardized Option Characteristics
Options have standardized expiration dates,
striking prices, and lot size.
option premium = intrinsic value + time value
If an option has no intrinsic value, it is out-ofthe-money. Otherwise, it is either in-themoney or at-the-money.
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Standardized Option Characteristics
Components of an Option Premium
Intrinsic
Value
+
Time Value
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=
Option
Premium
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Standardized Option Characteristics
An American option can be exercised
anytime prior to the expiration of the option.
A European option, on the other hand, can
only be exercised at expiration.
The option holder decides if and when to
exercise.
Valuable options are usually sold rather than
exercised.
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Standardized Option Characteristics
Fig 17-4 here
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The Futures Market
A futures contract is a promise.
The initial seller of the contract promises to
deliver a quantity of a standardized commodity
to a designated delivery point during a certain
delivery month.
The other party to the trade promises to pay a
predetermined price for the goods upon
delivery.
The person who promises to buy is said to be
long, while the person who promises to deliver
is said to be short.
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The Futures Market
Futures vs. options : Futures contracts do
not expire unexercised. Note that the
contract obligation may be satisfied by
making an offsetting trade.
Market participants :
Hedgers use futures to reduce price risk.
Speculators assume risk in the hope of
making a profit.
Marketmakers provide liquidity for the
marketplace.
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The Futures Market
Insert Figure 17-5 here.
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The Futures Market
Keeping the promise : Each exchange has a
Clearing Corporation which ensures the
integrity of the futures contract when a
member is in financial distress.
Categories of futures contracts :
Agricultural e.g. wheat, cotton, cattle.
Metals and petroleum e.g. platinum,
copper, natural gas, crude oil.
Financial e.g. foreign currency, stock
index, interest rate.
Others e.g. electricity, catastrophe, swap.
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Financial Futures : Stock Index Futures
A stock index future is a promise to buy or
sell the standardized units of a specific
index at a fixed price at a predetermined
future date.
Unlike most other commodity contracts,
there is no actual delivery mechanism
when the contract expires. For practicality,
all settlements are in cash.
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Financial Futures : Stock Index Futures
Insert Table 17-2 here.
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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.
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