Topic: Financial Derivatives

At the end of this chapter, you will be able to:

Explain and describe the common types of financial derivatives

Derive the price for a call option using Black Scholes Model.

Introduction

A derivative is a financial instrument that represents a claim to another asset. It is an asset that derives
its value from an underlying asset, such as:

Stock options
Currency forward
Oil futures

A derivative is a contractual relationship established by two or more parties where payment is based on
(or "derived" from) some agreed-upon benchmark. Since individuals can "create" a derivative product
by means of an agreement, the types of derivative products that can be developed are limited only by
the human imagination.

Hedging
Hedging reduces a firm exposure to fluctuations in all kinds of financial prices such as foreign exchange
rates, interest rates, commodity prices and equity prices.

There are three types of traders, who are attracted to derivative securities:

Speculators
Speculators take long or short positions in derivatives to increase their exposure to the market.
They are betting that the underlying asset will go up or go down.

Arbitragers
Arbitragers find mispriced securities and instantaneously lock in a profit by adopting certain
trading strategies.

Hedgers
Hedgers take positions in derivative securities opposite those taken in the underlying asset in
order to help manage risk. For example, consider an investor who owns 100 shares which is
currently priced at RM62. The person is worried that the stock might decline sharply in the next
two months. The person could buy put options to sell 100 shares at a price of RM60. The person
would pay the price of the options, but this would ensure that he could sell the stock for RM60
at expiration if the stock declines sharply.

The Risks
As derivatives are risk-shifting devices, it is important to identify and fully comprehend the risks being
assumed, evaluate those risks and continuously monitor and manage those risks. Each party to a
derivative contract should be able to identify all the risks that are being assumed before entering into a
derivative contract. These risks include:

Interest rate
Currency exchange
Stock index

1
 Long or short-term bond rates

Part of the risk identification process is a determination of the monetary exposure of the parties under
the terms of the derivative instrument. Since money is usually not due until the specified date of
performance of the parties' obligations, the lack of an up-front commitment of cash may obscure the
eventual monetary significance of the parties' obligations.

An important aspect in the use of derivatives is the need for constant monitoring and managing of the
risks represented by the derivative instruments. Unlike the purchase of an equity or debt security, one
cannot enter into a derivative transaction, place the paperwork in a drawer and forget it. The
relationships established in the derivative instrument require constant monitoring for signs of
unacceptable change.

We will now look at the four types of derivatives:

Options
Forward Contract
Futures & Contracts
Swaps

Option

What is Options?
An option is an instrument that provides the right but not the obligation to do something. There are two
types of option:

Call option
Gives the holder the right to buy the underlying asset by a certain date for a certain price.

Put option
Gives the holder the right to sell the underlying asset by a certain date for a certain price.

Here is an example that will convey the basics of options.

Suppose an apartment can be purchased for RM150, 000. You have some information that something
may occur in the next year that will increase the value of the apartment: a new road, or development, or
something. If it occurs, the property will be worth RM195, 000 in one year.

One thing you could do would be to purchase the apartment. If you do so, your rate of return will either
be 30 percent or zero, depending on what happens over the next year. Supposedly, you attach some
positive probability to the occurrence of the event that will cause the value to increase.

Here is an alternative. You go to the apartment owner and offer to do a deal. You will give him RM20,
000 if he will sign a contract that allows you to purchase the property for RM150, 000 any time during
the following year, at your option. If you decide not to exercise the option, the property owner will be
ahead of the game by RM20, 000 and you will be behind by RM20, 000.

Look at the possible outcomes. If the value of the property increases, you exercise the option and buy
the property for RM150, 000. If you immediately sell the property, your gross profit will be RM45, 000
(RM25, 000 net) on an investment of RM20, 000, or a 125 percent rate of return. (The assumption is
that you borrow the RM150, 000 for a few days and immediately sell the property and repay the loan.)

2
An example of an option is Stock Option. Stock options are exchange-traded contracts that call for the
purchase or sale of 100 shares of stock at a fixed price (called the strike, exercise, or price) within a
stated time period.

The instrument being traded is a contract. These contracts are traded on organized exchanges. The
contracts are standardized at 100 shares each, and most contracts expire within about 6 months,
although there are some longer terms options (called leaps) with expiration dates as far as two or three
years into the future.

There are two types of option contracts:

Calls

Calls are options to buy 100 shares of stock at a fixed price.

Puts
Puts are options to sell 100 shares at a fixed price.

There are two parties to every option contract: a buyer and a seller or writer.

The buyer pays the price or cost of the option (called the premium) to the seller or writer. The agents for
the buyer and seller meet on the floor of the exchange and establish the price of the option (the
premium). Option premiums are determined by supply and demand.

The call buyer pays the premium and gets the right to buy 100 shares at the strike price within the option
period. The call buyer is making a bet that the price of the underlying stock will increase during the
option period. The call buyer is said to be long the call and is bullish on the underlying stock. If the call
buyer chooses, he/she may exercise the option at any time. These are American options. European
options may only be exercised at expiration.

The call seller (writer) receives the premium and undertakes the obligation to sell at the strike price
within the option period. The call writer is making a bet that the price will not increase during the option
period. The call seller is said to be short the call and is bearish or neutral on the underlying stock.

The put buyer pays the option premium and gets the right to sell 100 shares at the strike price within the
option period. The put buyer is making a bet that the price of the underlying stock will decrease during
the option period. The put buyer is said to be long the put and is bearish on the underlying stock.

The put seller (writer) gets the put premium and undertakes the obligation to buy at the strike price within
the option period. The put seller is betting that the stock price will stay the same or increase. The put
seller is said to be short the put and is bullish or neutral on the underlying stock.

Options Terminology
Below are the options terminologies.

Price of the underlying asset: S t at time t.

Strike price or exercise price: The price at which the call (put) holder has a right to buy (sell) the
underlying asset. We will denote this by E.
Exercise: Exercise of a call option means the act of buying (in case of calls) or selling (in case
of puts) the underlying asset at the exercise price.
Expiration: The date by which the option must either be exercised, or it becomes worthless. We
will denote this by t.

3
Stock Option Valuation
There are two types of stock option valuation, which are:

European call option payoffs

European put option payoffs

European Call Option Payoffs

1. Payoff means the value of the option at expiration

2. Obviously, holder will exercise only if S t > E. Then the value of the option is S t E. If S t < E, the
option is worthless. This means the payoff to the holder is: Max (S t E, 0 ).
3. The payoff to the writer is exactly opposite of that of the holder: Max ( S t E, 0 ) =Min (E- S t , 0 ).

Figure 1: European Call Option Payoffs

European Put Option Payoffs

1. Again, payoff means the value of the option at expiration

2. Obviously, holder will exercise only if S t < E. Then the value of the option is E-S t. If S t >E, the
option is worthless. This means the payoff to the holder is: Max (E-S t , 0 ).
3. The payoff to the writer is exactly opposite of that of the holder: Max (E-S t, 0) = Min (S t -E, 0).

4
 Figure 2: European Put Option Payoffs

Call Option
The call option premium (C P ) consists of the sum of two components:

Time value premium (T V ) + Intrinsic value (I V )

The time value premium is what the buyer is willing to pay to make the bet that the stock price will
increase above the strike price. The intrinsic is the built-in profit on the option. If the market price of the
stock (S t ) is greater than the exercise or strike price of the call option (E), then the call option is said
to be "in the money" and the intrinsic value or built-in profit is S t E (stock price minus the strike price).
If S t < E (stock price less than the strike price), option is said to be "out of money" and intrinsic value
zero. If stock is equal (S t = E), then the call option is said to be "at the money".

Below is the illustration of call options.

Suppose a call option has a strike price of RM50 and the current stock price is RM54. The premium on
the call option is RM7 per share. The option is in the money by RM4 because it gives the holder the
right to buy for RM50 something that is currently worth RM54. The intrinsic value (built-in profit) is RM4.
Since the premium is RM7 and the I V is RM4, it follows that the T V must be RM3.

CP=TV+IV

I V = RM54 - RM50 = RM4

RM7 = TV + RM4

T V = RM7 RM4 = RM3

5
Now, if the market price of the stock increases so that the option gets further and further into the money,
then the option premium will increase dollar for dollar with the I V.

Figure 3: Listed Option Quotation

Referring to Figure 3: Listed Option Quotation:

a. AmOnline Jan 30.00 call

The closing price of America Online stock on the previous day was RM32.28. The strike price on the
option is RM30.00, and the option expires in Jan, specifically the Friday of the third full week of the
month. There were 298 contracts traded on the previous day and the option premium, on a per share
basis is RM6.00. Since each option is standardized at 100 shares, the market price of the option
(premium) is RM6.00 times 100 or RM600 plus commissions.

This option is in the money by RM2.28 since it allows the owner of the option to buy for RM30.00
something that currently has a market value of RM32.28. Thus the I V of the option is RM2.28, and since
the premium is RM6.00, it follows that the T V is RM6.00 RM2.28 = RM3.72

b. AmOnline Oct 32.50 call

This option is out of the money because the market price (RM32.28) is less than the strike price
(RM32.50). Thus, the premium (RM3.00) is all time value premiums. The total dollar cost of the option
is RM3.00 times 100 shares per option = RM300 plus commissions.

6
The buyer of this option would be betting that the price of America Online would increase above
RM32.50 per share between now and the end of October 2001. The seller would be betting that it would
not increase to that level. The buyer would have to pay $180.00 to make the bet and the seller would
get $180.00 to assume the obligation.

Put Option
The put option premium (P p) also consists of the sum of two components:

Time value premium (T V) + the intrinsic value (I V).

The time value premium is what the buyer is willing to pay to make the bet that the stock price will
decrease below the strike price. The intrinsic value is the built-in profit on the option. If the market price
of the stock (S t) is less than the strike price of the put option (E), (S t < E), then the put option is said to
be "in the money" and the intrinsic value or built-in profit is E - S t (the strike price minus the stock price).

If S t > E (stock price greater than the strike price), the option is said to be "out of the money" and the
intrinsic value is zero.

If the stock price and strike price are equal, then the put option is said to be "at the money".

Below is the illustration of put options.

Suppose a put option has a strike price of RM50 and the current stock price is RM49. The premium on
the put option (P p ) is RM5 per share. The option is in the money by RM1 because it gives the holder
the right to sell for RM50 something that is currently worth RM49. The intrinsic value (built-in profit) is
RM1. Since the premium is RM5 and the I V is RM1, it follows that the T V must be RM4.

CP=TV+IV

I V = RM50 RM49 = RM1

RM5 = TV + RM1

T V = RM5 RM1 = RM4

7
 Figure 4: Listed Option Quotation

Referring to Figure 4: Listed Option Quotation:

a. AmOnline Sept 37.50 put

AmOnline stock closed at RM32.28. The strike price is RM37.50 and the premium is RM5.50 per share
or RM550 for the whole 100 shares option. This put option is in the money because the strike price is
greater than the stock price.

This option is in the money by RM5.22 since it allows the owner of the option to sell for RM37.50
something that currently has a market value of RM32.28. Thus the I V of the option is RM5.22, and since
the premium is RM5.50, it follows that the T V is RM5.50 RM5.22 = RM0.28.

b. AmOnline Apr 30 put

The strike price is RM30 and the stock price is RM32.28. Thus, the option is out of the money because
the stock price is greater than the strike price. So the premium (RM4.10) is all time value premiums and
the intrinsic value is zero.

8
Profits and Losses on Puts and Calls
Options are traded in continuously functioning markets. Thus, there is a ready market to sell options that
have been purchased and to buy options that have been sold. This needs elaboration.

The market prices of options (premiums) will reflect Time Value Premiums and any built-in profit resulting
from the option being in the money. It is not necessary to exercise an option in order to realize profits,
although exercise is always an alternative for the buyer.

Illustration:

Suppose there are a call option with six-month expiration and a strike price of RM100. The price of the
underlying stock is currently also RM100, so the option is at the money. The agents for the buyer and
seller meet on the floor of the exchange and negotiate the price of RM10 per share or RM1, 000 per
100-share option. Thus, the call option premium is RM10.

Now, at expiration, the time value premium of any option is equal to zero. This is because there is no
more time for the bet to come through. Thus, nobody would pay money to make a bet that has no time
to run.

For the call buyer, one of three things must be true at expiration:

1. The call expires worthless.

This will happen at any stock price at expiration of less than RM100 per share. The option will have no
T V and no I V because it is out of the money. The call buyer will lose RM10 per share or RM1, 000 on
the whole option, which was the original cost.

2. The option is sold for its intrinsic value.

Suppose the stock price at expiration is RM115. The option will be in the money by RM15 and thus can
be sold for RM15 per share, or RM1, 500 total. This generates a net profit of RM5 per share, or RM500
total (the option cost RM10 and is sold for RM15 = net + R5). This is a 50% return (RM500/RM1, 000).

3. The option is exercised by the call buyer.

In this case, the call buyer would pay RM10, 000 for 100 shares of the stock at the exercise price of
RM100 per share (and, incidentally, pay a normal brokerage commission). The stock is currently worth
RM115 per share and so can be sold for RM11, 500, or a profit of RM1, 500 and a net profit of RM500
after the cost of the option.

The profit/loss on the above call option may be depicted graphically in what is called a profit/loss graph.
The horizontal axis is the stock price at the expiration of the option, and the vertical axis is the per share
profit or loss on the call option.

9
 Figure 5: Call Buyer Profit/Loss Graph

Notice that at any stock price below RM100 a share, the call buyer loses the whole call premium of
RM10 per share. If the stock price is RM110 at expiration, the call buyer will just break even because
he/she will be able to sell the option for its intrinsic value of RM10, which just covers the original cost of
the option. At any stock price of more than RM110 at expiration, the call buyer will make money.

For the naked call seller or writer, one of three things must also be true at expiration:

1. The call expires worthless.

This will happen at any stock price at expiration of less than RM100 per share. The option will have no
T V and no I V because it is out of the money. The call seller will profit by RM10 per share or RM1, 000
on the whole option, which was the original premium received.

2. The option is purchased for its intrinsic value.

Suppose the stock price at expiration is RM115. The option will be in the money by RM15 and thus can
be purchased for RM15 per share, or RM1, 500 total. This generates a net loss of RM5 per share, or
RM500 total (the option cost RM10 and is bought for RM15 = net - RM5).

Note: A call seller gets the premium and assumes an obligation to sell at the strike price. That obligation
may be satisfied by purchasing an option identical to the one that was originally sold.

The Option Clearing Corporation allows the seller to "offset" the short call with an identical long call. The
seller would profit or lose by the difference in prices of the sold and purchased options.

3. The option is exercised by the call buyer.

In this case, the call seller would get RM10, 000 for 100 shares of the stock at the exercise price of
RM100 per share (and, incidentally, pay a normal brokerage omission). Because the seller was naked
(didn't own the stock), he/she would have to buy the stock in the open market for the current market
price of RM115 per share.
10
So the stock is bought for RM11, 500, for a loss of RM1, 500 or a net loss of RM500 after the original
option premium received (RM1, 000).

The profit/loss on the above call option may also be depicted graphically.

Figure 6: Naked Call Writer Profit/Loss Graph

At any stock price below RM100 at expiration, the call seller gets to keep the whole RM10 premium. At
RM110, the seller just breaks even, and at any price above RM110, the naked call writer loses money.

Suppose that there is a put option with six-month expiration and a strike price of RM100. The price of
the underlying stock is currently also RM100, so the option is at the money. The agents for the buyer
and seller meet on the floor of the exchange and negotiate the price of RM9 per share, or RM900 per
100-share option. Thus, the put option premium is RM9.

Put options are similar to calls in that the T V is zero at expiration and the option will be worth the I V (if
any) at expiration. Suppose a speculator buys the above put option and the stock price is RM102 at
expiration. In this case, the option will expire worthless because the stock price is above the strike price
(and, incidentally, it wouldn't make any sense to exercise the option to sell for RM100 when stock can
be sold in the open market for RM102). If the stock price is RM91 at expiration, the put buyer will just
break even because the option can be sold for its intrinsic value (RM9), which is exactly the price
originally paid for the option. The put buyer makes money at any stock price below RM91 at expiration,
as depicted in the following profit/loss graph:

11
 Figure 7: Put Buyer Profit/Loss Graph

A put seller or writer would get the RM9 put premium when the put was sold and would take on the
obligation of buying (the put buyer gets the right to sell at the strike price) the stock at the strike price
during the option period. The put seller's profit/loss position is depicted graphically as follows:

12
 Figure 8: Put Writer Profit/Loss Graph

At any stock price above RM100 at expiration, the put seller gets to keep the whole RM9 per share
premium. The put seller will break even if the stock price is RM91 at expiration, and will lose money at
any price below RM91 at expiration.

Black Scholes Model

Black Scholes is one of the models used in option pricing.

The model begins with certain assumptions:

The market is efficient.

The option is a European option. This means that it cannot be exercised prior to expiration. This
assumption can be loosened without damage to the model.
Interest rates are constant, there are no commissions, and the stock pays no dividends.
Stock returns are normally distributed (actually, log normally distributed).

These assumptions can also be loosened with no damage to the model.

All the BS model does is to rigorously evaluate the probabilities in relation to the strike price, the stock
price, and the historic standard deviation of annual returns.

13
Where S is the stock price, E is the exercise price, R is the riskless interest rate, N (d 1) and N (d 2) are
probabilities and t is the time to expiration of the option.

Illustration:
The important determinants of call option premiums may be summarized in the following functional
relationship:

1. The greater the time to expiration, the greater the call option premium. Speculators will pay more to
make a bet that has longer to come through. Thus, the premium on a six-month option will be greater
than the premium on a six-day option.
2. The greater the interest rate, the greater the call option premium.
3. The more volatile the stock, the greater the call option premium.
4. The relationship between the stock price and the strike price. If the option is out of the money (stock
price less than strike price), there is some probability that it will come into the money. However, the
further out of the money, the lower is the probability the option will be profitable. Speculators will pay
more for options close to the money and less for those that are farther out of the money.

If the option is in the money (stock price greater than strike price), then the option will increase in value
as the stock price increases because the intrinsic value will increase dollar for dollar.

14
Forward Contracts

What is Forward Contracts?

A forward contract:

Specifies the exact quantity and type of asset that seller must deliver
Specifies delivery logistics, such as time, date and place
Specifies the price the buyer will pay at delivery
Obligates the seller to sell and buyer to buy, i.e. once contract is written, neither can back away

The important thing is that no cash exchanges hands today. The forward price simply represents the
price at which buyer and seller agree today to transact in the future.

Forward contracts are traded Over the Counter (OTC), which means that forward contracts are not
traded on an exchange. It is usually written between financial institutions, or between institution and
client and it is very popular for foreign exchange.

Notation and Jargon

Now is t =0

Maturity (agreed date of exchange of asset) is time T

Represent spot prices by S t i.e. today the asset is selling for S 0, and at maturity it will sell for a (yet
unknown) price S T.

F 0, T is the forward price, i.e. the price at which buyer and seller agree (at time 0) to exchange asset
(at time T)

Forward prices are determined (just like any other market price) by the laws of supply and demand. As
time passes, new forward contracts are written and a new forward price is established. This contract's
price is then called the delivery price K.

Consider this set of quotes made by a large international bank on Dec 22, 2004.

Figure 9: Exchange Rate Quotes

Now consider the treasurer of a U.S. corporation who knows that her firm will need 1 million British
pounds in 6 months:

She can buy the 1 million pounds forward from this bank at a price of 1.4359 $/GBP

15
 Here, T = 6 months from now i.e. June 22, 2005

F 0, T =1.4359 $/GBP

Note that S 0 = 1.4456 $/GBP is the spot price of the pound today

Here, the corporation has a long position, and the bank has a corresponding short position

On Jan 22,2005, the new forward price quoted by the bank might be 1.45 $/GBP. That does not change
our December contract. Then, the agreed 1.4359 $/GBP is called the delivery price K of the December
contract.

Payoff of a Forward Contracts

Fast-forward to June 2005:

1. The prevailing spot (offer) price of the British pound is S T = 1.5000 $/GBP.

The treasurer is happy, as she can use her contract to buy the same British pound at a previously
agreed upon price of $1.4359 $/GBP. In other words, the long position has a payoff of $(1.5000-
1.4359)/GBP = $0.0641/GBP, or $64,100 in total.

The opposite is true for the bank. They lose money, as they are obligated to sell to the treasurer at
$1.4359/GBP, while they could sell to someone else for $1.50/GBP. More precisely, the payoff of the
short position is $(1.4359-1.5000)/GBP = -$0.0641/GBP, or -$64,100 in total.

2. If the spot (offer) price is 1.4000 $/GBP on, 2005:

The roles are reversed: the treasurer is not very happy, while the bank is very pleased

In either case, note that:

Both parties must fulfill their obligation, i.e. they cannot walk away from the contract

One party gains; the other loses exactly the same amount: this is a zero-sum game.

16
Future Contracts

Futures & contracts are conceptually similar to a forward contract, i.e. a contract to take delivery of an
asset in exchange for cash at some point in the future, at a price agreed upon upfront

Futures are standardized contracts traded on an exchange (buyer does not need to know the identity of
the seller, same as in the stock market). The exchange specifies various features of the contract:

Precise definition of type of the asset (important for commodities, e.g. OJ)

Contract size (i.e. x units of frozen OJ)

Delivery arrangement (where and when)

Futures are traded on a bewildering variety of real and financial assets

Corn, wheat and other commodities that can be stored

Commodities such as electricity and weather that cannot be stored (Enron was a big player in the
electricity derivatives market)

Financial assets such as stock indices, currencies, and treasury bonds

Two details of futures markets are important and worth mentioning:

Margin account: Investors are required to deposit funds in a margin account with the exchange. This
is like earnest money; used to minimize default risk.

Marking to market: Unlike forward contracts where all cash transactions are settled at the maturity
date, a futures contract is settled daily using a method called marking-to- market.

Illustration: The S&P 500 Futures Contract

Underlying Asset: S&P 500 index.

Size: $250 X S&P 500 index

Months: Mar, Jun, Sep, Dec.

Settlement: Cash-settled, based upon opening price of S&P 500 on third Friday of expiration month.

Trading ends: Business day prior to determination of settlement price.

1. Suppose the S&P futures price is 1100. Say you wanted to buy (go long) 8 Futures contracts. This
means the value of our position is:

8 X 1100 X 250=$2.2 million

Note that no money is due from you at this time except the margin.

Assume an initial margin of 10%, and weekly settlement (both wrong assumptions). Further, assume
that there are 10 weeks to expiration of this contract.

17
 Both the buyer (you) and the seller (unknown to you) are required by the exchange to post an initial
margin of 10% of the contract value or $220,000. You earn a (continuously compounded) interest on
this amount, of say 6%.

Suppose that over the first week after you bought the contract, the futures price drops 72.01 points,
roughly 6.5%. This means your contract has lost:

8 X -72.01 X 250=-$144,020

Since we have assumed weekly settlement, you have to pay the exchange this money. Typically, it is
taken out of your margin balance. So, by the end of the first week, your margin balance will be:

220,000 X e 0.06 X 1/52 - $144,020 = $76,233.99

Notice that we have used continuous compounding in the above calculation.

2. What if the futures price drops too much and your margin balance gets dangerously low?

To avoid this possibility, the exchange specifies a maintenance margin, which is the minimum balance
that must be maintained at all times.

If at any time, your account falls below this, you have to send your broker cash to make up your margin
account. This is called a margin call.

If you failed to make up the margin, the broker will close out your position and return you the remaining
margin balance.

In practice, Futures contracts are marked-to-market daily, and margins vary widely, based on the
volatility of the underlying asset.

Daily marking-to-market means that gains and losses on a futures contract are realized day by day.
In contrast, in a forward contract, the whole gain or loss is realized at maturity.

The S&P 500 Futures contract is an example of a cash settled contract.

If you hold the contract until maturity, the seller will not actually physically acquire 500 stocks comprising
the index and deliver them to you at maturity. This would be too cumbersome and costly. Instead, the
contract is marked-to-market against the actual index on the expiration day. There are other futures
contracts (on commodities, for example) that are settled by physical delivery, i.e. the specified number
of gallons of OJ, or bushels of corn are actually delivered.

The majority of futures contracts are closed out before maturity. This is done by c losing out a contract
usually involving entering into another contract, which offsets the original contract. For example, in our
example involving S&P futures, if you decided to close out your position in week 5, you would enter into
a $2.2 million short S&P futures position, which has the same maturity as your long position. This
effectively closes out your long contract.

18
Swaps

A Swap is a simultaneous buying and selling of the same security or obligation. Perhaps the best-known
Swap occurs when two parties exchange interest payments based on an identical principal amount,
called the "notional principal amount".

Think of an interest rate Swap as follows:

Party A holds a 10-year $10,000 home equity loan that has a fixed interest rate of 7 percent, and Party
B holds a 10-year $10,000 home equity loan that has an adjustable interest rate that will change over
the "life" of the mortgage. If Party A and Party B were to exchange interest rate payments on their
otherwise identical mortgages, they would have engaged in an interest rate Swap.

Interest rate swaps occur generally in three scenarios. Exchanges of a fixed rate for a floating rate, a
floating rate for a fixed rate, or a floating rate for a floating rate.

The "Swaps market" has grown dramatically. Today, Swaps involve exchanges other than interest rates,
such as mortgages, currencies, and "cross-national" arrangements. Swaps may involve cross-currency
payments (U.S. Dollars vs. Mexican Pesos) and crossmarket payments, e.g., U.S. short-term rates vs.
U.K. short-term rates. Swaps may include " Caps," " Floors," or Caps and Floors combined (" Collars
").

A derivative consisting of an Option to enter into an interest rate Swap, or to cancel an existing Swap in
the future is called a " Swaption." You can also combine an interest rate and currency Swap (called a "
Circus " Swap).

Swaps generally are traded OTC through Swap dealers, which generally consist of large financial
institution, or other large brokerage houses. There is a recent trend for Swap dealers to Mark to Market
the Swap to reduce the risk of counterpart default.

Summary

This chapter discusses the common types of financial derivatives that could be used as a tool to reduce
companies exposure to fluctuation in key financial variables such as interest rate, exchange rates and
commodity prices. Emphasis was given to explain the mechanics of various financial derivatives
especially option and forward contracts.

Questions

1. What is a futures contract? How does it differ from a forward contract?

2. What is a futures option?

3. What is a swap?

4. A stock is selling for $33.50 a share and has a standard deviation of 30 percent. A 6-month
European option on the stock has an exercise price of $35. The risk-free rate is 5.5 percent,
compounded continuously. N(d1) is 0.51165 and N(d2) is 0.42743. What is the value of the call option?

19