CHAPTER 1

An Overview of Derivative Contracts

A derivative is a financial contract whose value is “derived from,” or depends on, the price of some
underlying asset. Equivalently, the value of a derivative changes when there is a change in the
price of an underlying related asset. This chapter provides a broad overview of the four classes of
derivative contracts: forwards, futures, swaps, and options. However, because forwards, futures,
and swaps are very similar types of contract, many believe that there are really only two types of
derivative: options and forwards. While other derivative contracts exist, a careful analysis of their
characteristics will reveal that they are merely variations of one (or more) of these major classes.
Mark Rubinstein (1976) was perhaps the earliest author to use “derivative” in a financial
contract context; in this particular article, he used the term to refer to options. A computerized
search found that it wasn’t until 1981 that an article in the popular press Business Week (1981)
used the term, with quotation marks around it. This article expressed the fear that trading in
options and futures (derivatives) detrimentally affects the markets of the underlying assets. It also
raised the issue of who—the Securities and Exchange Commission (SEC) or the Commodity
Futures Trading Commission (CFTC)—should regulate trading in derivatives. Currently,
“derivatives” is routinely used in business communication and all forms of media, and textbooks
and college courses are devoted to the study of the subject.
Individuals of many types use derivatives. Speculators who think they know the future
direction of prices use derivatives to try to profit from their beliefs. Arbitrageurs trade derivatives
to take advantage of times during which prices are “out of sync”: that is, one asset or derivative
contract is mispriced relative to another. Hedgers face the risk that a change in a price will hurt
their financial status; they use derivatives to protect, hedge, or insure themselves against such
harmful movement in prices. Of particular interest is the current indispensability of derivatives for
accomplishing many tasks necessary to the successful management of corporations, governments,
and large pools of money in general: managing exposure to price risk, lowering interest expense,
altering the structure of assets, liabilities, revenues, and costs, reducing taxes, circumventing
unwieldy regulations that make transactions difficult, and arbitraging price differentials.
We can characterize derivatives by the structures of the markets in which they trade. Some
derivatives trade on organized exchanges. In particular, there are options and futures exchanges in
existence all over the world.' These exchanges allow virtually anyone who meets some set of
financial criteria (e.g., the individual’s net worth or income) to trade these contracts. Price and
trade information are readily available, and at any point in time, the prices at which they can be
bought do not appreciably differ from the prices at which they can be sold. Other derivative
contracts actively trade in liquid and well-established over-the-counter (OTC) markets. These
markets are open only to large, financially sound corporations, governments, and other institutions.
 1 AN OVERVIEW OF DERIVATIVE CONTRACTS

Large, well-capitalized financial institutions such as Morgan Stanley Dean Witter, Goldman
ed
Sachs, and Deutsche Bank quote prices for these contracts; the bid—ask quotes are characteriz
by having narrow spreads, and trading is often quite active. Finally, many derivatives are custom
made by these financial institutions for a specific end user. Generally, the party desiring such
unique derivative contracts enters into the agreement with the intent of keeping the position until it
matures. In general, all derivatives that do not trade on an exchange are called OTC contracts.
For many assets, the size of the derivatives markets is many times larger than the size of
the cash market. Indeed, 3 trillion futures and options contracts traded on organized exchanges in
2000, an increase of over 24% from 1999 (Burghardt, 2001, p. 34). The Bank for International
Settlements (BIS) reported in its November 13, 2000, press release (www.bis.org/) that the
total notional principal” of outstanding OTC derivatives as of June 30, 2000 was $94 trillion!
The sizes of the individual markets will be noted in the following overviews of the four different
types of derivative. More detailed analyses of the contracts are contained in subsequent chapters.

1.1 FORWARD CONTRACTS AND FUTURES CONTRACTS

A forward contract gives the owner the right and obligation to buy a specified asset on a
specified date at a specified price. The seller of the contract has the right and obligation to sell the
asset on the date for that specified price. At delivery, ownership of the good is transferred and
payment is made. In other words, whereas the forward contract is executed today, and the price is
agreed upon today, the actual transaction in which the underlying asset is traded does not take
place until a later date.
Typically, no money changes hands on the origination date of a forward contract. However,
because forwards contain a promise to exchange the good for cash at a later date, each party
wants some form of assurance that the counterparty will strictly observe the terms of the contract.
Therefore, it is not unusual for the more creditworthy party to demand that the less creditworthy
party put up some collateral, or take other actions to reduce the possibility of default risk.
You have probably engaged in many forward transactions in your life. For example, if you
call your barber to set up an appointment for a haircut, you have transacted in a forward market.
Many major purchases of items such as cars are forward transactions, and sometimes, the
seller will ask for a down payment. Usually, in these informal forward contracts, a party will
not take legal action if the other party defaults. Imagine how you would feel if you made a reser-
vation at a restaurant (which is a forward contract to purchase a meal, and pay for it, at a later
date), failed to appear on time (or at all), and the restaurant brought legal action against you.
On the other hand, many hotels will charge you for a room if you fail to show up on time after
“taking on a long position in a forward contract” that obligates you to buy the use of a room for the
period specified.
Defaults on derivatives, including forwards, are taken very seriously in the financial markets.
A party that loses because its counterparty defaulted will typically take legal action. Furthermore,
the defaulting party’s reputation will be tarnished, likely making it difficult or impossible for the
defaulter to engage in future derivative transactions. It is interesting to note that only one party at
any time will have the incentive to default: the party that is losing as of that date. It would most
certainly not be in the best interest of the other party, which has unrealized profits on its positions,
to walk away from its obligations, since by doing so it would be giving up its rights to a likely
future cash inflow.
 1.1 FORWARD CONTRACTS AND FUTURES CONTRACTS

A futures contract is similar to a forward contract; the differences will be presented in

Chapter 6. Until then, think of a futures contract as a standardized forward contract® that can be
easily traded. Futures and forwards both obligate the buyer (the party with a long position in the
contract) to take delivery of the underlying asset at a future date and to pay for it upon delivery;
both contracts give the seller the obligation to deliver the good, asset, or service at a future date.
Money typically changes hands on the delivery date.
Default risk is lower on futures than on forwards for several reasons: (a) the counterparty to
all futures trades is actually the clearinghouse of the futures exchange, which guarantees that all
payments will be made; (b) futures contracts are marked to market daily (daily resettlement),
which means that any change in the value of the contract is realized as a profit or loss every day;
and (c) initial margin, which serves as a performance bond, is required when trading futures. In
contrast, because they are not marked to market, forward contracts can build up large unrealized
profits for one party and equally large unrealized losses for the other party.
For example, suppose that today you sell a forward contract that commits you to sell one bar-
rel of oil at $21/barrel. Then on each of the next five days, the forward price rises by $1/barrel per
day. After five days, you have an unrealized loss of $5. Had you instead sold a futures contract, you
would have been forced to pay $1 each day to the holder of the long position in this contract. In
other words, the futures contract is settled up daily. Profits and losses are realized each day in the
futures market, but they are realized only upon delivery in the forward market.
Because they are marked to market daily, a futures contract is like a portfolio (a time series)
of forward contracts. Put another way, a futures contract with a delivery date one month (30 days)
hence is equivalent to 30 forward contracts. The first forward contract originates today and is cash
settled on its delivery date, which is tomorrow. The second contract originates tomorrow, and is
cash settled the day after that. The last (the 30th) forward contract originates 29 days hence, and its
delivery date is 30 days hence.
The profit diagrams for forwards and futures are identical. If the spot price of the underlying
asset on the delivery date is above the forward price that was agreed upon when the contract was
originated, the party who is long profits. All derivatives are zero-sum games. Whatever amount of
money one party gains must equal the amount of money the other party loses. Alternatively, you
can think in terms of changes in the forward price. Suppose that today is June 3, 2000, and today’s
forward price for buying gold on February 3, 2001, is $285/oz. Then, suppose on December 3,
2000, the forward price for buying gold on February 3, 2001 is $245/oz. The party that is short the
forward contract has a profit of $40/oz. (this profit will still be unrealized as of December 3), and
the party that is long the forward contract has a loss of $40/oz. These concepts are illustrated in
Figure 1.1.
The concept of forward delivery, with contracts stating what is to be delivered for a fixed price
at a specified place on a specified date, existed in ancient Greece and Rome.* Perhaps the first
organized commodity exchange on which forward contracts traded was doing business in Japan in
the early 1700s. The first formal commodities exchange in the United States for spot and forward
contracting was formed in 1848: the Chicago Board of Trade (CBOT). Futures contracts began
trading on the CBOT in the 1860s. The Chicago Mercantile Exchange (CME) was formed in 1919,
though it essentially existed before that date under other names.
In an article published four years before he and two other Americans were awarded the 1990
Nobel Prize in economic science, Merton Miller wrote, “my nomination for the most significant
financial innovation of the last twenty years is: financial futures—the futures exchange style
trading of financial instruments” (Miller, 1986, p. 463).
 1 AN OVERVIEW OF DERIVATIVE CONTRACTS

Profit

Change in
forward price
Change in
forward price

(a) (b)
Figure 1.1 Profit diagrams for (a) a long forward position and (b) a short forward position.

The first financial futures contracts were the foreign currency futures contracts that began
trading on May 16, 1972, on the International Monetary Market (IMM), a division of the CME’;
400 contracts were traded on the first day of operations. The first interest rate futures contracts
that traded were the GNMA (Government National Mortgage Association) futures contracts,° on
the CBOT, on October 20, 1975. The Eurodollar Time Deposit futures contract was the first
“cash settled”’contract, and it began trading on the IMM on December 9, 1981. Another signifi-
cant innovation occurred on February 24, 1982, when futures contracts on a stock index, the
Value Line Index, began trading on the Kansas City Board of Trade; 1768 contracts traded on its
opening day.
On September 7, 1984, the Singapore International Monetary Exchange (SIMEX) and the
CME formed a trading link that permits investors to trade some contracts interchangeably on the
two exchanges (this is called “mutual offset’). This was the first of several networks and systems
that are leading to a globalized and increasingly automated world of 24-hour-a-day trading of
securities.
Trading in energy futures commenced in the late 1970s and is now one of the most heavily
traded sectors in the futures market. The New York Mercantile Exchange (NYMEX) introduced
trading in No. 2 heating oil futures in November 1978. Gasoline trading began in 1981 and crude
oil trading in 1983. Energy futures trade on many exchanges all over the world.
Figure 1.2 depicts how futures trading in the United States has exploded since the late 1960s.
Much of the increase from 14.6 million contracts in 1971 to over 400 million contracts in 1994 and
1995 came from financial futures contracts, including futures on interest rate instruments, stock
indexes, and foreign exchange. In 2000, 491.5 million futures contracts traded in the United States
and another 952.6 million futures contracts traded outside the country (Burghardt, 2001). The
notional principal of all the exchange traded derivatives (futures and options) traded in the world
in 2000 was estimated to be $383 trillion (see the March 2001 BIS Quarterly Review, which
can be viewed at www.bis.org/publ/); this was up 9.4% from the 1999 figure. Table 1.1
presents the actual number of futures contracts traded in the United States in several recent
years. Table 1.2 breaks down volume in the recent past by the U.S. exchange on which the
contracts traded.
It is interesting that futures trading, expressed in terms of number of contracts traded, peaked
in 1998, followed by drops in 1999 and 2000. This occurred for two reasons. First, 1998 was a
chaotic year in which Russia effectively defaulted on its debt and the currencies of many emerging
market nations plummeted in value. These events led to considerable derivatives trading in general
 1.1 FORWARD CONTRACTS AND FUTURES CONTRACTS

1000

800

© Options on security indexes,

individual equities, and foreign
600 currencies
@ Options on futures
& Futures
400

200

68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

Figure 1.2 Volume of futures and options trading on U.S. futures and securities exchanges, 1968-1995.
Source: © October/November 1996, reprinted with permission from Futures Industry.

TABLE 1.1 Average Estimated Number of Futures Contracts

Traded, All U.S. Markets Combined: FY 1990-FY 2000

Fiscal Year Total Contracts Traded

1990 272,306,699
1991 261,422,699
1992 289,453,855
1993 B25 ol. Ol
1994 411,056,929
1995 409,420,426
1996 394,182,422
1997 417,341,601
1998 500,562,510
1999 491,137,790
2000. 477,834,609

Source: CFTC website at www.cftc.gov/.

in 1998. Second, 1999 and 2000 were much calmer years. Also, the euro was not a traded currency
in 1998, so in 1998 there was trading in French francs, German marks, Italian lira, and so on. All
the trading in the different “Euroland” currencies consolidated into euro-trading in 1999.
Futures trading takes place on a huge scale internationally. Table 1.3 summarizes trading
activity for the most active exchange-traded futures and options contracts traded in the world
 1 AN OVERVIEW OF DERIVATIVE CONTRACTS

TABLE 1.2 Estimated Number of Futures Contracts Traded in U.S. Markets for Fiscal Years
Ending 9/30/99 and 9/30/00
Underlying Asset of
Volume of Trading Most Actively Traded
Exchange (number of contracts) Contracts

1998-1999 1999-2000 (1999-2000 volume)

Chicago Board of Trade (CBT) 203,662,672 187,048,113 U.S. Treasury bonds
67,008,924 contracts
U.S. 10-year Treasury notes
42,769,912 contracts

Kansas City Board of Trade (KCBT) 2,378,920 2,345,727 Wheat

2,324,744 contracts

Minneapolis Grain Exchange (MGE) 1,180,573 967,504 Wheat

963,054 contracts

MidAmerica Commodity Exchange (MCE) 2,586,219 1,913,154 U.S. Treasury bonds

763,334 contracts

Chicago Mercantile Exchange (CME) 175,488,669 181,852,421 Three-month Eurodollars

and International 100,452,601 contracts
Monetary Market (IMM)

New York Mercantile 89,869,532 87,753,321 Crude oil, light “sweet”

Exchange (NYMEX) 37,526,345 contracts
and Commodity
Exchange Inc. (COMEX)

New York Board of Trade 16,070,698 15,954,369 Sugar no. 11

(NYBT), New York Cotton 5,819,141 contracts
Exchange (NYCE), New York Futures
Exchange (NYFE), Coffee,
Sugar & Cocoa Exchange (CS&CE),
and Cantor Exchange (CFFE)

Total, all markets 491,137,790 477,834,609

Source: CFTC website at www.cftc.gov/.

during the first eight months of 2000. Table 1.4, which lists volume figures for the leading interna-
tional futures exchanges during 2000, illustrates the international importance of futures trading.

1.2
eSee ee
Swaps ee eee eee

In a swap contract, two parties agree to exchange cash flows at future dates according to a
prearranged formula. Like a futures contract, a swap is also equivalent to a portfolio of forward
contracts. However, whereas a futures contract is akin to a time series of one-day forwards, a swap
is like a portfolio of forwards, all of which originate today and all of which have different delivery
dates. Figure 1.3a illustrates the difference, using a futures contract with a delivery day (at time 4)
four days after origination (the origination day is on day 0), and a four-period swap.
 1.2. SWAPS

TABLE 1.3 Most Actively Traded Futures and Options Contracts for the Eight-Month
Period Ending August 30, 2000
So
e en ee e
Volume (number of contracts)
Contract Exchange January 1, 2000—August 31, 2000
Euro-BUND EUREX-Frankfurt 105,736,279
KOSPI 200 Options KSE, Korea 96,153,236
Eurodollars CME, U.S. 72,920,253
CAC 40 Index Options MONEP, France 54,795,638
U.S. Treasury Bonds CBOT, U.S. 45,006,113
Euro-BOBL EUREX-Frankfort 42,061,463
Three-month Euribor LIFFE, UK 38,689,860
Euro-notional bond Euronext Paris, France 33,049,313
U.S. T-bond options CBOT, U.S. 31,270,050
Euro-SCHATZ EUREX-Frankfurt 26,927,236

The exchanges are as follows: CBOT, Chicago Board of Trade (www.cbot.com); CME, Chicago Mercantile Exchange
(www.cme.com); EUREX, Eurex (www.eurexchange.com/); KSE, Korea Stock Exchange (www.asiadragons.com/
korea/finance/stock_market/); MONEP, Marché des Options Negociables de Paris (www.monep.ft/english/
defaultuk.html); Euronext Paris (www.euronext.com); LIFFE, London International Financial Futures and Options
Exchange (www.liffe.com).
Source: © October/November 2000, Futures Industry. Adapted with permission.

TABLE 1.4 Top Ten International Futures Exchanges in Terms of Number of Contracts
Traded in 2000

Exchange 1999 2000

EUREX (Germany and Switzerland) 244,686,104 289,952,183
Chicago Mercantile Exchange (CME, U.S.) 168,013,354 195,106,383
Chicago Board of Trade (CBOT, U.S.) 195,147,279 189,662,407
London International Financial
Futures and Options Exchange (LIFFE, U.K.) 97,689,714 105,712,717
New York Mercantile Exchange (NYMEX, U.S.) 92,415,006 86,087,640
Bolsa de Mercadorias & Futuros (BM&F, Brazil) 52,797,466 80,073,865
Paris Bourse SA (France) 35,129,074 62,968,653
London Metal Exchange (LME, U.K.) 57,563,009 61,413,076
Tokyo Commodity Exchange (Japan) 48,442,161 50,851,882
Euronext Brussels Derivatives Market (Belgium) 5,711,482 30,299,351

Source: © February/March 2001, Futures Industry. Reprinted with permission.

A simple, plain vanilla, interest rate swap illustrates how a formula is applied to the notional
principal® amount to determine the cash flows that are paid by one party to the other. In this swap,
I agree to pay you 8% of $40 million each year for the next five years. You Gee to pay me what-
ever one-year LIBOR is (times $40 million) for each of the next five years. ” The net payments are
therefore:
if LIBOR>8%, you pay me (LIBOR-—8%) x $40 million
if LIBOR <8%, I pay you (8% —LIBOR) x $40 million
 1 AN OVERVIEW OF DERIVATIVE CONTRACTS

2nd forward—»>|— 3rd forward + Ath forward —>|

(a) |— Ist forward —>|—

1 2 3) -
0
Futures contract

(b) 4th forward >

| 3rd forward .

2nd forward

| lst forward 5

0 1 2) 3 4
Swap

Figure 1.3 (a) A futures contract is like a time series of one-day forward contracts. (b) A swap is like a
portfolio of forward contracts, all of which originate on the swap origination day (day 0), and all of which
have different delivery dates.

Equivalently, I am long forward rate agreements, with delivery dates at the end of each of the next
five years. As long as LIBOR is above 8%, I will profit.
The size of the swaps market has grown enormously since the first swap was transacted 1976.
Continental Illinois, Ltd. and Goldman, Sachs arranged that first swap, which was a currency
swap, between a Dutch company (Bos Kalis Westminster) and a British firm (ICI Finance). The
currencies swapped were Dutch florins and British pounds. The first interest rate swaps took place
in 1981.'°
The growth in the swaps market is illustrated in Table 1.5, which shows that in terms of
notional principal, interest rate swap trading activity expanded from $387.8 billion in 1987 to
$17.1 trillion in 1997. The notional principal of interest rate swaps outstanding has grown from
$682.8 billion at the end of 1987 to $48 trillion as of June 30, 2000. Trading activity of currency
swaps grew from $85.8 billion in 1987 to $1.1 trillion in 1997, while the notional principal out-
standing of currency swaps grew from $182.8 billion at the end of 1987 to $2.605 trillion in June
2000. The Bank for International Settlements (BIS) reported that outstanding OTC derivatives,
including swaps, forwards, and OTC options, had grown to $94 trillion in notional principal on
June 30, 2000 (see the press release at www.bis.org/publ/).
Table 1.5 also illustrates the expansion in the OTC interest rate options market. The amount
outstanding increased from $327.3 billion to almost $8 trillion between the end of 1988 and
the end of 1998. The BIS reports the size of the entire (foreign exchange, interest rates,
equity-linked, and commodity) OTC options market to be $13.2 trillion as of June 30, 2000
(www.bis.org).
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 1 AN OVERVIEW OF DERIVATIVE CONTRACTS

TABLE 1.6 The Global OTC Interest Rate Derivatives Market Amounts Outstanding
(billions of U.S. dollars)!
By Currency

December 31, 1998 December 31, 1999 June 30, 2000

U.S. dollar $13,763 $16,510 $17,606

Euro $16,461 $20,692 $22,948

Japanese yen $9,763 $12,391 $12,391

Pound sterling $3,911 $4,588 $4,741
Swiss franc $1,320 $1,414 $1,409
Canadian dollar $747 $825 $846
Swedish krona $939 $1,373 $1,255
Other $3,113 $2,298 $2,558
By Maturity”

Up to one year $18,185 $24,874 $25,809

Between one and five years $21,405 $23,179 $24,406
Over five years $10,420 $12,038 $13,910
Total contracts $50,015 $60,091 $64,125

"All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions
vis-a-vis other reporting dealers.
Residual maturity.
Source: Press release dated November 13, 2000 (www.bis.org). Reprinted with permission of the Bank for Interna-
tional Settlements.

A more detailed breakdown, by currency and maturity, of recent OTC derivatives activity is
provided in Tables 1.6 and 1.7. Table 1.6 presents the notional amount outstanding of interest rate
derivatives, most of which are interest rate swaps. Table 1.7 shows the same information for for-
eign exchange derivatives, most of which are currency swaps. The tables show that interest rate
derivatives involving the euro (i.e., the formulas were expressed in terms of euro-denominated
interest rates, and all cash flows were in euros) is the largest market, with U.S.$22.9 trillion
amount outstanding as of June 30, 2000. Another $17.6 trillion of OTC interest rate derivatives
involved the U.S. dollar. The third most popular currency for interest rate derivatives is the
Japanese yen. Foreign exchange derivatives involving the U.S. dollar (and some other currency)
comprise the largest market in terms of currencies. The size of the U.S. dollar foreign exchange
derivatives market, in terms of notional principal amount outstanding, was $14 trillion, which was
45.1% of the total market.
Other tables in the BIS report show that 40.2% of all interest rate derivatives had a maturity of
less than one year, and another 38.1% matured in one to five years. Eighty-five percent of all out-
standing currency swaps had a maturity of less than one year.
The BIS data indicated that the total notional principal of outstanding privately negotiated
(OTC) interest rate swaps and currency swaps as of June 30, 2000 stood at $50.6 trillion.
Swap dealers have regretted that they express the sizes of their markets in terms of notional
principal. The regret arises when government legislators and others voice alarm at the size of this
unregulated (by the U.S. government) market. Upon hearing the size of this market: $94 trillion (in
notional principal), a naive person would fret over what would happen to the world’s financial
system if trading abuses and/or massive defaults occurred. One party might not abide by the terms
 1.2 SWAPS

TABLE 1.7 The Global OTC Foreign Exchange Derivatives Market Amounts
Outstanding in Billions of U.S. dollars!”
ee
By Currency

December 31, 1998 December 31, 1999 June 30, 2000

U.S. dollar $15,810 $12,834 $13,178
Euro $7,758 $4,667 $5,863
Japanese yen $5,319 $4,236 $4,344
Pound sterling $2,612 $2,242 $2,479
Swiss franc $937 $880 $906
Canadian dollar $594 $647 $605
Swedish krona $419 $459 $451
Other $2,674 $2,723 $2,380
By Maturity?
Up to one year $15,791 $12,140 $13,178
Between one and five years $1,624 $1,539 $1,623
Over five years $592 $666 $693
Total contracts $18,011 $14,344 $15,494

"All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving
positions vis-a-vis other reporting dealers.
* Counting both currency sides of every foreign exchange transaction means that the currency breakdown sums
to 200% of the aggregate.
> Residual maturity.
Source: Press release dated November 13, 2000 (www.bis.org). Reprinted with permission of the Bank for
International Settlements.

of its contracts, and this in turn would cause a second party to default, and so on. Some fear that
such a domino effect would result in the collapse of our entire financial system and economy!
These fears are largely unfounded for several reasons.
1. Stating the market in terms of notional principal overstates the size of the market. The
Government Accounting Office (GAO) has estimated that the present value of expected payments
on existing swaps is only 1% of the notional principal amounts. The Bank for International Settle-
ments (BIS) estimates that the estimated gross market value of all global OTC interest rate deriva-
tives is only 2.2% of the reported notional amounts, and for OTC foreign exchange derivatives, its
only 4.6%. These figures exclude netting (see item 2) and other risk-reducing arrangements. It is
only this present value of expected swap cash flows that is at risk, since the notional principal is
never exchanged. To illustrate, contrast an ordinary bond issue in the amount of $40 million (a
fixed-income debt instrument) to a swap with a notional principal of $40 million. The principal
amount of a bond is initially exchanged from the lenders to the borrower. At this time, the amount
exposed to default risk is actually $40 million, which equals the present value of the remaining
cash flows that the borrower is contractually obliged to repay the investors. If interest rates remain
unchanged, and if no principal is ever retired, the amount exposed to default risk remains at $40
million. But now, consider the plain vanilla interest rate swap example we discussed just a bit ear-
lier, in which I agreed to pay you 8% of $40 million each year and you agreed to pay me one-year
LIBOR times $40 million. The $40 million notional principal is never exchanged. If LIBOR is
14 1 AN OVERVIEW OF DERIVATIVE CONTRACTS

expected to remain at 8% for the entire term of the swap, the present value of the expected swap
cash flows is zero! And if one of the parties defaulted at any time that LIBOR was expected to stay
at 8%, there would be virtually no economic impact caused by the default.
2. Only one party to a given swap has the incentive to default at any time. This party is the
one that expects to make most of the remaining swap payments. Thus, a party to a swap may
actually go bankrupt because of events external to the swap contract. But if this party expects its
swap cash flows to be positive, it will not default on its swap obligations. Furthermore, most, if not
all, swaps that originate now have bilateral netting agreements. This arrangement means that if a
party defaults on one swap, then all other swaps to which it is a party and which have a positive
value (the defaulting party expects to be receiving future cash flows) are also closed out. This
prevents a party from defaulting only on the swaps on which it is losing money.
3. Many swaps are marked to market daily, so that there is never a large buildup of unrealized
losses that would provide an incentive to default.
4. The less creditworthy parties to many swaps are required to post collateral.

1.3. OPTIONS
A call option is a contract that gives the owner the right, but not the obligation, to buy an
underlying asset, at a fixed price, on (or before) a specific day. The call seller (usually known as
the “writer’”) is obligated to deliver the underlying asset. Thus, options separate rights (option
owners have rights) from obligations (option writers have the obligation to respond if the owner
exercises his or her option).
The fixed price of an option is called the strike price, or the exercise price, and is symbolically
denoted with the letter K. When an option can be exercised only on a specific day, it is called a
European option. If it can be exercised at any time up to and including the expiration day, then the
option is American. Options have value for the owner. At worst, the owner of a worthless option
can throw it away, since he or she is not obligated to do anything with it.
A put option is a contract that gives the owner the right but not the obligation to se// the
underlying asset at the strike price. The put seller (writer) is obligated to purchase the underlying
asset, and pay the strike price for it. But the put seller will be forced to buy the underlying asset if
and only if the put owner exercises the option.
Whereas forwards, futures (which are just portfolios of forwards), and swaps (which are also
just portfolios of forwards) provide profit diagrams that are just 45° straight lines, option profit
diagrams consist of kinked, piecewise linear portions. If there are kinks, they will always exist at
the strike prices. Before we illustrate the profit diagrams for call options, let’s define a set of new
terms: in, out of, and at the money. If S denotes the price of the underlying asset, and K denotes the
strike price, then a call is:

In the money if S>K

Out of the money if S<K
At the money if S~ K (i.e., S is close to K)
Deep in (out of ) the money if S>>K (S<<K)
The payoff diagram of an option illustrates the cash flows that occur on the expiration day
of the option. Figure 1.4 is the payoff diagram for the owner of a call option. If the call finishes out
 15

of the money, then it has expired worthless, the call owner will not exercise her option, and there
is no expiration day cash flow. If, on the other hand, the option finishes in the money, the option
owner will exercise her option and buy the underlying asset for $K. The asset itself is worth $57.
So, the option owner is purchasing something for less than it is worth. Because the call is in the
money at expiration, S;>K, and the expiration day payoff to the owner of the call is S;—K.
To generate a profit diagram, we now only need to account for the initial requirement that the
owner pay for that option. Figure 1.5 shows that the payoff diagram is just uniformly lowered by
the amount the call buyer originally paid for the option. Denote this initial cost (it is frequently
called the option “premium’’) as Co.
Calls are one type of options. Puts are the other type.
Figure 1.6 is the payoff diagram for a long put position, and Figure 1.7 is the profit diagram
for the long put. A long position refers to the owner of the put.
You have used options many times and probably did not even realize it. If you own a
home, you have probably borrowed money, perhaps for 15 or 30 years, to make the purchase. You
also know that if you sell your house, or if interest rates drop sharply, you can pay your loan
off early. This is called a prepayment option. A floating-rate mortgage, which has limits on how
much the interest rate can rise or fall each year, is another example of an option; these limits
are caps and floors, which are interest rate options. You have entered into an option agreement if
you ever rented furniture or a car, with an option (a call) to buy. Perhaps you have purchased

Expiration day value

Figure 1.4 Payoff (at expiration) diagram for a long call.

Profit

Call premium

ST
Co

the
Figure 1.5 Profit diagram for a long call obtained by lowering the payoff diagram (Figure 1.4) by
call premium.
16 1 AN OVERVIEW OF DERIVATIVE CONTRACTS

Expiration day value

Figure 1.6 Payoff diagram for a long put.

Profit

Put premium

Figure 1.7 Profit diagram for a long put, obtained by lowering the payoff diagram (Figure 1.6) by the put
premium.

options to get preferred seating at concerts and/or shows. When you purchase goods covered by a
warranty, you have the option (a put) of returning the items within a specified period if you are
unsatisfied in any way.
Options are often called “contingent claims” because their payoffs are contingent on some event.
For example, option payoffs are contingent on whether they finish in the money or out of the money.
Options trading has a long history.'' The concept of an option existed in ancient Greece and
Rome. Options were used by speculators in the tulip craze of seventeenth-century Holland.'”
Unfortunately, there was no mechanism to guarantee the performance of the options’ terms, and
when the tulip craze collapsed in 1636, many speculators were wiped out. In particular, put writers
would not take delivery of the tulip bulbs and refused to pay the high prices they had originally
agreed to pay. Puts and calls, mostly on agricultural commodities, were traded in the nineteenth
century in England and in the United States. Options on shares of common stock were available in
the United States on the OTC market only until April 1973. The terms of these OTC options
were negotiated by the buyer and seller, with a member of the Put and Call Brokers and Dealers
Association serving as an intermediary or as one party to the contract. Thus an investor could buy
a call option on 250 shares of AAA Corp. at a specified price of $26.125 per share, with an expira-
tion date of the next April 30. Liquidity was lacking for these “custom-made” contracts, and each
party had reason to be concerned about the other’s ability to conform to the terms of the contract.
After five years of development that cost $2.5 million, the Chicago Board Options Exchange
(CBOE) opened on April 26, 1973, in an old lunchroom at the Chicago Board of Trade.
 1.4 WHY IS IT IMPORTANT TO LEARN ABOUT DERIVATIVES? 17

Initially, 16 standardized call option contracts on individual stocks were listed on the exchange,
and first-day volume totaled 911 contracts. Each founding member of the CBOE paid $10,000 for
a seat (in 2001, the price of a seat was around $370,000). Put options began trading on the CBOE
and four other options exchanges on June 3, 1977. On March 11, 1983, the first index option began
trading on the CBOE; it was originally called the CBOE 100 Index, and later renamed the
S&P 100 Index, or OEX (its ticker symbol). Options on futures contracts, which were temporarily
banned by Congress in 1978,'* were reintroduced to the marketplace on October 1, 1982. The
first contracts were options on Treasury bond futures contracts (4080 T-bond futures options traded
that day) on the CBOT, and sugar futures options on the New York Coffee, Sugar, and Cocoa
Exchange.
The Bank for International Settlements estimated that at the end of 2000, the notional princi-
pal of the assets underlying outstanding exchange-traded options was $5.9 trillion. Actual trading
activity of these options came to $66 trillion (notional principal) in 2000. Burghardt (2001) reports
that in 2000, 156.9 million option contracts traded in the United States, and another 421.2 million
contracts traded outside the country; these figures do not include options on individual stocks.
Another 970 million option contracts on individual equities traded globally in 2000. A total of 578
million option contracts actually traded in 2000. The market for options that are created by securi-
ties dealers in the OTC market is even larger: the BIS reported that the notional principal of the
OTC options market was $13.2 trillion at the end of June 2000.

1.4. Why Is It IMporTANT TO LEARN ABouT DERIVATIVES?

One obvious motivation (at least to the authors) for learning about derivatives is the sheer size of
the market. It is difficult to justify ignorance about a market that, as of the end of 1999, was esti-
mated to be $88 trillion.
Certainly, any student who hopes to work in the financial marketplace should have some
knowledge about derivatives and how she might be able to use these products in her job. These
contracts can be used to control risk exposures or to speculate on future price movements. Firms,
institutions, and governments can all use derivatives to manage risk and/or to increase profitability.
The prices of many commodities, interest rates, currencies, and equities have become increasingly
volatile at times in the recent past. Price volatility can result in financial hardship, even bank-
ruptcy, for some firms. Derivatives allow the user to transfer these risks to other parties who are
willing and able to accept them. Everyone who works in the world of finance must understand how
derivatives work.
Derivatives can have a tremendous impact on spot markets, and this is yet another reason for
reading this book. Hardly a week passes that financial commentators in the media do not attribute
the stock market’s price movements to program trading. A program trade is an order, usually
placed by a large institution, to buy or sell large amounts of stock of many different companies.
Put another way, it is the trade of a large portfolio of stocks as a group. Many program trades also
involve options and/or futures. Indeed, many program trades are performed to arbitrage small
price discrepancies that exist between the spot, options, and/or futures markets. The actions of
derivatives traders affects stock prices, interest rates and the prices of foreign currencies.
Options and futures trading has been blamed for almost every large stock market move since
1987, including the stock market crash of October 19, 1987, when the Dow Jones Industrial
Average fell an unprecedented 508 points, down 22.6% on one day. If derivatives trading exists for
18 1 AN OVERVIEW OF DERIVATIVE CONTRACTS

a given commodity, then at times, that trading will almost certainly affect the spot price of that
commodity. Thus options and futures trading has an impact on the lives of all consumers and
suppliers of products and services, and on the experiences of all investors.
Last, but hardly least, you should understand futures and options to be able to protect
yourself. Only if you understand derivatives can you decide intelligently whether you should ever
use them. You will also be better able to avoid being defrauded or cheated.
Many investors lost huge amounts of money in the stock market crash of October 1987
because they listened to stockbrokers who advised that a particular strategy—writing naked
puts—was a low risk route to profits. '4 Others have lost their life savings by speculating in futures,
after being fast-talked into futures trading by high-pressure brokers, or by doing business with
unscrupulous members of the futures industry. Individuals are not alone. Very large corporations
(e.g., Procter & Gamble), financial institutions (e.g., Barings), and governments (e.g., Orange
County, California) lost billions of dollars by using derivatives. By studying the material in
this book, you will be better educated about such risks. You will also be better able to gauge the
knowledge of any derivatives salespeople with whom you might do business.
Derivatives are not mere financial curiosities—the explosive growth in their number and
usage is a direct result of their value in managing risks and returns. Financial engineers use
derivative securities to manage risk and exploit opportunities to enhance returns. They create
derivatives of different types that possess payoff patterns that meet investment or risk management
needs, just as “typical” engineers create structures (manufacturing plants, bridges, roads, circuit
boards) that meet the needs of the user.
In recent years, managing traditional price risks has mushroomed into managing the total
risks of the firm. Financial engineers now have their own professional group, The International
Association of Financial Engineers (www.iafe.org/). Risk managers also have a professional
group, known as GARP, the Global Association of Risk Professionals (www.garp.com).

1.5 SUMMARY
In today’s increasingly complex world of finance, both investors and financial managers must be
aware of options and futures. They are important as speculative vehicles, and as risk management
tools. This book takes the view that it is important for users of options and futures to know the
principles of valuation and to learn how they can be used to manage price risk.
Speculators use derivatives (usually futures and options) to attempt to profit from expected
price changes. Because derivatives are usually highly levered assets, huge profits can be realized if
a speculator’s prediction of the direction and amount of price change is correct. Consistent with
the central concept that greater expected returns exist only where greater risks exist, it must be
noted that many speculators have lost huge sums of money by being wrong about future price
movements. Still, derivatives allow investors to establish, at low cost, return distributions that
match up with their levels of risk aversion.
Hedgers use these contracts to control the risks they face regarding price changes. Hedgers
include individuals, corporations, financial institutions, traders, and other entities facing the
possibility that a price change will reduce the value of their net worth. Under ideal conditions,
hedgers might be able to reduce the price risks they face to almost zero. Other hedgers might
prefer the purchase of insurance, using options, rather than shrinking the range of possible future
outcomes. Derivatives facilitate hedging and insuring. To successfully use these contracts, the
 NOTES

basics of valuation and the principles of how derivatives can be used to manage risk must both be
thoroughly understood, and this text attempts to promote such understanding.

References

Burghardt, Galen 2001. “Whassup?” Futures Industry, Vol. 11, No. 1, February/March, 2001, pp. 33-41.
Business Week. 1981. “An Explosion of Options and Futures,” Vol. 62, No. 9, March 23, pp. 88-90.
Chicago Board of Trade. 1985. Commodity Trading Manual, Chicago: CBOT.
Das, Satyajit. 1994. Swap and Derivative Financing, rev. ed. Burr Ridge, IL, Irwin Professional Publishing.
Garber, Peter M. 1989. “Tulipmania.” Journal of Political Economy, Vol. 97, No. 3, June, pp. 535-560.
Gastineau, Gary L. 1988. The Stock Options Manual, 3rd ed. New York: McGraw Hill.
Johnston, Elizabeth Tashjian, and John J. McConnell. 1989. “Requiem for a Market: An Analysis of the Rise
and Fall of a Financial Futures Contract.” Review of Financial Studies, Vol. 2, No. 1, pp. 1-23.
Miller, Merton H. 1986. “Financial Innovation: The Last Twenty Years and the Next.” Journal of Financial
and Quantitative Analysis, Vol. 21, No. 4, December, pp. 459-471.
Options Institute, ed. 1990. Options: Essential Concepts and Trading Strategies. Homewood, IL: Business
One, Irwin.
Rubinstein, Mark. 1976. “The Valuation of Uncertain Income Streams and the Pricing of Options.” Bell
Journal of Economics, Vol. 7, No. 2, Autumn, pp. 407-425.

Notes

'Futures Industry lists 58 futures and options exchanges in existence in 26 different countries in 2000
(Burghardt, 2001, pp. 40-41).
The notional principal is just the amount of money that is used to determine the cash flows of a swap. When
the principal amount is notional, it is not actually exchanged; it simply represents the amount to which a for-
mula is applied so that periodic cash flows can be computed.
3A standardized contract has terms that are identical to those of all other contracts. In other words, it
specifies an exact amount of a good, the quality of the good, where and when it is to be delivered, and so on.
All the contract’s terms are stated, except the price. Thus, every gold futures contract that calls for delivery in
a given month is identical to every other gold futures contract for that month. Standardization of futures
contracts contributes to their liquidity.
4Much of the following history of forward transacting and futures trading is drawn from the Chicago Board
of Trade’s Commodity Trading Manual, (1985).
5Actually, foreign exchange futures began trading on the International Commercial Exchange (ICE), which
was part of the New York Produce Exchange, in 1970. This venture failed after the IMM commenced opera-
tions, perhaps because of high initial margin requirements at the ICE, and perhaps because the ICE failed to
adequately promote and market itself.
64 GNMA certificate is a security that is backed by a pool of mortgages. Investors in GNMAs receive the inter-
est and principal that are paid by the homeowners, less some fees. The U.S. government guarantees these pay-
ments of interest and principal. The values of GNMAs rise as interest rates fall and decline as rates rise.
20 1 AN OVERVIEW OF DERIVATIVE CONTRACTS

Volume in GNMA futures rose sharply in the early years of trading, reaching more than 9000 contracts per day in
1980. However, the contract’s terms were complex, and other interest rate futures contracts became much more
popular. Trading volume shrunk and in January 1988, the GNMA futures contract (in its original form, at least)
ceased to exist. See Johnston and McConnell (1989) for an analysis on what contributed to the contract’s failure.
7By “cash-settled,” we mean that no delivery of the underlying good ever takes place. At delivery, all profits
and losses are received and paid in cash.
8See note 2 in this chapter.
9LIBOR is the acronym for the London interbank offer rate. U.S. dollar LIBOR is the rate at which major
London banks lend Eurodollar deposits. There is a LIBOR for each different maturity and for different
currencies. Thus, we can speak of 3-month U.S. dollar LIBOR, and 6-month Japanese yen (JPY) LIBOR.
“Burodollars” is the term used for dollars that are borrowed and lent outside of the United States. Any dollars
deposited in any bank located outside the United States (even if that bank is in Asia) are called Eurodollars.
A more general term is Eurocurrency, which refers to any currency that is deposited in a bank located
outside its country of origin (e.g., Euroyen are yen that are deposited in any bank outside of Japan).
!0Das (1994, Chap. 1) provides a history of the swap markets.
'ISee Chapter 3 of Gastineau (1988), and Chapter 1 in Options: Essential Concepts and Trading Strategies,
edited by the Options Institute (1990) for more details on the history of options.
!2See Garber (1989) for details on the tulip bulb speculative bubble.
'3In the 1970s, futures options were not traded on exchanges, but were instead often promoted by “boiler
room” sales people, who pressured naive investors into buying the contracts. Furthermore, there was
frequently no seller of the futures option, and by the time an investor tried to sell his option, the salesman
and his operation had disappeared. Later, having introduced a stringent set of regulations and disclosure
requirements, the Commodity Futures Trading Commission was able to persuade Congress to rescind the
ban. Option contracts had been temporarily banned in England for several periods, beginning in 1733, when
Bernard’s Act was passed, until the 1950s.
'44 front-page article in the December 2, 1987, issue of The Wall Street Journal recounts some of these
horror stories.

PROBLEMS
1.1 On July 10, party A buys a forward con- 1.4 If the price of the underlying asset rises,
tract from party B (B is the seller of the con- explain why being long a futures contract would
tract). The forward price is $38, and delivery is likely be preferred to having a long forward
on October 10. One month prior to delivery, position in that underlying asset, all else equal.
the forward price for new contracts that call for
the delivery of the underlying asset on October 1.5 Explain why notional principal overstates
10 is $35. Which party is more likely to default the size of the derivatives market.
on the contract on September 10? 1.6 An arbitrageur
1.2 Describe how OTC derivatives differ from a. tries to profit by trading mispriced assets
derivatives traded on public exchanges. b. tries to manage risk exposure via
1.3 “Both futures and swaps are equivalent to hedging
portfolios of forward contracts.” Explain this c. tries to manage risk exposure via
statement. insurance
 PROBLEMS 21

d. tries to profit by buying low today and c. Futures have more default risk than
selling high in the future forwards because forwards are custom-
e. has a view on where the market is head- made contracts.
ing and tries to profit on those beliefs d. Forwards have more default risk than
; : 5 futures because the clearinghouse will
1.7 Which of the following statements is true? protect traders of futures contracts.
a. Futures have more default risk than
e. Forwards have more default risk than
forwards because the clearinghouse
futures because futures are custom-
will protect traders of forward contracts.
; made contracts.
b. Futures have more default risk than
forwards because forward contracts are
settled daily (marked to market daily).