LG 10-1. Distinguish between forwards and futures contracts
LG 10-2. Understand how a futures transaction is conducted
LG 10-3. Identify information that can be found in a futures quote LG 10-4. Recognize what option contracts are.
LG 10-5. Examine information found in an option quote.
LG 10-6. Know the main regulators of futures and option markets LG 10-7. Describe an interest rate swap
LG 10-8. Understand caps, floors, and collars
LG 10-9. Identify the biggest derivative securities markets globally
Derivative securities: Chapter overview
* Derivative security: a financial security whose payoff is linked to another, previously issued security. * Generally involves an agreement between two parties to exchange a standard quantity of an asset of cash flow at a predetermined price and at a specific date in the future. * Value of underlying security changes, value of the derivative changes too. * Derivatives = buying and selling, or transference of risk. * Allows individuals who want to bear risk to take risk and people who want to avoid it to transfer if elsewhere. * Failure of derivatives = failure of Lehman Brothers, Bear Sterns, Merrill Lynch, AIG, Citigroup, Countrywide Financial, and the government Fannie Mae and Freddie Mac. * Losses by the mortgage back securities reached over $1 trillion worldwide through 2009. * Option contracts = derivatives because value depends on some underlying asset * Growth of derivative markets mainly started in 1970s
* First Wave = Foreign currency futures (from intro of floating exchange rates) * Second Wave = Interest rate derivative securities (from increased volatility of interest rates in late 1970s. * As Interest Rate volatility increased, sensitivity of net worth increased as well. * Third Wave = Credit Derivatives (credit forwards, credit risk options, and credit swaps) – 1990s * Credit forward: a forward agreement hat hedges against an increase in default risk on a loan. * Financial institutions are the major participants in the derivatives securities market. * 1050 US banks use derivatives but 95% of the derivative users are from JP Morgan, BOA, Citi, and Goldman Sachs * March 2010, Notional value of credit derivatives held by US banks = $14.36 trillion * 2000s, derivatives trading on electronic exchanges and by 2010, trading of derivatives online = 80%. * Critics charged that derivatives contracts contain potential losses that can materialize. * It can either reduce FI’s risk or increase insolvency risk. * Financial Accounting Standards Board (FASB) – require all derivatives be marked to market and mandated that losses and gains be immediately transparent on FIs Financial statements
Forwards and Futures. LG 10-1.
* Spot Contract: agreement made between a buyer and seller at time 0 for the seller to deliver the asset immediately and the buyer to pay for the asset immediately * Forward Contract: agreement between a buyer and a seller at time 0 to exchange a nonstandardized asset for cash at some future date. The details of the asset and price to be paid at the forward contract expiration date are set at time 0. Price is fixed over the life of the contract. * Futures Contract: agreement between a buyer and a seller at time 0 to exchange a standardized asset for cash at some future date. Each contract has a standardized expiration and transactions occur in a centralized market. The price of the futures contract changes daily as the market value of the asset underlying the futures fluctuates. * Futures contract are mark to market everyday.
* Delivery vs. payment immediate of simultaneous exchange of cash for securities. * Spot transactions are made when the buyer thinks that the price will go up in the immediate future. Forward Markets
* Forward contract is bought when the future (spot) price or interest rate is uncertain. This is...