Even if a student finds the answer on the web, s he still has to work out where it comes from. CHAPTER 1 Introduction This chapter introduces the markets for futures, forward, and option contracts and explains the activities of hedgers, speculators, and arbitrageurs.
Issues concerning futures contracts such as margin requirements, settlement procedures, the role of the clearinghouse, etc are covered in Chapter 2. Some instructors prefer to avoid any mention of options until the material on linear products in Chapters 1 to 7 has been covered. I like to introduce students to options in the first class, even though they are not mentioned again for several classes. This is because most students find options to be the most interesting of the derivatives covered and I like students to be enthusiastic about the course early on.
The way in which the material in Chapter 1 is covered is likely to depend on the backgrounds of the students. If a course in investments is a prerequisite, Chapter 1 can be regarded as a review of material already familiar to the students and can be covered fairly quickly. If an investments course is not a prerequisite, more time may be required.
Increasingly, some aspects of derivatives markets are being covered in introductory corporate finance courses, accounting courses, strategy courses, etc. In many instances students are, therefore, likely to have had some exposure to the material in Chapter 1.
I do not require an investments elective as a prerequisite for my elective on futures and options markets and find that 1 12 to 2 hours is necessary for me to introduce the course and cover the material in Chapter 1. To motivate students at the outset of the course, I discuss the growing importance of derivatives, how much experts in the field are paid, etc.
It is not uncommon for students. I defer a discussion of the crisis until the Chapter 8 material is covered. Towards the end of the first class I usually produce a current newspaper and describe several traded futures and options.
I then ask students to guess the quoted price. Sometimes votes are taken. This is an enjoyable exercise and forces students to think actively about the nature of the contracts and the determinants of price.
It usually leads to a preliminary discussion of such issues as the relationship between a futures price and the corresponding spot price, the desirability of options being exercised early, why most options sell for more than their intrinsic value, etc.
While covering the Chapter 1 material, I treat futures as the same as forwards for the purposes of discussion. I try to avoid being drawn into a discussion of such issues as the mechanics of futures, margin requirements, daily settlement procedures, and so on until I am ready.
These topics are covered in Chapter 2. As will be evident from the slides that go with this chapter, I usually introduce students to a little of the Chapter 5 material during the first class. I discuss how arbitrage arguments tie the futures price of gold to its spot price and why the futures price of a consumption commodity such as oil is not tied to its spot price in the same way.
Problem 1. I find that Problems 1. I sometimes ask students to consider it between the first and second class. We then discuss it at the beginning of the second class. The other further questions can be used either as assignment questions or for class discussion. I do not spend a great deal of time in class going over most of the details of how futures markets work.
I let students read these for themselves. But I do find it worth spending some time going through Table 2. After the essentials of the operations of futures markets have been explained, I ask students to consider Problem 2. I usually use about 1 12 hours to cover the material in the chapter.
In many ways, OTC markets are becoming more like exchange-traded markets as a result of post-crisis regulation. Once the way margin accounts are used for futures has been explained it is natural to talk about how collateralization works in the OTC market see Section 2. The new title to this chapter reflects the fact that CCPs are very like futures clearing houses.
There are many ways of making a discussion of futures markets fun. An easy-toorganize trading game that was explained to me by a Wall Street training manager works. The instructor chooses two students to keep trading records on the front board and divides the rest of the students into about ten groups.
Each group is given an identifier. They display the card when they want to make trades. The instructor chooses a seven-digit telephone number, but does not reveal this to students. The groups trade the sum of digits of the telephone number by entering long or short positions. For example, group B might bid i. If this is accepted by another group say group D , the record keepers show that B is long one contract at 35 and D is short one contract at The instructor controls the trading, asks for bids or offers as appropriate, and shouts trades to the record keepers.
Every two minutes the instructor reveals one of the digits of the number. This game nearly always works very well for me. Trading typically starts slowly and then becomes very intense. The game gives students a sense of what futures trading is like. I insist that they use the words bid and offer rather than buy and sell. It shows how prices are formed in markets. After the game is over we discuss how the market price moved during the game.
The records also usually show different trading strategies. Some groups are usually speculators all trades are long or all are short and others are like day traders e. I point out to students that we need both types of traders to make the market work.
There are many stories that can be told about futures markets. Students are often interested in attempts to corner markets. The brothers tried unsuccessfully to sue the exchange. Business Snapshot 2. Problems 2. It covers basis risk, hedge ratios, the use of stock index futures, and stack and roll strategies. The discussion of tailing the hedge has been improved for this edition. As will be evident from the slides, I cover the material in the chapter in the order in which it is presented.
The section on arguments for and against hedging often generates a lively discussion. It is important to emphasize that the purpose of hedging is to reduce the standard deviation of the outcome, not to increase its expected value. I usually discuss Problem 3. Business Snapshot 3. I use this to emphasize the importance of communicating with shareholders.
I also like to discuss. This is the second part of Business Snapshot 3. I also like to ask students. If more gold producers choose to hedge, does the gold lease rate go up or down?
The answer is that it goes up because there is a greater demand on the part of investment banks for gold borrowing. Any of the Problems 3. My favorite is Problem 3. It covers the OIS rate and explains that OIS rates are used as proxies for risk-free rates when derivatives are valued. In the 9th edition this material was in Chapter 9. The example for determining Treasury zero rates has been changed and an example showing how OIS zero rates can be determined has been included.
I like to spend a some time explaining compounding frequency issues. I make it clear to students that we are talking about nothing more than a unit of measurement for interest rates.
Moving from quarterly compounding to continuous compounding is like changing the unit of measurement of distance from miles to kilometers. When students are introduced to continuous compounding early in a course, I find they have very little difficulty with it. The first part of the chapter discusses zero rates, bond valuation, bond yields, par yields, and the calculation of Treasury and OIS zero curves. The slides mirror the examples in the text. When covering the bootstrap method to calculate zero curves, I point out that the bootstrap method is a very popular approach, but it is not the only one that is used in practice.
For example, some analysts use cubic or exponential splines. I spend some time on the relationship between spot and forward interest rates and combine this with a discussion of FRAs and theories of the term structure. I explain that it is possible to enter into transactions that lock in the forward rate for a future time period and then discuss the Orange County story Business Snapshot 4.
Orange County entered into contracts often highly levered that paid off if the forward rate was higher than the realized future spot rate An example of such a contract is an FRA where fixed is received and floating is paid. This worked well in and , but led to a huge loss in Sections 4. Duration is a widely used concept in derivatives markets. When some other compounding frequency is used the same relationship is true provided D is defined as the modified duration.
I like to illustrate the truth of the duration relationship with numerical example similar to those in the text. Problems 4. My favorites are 4. The approach used in the chapter is to produce results for forward prices first and then argue that futures prices are very close to forward prices.
The early part of the chapter explains short selling and the difference between investment and consumption assets. I usually go through the material in Section 5. Business Snapshot 5. I then go through Sections 5. However, it is necessary to explain carefully the difference between a known cash income and a known yield.
When covering Section 5. This often causes confusion. I like to go through Business Snapshot 5. The material in Sections 5. I try to illustrate all of the formulas with numerical examples taken from current market quotes. The interpretation of a foreign currency as an investment providing a yield equal to the foreign risk-free rate needs to be explained carefully.
I also like to spend some time discussing the fact that the variable underlying the CME Nikkei futures contract is not something that can be traded see Business Snapshot 5. It is important that students understand the distinction between assets that are held solely for investment by a significant number of investors and those that are not.
This distinction is made right at the beginning of the chapter. Section 5. Problems 5. My favorite assignment questions are 5. I start by discussing the material in Sections 6. It is fun to talk about Business Snapshot 6. I like to spend some time making sure students are comfortable with the Treasury bond futures contracts and the Eurodollar futures contract.
In the case of the Treasury bond futures contract they should understand where conversion factors come from, the cheapest-to-deliver bond calculations, and the wild card play see Business Snapshot 6.
Students should also appreciate that a convexity adjustment is necessary to calculate a forward rate from a Eurodollar futures quote. They will not at least at this stage understand where equation 6.
The first is that futures are settled daily; forwards are not. The second is that futures if not daily settled would provide a payoff at the beginning of the period covered by the rate; forwards provide a payoff at the end of the period covered by the rate. The payoff from a forward contract can be at the beginning of the period, but it is the present value of the payoff that would normally happen at the end of the period.
The final part of the chapter covers the use of interest rate futures for duration-based hedging. I usually illustrate this material with a numerical example. Problems 6. My favorites are 6. It has been rewritten for the 10th edition. OIS discounting has now become the standard approach to valuing derivatives. I explain this by saying that OIS is a better proxy for the risk-free rate than LIBOR, but many practitioners would argue that OIS discounting is simply a reflection of the interest paid on cash collateral.
As a result, the valuation material in this chapter is simpler. The examples in the chapter have been changed to emphasize the role of banks and other financial intermediaries I believe that it makes sense to teach swaps soon after forward contracts are covered because a swap is nothing more than a convenient way of bundling forward contracts.
However, other instructors may have other preferences as far as this is concerned and the Chapter 7 material can be taught later in a course if desired. The growth of the swaps since the early s makes them one of the most important derivative instruments. This chapter covers interest rate and currency swaps. Credit default swaps and nonstandard swaps are briefly covered at the end of this chapter and in more detail in Chapters 25 and After explaining how swaps work and the way they can be used to transform assets and liabilities, I present the traditional comparative advantage argument for plain vanilla interest rate swaps and then proceed to explain why it is flawed.
This usually generates a lively discussion. The key point is that the comparative advantage argument compares apples with oranges. Borrowing floating and swapping to fixed appears attractive. But this ignores a key point. A fixed-rate loan will lead to exactly the same rate of interest applying each year for five years. By contrast, the spread over LIBOR on the floating-rate loan usually applies for the first accrual period.
If the creditworthiness of the company declines, the rate is liable. For us to be comparing apples to apples. Instruments known as note issuance facilities do this and when they are used the comparative advantage disappears. A possible exercise is to take a situation such as that shown in Figure 7. Some of the material previously in this chapter on the nature of swap rates has been moved to Chapter 4 in the 10th edition. In the case of currency swaps the exchange of principal needs to be explained.
All the further questions can be used as assignment questions. I usually require students to hand in two of them. Which of the following is not true circle one a. An American option can be exercised at any time during its life c.
An call option will always be exercised at maturity if the underlying asset price is greater than the strike price d. A put option will always be exercised at maturity if the strike price is greater than the underlying asset price. Show a dollar amount and indicate whether it is a gain or a loss. A trader buys European call options i. A trader sells European put options i. How high does the stock price have to rise for an investment in options to lead to the same profit as an investment in the stock?
Suppose that a trader buys two call options and one put option. Which of the following is true circle one a Both forward and futures contracts are traded on exchanges. I am delighted that half the purchasers of the book are analysts, traders, and other professionals who work in derivatives and risk management. One of the key decisions that must be made by an author who is writing in the area of derivatives concerns the use of mathematics.
If the level of mathematical sophistication is too high, the material is likely to be inaccessible to many students and practitioners. If it is too low, some important issues will inevitably be treated in a rather superficial way. I have tried to be particularly careful about the way I use both mathematics and notation in the book. Nonessential mathematical material has been either eliminated or included in end-of-chapter appendices and the technical notes on my website.
Concepts that are likely to be new to many readers have been explained carefully and many numerical examples have been included. Options, Futures, and Other Derivatives can be used for a first course in derivatives or for a more advanced course. There are many different ways it can be used in the classroom. Instructors teaching a first course in derivatives are likely to want to spend most classroom time on the first half of the book. Instructors teaching a more advanced course will find that many different combinations of chapters in the second half of the book can be used.
I find that the material in Chapter 36 works well at the end of either an introductory or an advanced course. DerivaGem Software DerivaGem 3. The Options Calculator consists of easy-to-use software for valuing a wide range of options. The Applications Builder consists of a number of Excel functions from which users can build their own applica- tions.
A number of sample applications enabling students to explore the properties of options and use different numerical procedures are included.
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