Charles Cao 1
Derivative Securities
Quanwei Cao
Department of Finance
Tsinghua University
2Charles Cao
1,Introduction
Summary
Introduction to Derivatives
Futures Contracts
Underlying Assets
Forward Contracts
Types of Traders
3Charles Cao
What is a Derivative?
Futures,options and swaps
A derivative is a financial contract which
has a value determined by the price of
something else
4Charles Cao
Example
Your family grows corn
Your friend’s family buys corn to mill
into cornmeal
A bushel of corn is not a derivative
It is a commodity
5Charles Cao
Example
You enter into an agreement with your
friend that says:
If the price of a bushel of corn in one year is
greater than $3,you will pay your friend $1
If the price of corn is less than $3,the
friend will pay you $1
This is a derivative
6Charles Cao
Example
Derivatives provide insurance
You earn $1 if your family’s corn sells
for a low price; this supplement your
income
Your friend earns $1 if the corn his
family bought is expensive; this offset
the high cost of corn
7Charles Cao
What is a Derivative?
Derivatives can be thought of as bets
But the bet hedges you both against
unfavorable outcomes
The contracts has reduced risk for both
of you
Investors can use derivatives to
speculate on the price of corn
Key point,how it is used
8Charles Cao
Use of Derivatives
Risk management
Derivatives can be used to reduce risks
Hedging
Insurance (auto insurance)
Speculation
Derivatives can serve as investment
vehicles
Making bets highly leveraged
9Charles Cao
Use of Derivatives
Reduced transaction costs
Low-cost way to effect a transaction
Mutual-fund mangers wish to sell stocks
and buy bonds
Paying fees and trading costs
Futures contracts have low costs
10Charles Cao
Futures Contracts
An agreement to buy or sell an asset at
a specified price at a certain time in the
future
Traded on exchanges,e.g.,
the Chicago Board of Trade (CBOT)
the Chicago Mercantile Exchange (CME)
11Charles Cao
Futures Contracts
Long futures position
Short futures position
The contracts between two parties will
be honored by the exchange
12Charles Cao
Underlying Assets
CBOT
Corn,oats,soybeans,wheat,Treasury bonds,
S&P500 Index,Nasdaq100 Index
CME
Commodities (pork bellies,live cattle,live hogs,
feeder cattle)
Foreign currencies (Euro,BP,JY,SF)
NYM
Crude oil,heating oil,natural gas
Actively Traded U.S,
Futures Contracts
Rank Contract Exchange
Estimated
Volume
Open interest
Nov,25,2003
1 Eurodollar CME 146,241,144 4,984,715
2 S&P 500 CME 134,618,400 460,200
3 T-bond CBOT 74,744,208 508,648
4 Crude Oil NYMEX 47,459,412 579,474
5 Gold COMEX 27,720,000 273,852
6 Soybeans CBOT 10,657,080 240,532
13Charles Cao
Actively Traded U.S,Options
on Futures Contracts
Rank Contract Exchange Volume
Open interest
Nov,18,2003
1 T-notes CBOT 57,458,016 1,021,600
2 Eurodollar CME 39,403,728 4,982,122
3 T-bonds CBOT 25,414,704 582,629
4 Crude Oil NYMEX 10,144,764 386,848
5 Gold COMEX 9,028,152 487,585
6 S&P500 CME 5,082,588 105,868
14Charles Cao
15Charles Cao
V o l u m e o f Fu t u r e s Tr a d i n g i n U n i t e d S t a t e s,
1 9 7 0 - 2 0 0 0
0
100
200
300
400
500
600
700
1970 1975 1980 1985 1990 1995 2000
Y e a r
M i l l i o n s o f
C o n t ra c t s T ra d e d
V o l u me o n U,S,F u t u re s Ex ch a n g e s
0
100
200
300
400
500
600
700
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
M i l l i o n s o f
C o n t r a ct s T r a d e d
A g r i cu l t u r a l E n e r g y F i n a n ci a l s C u r r e n ci e s
Charles Cao 16
Source,CFTC Annual Report
Charles Cao 17
C h i ca g o B o a r d O p t i o n E x ch a n g e
O p t i o n V o l u m e
0
50
100
150
200
250
1
9
7
3
1
9
7
5
1
9
7
7
1
9
7
9
1
9
8
1
1
9
8
3
1
9
8
5
1
9
8
7
1
9
8
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
Y e a r
M illio n s o f
C o n t r a c t s
T r a d e d
Source,CBOE,Market Statistics
Sh a re s o f F u t u re s T ra d i n g
By C o n t ra ct T yp e,1 9 8 3 a n d 1 9 9 9
0
5
10
15
20
25
30
35
40
45
50
I
n
t
e
r
e
st
R
a
t
e
s
E
q
u
i
t
y
I
n
d
e
ce
s
FX
A
g
r
icu
l
t
u
r
a
l
s
M
e
t
a
ls
E
n
e
r
g
y
C o n t r a c t T y p e
Pe rc e n t o f
T o t a l V o l u m e
1983 1999
18Charles Cao
Exchange Number of Contracts Traded (in millions)
EUREX (Germany-Switzerland) 245
Chicago Board of Trade 195
Chicago Mercantile Exchange 168
London Intl,Financial Futures Exchange 98
New York Mercantile Exchange 92
London Metal Exchange 58
Bolsa de Mercadorias & Futoros (Brazil) 53
Tokyo Commodity Exchange 48
Sydney Futures Exchange
Singapore Intl,Monetary Exchange
27
24
Trading Volume on Top Ten
Global Futures Exchanges
19Charles Cao
Chicago Board of Trade $422,000
Chicago Board Options Exchange $400,000
Chicago Mercantile Exchange 237,000
Coffee Sugar & Cocoa Exchange 44,000
Commodity Exchange 115,000
Minneapolis Grain Exchange 7,600
New York Cotton Exchange 40,000
New York Futures Exchange 4,250
New York Mercantile Exchange 142,000
Seat Price on U.S,Exchanges
20Charles Cao
(Source,Futures Industry,Feb,2000)
Charles Cao 21
C h i ca g o Bo a rd O p t i o n s Ex ch a n g e
Se a t Pri ce
0
100
200
300
400
500
600
700
800
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Y e a r
P
r
i
ce
o
f
L
a
st
S
a
l
e
(
i
n
t
h
o
u
sa
n
d
s)
(Source,Chicago Board Options Exchange)
22Charles Cao
Forward Contracts
An agreement to buy or sell an asset at a
specified price at a certain time in the
future
The contract is between two financial
institutions or between a financial
institution and one of its clients
The specified price is the delivery price
Contract is settled at maturity
23Charles Cao
Types of Traders
Hedgers:
Reduce a risk they face
Make the outcome more certain
It does not necessarily improve the
outcome
24Charles Cao
Types of Traders
Speculators:
Take a position in the market
Bet that the price will go up or go down
Speculator using futures contracts,require
no initial cash payment (leverage)
Speculator using underlying asset,require
initial cash payment
25Charles Cao
Types of Traders
Arbitrageurs:
Arbitrage is possible when the futures price
of an asset gets out line with its cash price
Cross-contract arbitrage
Cross-market arbitrage
Derivative Securities
Quanwei Cao
Department of Finance
Tsinghua University
2Charles Cao
1,Introduction
Summary
Introduction to Derivatives
Futures Contracts
Underlying Assets
Forward Contracts
Types of Traders
3Charles Cao
What is a Derivative?
Futures,options and swaps
A derivative is a financial contract which
has a value determined by the price of
something else
4Charles Cao
Example
Your family grows corn
Your friend’s family buys corn to mill
into cornmeal
A bushel of corn is not a derivative
It is a commodity
5Charles Cao
Example
You enter into an agreement with your
friend that says:
If the price of a bushel of corn in one year is
greater than $3,you will pay your friend $1
If the price of corn is less than $3,the
friend will pay you $1
This is a derivative
6Charles Cao
Example
Derivatives provide insurance
You earn $1 if your family’s corn sells
for a low price; this supplement your
income
Your friend earns $1 if the corn his
family bought is expensive; this offset
the high cost of corn
7Charles Cao
What is a Derivative?
Derivatives can be thought of as bets
But the bet hedges you both against
unfavorable outcomes
The contracts has reduced risk for both
of you
Investors can use derivatives to
speculate on the price of corn
Key point,how it is used
8Charles Cao
Use of Derivatives
Risk management
Derivatives can be used to reduce risks
Hedging
Insurance (auto insurance)
Speculation
Derivatives can serve as investment
vehicles
Making bets highly leveraged
9Charles Cao
Use of Derivatives
Reduced transaction costs
Low-cost way to effect a transaction
Mutual-fund mangers wish to sell stocks
and buy bonds
Paying fees and trading costs
Futures contracts have low costs
10Charles Cao
Futures Contracts
An agreement to buy or sell an asset at
a specified price at a certain time in the
future
Traded on exchanges,e.g.,
the Chicago Board of Trade (CBOT)
the Chicago Mercantile Exchange (CME)
11Charles Cao
Futures Contracts
Long futures position
Short futures position
The contracts between two parties will
be honored by the exchange
12Charles Cao
Underlying Assets
CBOT
Corn,oats,soybeans,wheat,Treasury bonds,
S&P500 Index,Nasdaq100 Index
CME
Commodities (pork bellies,live cattle,live hogs,
feeder cattle)
Foreign currencies (Euro,BP,JY,SF)
NYM
Crude oil,heating oil,natural gas
Actively Traded U.S,
Futures Contracts
Rank Contract Exchange
Estimated
Volume
Open interest
Nov,25,2003
1 Eurodollar CME 146,241,144 4,984,715
2 S&P 500 CME 134,618,400 460,200
3 T-bond CBOT 74,744,208 508,648
4 Crude Oil NYMEX 47,459,412 579,474
5 Gold COMEX 27,720,000 273,852
6 Soybeans CBOT 10,657,080 240,532
13Charles Cao
Actively Traded U.S,Options
on Futures Contracts
Rank Contract Exchange Volume
Open interest
Nov,18,2003
1 T-notes CBOT 57,458,016 1,021,600
2 Eurodollar CME 39,403,728 4,982,122
3 T-bonds CBOT 25,414,704 582,629
4 Crude Oil NYMEX 10,144,764 386,848
5 Gold COMEX 9,028,152 487,585
6 S&P500 CME 5,082,588 105,868
14Charles Cao
15Charles Cao
V o l u m e o f Fu t u r e s Tr a d i n g i n U n i t e d S t a t e s,
1 9 7 0 - 2 0 0 0
0
100
200
300
400
500
600
700
1970 1975 1980 1985 1990 1995 2000
Y e a r
M i l l i o n s o f
C o n t ra c t s T ra d e d
V o l u me o n U,S,F u t u re s Ex ch a n g e s
0
100
200
300
400
500
600
700
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
M i l l i o n s o f
C o n t r a ct s T r a d e d
A g r i cu l t u r a l E n e r g y F i n a n ci a l s C u r r e n ci e s
Charles Cao 16
Source,CFTC Annual Report
Charles Cao 17
C h i ca g o B o a r d O p t i o n E x ch a n g e
O p t i o n V o l u m e
0
50
100
150
200
250
1
9
7
3
1
9
7
5
1
9
7
7
1
9
7
9
1
9
8
1
1
9
8
3
1
9
8
5
1
9
8
7
1
9
8
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
Y e a r
M illio n s o f
C o n t r a c t s
T r a d e d
Source,CBOE,Market Statistics
Sh a re s o f F u t u re s T ra d i n g
By C o n t ra ct T yp e,1 9 8 3 a n d 1 9 9 9
0
5
10
15
20
25
30
35
40
45
50
I
n
t
e
r
e
st
R
a
t
e
s
E
q
u
i
t
y
I
n
d
e
ce
s
FX
A
g
r
icu
l
t
u
r
a
l
s
M
e
t
a
ls
E
n
e
r
g
y
C o n t r a c t T y p e
Pe rc e n t o f
T o t a l V o l u m e
1983 1999
18Charles Cao
Exchange Number of Contracts Traded (in millions)
EUREX (Germany-Switzerland) 245
Chicago Board of Trade 195
Chicago Mercantile Exchange 168
London Intl,Financial Futures Exchange 98
New York Mercantile Exchange 92
London Metal Exchange 58
Bolsa de Mercadorias & Futoros (Brazil) 53
Tokyo Commodity Exchange 48
Sydney Futures Exchange
Singapore Intl,Monetary Exchange
27
24
Trading Volume on Top Ten
Global Futures Exchanges
19Charles Cao
Chicago Board of Trade $422,000
Chicago Board Options Exchange $400,000
Chicago Mercantile Exchange 237,000
Coffee Sugar & Cocoa Exchange 44,000
Commodity Exchange 115,000
Minneapolis Grain Exchange 7,600
New York Cotton Exchange 40,000
New York Futures Exchange 4,250
New York Mercantile Exchange 142,000
Seat Price on U.S,Exchanges
20Charles Cao
(Source,Futures Industry,Feb,2000)
Charles Cao 21
C h i ca g o Bo a rd O p t i o n s Ex ch a n g e
Se a t Pri ce
0
100
200
300
400
500
600
700
800
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Y e a r
P
r
i
ce
o
f
L
a
st
S
a
l
e
(
i
n
t
h
o
u
sa
n
d
s)
(Source,Chicago Board Options Exchange)
22Charles Cao
Forward Contracts
An agreement to buy or sell an asset at a
specified price at a certain time in the
future
The contract is between two financial
institutions or between a financial
institution and one of its clients
The specified price is the delivery price
Contract is settled at maturity
23Charles Cao
Types of Traders
Hedgers:
Reduce a risk they face
Make the outcome more certain
It does not necessarily improve the
outcome
24Charles Cao
Types of Traders
Speculators:
Take a position in the market
Bet that the price will go up or go down
Speculator using futures contracts,require
no initial cash payment (leverage)
Speculator using underlying asset,require
initial cash payment
25Charles Cao
Types of Traders
Arbitrageurs:
Arbitrage is possible when the futures price
of an asset gets out line with its cash price
Cross-contract arbitrage
Cross-market arbitrage
