Derivatives. Pirie Wendy L.

liquidity, loosely defined, but the cost of liquidity can be quite high. The factors that can lead to low liquidity for derivatives are similar to those for securities: little trading interest and a high level of uncertainty.

4

Exchanges are owned by their members, whose memberships convey the right to trade. In addition, some exchanges are themselves publicly traded corporations whose members are shareholders, and there are also non-member shareholders.

5

Such notations as t = 0 and t = T are commonly used in explaining derivatives. To indicate that t = 0 simply means that we initiate a contract at an imaginary time designated like a counter starting at zero. To indicate that the contract expires at t = T simply means that at some future time, designated as T, the contract expires. Time T could be a certain number of days from now or a fraction of a year later or T years later. We will be more specific in later readings that involve calculations. For now, just assume that t = 0 and t = T are two dates – the initiation and the expiration – of the contract.

6

This point is covered more fully elsewhere in the readings on derivatives, but we will see it briefly later in this reading.

7

The actual amount of money charged and credited depends on the contract size and the number of contracts. A price of £120 might actually refer to a contract that has a standard size of £100,000. Thus, £120 might actually mean 120 % of the standard size, or £120,000. In addition, the parties are likely to hold more than one contract. Hence, the gain of £2 referred to in the text might really mean £2,000 (122 % minus 120 % times the £100,000 standard size) times the number of contracts held by the party.

8

For example, let us go back to when the short had a balance of £4, which is £2 below the maintenance margin and £6 below the initial margin. The short will get a margin call, but suppose he elects not to deposit additional funds and requests that his position be terminated. In a fast-moving market, the price might increase more than £4 before his broker can close his position. The remaining balance of £4 would then be depleted, and the short would be responsible for any additional losses.

9

Because of this equivalence, we will not specifically illustrate the profit graphs of futures contracts. You can generally treat them the same as those of forwards, which were shown in Exhibit 1.

10

Banks prefer to make floating-rate loans because their own funding is typically short term and at floating rates. Thus, their borrowing rates reset frequently, giving them a strong incentive to pass that risk on to their customers through floating-rate loans.

11

Recall that US dollar Libor (London Interbank Offered Rate) is the estimated rate on a dollar-based loan made by one London bank to another. Such a loan takes the form of a time deposit known as a Eurodollar because it represents a dollar deposited in a European bank account. In fact, Libor is the same as the so-called Eurodollar rate. The banks involved can be British banks or British branches of non-British banks. The banks estimate their borrowing rates, and a single average rate is assembled and reported each day. That rate is then commonly used to set the rate on many derivative contracts.

12

It is possible that the notional principal will be exchanged in a currency swap, whereby each party makes a series of payments to the other in different currencies. Whether the notional principal is exchanged depends on the purpose of the swap. This point will be covered later in the curriculum. At this time, you should see that it would be fruitless to exchange notional principals in an interest rate swap because that would mean each party would give the other the same amount of money when the transaction is initiated and re-exchange the same amount of money when the contract terminates.

13

For example, you do not associate French dressing with France. It is widely available and enjoyed worldwide. If you dig deeper into the world of options, you will find Asian options and Bermuda options. Geography is a common source of names for options as well as foods and in no way implies that the option or the food is available only in that geographical location.

14

The reference to only three tranches is just a general statement. There are many more types of tranches. Our discussion of the three classes is for illustrative purposes only and serves to emphasize that there are high-priority claims, low-priority claims, and other claims somewhere in the middle.

15

Unfortunately, the industry has created some confusion with the terminology of these instruments. They are often referred to as stock options, and yet ordinary publicly traded options not granted to employees are sometimes referred to as stock options. The latter are also sometimes called equity options, whereas employee-granted options are almost never referred to as equity options. If the terms executive stock options and employee stock options were always used, there would be no problem. You should be aware of and careful about this confusion.

16

A warrant is a type of option, similar to the employee stock option, written by the company on its own stock, in contrast to exchange-traded and OTC options, in which the company is not a party to the option contract. Also note that, unfortunately, the financial world uses the term warrant to refer to a number of other option-like instruments. Like a lot of words that have multiple meanings, one must understand the context to avoid confusion.

17

As you will see later, there are also futures in which the underlying is an interest rate (Eurodollar futures) and forwards in which the underlying is an interest rate (forward rate agreements, or FRAs).

18

To put it in perspective, it would take 19 million years for a clock to tick off 600 trillion seconds!

19

The Chicago Board Options Exchange publishes a measure of the implied volatility of the S&P 500 Index option, which is called the VIX (volatility index). The VIX is widely followed and is cited as a measure of investor uncertainty and sometimes fear.

20

Politicians and regulators have been especially critical of energy market speculators. Politicians, in particular, almost always blame rising oil prices on speculators, although credit is conspicuously absent for falling oil prices.