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Unformatted text preview: Chapter 10 - DERIVATIVE SECURITIES MARKETS Derivative Security is an exchange-traded financial security whose payoff is tied to an underlying asset, or previously issued security. The derivative "derives" its value from the value of some underlying asset or security. Example: Futures contract for Yen, gold, oil, corn, T-bonds, sugar, S&P 500 Index, temperature, etc. Option contract for GM, Microsoft, British pound, oil futures contract, etc. A MBS is a form of derivative assets, as is a mutual fund, or an ADR. Derivative securities markets are the markets where derivatives trade, e.g., CBOT, CME, NYME, etc. Futures trading started in 1840s at CBOT, but derivative markets really took off in the 1970s, 1980s and 1990s. Currency futures trading started in 1972-1973 in response to increased exchange rate volatility due to _______________. Interest rate derivatives trading started to explode in the late 1970s and 1980s in response to increased interest volatility, CBOT introduced many interest rate futures to hedge short and long term interest rate risk. In 1980s, derivative securities were introduced for stock index futures and options. In 1990s, credit risk derivatives became popular, e.g., credit forward contracts to hedge default risk, for ___________. FORWARDS AND FUTURES (see Table 10-1 on p. 286) Spot Markets - Cash markets for immediate delivery, the immediate and simultaneous exchange of cash for securities, commodity, CDs, FX, or asset. Forward Contracts- Agreement between buyer and seller on P and Q, at time 0, for future delivery (1 week, 1 month, 1 year, 10 years). Example: Three-month forward contracts for 10-year T-bond futures contracts trading at F = 98. In three months the seller agrees to deliver 10-year T-bonds for a price of 98% of face value, buyer agrees to buy at 98, regardless of current market (97, 99, etc.). Forward Rate Agreements (FRAs) can be for FX, commodities, stock indexes, and interest rates (to hedge int. rate risk). For example, FRA for 3-month LIBOR, at some date in the future, e.g. Feb 2006 (in three months). If FRAs on 3-mo LIBOR are available for F=94.3, that locks in an interest rate of 5.70%. Contract size is $1m. A borrower agrees to pay 5.70% interest on a $1m, 3-month loan starting in 3 months, and the lender agrees to receive 5.7% on $1m for three months. Both parties lock- in to an interest rate three months ahead of time, to eliminate interest rate risk. Commercial and investment banks buy/sell FRAs to MNCs. Huge market, $8.15T FRAs held by commercial banks. FRAs are not standardized, the terms are flexible and can be customized, just like a bank loan. Banks can acts as brokers, bringing buyer/seller or borrower/lender together and charging a fee (bid-ask spread). Or they can act as traders, where they take a position themselves, and then accept risk. Examples of FRAs: MNC agrees to buy 10m from a bank in 4 months at $1.10/, or MNC agrees to pay 6.25% for a one-year loan starting in 6 months. Broker bank will find another client agrees to pay 6....
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- Spring '11