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A BRIEF HISTORY OF FUTURES MARKETS

April 25th, 2009

Although vestiges of futures markets appear in the Japanese rice markets of the 18th century and perhaps even earlier, the mid-1800s marked the first clear origins of modem futures markets. For example, in the United States in the 1840s, Chicago was becoming a major transportation and distribution center for agricultural commodities. Its central location and access to the Great Lakes gave Chicago a competitive advantage over other U.S. cities. Farmers from the Midwest would harvest their grain and take it to Chicago for sale. Grain production, however, is seasonal. As a result, grain prices would rise sharply just prior to the harvest but then plunge when the grain was brought to the market. Too much grain at one time and too little at another resulted in severe problems. Grain storage facilities in Chicago were inadequate to accommodate the oversupply. Some farmers even dumped their grain in the Chicago River because prices were so low that they could not afford to take their grain to another city to sell.
To address this problem, in 1848 a group of businessmen formed an organization later named the Chicago Board of Trade (CBOT) and created an arrangement called a “to-arrive” contract. These contracts permitted farmers to sell their grain before delivering it. In other words, farmers could harvest the grain and enter into a contract to deliver it at a much later date at a price already agreed on. This transaction allowed the farmer to hold the grain in storage at some other location besides Chicago. On the other side of these contracts were the businessmen who had formed the Chicago Board of Trade.
It soon became apparent that trading in these to-arrive contracts was more important and useful than trading in the grain itself. Soon the contracts began trading in a type of secondary market, which allowed buyers and sellers to discharge their obligations by passing them on, for a price, to other parties. With the addition of the clearinghouse in the 1920s, which provided a guarantee against default, modem futures markets firmly established their place in the financial world. It was left to other exchanges, such as today’s Chicago Mercantile Exchange, the New York Mercantile Exchange, Eurex, and the London International Financial Futures Exchange, to develop and become, along with the Chicago Board of Trade, the global leaders in futures markets.

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Premiums and Values of Traded Options

April 20th, 2009

The asymmetric nature of returns with regard to the price of the underlying instrument, and mirror image of returns to the holder and the writer, mean that options have a value to the holder even if the current stock price is below the call option’s strike price or above the put option’s strike price. The holder of such an option should be able to sell the option for a cer tain amount to a third par ty. This is referred to as the option’s premium. The price of a traded option can be broken into two par ts, its intrinsic value and its life or time value:
Intrinsic value. The intrinsic value is simply the profit that would be realized if the option was in-the-money and exercised. The intrinsic value is zero when the option is either at-the- money or out-of-the-money.
Life or time value. In addition to the price of the underlying instrument there are three factors that determine the value of an option’s premium, the volatility of the price of the underlying instrument, time to expiration and the level of interest rates.
Time. The longer the exercise period the greater the value of the option’s value. This is pretty obvious. If the option is out-of-the-money and expires next week there is less oppor tunity for the bond’s price to rise above that of the strike price than if it expires in six months.
Volatility. The value of the bond will var y with changes in the yield cur ve. The more volatile that interest rates are the more volatile will be the bond’s price. Higher volatility is good for option holders due to the asymmetric nature of returns relative to the bond’s price. If the bond price falls below the strike price it doesn’t matter if it falls a little or a lot as we won’t exercise the option in any event. If the bond’s price rises a lot our profit on exercise will be much greater than if it only rises a little.
The writer (or seller) of an option is paid a premium by the holder (buyer) of the option. This price may be lower or higher than the value implied from option valuation models.
The option’s premium also varies with the level of interest rates but this is far less significant as a factor than either time or volatility. Its effect is also far more subtle and difficult to explain simply. For our pur poses it is sufficient to note that the level of interest rates does affect an option’s value and leave it at that for now.
The first of the following two char ts shows the traded and intrinsic values of the above call option plotted against bond price. The following characteristics are wor th noting:
The value of the premium falls as the option moves deep into or out-of-the-money.
When the option is either deep in-the-money or deep out-of-the-money its value varies with that of the bond’s price.
The second char t shows the rate of change in percentage terms of the option’s traded value against the bond’s price. In the context of this chapter this has little significance but we will be picking up on this in Par t III when we look at trading strategies and risk management. This has the following impor tant characteristics:
The rate of change of the option’s value does not var y in a linear way with bond price.
The rate of change is greatest when the option is close to being at-the-money and
The rate of change reverses direction at a par ticular bond price. Char ts of the first form, which plot the price of one instrument against a single factor (in this case bond price), are sometimes referred to as delta char ts. Risks resulting from changes in the price against this factor are referred to as delta risk.

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Call and Put Options

April 15th, 2009

There was a time when opening the mail was something that people looked forward to. That is no longer the case. So imagine your sur prise if one morning you received a letter from your stockbroker enclosing a cer tificate, given in recognition of past business you have given them, that gave you the “oppor tunity” to buy a 15-year government bond at a price of $11 500. The offer is for one month only and can be taken up by presenting the cer tificate plus $11 500 in cash to the broker at any time till then. A quick look at a financial newspaper, however, shows that its current market price is just $11 015. At first glance this does not appear to be a very attractive offer. If you wanted to hold the bond then you could simply buy it in the market today at $11 015.
A little thought, however, shows that the cer tificate is wor th holding onto. If the bond price rises above $11 500 at any time during the offer period then you can exercise this “option” and immediately sell the bond in the market. The difference between the then market price and the exercise price will be straight profit.
There are two types of options, call options and put options:
Call option. The above free offer is an example of a call option. In formal terms a call option gives the holder the right, but not the obligation, to buy a specified asset at a specific price (the exercise or strike price) until a par ticular date (the expir y date). The par ty giving the option is called the option writer.
Put option. The second type of option is a put option. This gives the holder the right, but not the obligation, to sell a specified asset at a specific price (the exercise or strike price) until a par ticular date (the expir y date). If the price of the bond is below the bond price then the holder can simply buy the bond in the market and exercise the option to immediately sell the bond at the exercise price. The holder’s profit then is the difference between the bond’s market price and the strike price.
The returns for this option for the holders and writers of a call option and a put option, plotted against bond price, are shown in the following char ts. It is wor th noting that trading options is a zero sum game, what one par ty gains another loses.
Call option. The call option returns have the following characteristics:
If the price remains below the strike price the holder will not exercise the option and it will simply expire.
The returns to the holder and the writer are mirror images of one another.
The returns are asymmetric in form with regard to bond price.
If the price rises above the strike price profits to the holder and losses to the writer have no limit.
Put option. The put option returns have the following characteristics:
If the price remains above the strike price the holder will not exercise the option and it will simply expire.
The returns to the holder and the writer are mirror images of one another.
The returns are asymmetric in form with regard to bond price.

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Impact of Shifts in Yield Curve on Bond Valuations

April 11th, 2009

Changes in the supply of and demand for money occur for many different reasons causing the yield cur ve to shift. We will consider two possible cases:
Parallel shifts. Demand for fixed income investments at all maturities falls. This will push down the price of money and hence result in lower bond prices and higher yields. Investors will demand higher yields on new issues and prices for bonds already issued will fall until they offer the same yields as equivalent new issues. We will assume that yields fall by 100 bpts at all maturities. This is referred to as a parallel shift in the yield cur ve.
Non-parallel shifts. For our second case we will assume that supply of new money at the short end is restricted but that demand for bonds with longer maturities increases. This will push up returns demanded (reduce prices) for bonds at the shor t end and push up prices (lower yields) of bonds at the long end. This type of change in the shape of the yield curve is called a non-parallel shift. The following example is a tilted shift but non-parallel shifts can take many forms.
This par ticular example is characteristic of changes in yield cur ves that take place when inflationary expectations have risen, pushing up yields on long-term instruments and the central bank has then acted to tighten liquidity and push up the level of shor t-end rates. As liquidity tightens the economy star ts to slow, inflationar y fears recede and long-term required returns and hence bond yields fall.

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