Options

What are options?

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a commodity or other instrument at a specific price within a specified period of time, regardless of the market price of that instrument. (Source: CFTC)

Options are contracts giving the purchaser the right to buy or sell a security, such as stocks, at a fixed price within a specific period of time. (Source: SEC)

An option contract is an agreement in which the buyer (holder) has the right (but not the obligation) to exercise by buying or selling an asset at a set price (strike price) on (European style option) or before (American style option) a future date (the exercise date or expiration); and the seller (writer) has the obligation to honor the terms of the contract. Since the option gives the buyer a right and the writer an obligation, the buyer pays the option premium to the writer. The buyer is considered to have a long position, and the seller a short position.

Given that the contract's value is determined by an underlying asset and other variables, it is classified as a derivative.

The most common way to trade stock options is trading standardized options contracts that are listed by various futures and options exchanges -- there are currently six exchanges in the United States that list standardized options contracts based on underlying stocks -- The Philadelphia Stock Exchange (PHLX), American Stock Exchange (AMEX) and NYSE Arca in New York City, and the Chicago Board Options Exchange (CBOE) which are all open-outcry marketplaces, and the International Securities Exchange (ISE) and Boston Options Exchange (BOX) are electronic marketplaces. However, even for the non-electronic exchanges, competition and the introduction of automated execution (AutoEx) has led, by late 2006, to hybridization where all but the largest trades are executed electronically. In Europe the main exchanges where stock options are traded are Euronext.liffe and Eurex.

There are also over-the-counter options contracts that are traded not on exchanges, but between two independent parties. At least one of those parties is usually a large financial institution with a balance sheet big enough to underwrite such a contract. (Source: Wikipedia)

Key Terms: Option, Options, Option Market, Options Market

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Swap

What is a swap?

In general, a swap is the exchange of one asset or liability for a similar asset or liability for the purpose of lengthening or shortening maturities, or raising or lowering coupon rates, to maximize revenue or minimize financing costs. This may entail selling one securities issue and buying another in foreign currency; it may entail buying a currency on the spot market and simultaneously selling it forward. Swaps also may involve exchanging income flows; for example, exchanging the fixed rate coupon stream of a bond for a variable rate payment stream, or vice versa, while not swapping the principal component of the bond. Swaps are generally traded over-the-counter. (Source: CFTC)

Bond Swaps

A bond swap occurs when an investor sells one bond and uses the proceeds to purchase another bond, often at the same price. Investors engage in bond swaps for a variety of reasons. For example, investors may want to take a tax loss by selling one bond at a loss but then preserve their investment by simultaneously buying a similar bond. At other times, investors swap bonds to obtain a higher yield and return on their bond investments. (Source: SEC)

In finance, a swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The cash flows are calculated over a notional principal amount. Swaps are often used to hedge certain risks, for instance interest rate risk. Another use is speculation.

Swaps are over-the-counter (OTC) derivatives. This means that they are negotiated outside exchanges. They cannot be bought and sold like securities or futures contracts, but are all unique. As each swap is a unique contract, the only way to get out of it is by either mutually agreeing to tear it up, or by reassigning the swap to a third party. This latter option is only possible with the consent of the counterparty. (Source: Wikipedia)

Futures Contracts and Futures Trading

What is a futures contract? What is futures trading?

A futures contract is an agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied by delivery or offset.

The futures price is commonly held to mean the price of a commodity for future delivery that is traded on a futures exchange; or simply the price of any futures contract. (Source: CFTC)

A futures contract is an agreement to buy or sell a specific quantity of a commodity or financial instrument at a specified price on a particular date in the future. Commodities include bulk goods, such as grains, metals, and foods, and financial instruments include U.S. and foreign currencies.

With limited exceptions, the trading of futures must be executed on the floor of a commodity exchange. Similar to broker-dealers that are members of the National Association of Securities Dealers, Inc. or some other self-regulatory organization, all firms and individuals who trade futures with the public or give advice about futures trading must be registered with the National Futures Association (NFA). (Source: SEC)

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date.

A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. If it is an American-style option, it can be exercised on or before the expiration date; a European option can only be exercised at expiration. Thus, a Futures contract is more like a European option. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.

Futures contracts, or simply futures, are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use.

Hedgers typically include producers and consumers of a commodity.

For example, in traditional commodities markets farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.

The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator for example. (Source: Wikipedia)

Eurodollars

What are eurodollars?

US dollar deposits placed with banks outside the US. Holders may include individuals, companies, banks, and central banks. (Source: CFTC)

Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the United States, allowing for higher margins.

Historically, such deposits were held mostly by European banks and financial institutions, and thus became known as "eurodollars". Such deposits are now available in many countries worldwide, but they continue to be referred to as "eurodollars" regardless of the location.

Futures Contract

At the same time, eurodollar refers to the financial futures contract based upon these deposits. Traded at the Chicago Mercantile Exchange (CME) in Chicago, the contract has a notional or 'face value' of $1,000,000, though the leverage used in futures allows one to trade a contract for just hundreds of dollars. Trade in Eurodollar futures is extensive, thus offering uniquely deep liquidity. A purchase or sale is, in effect, a bet on U.S. short-term interest rates. Prices are quite responsive to Fed policy, inflation, and other economic indicators.

The price of a Eurodollar futures contract is equal to 100 minus the yield (interest rate) for the given future date. Thus, a price of 95 would imply a 5% yield on the Eurodollar deposit. If you believe that interest rates will fall, you would then buy a Eurodollar contract (and vice versa; if you believe rates will rise, you would sell a Eurodollar contract). Each "tick" (.01) on the price of a Eurodollar contract is worth $25 and is equal to one basis point (i.e., a move from 95.010 to 95.020, but the Eurodollar trades in half ticks (.005, $12.50 per contract) and quarter ticks (.0025, $6.25 per contract).

The CME eurodollar contract is used to hedge interest rate swaps. There is an arbitrage relationship between the interest rate swap market and the Eurodollar contract. Eurodollar futures can be traded by implementing a spread strategy among multiple contracts to take advantage of movements in the forward curve for future pricing of interest rates.

The front month contracts are among the most liquid futures markets in the world. The contract suite has quarterly expirations out to 10 years. Each year has a reference color, with the first year from today being referred to as 'front' months.

Finance

In finance, the prefix "euro" as in "eurodollars" or "euroyen" refer to currency deposited outside the country of their origin.

Eurodollars are time deposits denominated in United States dollars at banks headquartered outside the United States, or in foreign branches of banks headquartered within the United States. There is nothing "European" about Eurodollar deposits; a US dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar deposits. Such deposits are normally in excess of $1,000,000, and typically (although not exclusively) involve deposits placed by one financial institution with another financial institution. As such, the Eurodollar rate is reflective of a large bank's cost of funds. Trading is extensive and quite active, particularly in maturities ranging from one day to six months; there is some very light trading that may run out as far as five years.

Although paid on deposits booked elsewhere in the world, the Eurodollar rate is driven primarily by the American economy (because it represents an interest rate paid on US dollar-denominated deposits). By and large, when the Fed tightens (or is expected to tighten within the lifetime of the deposit) the Eurodollar rate goes up, and when the Fed eases (or is expected to ease) the Eurodollar rate goes down.

In addition, the interest rate on Eurodollar deposits can and does vary throughout the day in response to supply and demand. This can be problematic for market participants who seek to use Eurodollar rates as benchmarks. The LIBOR rate and other similar rates were therefore developed for that purpose, representing a snapshot of the Eurodollar market in a specific locality and point in time (11:00 a.m. in London in the case of LIBOR).

Eurodollar rates should not be confused with the currency called the euro, which is the common currency of some members of the European Union. Prior to the introduction of this currency, traders in Eurodollars would colloquially refer to them as "Euros", but this practice has diminished since 2002.

The market for Eurodollar futures has grown to be highly liquid with the introduction of online trading. (Source: Wikipedia)

Derivatives

What are derivatives?

A financial instrument, traded on or off an exchange, the price of which is directly dependent upon (i.e., "derived from") the value of one or more underlying securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed upon pricing index or arrangement (e.g., the movement over time of the Consumer Price Index or freight rates). Derivatives involve the trading of rights or obligations based on the underlying product, but do not directly transfer property. They are used to hedge risk or to exchange a floating rate of return for fixed rate of return. Derivatives include futures, options, and swaps. For example, futures contracts are derivatives of the physical contract and options on futures are derivatives of futures contracts. (Source: CFTC)

Derivatives are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security or index. For example, a stock option is a derivative because its value changes in relation to the price movement of the underlying stock. (Source: SEC)

In finance, a derivative is a financial instrument derived from some other asset; rather than trade or exchange the asset itself, market participants enter into an agreement to exchange money, assets or some other value at some future date based on the underlying asset. A simple example is a futures contract: an agreement to exchange the underlying asset (or equivalent cash flows) at a future date. The exact terms of the derivative (the payments between the counterparties) depend on, but may or may not exactly correspond to, the behaviour or performance of the underlying asset.

There are many types of financial instruments that are grouped under the term derivatives, but options/futures and swaps are among the most common. Options are contracts where one party agrees to pay a fee to another for the right (but not the obligation) to buy something from or sell something to the other. For example, a person worried that the price of his Microsoft stock may go down before he plans to sell it may pay a fee to another person (the writer of a put option) who agrees to buy the stock from him at the strike price. The person in this example is using an option to manage the risk that his stock may go down, while the writer of the put option may be using the option as a way to benefit from the increase in the stock price and the fee income. In contrast to a put option, a call option gives the buyer of the option the right to purchase the underlying asset at a later date and at the specified strike price.

Later, contracts known as swaps appeared, where one party agrees to swap cash flows with another. For example, a business may have a fixed-rate loan, while another business may have a variable-rate loan; each of the businesses would prefer to have the other type of loan. Rather than cancel their existing loans (if this is possible, it may be expensive), the two businesses can achieve the same effect by agreeing to "swap" cash flows: the first pays the second based on a floating-rate loan, and the second pays the first based on a fixed-rate loan (in practice, the two will net out the amounts owing). By swapping the cash flow, each has "converted" one type of loan into another.

Derivatives can be based on different types of assets such as commodities, equities or bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions). Their performance can determine both the amount and the timing of the payoffs. The main use of derivatives is to either remove risk or take on risk depending if one were a hedger or a speculator. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. The main types of derivatives are futures, forwards, options and swaps. In today's uncertain world, derivatives are increasingly being used to protect assets from drastic fluctuations and at the same time they are being re-engineered to cover all kinds of risk and with this the growth of the derivatives market continues.

Types of derivatives

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market:

• Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding notional amount is USD 298 trillion (as of 2005).

• Exchange-traded derivatives are those derivatives products that are traded via Derivatives exchanges. A derivatives exchange acts as an intermediary to all transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest[2] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), Chicago Mercantile Exchange and the Chicago Board of Trade. According to BIS, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2005.

Common contract types

There are three major classes of derivatives:

• Futures/Forwards, which are contracts to buy or sell an asset at a specified future date.
• Options, which are contracts that give the buyer the right (but not the obligation) to buy or sell an asset at a specified future date.
• Swaps, where the two parties agree to exchange cash flows.

(Source: Wikipedia)