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49
2 Global Financial Instruments


A. The Bond Market
TA B L E 2.7
Sector Size ($ billions) Percentage of Market
The U.S. bond
market and its
Treasury $ 3,048.4 23.6%
indexes
Gov™t sponsored enterprise 1,957.6 15.2
Corporate 2,441.3 18.9
Tax-exempt* 1,629.3 12.6
Mortgage-backed 2,635.8 20.4
Asset-backed 1,201.8 9.3
Total $12,914.2 100.0%

*Includes private purpose tax-exempt debt.


B. Profile of Bond Indexes

Lehman Brothers Merrill Lynch Salomon Smith Barney

Number of issues Over 6,500 Over 5,000 Over 5,000
Maturity of included 1 year 1 year 1 year
bonds
Excluded issues Junk bonds Junk bonds Junk bonds
Convertibles Convertibles Convertibles
Floating rate Floating-rate bonds
Weighting Market value Market value Market value
Reinvestment of No Yes (in specific Yes (at one-month
intramonth cash bond) T-bill rate)
flows
Daily availability Yes Yes Yes

Sources: Panel A: Flow of Funds Accounts, Flows and Outstandings, Board of Governors of the Federal Reserve System, June 2001 and The Bond Market
Association. Panel B: Frank K. Reilly, G. Wenchi Kao, and David J. Wright, “Alternative Bond Market Indexes,” Financial Analysts Journal (May“June 1992),
pp. 44“58.




When the market price exceeds the exercise price, the option holder may “call away” the
asset for the exercise price and reap a benefit equal to the difference between the stock price
and the exercise price. Otherwise, the option will be left unexercised. If not exercised before
the expiration date, the option expires and no longer has value. Calls, therefore, provide
greater profits when stock prices increase and so represent bullish investment vehicles.
A put option gives its holder the right to sell an asset for a specified exercise price on or put option
before a specified expiration date. An October put on IBM with exercise price $100 entitles its The right to sell an
owner to sell IBM stock to the put writer at a price of $100 at any time before expiration in asset at a specified
October even if the market price of IBM is lower than $100. While profits on call options in- exercise price on or
before a specified
crease when the asset increases in value, profits on put options increase when the asset value
expiration date.
falls. The put is exercised only if its holder can deliver an asset worth less than the exercise
price in return for the exercise price.
Figure 2.11 presents stock option quotations from The Wall Street Journal. The highlighted
options are for IBM. The repeated number below the name of the firm is the current price of
IBM shares, $101.26. The two columns to the right of the firm name give the exercise price
and expiration month of each option. Thus, we see listings for call and put options on IBM
with exercise prices ranging from $90 to $110, and with expiration dates in October, Novem-
ber, and January.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition




Understanding the World of Derivatives
trade a given asset at a set price on a future date. These
What are derivatives anyway, and why are people say-
are “price-fixing” agreements that saddle the buyer with
ing such terrible things about them?
the same price risks as actually owning the asset. But
Some critics see the derivatives market as a multi-
normally, no money changes hands until the delivery
trillion-dollar house of cards composed of interlocking,
date, when the contract is often settled in cash rather
highly leveraged transactions. They fear that the de-
than by exchanging the asset.
fault of a single large player could stun the world finan-
Q: In business, what are they used for?
cial system.
A: While derivatives can be powerful speculative in-
But others, including Federal Reserve Chairman
struments, businesses most often use them to hedge.
Alan Greenspan, say the risk of such a meltdown is
For instance, companies often use forwards and
negligible. Proponents stress that the market™s hazards
exchange-listed futures to protect against fluctuations
are more than outweighed by the benefits derivatives
in currency or commodity prices, thereby helping to
provide in helping banks, corporations, and investors
manage import and raw-materials costs. Options can
manage their risks.
serve a similar purpose; interest-rate options such as
Because the science of derivatives is relatively new,
caps and floors help companies control financing costs
there™s no easy way to gauge the ultimate impact these
in much the same way that caps on adjustable-rate
instruments will have. There are now more than 1,200
mortgages do for homeowners.
different kinds of derivatives on the market, most of
Q: Why are derivatives potentially dangerous?
which require a computer program to figure out. Sur-
A: Because these contracts expose the two parties
veying this complex subject, dozens of derivatives ex-
to market moves with little or no money actually chang-
perts offered these insights:
ing hands, they involve leverage. And that leverage
Q: What is the broadest definition of derivatives?
may be vastly increased by the terms of a particular
A: Derivatives are financial arrangements between
contract. In the derivatives that hurt P&G, for instance,
two parties whose payments are based on, or “derived”
a given move in U.S. or German interest rates was mul-
from, the performance of some agreed-upon bench-
tiplied 10 times or more.
mark. Derivatives can be issued based on currencies,
When things go well, that leverage provides a big
commodities, government or corporate debt, home
return, compared with the amount of capital at risk.
mortgages, stocks, interest rates, or any combination of
But it also causes equally big losses when markets
these.
move the wrong way. Even companies that use deriva-
Company stock options, for instance, allow employ-
tives to hedge, rather than speculate, may be at risk,
ees and executives to profit from changes in a com-
since their operation would rarely produce perfectly off-
pany™s stock price without actually owning shares.
setting gains.
Without knowing it, homeowners frequently use a type of
Q: If they are so dangerous, why are so many busi-
privately traded “forward” contract when they apply for
nesses using derivatives?
a mortgage and lock in a borrowing rate for their house
A: They are among the cheapest and most readily
closing, typically for as many as 60 days in the future.
available means at companies™ disposal to buffer them-
Q: What are the most common forms of
selves against shocks in currency values, commodity
derivatives?
prices, and interest rates. Donald Nicoliasen, a Price
A: Derivatives come in two basic categories”
Waterhouse expert on derivatives, says derivatives “are
option-type contracts and forward-type contracts.
a new tool in everybody™s bag to better manage busi-
These may be exchange-listed, such as futures and
ness returns and risks.”
stock options, or they may be privately traded.
Options give buyers the right, but not the obligation,
SOURCE: Lee Berton, “Understanding the Complex World of
to buy or sell an asset at a preset price over a specific
Derivatives,” The Wall Street Journal, June 14, 1994. Excerpted by
period. The option™s price is usually a small percentage permission of Dow Jones & Company, Inc. via Copyright Clearance
of the underlying asset™s value. Center, Inc. © 1994 Dow Jones & Company, Inc. All Rights Reserved
Forward-type contracts, which include forwards, fu- Worldwide.
tures, and swaps, commit the buyer and the seller to




50
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition




51
2 Global Financial Instruments




F I G U R E 2.11
Listing of stock option
quotations
Source: From The Wall
Street Journal, October 19,
2001. Reprinted by
permission of Dow Jones &
Company, Inc. via
Copyright Clearance Center,
Inc. © 2001 Dow Jones &
Company, Inc. All Rights
Reserved Worldwide.




The next four columns provide the trading volume and closing prices of each option. For ex-
ample,16,292 contracts traded on the October expiration call with an exercise price of $100.
The last trade was at $1.80, meaning that an option to purchase one share of IBM at an exercise
price of $100 sold for $1.80. Each option contract (on 100 shares of stock), therefore, costs
$1.80 100 $180.
Notice that the prices of call options decrease as the exercise price increases. For example,
the October 2001 maturity call with exercise price $105 costs only $.20. This makes sense, as
the right to purchase a share at a higher exercise price is less valuable. Conversely, put prices
increase with the exercise price. The right to sell a share of IBM in October at a price of $100
costs $0.80 while the right to sell at $105 costs $4.
Option prices also increase with time until expiration. Clearly, one would rather have the
right to buy IBM for $100 at any time until November than at any time until October. Not sur-
prisingly, this shows up in a higher price for the November expiration options. For example,
the call with exercise price $100 expiring in November sells for $5.20, compared to only
$1.80 for the October call.


<
6. What would be the profit or loss per share of stock to an investor who bought the Concept
October maturity IBM call option with exercise price $100, if the stock price at the
CHECK
expiration of the option is $104? What about a purchaser of the put option with
the same exercise price and maturity?


Futures Contracts
A futures contract calls for delivery of an asset (or in some cases, its cash value) at a speci- futures contract
fied delivery or maturity date, for an agreed-upon price, called the futures price, to be paid at Obliges traders to
contract maturity. The long position is held by the trader who commits to purchasing the com- purchase or sell an
modity on the delivery date. The trader who takes the short position commits to delivering the asset at an agreed-
upon price at a
commodity at contract maturity.
specified future date.
Figure 2.12 illustrates the listing of several futures contracts for trading on October 26,
2001, as they appeared in The Wall Street Journal. The top line in boldface type gives the con-
tract name, the exchange on which the futures contract is traded (in parentheses), and the con-
tract size. Thus, the first contract listed is for corn traded on the Chicago Board of Trade
(CBT). Each contract calls for delivery of 5,000 bushels of corn.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition




52 Part ONE Elements of Investments




F I G U R E 2.12
Listing of commodity
futures contracts
Source: From The Wall Street
Journal, October 29, 2001.
Reprinted by permission of
Dow Jones & Company, Inc.
via Copyright Clearance
Center, Inc. © 2001 Dow
Jones & Company, Inc. All
Rights Reserved Worldwide.




The next several rows detail prices for contracts expiring on various dates. The December
2001 maturity contract opened during the day at a futures price of $2.065 per bushel. The
highest futures price during the day was $2.0675, the lowest was $2.0475, and the settlement
price (a representative trading price during the last few minutes of trading) was $2.055. The
settlement price decreased by $.01 from the previous trading day. The highest and lowest fu-
tures prices over the contract™s life to date have been $2.75 and $2.0225, respectively. Finally,
open interest, or the number of outstanding contracts, was 211,394. Corresponding informa-
tion is given for each maturity date.

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