Chap 01 Aem 421

Jarrow, Turnbull, Chatterjea
Derivatives Trading and Risk Management
Chapter 1 Derivatives Trading and Risk Management
1.1
1.2
1.3
1.4
1.5
1.6
Introduction
Financial Securities and Derivatives
Growing Financial Markets
Derivative Securities
Markets and Trading
Primary and Secondary Markets
Exchanges and OTC Markets
Brokers and Dealers
Trading Stocks at the New York Stock Exchange
Order Placement Strategies
Other Ways of Trading Securities
Execution, Settlement, and Clearance
Scalpers, Day Traders, and Position Traders
Market Microstructure
Defining, Measuring, and Managing Risk
Portfolio Risk
Regulators Classification of Risks
Value-at-Risk
Some Risks that Businesses Face
Summary
Further Information, References, Questions and Problems
Information
References
Questions and Problems
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1.1
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Introduction
The last three decades of the twentieth century have seen an explosion in the number and
kind of derivative securities traded in the global financial markets. A derivative security or a
derivative derives its value from something else: a stock price, a commodity price, an
exchange rate, or even an index. A derivative can reduce riskby providing insurance or, by
enabling a trader to fix a price for a future transaction nowor it can magnify it. Derivatives
provide endless ways of investing and managing wealth.
Zip back to the Sixties. Only a handful of people studied derivatives: there were no
books, and no college or university offered courses on them. The markets were small, located
mostly in the United States and parts of Western Europe. The practitioners included a limited
number of traders in futures markets, and a small number of people in Wall Street firms. The
options market was illiquid and informalcheating charges gave it disrepute. Nobody had
heard about swaps because the first swap deal was negotiated in 1981. Talk of derivatives
didnt add sparkle to cocktail conversation. Brash, young, successful derivatives traders
didnt drive Mercedes and BMWs. These swashbuckling traders who can move millions at
the touch of a computer button didnt exist then. Einstein had developed the theory of
relativity, scientists had probed microbes and split atoms, and astronauts had landed on the
moon, but nobody knew how to price an option.
What a difference three decades have made! Derivative markets have grown by leaps and
bounds and new products are constantly being introduced. The markets have gone global and
derivatives experts are in great demand. Hundreds of academics study derivatives and
thousands of articles have been written on this topic. Colleges and universities offer many
courses on derivatives. Derivative based journals and books have mushroomed. Directly or
indirectly, derivatives now affect the livelihood of millions and plenty of people (including
some academics!) derive a good living from it. Wall Street firms hire Ph.D.s in mathematics,
natural and social sciences to design new derivativesthese folks are admirably called
rocket scientists, suggesting a level of math skill akin to the scientists designing rockets for
the space program (Quants is another name that they go by.) If you know derivatives, then
you know cool stuff, and you are hot. Rhetoric asidederivatives have become an integral
part of the finance curriculum as this knowledge is needed in most finance jobs.
But why these changes? Why have they happened now? We will examine several
probable causes in this chapter. And what are the different kinds of derivatives? How do you
price them? How do you use them? Why would you use them? Well, thats what this book is
1
A security, such as a stock or a bond or an option, gives the holder ownership rights over some assets. It
exists as a paper document or an electronic entry record, and usually trades in an organized market. See
Securities Exchange Act of 1934 (which is available on the internet) for a technically correct, detailed definition
of a security.
2 People often use the term Wall Street firms to mean investment banking companies, many of which have
offices in and around Wall Street in New Yorks financial district. Such firms typically run many lines of
businesses like a) generating financial research for own and client use, b) advising clients on mergers and
acquisitions, c) helping a company go public, b) buying and selling securities and e) designing and selling a
variety of financial products catered to client needs (the last two activities may be called security dealership).
3 In 1993, one of the authors asked a manager at a baby Bell company about the extent of derivatives use in
their billion-dollar pension fund portfolio. When pressed, he acknowledged, We dont understand derivatives
very well and stay away from them. Such ignorance is fast disappearing among the new generation of finance
graduates. Still, in a job interview, a light goes on when derivatives is on your resume.
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about. We will introduce you to the fascinating world of derivativesfutures and forwards,
options, and swaps and their markets. You will learn to price derivatives, to combine them
with other securities to form complex financial instruments, and to break down a complicated
derivative into simpler parts. You will be able to use them in trading strategies and risk
management plans. Through definitions, descriptions, and examples this book will give you a
solid foundation that will serve you well in many finance careers and also prepare you for
further studies on derivatives.
The first three chapters lay the basic foundation of this book by discussing financial
securities and derivatives markets, trading and the traders, risks from derivatives, an
introduction to the major kinds of derivatives, the concepts of arbitrage and interest rates, the
U.S. Government Treasury securities markets, and finally, compounding and discounting of
cash flows using Treasury zero coupon bonds. The later chapters build on this common
foundation to study the three major kinds of derivatives in greater detail.
We begin this chapter with a brief introduction to financial securities and derivatives. The
markets and the trading process come next. Brokers and dealers are those professionals who
earn a living by helping investors trade. They finely balance the risks and returns for survival
charging too much will drive away their customers while charging too little will drive
them out of business. Risks can come from many sourcesin the commissions to charge, the
margins to keep, and the amount of securities to offer at any particular price. When trading
with someone better informed than they arethe brokers and dealers constantly juggle these
risks to survive in ruthlessly competitive markets.
Who are the traders in the derivatives markets? Broadly speaking, they are classified as
hedgers or speculators by their motives as to whether they use derivatives for risk reduction
(hedging) or risk acceptance (speculation). The speculators can be scalpers, day traders or
position traders depending on their trading strategies and how long they hold their trade. We
can add a third category of tradersarbitrageurs who try to find price discrepancies and
extract riskless arbitrage profits by buying low and selling high the mispriced securities.
Much of the derivatives market has grown around hedgers. You may have heard the
expression hedging ones bets. This means taking steps to protect oneself from the wild
swings in some outcome. Sometimes a hedge may come naturally. For example, Figure 1-1
shows a man selling stuff on some tourist spot, perhaps a beach. If he chooses his wares
wisely, say by carrying an assortment of umbrellas and sunglasses, then he has hedged well;
come rain, come shinehe has something to sell. At other times, you may use derivatives to
reduce price risks; or just decide to leave the risk alone. In fact, before allowing a new
futures contract for trading, the federal regulatory body Commodity Futures Trading
Commission carefully checks whether it can be used by hedgers for reducing some preexisting risk. Due to its paramount importance in risk management, we will discuss hedging
in this chapter and throughout the book.
And what about the trading process? Market microstructure is a subfield of finance that
studies this process and how the rules of trading affect price formation. It provides common
sense explanations of many observed phenomena in stock, bond, and derivatives markets.
4
Jarrow and Turnbulls Derivative Securities (2000) picks up where this book ends. Its presentation is
suitable for sophisticated practitioners, advanced MBAs, and the beginning Ph.D.s. If you are interested in
delving deeper for a unified treatment of derivatives on fixed income securities, and the most up-to-date
material used by the major finance companies and market professionals, then we recommend Jarrows
Modeling Fixed Income Securities and Interest Rate Options (2002).
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Although risky by nature, derivatives can do wonders for managing the risk of a
portfolio, which is a collection of securities. You will learn how to do this too. But
derivatives are not all stardust and glitter. There are disturbing, boring, uninteresting
problems that come along with derivativesa contract may be written poorly, a derivative
may show little trading activity, or a clerk may not enter an order correctly. Such problems
are not unique to derivativesthey exist whenever you are trading securities. However,
financial market regulators deeply worry about these risks as well as market risks like default
and adverse price movements. They wrote a report in 1994 that stressed the need for
oversight in risk management. We briefly discuss these risks as well for we will study them
later on in this book.
Nowadays journals, books, booklets, newspapers, magazines, periodicals, as well as
Internet websites carry a wealth of information on derivatives. We list several such sources
for you to explore. As in the later chapters, we end with a collection of problems, and
encourage you to solve them.
FIGURE 1-1
WISELY HEDGEDCOME RAIN, COME SHINE, HE HAS SOMETHING TO SELL
Umbrella
$10
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Umbrella
$10
Sunglass
1.2
Financial Securities and Derivatives
Growing Financial Markets

The world financial markets are growing at a rapid pace. A trillion dollars worth of assets
change hands daily in smooth functioning financial markets. A myriad of securities are
offered for sale. Have you pondered why?
Well, financial securities let you do things that are otherwise difficult or even impossible.
They can help you to advance or postpone cash-flows (borrowing and lending), to transfer
wealth (saving), to protect against disasters (insurance), to commit funds to earn a financial
return (investment), to accept high risks in the expectation of big returns (speculation or
gambling), and to reduce the risk of a collection or portfolio of assets (hedging). As
economies grow, so do the financial markets. Banks grow, demand as well as supply of a
variety of financial services increase, credit markets work better, monetary policies work
faster, and the markets become more efficient so that security prices better reflect
information. It is no surprise that the demand for securities continues to grow in todays
intricate and interconnected market economies.
Many factors have fueled such growth. These include regulatory changes, growth of
international commerce, population growth, creation of market economies through political
changes, integration of the world economy, and the onset of the information age with
powerful new computers. The interrelated financial markets have become more susceptible to
global shocks, and the number of players in the world economy has increased. The world has
become a more complex place, economically speaking! No wonder regulators are concerned
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war, terrorist attacks, business cycles, systems meltdown, computer glitches, debt default
by sovereign nations, and imprudent trading by rogue traders and hedge funds. These
problems could easily shake the financial markets to the core. When several things go wrong
at the same time, regulators worry that sustained miseries like the Great Depression of the
nineteen thirties arent far behind.
What do you do in a world where these kind of dangers lurk? You have no choice but to
be proactive. These dangers can make and break your businessthey must be cured,
controlled or endured. With unjaundiced eyes, you should first assess all the risks that can
affect your business and then decide which ones to accept and the ones to control.
Derivatives are an invaluable set of tools for this purpose. The following examples show why
derivatives are useful for risk management in recent times.
The foreign exchange market is the worlds largest financial marketbillions of dollars
worth of currencies trade daily. From the mid nineteen forties up until the early seventies, the
world economy operated under the Bretton Woods system of fixed exchange ratesall the
currencies were pegged to the U.S. dollar, while the dollar was pegged to gold at $35 per
ounce. This led to a stable monetary system that served the world well for decades. Problems
arose when gold prices soared. Non U.S. countries converted their currencies into dollars and
bought gold from the U.S. at the cheap price of $35 per ounce, making huge profits. As a
result, the U.S. gold reserves suffered a terrible decline. As all the currencies were pegged to
the dollar, the U.S. could not adjust on its own the dollars exchange rate to alleviate this
imbalance. This situation could not continue indefinitely. Finally, President Nixon abandoned
the Bretton Woods system in 1971.
Currencies now float vis--vis one another in a free market, although their values are
frequently manipulated by the central banks. The floating exchange rates, which are the
values of one currency in terms of others, have become extremely volatile. This increase in
exchange rate volatility has created the huge market for foreign exchange based futures and
forwards, options, and swaps. Foreign exchange based options enable a business to avoid the
possibility of an unfavorable price movement in lieu of a premium, forwards and futures let
them lock in a price for a future transaction, and swaps, like the futures and forwards, allow
them to fix prices for several transactions at later dates.
The central bank of the United States, the Federal Reserve Bank (the Fed), used
monetary policy tools to keep interest rates stable. In 1979, the Fed stopped fixing interest
rates and began targeting money supply growth instead. Moreover, oil shocks and other
supply-side disturbances created double digit inflation rates in the seventies and the eighties,
which in turn led to double digit U.S. interest rates and a wiggling of U.S. interest rates quite
unlike what had been seen before. U.S. interest rates became highly volatile. This created a
need for securities that would eliminate interest rate risks from transactions. As with foreign
currency based derivativesinterest rate based derivatives emerged to help.
5
See Smithson et al (1995) for a discussion of how macroeconomic changes have affected risk management.
The agreement to create a Gold Exchange Standard was signed in 1944 by 44 members of the United
Nations in Bretton Woods, New Hampshire, USA. Courses in International Trade and Finance study the pros
and cons of the different exchange rate regimes, the factors holding the exchange rates together, and the
implications of trading policies adopted by nations.
7 Courses in Macroeconomics, Money and Finance, Banking, or Financial Markets and Institutions will help
you understand how the central banks can fine tune the economy using the tools of monetary policy likea)
setting the discount rate, b) fixing the bank reserve requirements, and c) buying and selling of government
bonds (Open Market Operations).
6
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Nowadays, the Fed doesnt pursue any single monetary policy target. They use discretion
rather than clear-cut rules in conducting monetary policy. Nobel Laureate Merton Miller
(1986) has argued that regulations and taxes are the major impulses to financial innovation:
each successful innovation earns an immediate reward for its adopters in the form of tax
money saved. This certainly seems to be the case for foreign currency and interest rate
derivatives.
Volatility increase has also been observed in many other markets. Notably, the inflation
rate and commodity prices have become more prone to fluctuations. Not surprisingly,
demand for derivatives that hedge these risks is also growing. Volatility is disruptive. Often a
business may avoid price uncertainty by accepting a lower price through a derivative contract
we show this in the forward contract example later in this chapter. Derivatives help to
reduce risk, but like other good things in the world, they dont come free. If you want
something, you have to pay for it. In seeking risk reduction, you either pay a premium for the
derivative (as in the case of options) or agree to trade at a bad price (as with futures and
forwards). To summarize, a careful study of derivatives will give you more flexibility in
managing risk and uncertainties, open up new ways of investing, make you more
knowledgeable of finance, and consequently more valuable in your job.
Derivative Securities
Many different securities trade. You are familiar with bonds, which are debts of the issuer,
and stocks, which give investors part ownership in the issuing company. Bonds and stocks
require an initial investment. Most bonds pay back this amount (principal) at maturity. Some
bonds pay interests (coupons) on a regular basis, while others are zero coupon bonds that
pay no interest but are sold at a discount from the principal. The investment in stock is never
repaidas compensation stockholders usually get paid dividends on a quarterly basis. Stock
prices can increase and cause capital gains for the investors. These profits are realized by
selling the stock.
Stocks and bonds are used to create new classes of securities called derivativesand
thats where much of the variety comes in. A derivative security is a financial contract
whose value is derived from one or more underlying variablesthe underlying variable can
be a stock, a bond, another security, a commodity, an index, an interest rate, or even another
derivative security. Forwards and futures, options, and swaps are the basic types of
derivatives. When you combine several types of securities together into one financial
instrument, it usually ends up being a derivative.
To conceptualize, lets define various entities:
a) Real and financial assets are land, buildings, machines, commodities, stocks, bonds, and
foreign currencies, which have tangible values.
b) Notional variables are interest rates, inflation rates, and security indexes that exist as
notions or ideas rather than as tangible assets.
Derivative securities are either created from real assets and securities or by writing
contracts on notional variables. Early derivatives were solely created from financial and real
assets. Even in the nineteen sixties corn was king and agricultural product based futures
composed the nine most actively traded contracts in the U.S.
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As economies become complex, more and more notional variables are devised to
summarize the state of the economy. Just open the Money and Investing Section of the Wall
Street Journal and you will be amazed by the varietythe last five years have seen a boom in
the indexes that are out there. New derivatives based on such notional variables are
constantly being introducedsome survive in the marketplace, some dont. But when they
do survive, they can be very useful for sophisticated risk management techniques.
Zip back to the U.S. in the new millennium. Financial futures are the most popular
futures contracts of the day. The two most active contracts, Eurodollar and U.S. Treasury
bond futures, didnt even exist 30 years back. Corn and soybean based futures have barely
stayed in the top ten list. And what underlies some of the most active contracts? The
underlyings are: crude oil, the S&P 500 index, Treasury bonds, Eurodollars, Euros, Japanese
Yen, Swiss Francsesoteric and fancy stuff, contracts based on which didnt even exist in
the sixties. We can now invest in many kinds of securities with different kinds of payoffs.
This is linked with the economists idea of a complete market in which existing securities
can generate all possible future payoffs. Economists and finance academics applaud the fact
that derivatives help markets become more complete. Moreover, derivatives promote trading
efficiency by allowing investments with low trading costs. Derivatives have become an
integral part of risk management.
Risk management isnt what it used to bebuy a couple of derivatives and pray. It has
become incredibly sophisticated with lots of risks to hedge, plenty of techniques to
implement, and a plethora of derivatives to choose from. Quite understandably, derivatives
now form a sizable chunk of the financial markets. Its easy to speculate with derivatives:
buy them up, make huge one-sided bets and laugh on your way to bank or cry on your way to
bankruptcy. Such nave bets have caused huge losses at firms like Proctor and Gamble and
Barings and have given derivatives a bad rap. A cartoon in the Wall Street Journal showing a
boy begging alms from a well-dressed man, Dad was in Derivatives, aptly portrays the
sentiment. Imprudent risk taking without adequate checks and balances has been the
problem. Derivatives, by allowing high leverage, only made such risk taking easier. People
are uncomfortable with derivatives because they are complex instruments, difficult to
understand, and highly leveraged. Legendary investor Warren Buffett and the famous money
manager Peter Lynch of Fidelity Investments said that options should be outlawed (Lynch,
1989). However, most Fortune 500 companies as well as many smaller firms increasingly use
derivatives (including options) for risk managementa trend that is expected to continue.
Derivatives can be extremely useful for risk reduction or hedging. Derivatives trade in
zero-supply markets, where for each buyer there must be a seller. In fact, when you buy a
derivative for hedging, it is likely that the other side in the transaction (counterparty) is
selling it for speculative reasons or profit motives. Consider a simple example.
8
10
Not only will you find regular stock indexes like the Dow-Jones and the Standard and Poors, but a collection
of indexes like the ones based on technology stocks, pharmaceuticals stocks, Mexican stocks, Utility stocks, and
the Value Line stocks. Moreover, you will find price quotes of derivatives that are based on such indexes.
9 High leverage means that small changes in the underlying assets price can cause large swings in the
derivatives price.
10 At the end of this Chapter, there is a discussion of derivatives usage by the blue chip company, consumer
products giant Proctor and Gamble.
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Example 1-1 Hedging and speculation in a derivative (forward contract) transaction

Now its April, the beginning of the corn-growing season, and you are a farmer in
Indiana. You combine the necessary inputs like land, labor, seeds, fertilizers, and
pesticides to produce corn cheaply, and you anticipate selling your harvested produce in
September.
Expertise in growing corn does not provide a crystal ball to forecast corn prices at harvest
times. In fact, if you like working hard during the day and sleeping peacefully at night,
you may decide to immediately lock in a selling price for September. Even if it means
that you take a price lower than your forecasted selling price.
Lets make a leap of faith and move away from the great American humorist Mark
Twains world where difference of opinion makes horse races, and assume that
everyone has the same beliefeverybody expects today that the corn price will be $2.00
per bushel in September. A trader, who happens to be a speculator, offers to buy your
corn in September for $1.95 per bushel. This is called a forward contract, and $1.95 is the
forward price.
You readily agree. Although you are losing 5 cents, you are happy to fix the selling price.
You have one less thing to worry aboutthe forward contract has removed output price
uncertainty from your business. You abhor risk (economists will say that you are risk
averse) and have managed to trade it away for a price. Having hedged your corn, you
can refocus on what you likegrowing corn.
The speculator is happynot that he is wild and crazy about risks. He is a rational guy
who accepts some unwanted risk expecting to earn 5 cents as the compensation for this
service.
But, we have been talking only in terms of expectations. What is likely to happen in most
cases, in reality, is that the price may end up anywhere in September, and either of you
may win or lose.
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Derivatives have many uses. Consider some more examples:

A money manager whose portfolio has reaped huge gains can protect those gains by
buying index put options (portfolio insurance).
A pension fund manager who is worried that her bond portfolio will get clobbered by
rising interest rates can use Treasury bill futures (or options on those futures) to protect
her portfolio.
A meat processor can hedge input prices by buying pork belly futures.
An American manufacturer buying machines from Germany for which payment is due in
three months can remove price risk from the dollar / euro exchange rates by buying a
euro forward contract.
A speculative trader has greater investment choices and a chance to leverage her portfolio
through derivatives.
A sophisticated investor can alter her portfolios risk-return tradeoff by trading
derivatives.
It were not best that we should all think alike; it is difference of opinion that makes horse races, (Mark
Twains The Tragedy of Pudd'nhead Wilson, Hartford, Connecticut: American Publishing Co., 1894)
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A manufacturer of silver jewelry who plans to buy silver in six months can save on
transaction costs by buying silver futures.
An investor who would like to fix a buying price for gold but retain the flexibility of
changing her mind can buy options on gold futures.
A company can transform a fixed interest rate paying loan to a floating interest rate
paying loan through a swap.
An airline can lock fuel costs by entering a commodity swap or by buying oil futures or
forward.
A trader can avoid short selling restrictions on the New York Stock Exchange by easily
taking a sell position in the options or the futures market.
And a wretch can gamble away her inheritance with options.
One of the greatest recognitions for derivatives came in 1997 when Robert Merton and
Myron Scholes were awarded the Nobel Memorial Prize in Economics for developing in
1973 the seminal Black-Scholes-Merton (BSM) model for option valuation. This formula
is extremely usefuloption traders have it programmed into their calculators and computers.
It has also been applied in other branches of economics and business to study problems like
investment valuation, strategic decision-making, and resource extraction. The BSM model
really started derivatives as an academic field in its own right.
The Black-Scholes-Merton model makes a number of restrictive assumptions.
Subsequent researchers have built more powerful valuation models by relaxing these
assumptions and developing pricing models for other kinds of derivatives. A secondgeneration model that is very popular in both Wall Street and among academics is the HeathJarrow-Morton (HJM) model. It relaxes the constant interest rate assumption of the BSM,
extracts information from the interest rate yield curve and builds that into the pricing model.
HJM can price a whole range of derivatives that could not be priced by the BSMin
particular, it can price interest rate sensitive contracts and long-lived derivatives. Introductory
texts avoid HJM due to its complex mathematics. A unique contribution of this book is a
simple intuitive presentation of the HJM model (see Chapter 15). Science is replete with
examples of todays esoteric notions gaining wide acceptance in tomorrows worldwhat
once belonged to specialists soon belongs to the public. This happened to the BSM model.
Learning HJM will give you an advantage when its of even wider use.
Why develop and study better models? Suppose you trade a variety of securities, many
times a day. If your pricing models are better, you have an edge over your counterparties and
competitors. Over many transactions, you will win on the average. Investment banking firms
and other Wall Street companies have no choice but investing in the best modelsits just
too important for their survival. The same applies to other companiesmaybe a little later.
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Nobel Prizes are not awarded posthumouslyFischer Black, a prime originator of the model, died two years
earlier and thus missed the honor. Three other academicsHarry Markowitz, Merton Miller, and William
Sharpewon the 1990 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel (Nobel
Memorial Prize) for their contributions to Finance. Paul Samuelson, John Hicks, James Tobin, Franco
Modigliani, and Robert Engle are other Nobelists who have done significant work in Finance and related fields.
One of the all time great economists John Maynard Keynes studied the properties of futures prices, the role of
the stock market and speculators, and other finance topics. Finance has not only won great acceptance in every
day business life but has also attracted some of the finest academic minds.
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Before studying powerful models with esoteric mathematics, lets keep an eye on reality
and try to understand the basics of trading and the organization of the financial markets. This
is useful because finance, as a field, focuses on institutional details. Moreover, the different
derivatives markets that we discuss later have similar structures to those discussed here.
1.3
Markets and Trading
Primary and Secondary Markets

As a small company grows, it needs more cash. It taps the capital market by going public. A
privately held company sells shares to the general public for the first time in an initial public
offering (ipo). This is the primary market. Subsequently, shares trade in a secondary
marketa market for second-hand transactions in securities. Exchanges and OTC markets
are the two basic secondary markets. Exchanges have a central physical location where
buyers and sellers gather to trade, while OTC (over-the-counter) markets (also called
interbank markets) have no central locationtelephone, telex, and computer networks
bring together the traders who can be dispersed around the globe.
For issuing stocks and bonds, you have to hire an investment banker who will hold your
hand through the process, go through cumbersome paperwork, publish information
brochures, get approval from government agencies like the Securities and Exchange
Commission (SEC), follow a set of procedures, and incur a lot of expenses. Not so for
derivativesin the OTC market pretty much anything goes, and for exchange traded
contracts, you just need government approval for the derivative to trade. For example, the
exchange may have approved gold futures contracts for trading and standardized it for your
convenience. By purchasing, you create a new gold futures contract, and the exchange finds
someone who will take the other side (counterparty) and trade. Derivatives dont even have
certificates like stocks and bondsthey only exist as records in a brokerage firms computer
accounts.
So the derivatives take birth, live, and die in an exchange or an OTC market. Such life
and death processes are best studied on a case by case basis, but theres one thing common to
all the derivativeslike a magician pulling a hare out of his hat, derivatives get created out
of thin air! They are created when one party wants to trade a particular derivative security,
finds another party who will take the other side of the transaction, negotiates a price, and the
deal is done. If you agree to buy at a future date then you have a long position or you are
going long. If you agree to sell at a future date, then you are taking a short position or you
are going short. For exchange traded contracts, by trading one specified unit of the
derivative, traders create one contract of trading volume. At any time, there is a certain
number of exchange traded derivatives of a particular kind that will expire on a known future
datethis number is called the open interest. We will say more about these later. For now,
lets understand a forward contract through an example.
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Stocks and bonds are also moving towards a certificateless existence; e.g., since January 1983, all U.S.
government securities issued are in book entry form at the Federal Reserve Bank, with the owners getting a
receipt of ownership.
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FIGURE 1-2
TIMELINE FOR A FORWARD CONTRACT
Now (January 1)
|
Intermediate date
|
Delivery date (May 15)

|
You agree to buy gold on May 15.

I agree to sell gold on May 15.
No money is paid now.
We agree on the forward price, $300.*
We can close-out our positions You buy my gold for $300.

by making a reverse trade
If gold price > $300, you win.
(sell if long, buy if short).
If gold price < $300, then I win
If we dont close-out our
(zero sum gameones gain
positions, we meet on
is others loss).
May 15.
_______
* Prices are per ounce
Example 1-2 Derivative (forward contract) creation, trading, and maturity (see Figure 1-2)
Today is the 1st of January. You want to enter a gold forward contract that will oblige you
to buy 50 ounces of gold at $300 per ounce on May 15.
Your agent (broker) finds me through my broker. I agree to sell a gold forward contract at
your offered price. I will sell 50 ounces of gold at $300 per ounce on May 15.
No money changes hands between us now. The brokers collect commissions from you
and me for this matching service. Following verification, the transaction gets recorded in
their respective computers. Thus, we created a derivative (forward contract) through
mutual agreement!
If we want, we can close-out our positions by selling our respective side of the trade to
other investors in the same secondary market where it was first created. If we dont closeout our positions, we meet on May 15.
Assume that the prices are per ounce. If gold is worth more than $300 on May 15, the
delivery date, then you win. Say, gold is worth $305then you pay only $300 for gold
thats worth $305 in the spot (cash) market (market for immediate buying and selling).
You make $5 per ounce, or (305-300) 50 = $250 on the contract at my expense.
If gold is worth less than $300, then you lose, for you will be paying $300 for gold thats
worth less in the spot market.
Chapter 1, Page 13
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Exchanges and OTC Markets

Earlier we said that trading takes place in an exchange or an OTC (over-the-counter) market.
Buyers and sellers gather to trade on the exchanges trading floor. If all trades take place in a
central location, many people believe that it provides a level playing field and leads to fair
price formation. The privilege to trade in an exchange and physically be on the trading floor
comes from an exchange membership, also called a seat. The seats are held by individuals
being valuable assets of limited supply, they can be quite expensive. Seat prices reflect
moneymaking opportunities on the floora seat on the New York Stock Exchange (NYSE)
fetched a record 2.6 million dollars in August 1999!
The stock exchanges are regulated by a government agency called the SEC (Securities
and Exchange Commission). The SEC tries to protect investors and prevent fraud. Before
SECs formation in the 1930s, fraud was associated with the stock exchanges and this gave
the industry a bad rap. Interestingly, many folks no longer consider stock exchanges as bad
or risky as before. The derivatives exchanges, riding a wave of mysticism and intrigue,
have easily snatched that accolade!
In order to trade in a stock exchange, a company must satisfy some listing requirements
in terms of the companys assets, earnings, shareholder interests, audit requirements, etc. The
NYSE has the steepest requirements among the exchanges, and the U.S. has stricter listing
requirements than either Japan or Europe.
Like stocks and bonds, derivatives require approval to trade. Each kind of derivative must
be approved for trading on an exchange by the CFTC (Commodity Futures Trading
Commission), a government agency that regulates the futures markets. Many people believe
that listing on an exchange gives credibility to that company or the security and it minimizes
the fear of fraud. Exchanges typically have strict rules and regulations governing trading.
Securities are standardized so that they can be easily bought and sold.
Exchanges are non-profit institutions, but that doesnt prevent its members from avidly
chasing greenbacks. What then are the checks and balances? The exchanges dont want to
kill the goose that lays the golden eggsmost U.S. exchanges try to maintain a good
reputation through strict rules, codes of conduct for members, as well as self-governance
procedures. If self-regulation increases the cost of trading and hurts profitswhats the
incentive for self-governance? Seemingly none, but careful thinking suggests many. The last
thing an exchange wants is government regulators hounding thema good self-governance
procedure may satisfy the Feds and keep them away! Second, a solid self-governance
procedure will attract business by enhancing the reputation of the exchange. Third, selfregulation minimizes the likelihood of fraud or manipulation, encouraging more trading
14
15
14
Nowadays, most exchanges have parallel running computer systems for handling small orders.
In his first term as Vice President, Al Gore suggested a new set of regulations that would clean the
environment, make the companies efficient, and thus increase the rate of economic growth. Nobel Laureate
Gary Becker of the University of Chicago said in a TV interview that this argument is fallacioushow can you
raise economic growth when you are raising the cost of doing business? Economists however distinguish
between regulation and self-regulation: they understand that regulation is costly, they decry excessive
government regulation as bad, but they think that private entities will produce optimal amounts of selfregulation to attract customers and enhance the reputation of their business.
15
Chapter 1, Page 14
AEM 421, Fall
volume (and a reduction in perceived market risk). Fourth, it can stave off lawsuits from
angry customers who feel cheated.
Along with self-regulation, most exchanges have a system of mediating disputes
(arbitration) that handles problems early in the process and lowers the chances of lawsuits.
While sneaky little problems may avoid detection, the big offenders are often punishedthe
Wall Street Journal regularly reports the names of guilty individuals as well as punishments
meted out by the exchanges.
An OTC (over-the-counter) market has fewer restrictions than an exchange. The
geographically separated traders communicate by phone, telexes, and increasingly by
computers. Sometimes an OTC market may be just like a stock exchangeNASDAQ
(National Association of Securities Dealers Automatic Quote System) offers a market for
many big stocks, but also for vastly more small company stocks.
Any transaction that you and I decide to execute, with or without the help of a broker and
without going through an exchange, will be called an OTC transaction. The contract will be
customized to our liking. For example, if you want to buy a highly customized derivative
which has a 4 years life, derives its value from the price of electricity, and a Wall Street
firm executes it for youthen this is an OTC transaction. OTC markets offer great flexibility
but little protection. The U.S. Treasury securities market is an extremely honorable OTC
market where traders go by the maxim My word is my bond. For many OTC markets, even
Treasury markets, when the going gets tough you run the risk of the counterparty failing to
honor the other side of the contract. In OTC markets, as in life, never forsake the adage
Know your customer. Example 1-3 lists some major U.S. and international exchanges and
OTC markets.
Example 1-3 Major U.S. and international exchanges and OTC markets
Major U.S. exchanges:
The New York Stock Exchange (NYSE) is the major U.S. stock exchange.
The Chicago Board of Trade (CBT or CBOT) and The Chicago Mercantile
Exchange (CME) are major futures exchanges.
The Chicago Board Options Exchange (CBOE) is the major U.S. options exchange.
Most securities that we will encounter in this book trade in one of these four exchanges.
Major U.S. based OTC markets:

National Association of Securities Dealers Automated Quotation System (NASDAQ
or Nasdaq, pronounced Naz-dak) is the major OTC market where thousands of stocks
including those of the smallest public companies are traded.
The money market, where very low risk bonds with maturities of one year or less (e.g.
the U.S. Treasury bills) trade, is an OTC market.
OTC instruments are very usefulmany of our examples use OTC instruments reduced
to their basics. The money market provides risk free interest rates that are vital for moving
funds across time and thus for pricing different derivatives.
Some major international derivatives exchanges:
Chapter 1, Page 15
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Started by Deutsche Brse AG and Swiss Exchange as a joint platform for trading and
clearing derivatives trade, Eurex, which operates very much like an OTC market, is the
worlds largest derivatives exchange.
The Hong Kong Futures Exchange (HKFE).
The London International Financial Futures & Options Exchange (LIFFE).
The March terme d'instruments financiers (MATIF).
The Singapore International Monetary Exchange (SIMEX).
The Sydney Futures Exchange (SFE).
The Tokyo International Financial Futures Exchange (TIFFE).
The Toronto Stock Exchange (TSE).
Some major international OTC markets:
Foreign exchange market, a loose telecom network of dealers and brokers, is the
worlds largest and arguably the most important financial market.
The swap market centered in London is a huge OTC market.
We will study many of these markets and securities later in the book.
Brokers and Dealers

The two major classes of participants in the trading process are the dealers and the brokers.
Brokers are intermediaries who match buyers and sellers: they earn commissions for this
service. They dont trade for their own account. Dealers (market makers) on the other hand
take positions in and maintain an inventory of the securities for which they make a market.
They earn a living by posting a bid-ask (bid-offer) spread. The dealer offers the security at
the offer or the ask price and bids the security away from the customer at the bid price. Thus
ask is the buying price for the customer (abc).
Trading Stocks at the New York Stock Exchange
On the floor of the Big Board (a popular name for the New York Stock Exchange) are trading
posts where stand the specialists. They are dealer-broker market makers whose job is to
make an orderly market in the stocks assigned to them. For example, one specialist makes a
market in IBM, another in GM, another in Ford and so on; and there could be some 30 to 50
stocks in which any particular specialist is the sole market maker. The NYSE allows dual
tradingthe specialist acts as broker as well as a dealer on the same day, though not in the
same transaction. By contrast, most U.S. derivative markets ban dual tradingon each
trading day, a seat holder has to notify the exchange whether she wants to wear the hat of a
broker or the garb of a dealer for the entire day. This works because NYSE trades are more
strictly audited than those in the loosely regulated derivatives markets are.
Chapter 1, Page 16
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Example 1-4 Trading Stocks (see Figure 1-3)

Suppose you want to buy a round lot (100 shares) of IBM. Like many major U.S.
companies, IBM trades on the Big Board. You call up your broker, who routes your trade
based on how big is your order. Orders are usually directed to a floor broker, handler of
customer orders on the NYSE floor, who takes it for execution to the specialists post.
These days, smaller orders for up to 1,200 shares go directly to the specialist via Super
DOT (Designated Order Turnaround) system. Huge orders called block trades that
involve 10,000 shares or more, are often negotiated away from the trading floor in what
is known as the upstairs market.
FIGURE 1-3
PLACING A TRADE ON THE NEW YORK STOCK EXCHANGE (NYSE)
Buyer of IBM shares
Buyers Broker
Big order
Super Dot
(small order)
Huge order (e.g., Block trade)
Floor Broker
Negotiated in
upstairs market
Order reaches Specialist.

If market ordertrade with a seller or the Specialist.
If limit orderstays in limit order book until filled.
The specialist maintains a limit order book that records orders waiting to be filled.
Based on standing orders as well as what he thinks is a prudent price (he steps in to trade
on his account if he can offer a better price than those in the order book), specialist quotes
a price of $100.00 to $100.10. This means that he is willing to buy stocks from you at
Chapter 1, Page 17
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$100.00 per share (the bid price) and sell stocks to you at $100.10 (the ask price or the
offer price).
Suppose you submit a market order, which gets executed immediately at the best
available price. If nobody else comes to the trading booth with a better price, the
specialist steps in and sells you 100 IBM stocks at the ask price of $100.10 per share.
Market orders are always filled.
16
Order Placement Strategies

Placing market orders is not the only way to trade. There are many other ways of placing an
order, which determines what price you may get and what is the probability that your order
will be filled. Clever strategies may even allow you to protect your gains and limit your
losses. But there is a tradeoff: sure execution may fetch a bad price, while price
improvement strategies may never be filled. Familiarize yourself with as many order
placement strategies as possible. This would help you in any trading situation: analyze all
relevant factors and choose a strategy from your arsenal thats best for you. Example 1-5
presents some hypothetical situations and considers several order placement strategies that
may be useful (Figure 1-4 shows a classification of these orders)
16
Following a tradition that goes back two centuries, share prices traded in increments of 1/32 nds in the New
York Stock Exchange. For example, a realistic quote for IBM would have been $100 to $100 1/8. To be
competitive with the rest of the world where decimal pricing is the norm and to stave off mounting pressure
from the SEC, the NYSE and other U.S. exchanges recently started quoting stock as well as equity option prices
in one cent increments.
Chapter 1, Page 18
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FIGURE 1-4
A CLASSIFICATION OF SOME ORDER PLACEMENT STRATEGIES
TRADE ORDERS
MARKET ORDER
(Immediate execution)
PRICE DEPENDENT
ORDERS:
Limit order
MIT order
Stop order
Stop limit order
CONTINGENT (STRATEGIC) ORDERS (day or gtc orders)
TIME
DEPENDENT
ORDERS:
Time-of-day order
MOC order
FOK order
All or none order
DRT order
COMBINATION
ORDERS:
Spread order
OCO order
Switch order
Scale order
Cancel order
Example 5-1 Order placement strategies in some hypothetical situations

We begin by considering some order placement strategies for purchasing stock. Later, we
consider strategies that are more relevant for trading futures. Options can also be traded
by adopting strategies that we describe. Also see Figure 1-5 below for a simplified
discussion of some of the order placement strategies.
17
Simplest is a market order

IBM is trading at $100.00 (bid) and $100.10 (ask). Hoping that it will rally, you want to
buy IBM in a hurry (but remember that it is very hard to predict prices unless you have
inside information; in U.S. you risk jail time if you trade on inside information). Place a
market buy order, which gets immediately executed at the best price your broker can
getvery likely at $100.10. Market orders are always filled. You may be forced to pay a
bit more if your counterparty desires, or may be lucky to pay slightly less if a spate of sell
orders suddenly come in and link up with youbut usually you will be able to buy for
17
See Duffie (1989) or a practical futures trading book like Bernstein (2000) for a discussion of many different
order placement strategies.
Chapter 1, Page 19
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$100.10, especially if you are placing a small order. Market order is also the simplest way
to buy other securities such as futures and options.
Orders may depend on a specified price
When a seer was asked about the direction of the market, he replied, market will
fluctuate. Sometimes you may get a better price by waiting. You can try this by placing
a limit order that must be executed at the stated or a better price, or not executed at all.
You must specify whether this would be a day order or a good-till-canceled order: an
unfilled day order automatically cancels at the day end while a good-till-canceled
(GTC) order stays indefinitely open in specialists order book until you knock it off.
Suppose you place a limit buy order at $99.00. If stock price fluctuates and your
trade goes through, then you have made $1.10 price improvement. But you also run the
risk that the stock may rally and the order may never be filled. A limit buy order at $95.00
may give a much better price but has a much higher chance of not being filled.
Even if IBM touches $99.00, your limit order may not be filled. This occurs when there
are many outstanding limit orders at $99.00 and the price moves up before your order
gets filled. If you really want to trade at a price of $99.00 or something close, place a
market-if-touched (MIT) order. It becomes a market order after a trade occurs at your
specified price $99.00.
Suppose you want to buy IBM if you think a rally would develop. For example, you may
place a stop order to buy (or buy stop order) IBM at $101.00, which is above the
current prices $100.00 to $100.10. This becomes a market order as soon as a bid or an
offer or a trade price for IBM hits $101.00 or higher. One fact needs clarification: limit
and stop orders have very different purposes. Note that while limit buy orders are placed
below going prices, a buy stop order is placed above. The motive behind this seemingly
contradictory instruction of buying at a higher price clears up if you understand the
reason behind.
The opposite of a buy stop is a stop-loss order (or a sell stop order) that is placed
below current market prices. Suppose that IBM has a big run-up after you buy and it
settles at $120.00. You may like to lock in your gainbenefit from a rally but cut down
losses if the price suddenly sinks. Place a stop order to sell IBM if the price falls below
$118. Should IBM rise further, you will profit more; if it falls, you can protect a big
chunk of your earlier profits by selling the stock at $118.
Another possibility is placing a buy stop-limit order. Suppose you place a stop-limit
order to buy IBM stock at $101.00, which is above the current prices. This order becomes
a limit buy order as soon as a bid, or an offer or a trade price hits $101.00 or higher.
This has the risk of never being filled. For example, if the market pierces $101 and
immediately shoots up, then your broker will be unable to buy at $101.00 or a lower
price.
You may also specify separate stop and limit prices. Due to their complex nature,
many exchanges do not accept stop-limit orders.
Chapter 1, Page 20
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FIGURE 1-5
SOME ORDER PLACEMENT STRATEGIES
101.00 (Note: a
buy stop is a buy
order placed
above ask)
100.10 (Ask: if you buy immediately)

Specialist
quotes
Place BUY orders below ask (generally)

Place SELL orders above bid (generally)
100.00 (Bid: if you sell immediately)
98.00 (Note: a stoploss is a sell order

placed below bid)
Note: Longer, thicker lines suggest higher probability of being filled.
Orders may depend on a specified time or other characteristics

A time-of-day order specifies execution at a particular time or interval of time. For
example, you may request execution at 2.00 P.M. in the afternoon; or, you may request
execution between 2:30 P.M. and 3:00 P.M.
A good this week order (GTW) is valid only for the week in which it is placed.
A market on close order (MOC order) becomes a market order during the last minute
of trading. As you are likely to get a bad price when hurriedly winding up things at day-
Chapter 1, Page 21
AEM 421, Fall
end (your potential counterparties know that you are trying to escape before the barn door
gets bolted), MOC is also called murder on close order!
A fill-or-kill order (FOK order) must be immediately filled or it is canceled. Dont
place them too far from the current pricesit is unlikely to go through and will only
irritate your broker. Expert traders sometimes use them to test the strength or weakness of
the market.
An all or none order must be executed in full. Suppose you place a limit order to buy
3,000 shares of YBM. A trader is willing to sell you only 1,000 shares. Normally, the
limit order will go through and you will get a partial execution. Someone else may sell
you the remaining 2,000 shares at your price or those may never be filled. With an all or
none order, your broker must get 3,000 shares to match your 3,000 buys. Otherwise, this
limit order will not go through.
A discretionary order (or market-not-held or disregard tape, DRT order) is a market
order but the filling broker may delay it in an attempt to get a better price. This can be
useful for executing large trades, as it gives the broker more leeway to do a better job.
A group of connected orders may be placed in combination (futures trading examples)

Consider futures trading strategies. Futures, like forwards, are deferred delivery
derivative contracts but with some key differences that are explored in detail in Chapter
4. Suppose that two futures contracts tradeone enables you to buy gold in June by
paying an amount roughly equivalent to the ongoing futures price while the other would
let you to do so in December. All the order placement strategies that we have just
discussed could also be used for trading futures. Let us now turn to some trading
strategies that are more relevant for trading futures (and options).
Suppose you find (as in Table 4-6) that the spread or price difference between June and
December 2004 gold futures is $7.80. You consult price charts and conjecture that this
spread would revert back to this level even if it reaches a higher value. You can set up a
spread order involving one market order to buy and another to sell should a perceived
mispricing happen. Place a December 10 dollars over on June-December 2004 gold
futures spread (buy gold for June 2004 delivery and sell gold for December 2004
delivery). This will be executed whenever the price difference between the two futures
rises to $10.00. If the spread falls to $7.80, reverse your trades to book $2.20 in profit.
Spread orders do not consider absolute price levels and focus only on the difference
between two variables. You will see more of spread strategies in Chapter 6.
One cancels the other order (OCO order) or alternative order involves a group of
orders where the execution of one cancels the other. For example, if you place an OCO
order to buy October gold futures at a limit price of $297.00 or December futures at
$299.00, then the execution of any one will cancel the other. OCO helps choose the
contract that reaches a favorable price earlier.
A switch order is a spread order that relates to a previous position. Suppose you buy
December gold futures hoping that the gold will rally. Dark November days came and
went, but nothing happened, and you still have hope. Place a switch order to replace the
maturing December with futures contract that matures next April.
A scale order requests a series of trades at staggered prices. Suppose you are buying 40
December gold futures, which is currently trading at $300.00. Worried that the price
Chapter 1, Page 22
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impact of your trade will lead to partial fulfillment, you may place a scale order to buy 10
contracts at $299.80, 10 at $300.00, 10 at $300.20, and 10 at $300.40.
A cancel order or a straight cancel order completely cancels a previous order. A cancel
replace order replaces an existing order with a new one.
Other Ways of Trading Securities

But a specialist system is hardly the only way to trade. Some exchanges like Pariss MATIF
let stock buy and sell orders accumulate, and then periodically set a price at which all those
orders are traded. Many derivatives exchanges like the Chicago Board of Trade use an open
outcry method that has been there for over a century. Here, each transaction is cried out in a
circular area of the exchange floor called the pit. All the assembled traders get a chance to
participate and the trade is supposed to take place at the best possible price.
Even the open outcry system has come under attack. Ending more than two decades of
floor trading, Hong Kong's futures exchange went completely electronic on June 5, 2000.
Computer screens that display buy and sell orders and match trades have replaced humans.
No wonder that some seers predict that computers will completely replace human beings as
matchmakers in the trading process. But, perhaps not at the Big Board. Through a heavy
investment in technology, they have built a system that can trade a billion shares a day
without glitch. But, everything is developed around the specialistthe technology aids the
specialist, and does not aim at replacing him.
Execution, Settlement, and Clearance

After the broker sends your order to the exchange floor, a counterparty is found who will
take the other side of the trade. This can be another investor who trades away from the floor
or one of the professional dealers who is present on the floor. In the case of the Big Board,
the specialist steps in to trade whenever he can offer a better price. The process of transacting
the order is called execution.
Subsequently, a trade is recognized by the exchange through a process called clearing.
Exchanges have clearinghouses for that purpose, and some brokers and dealers become
clearing members who clear clients trades and also those of non-clearing brokers and
dealers. An elaborate process of margins (security deposits) and fees greases the wheel and
ensures a smooth running of the process.
Finally, a trade ends with an actual cash settlement where the buyer pays money and gets
securities from the seller (see Figure 1-4 for a diagram showing these three operations). The
whole process works quickly for stock trades: for example, the trades in the NYSE are settled
on the next business day.
Chapter 1, Page 23
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FIGURE 1-4
EXECUTION, CLEARING, AND SETTLEMENT IN THE STOCK MARKET
A) EXECUTION
Seller
Buyer
Broker
Broker
Agree on trade
(Alternately, a dealer may replace a trader and her broker)

B) CLEARING (after market closing but before next business day)
Brokerage firm Reps meet with clearinghouse officials to help them clear (recognize and
record) a trade.
C) SETTLEMENT (one or more business days after execution)

Buyer pays seller and gets ownership of the securities.
Exchange-traded options and futures are handled through a more complex process. A
trade is executed and settled, but someone has to guarantee that the traders will honor their
transaction. This is where the clearinghouse steps in. It guarantees each contract and acts as a
seller to every buyer as well as a buyer to every seller. The clearinghouse charges a fee for
this service and protects itself by requiring margins from traders. Traders dont have to worry
about default risk anymore. They can focus on trading strategies without worrying about
possible snags in contract performance.
Chapter 1, Page 24
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Scalpers, Day Traders, and Position Traders

Based on trading strategies, traders can be categorized as hedgers who use derivatives for
risk reduction and speculators who accept risk with profit expectations. We can also add a
third categoryarbitrageurs who try to find price disequilibrium, and trade to take
advantage of such price discrepancies. These roles arent ironclad and traders can easily
switch from one role to another. Still, these are fundamental distinctions made in any
discussion of derivative securitiesyou will find hedgers, speculators and arbitrageurs in
forwards, futures, options, and swaps markets.
The speculators can be further classified on the basis of their trading strategies and how
long they hold their trade:
a) Scalpers trade many times a day with the hope of picking up small profits from each
transaction. They are physically present on exchanges trading floors and pay very low
trading costs. Scalper have very high portfolio turnover and their holding periods are
often measured in minutes and seconds.
b) Day traders attempt to profit from price movements over the day, and close out all
trading positions by day-end. They trade on or away from the trading floor, and
sometimes place their trades around government statistics announcements.
c) Position traders maintain speculative trading position for long periods of time. They
usually trade away from the trading floor. Position traders often try to identify and
capture abnormal price difference between two assets (a spread), with the hope of
reaping a profit when the spread is restored to its historical level.
We need to analyze the motives of different traders and the constraints they face in order
to understand how the bid-ask spreads are formed in securities markets. That leads to a
discussion of market microstructure.
Market Microstructure
What determines the bid-ask spread? Market microstructure tries to find answers to this
question. This literature studies the trading process itself and determines how the rules of
trading affect price formation. We can think of three factors determining the bid-ask spreada) Order processing costs. There are the physical costs of trading like seat costs,
accounting and computer costs, exchange fees, security deposits (margins), taxes, etc. As
real as your income taxes, these costs are necessary to trade.
b) Inventory theory of trading suggests that the dealer adjusts the bid-ask spread to
maintain an optimal inventory.
Example: A dealer quotes $100.00 to $100.50 for a stock but still finds that his inventory
is rapidly growing. Everybody is selling to the dealer. He should first lower the bid price
from $100.00 to $99.50 so that the sell orders fall and the inventory size stabilizes and he
can lower the ask price to make the stock more attractive to the customers. On the other
hand, if the inventory is shrinking, the dealer should first raise the ask price from $100.50
Chapter 1, Page 25
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and then raise the bid so that customer buying falls and a more reasonable inventory gets
built up.
c) Information theory of trading assumes that some economic agents are better informed
about financial markets than others are. This theory suggests that there are two types of
traders: (1) the informed traders who have special information and trade strategically
and (2) the uninformed traders who dont have such information but trade to convert
assets to cash or to rebalance their portfolio. These traders trade with one another and
also with the dealer. Two kinds of gains and losses come from trading securities: (1)
market gains or losses due to rise or fall in the market and (2) trading gains or losses
due to information costs. Investors often think that they are brilliant in picking stocks,
when it may only be a market gain. Only the informed traders make trading gains. The
uninformed traders make trading losses. The dealer always loses when trading with an
informed trader, who knows when to buy or when to sell or when not to trade. To protect
himself from the informed trader, the dealer (1) maintains a bid-ask spread, and (2) offers
to trade only a limited amount at the posted bid and ask prices. The dealer can widen the
spread to make it harder for the informed trader to make money. The dealer recoups
losses by trading with the uninformed traders. Uninformed traders include those who read
the Wall Street Journal and think that they are making informed tradesin reality, that
information has long been built into the prices. The more uninformed are the trades, the
happier is the dealerhe can actually lower the bid-ask spread.
Bottomline: On average, (1) the dealer makes zero profit (normal profit in economics
parlance), (2) the informed traders make positive profits, and (3) the uninformed traders
make negative profits. The dealer acts as a conduit through which funds flow from the
uninformed to the informed trader.
18
Practical relevance of the information theory

This theory helps explains several phenomena observed in financial markets
a) There is the risk of trading with someone better informed than you. Trading on nonpublic proprietary information about a company (insider information) is illegal in the
U.S., but such restrictions are much looser in many countries including Germany and
Japan. When you are enthusiastic about loading up on foreign stocks, please remember
that very few countries in the world have insider trading restrictions as strict as those of
the U.S. Even in the U.S., informed trading may avoid detection. Information comes in
many hues and shadesoften its quite diffused and hardly recognizable to outsiders.
b) Actively traded stocks have small spreads. They are followed by analysts and are widely
held by investors.
Example: Microsoft has a much smaller spread than inactive NASDAQ stocks in both
absolute and relative terms.
c) Prices reflect information. When bad things happen to a company, people trade on that
information and sell stocksthis information soon gets built into the price. Further trades
will not be rewardedyou cannot profit from stale information. Finance economists say
that the markets are efficient because the price reflects the underlying information.
19
18
Gambler, a Kenny Rogers song illustrates this strategy well, You got to know when to hold them, you got
to know when to fold them, you got to know when to walk away, you got to know when to run.
19 For an overview of insider trading laws and prosecution around the world, see Bhattacharya and Daouk, "The
World Price of Insider Trading", Journal of Finance, 2002, vol 57, p 75-108. http://ssrn.com/abstract=200914
Chapter 1, Page 26
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If the markets are efficient and security prices reflect underlying information, then
why do people trade? Perhaps to earn a normal return consistent with the risk-return
tradeoff. Or, perhaps people have different information and thus different beliefs about
what the price should be. Remember again Mark Twains famous quote that differences
in opinion makes a horse race. When somebody gets too enthusiastic about an
investment prospect, finance academics sometimes caution, Do you think you know
more than the market?
d) Direction of trade carries information, so does trade size. Buy orders will put upward
pressure on prices. Large buy orders will move the price up.
Example: Suppose you are a dealer for a small stock in the NASDAQ. No analyst follows
the company and nobody is interested in the stock. An average of 300 shares trades each
day. Suppose you suddenly see a buy order for 10,000 shares on the NASDAQ system.
You will immediately infer that good things are happening to the company. So, you raise
both your bid and ask prices.
e) Informed traders make markets illiquid. Liquidity, a desirable feature of securities
markets, is hard to define. Its the ease with which an asset can be converted to cash and
vice-versa. In a liquid market, trades take place around existing prices, many limit orders
exist above and below the current price, small orders have little price impact, and orders
come rapidly to the market when an order imbalance causes prices to change. In liquid
markets, the spread is small. In contrast, informed traders take innocence away from
the market by placing surefire trades. When trading with the informed, the dealer loses
out on average. He has no option but to widen the spread and make the market more
illiquid.
f) Due to insider trading restrictions, the informed traders operate less in the stock markets
and more in the loosely regulated derivatives markets.
Example: When the options market opened in the U.S., stock-trading volume fell as many
traders moved to the options market. Competition as well as the departure of informed
trading tightened the spread in stock prices.
These concepts are quite relevant for analyzing securities, explaining markets, and
understanding trader behavior. They make you ponder about economic behavior in financial
markets and how to protect yourself from trading losses. But these arent the only risks that
traders face. We next discuss portfolio risk (as we define in finance) and the six major classes
of risks that the market regulators are concerned about.
1.4
Chapter 1, Page 27
AEM 421, Fall
Defining, Measuring, and Managing Risk
Risk is an elusive conceptits hard to define. While dictionaries typically define risk as
something bad that can happen; in modern finance it often means the fluctuation possibilities
of a variable, or default chances on a debt. In finance and business, risk can be defined and
measured in many ways, none of them completely satisfactory. But it does not hurt to try.
20
Portfolio Risk
One of the first things that you learn in finance is a much quoted pearl of wisdom: if you
expect higher returns, then you have to accept higher risks. Whether investing in a single
security or a string of assets that make up a portfolio, the return you expect to earn goes hand
in hand with the risks to which you are exposed. This portfolio risk, which is measured by
the standard deviation of returns, can be broken into two parts: (1) nondiversifiable risk that
comes from market wide sources, and (2) diversifiable risk that is unique to the security and
can be eliminated by careful diversification. Pioneering works by Harry Markowitz, William
Sharpe, John Lintner and others gave us the Capital Asset Pricing Model, the alphas and the
betas, concepts admired by market professionals and finance academics alike. But these
arent the only risks that concern the market regulators.
Regulators Classification of Risks

In 1994, international banking and securities regulators got together and issued guidelines for
the supervision of the booming derivatives market (The Wall Street Journal dated 27 July
1994). In a joint statement, the Basel Committee on Banking Supervision (groups of bank
regulators from major industrial countries) and the International Organization of
Securities Commissions recommended that in the interest of a stable world financial system,
the national regulators must ensure that banks and securities firms have adequate controls
over the risks they incur when trading derivatives.
These regulators identified six major classes of risk in derivative trading:
Credit risk is the risk that one party fails to fulfill its side of a contract.
Market risk is the risk that movement in prices or value will result in a loss in securitys
value.
Liquidity risk is the risk that a securities firm or bank is unable to liquidate or offset a
position because of a lack of counterparties in the market.
Settlement risk is the risk that the counterparty fails to provide funds or instruments at
the agreed time.
20
Websters New American Dictionary (1995) defines risk as Exposure to possible loss or injury. The
American Heritage Dictionary of the English Language defines risk as (1) the possibility of suffering harm or
loss, or, (2) the variability of returns from an investment, or, (3) the chance of nonpayment of a debt.
Chapter 1, Page 28
AEM 421, Fall
Operations risk is the risk that a loss results from human error or deficiencies in systems
or control.
Legal risk is the risk that contracts are unenforceable or inadequately documented.
Credit risk evaluation is a subject of advanced research. Studying and managing market
risk, as we have emphasized before, is the subject of this book. Liquidity risk is a real
problem for tradersthey choose markets where they can easily buy and sell securities. We
have already discussed what makes markets illiquid. We assume away settlement risk in this
booka system of margins (security deposits) kept by investors and guaranteeing of
contracts by the exchanges eliminates such risk. In later chapters we will discuss how these
work in specific derivative markets. Operations risk is a reality one has to live withit can
be reduced by appropriate checks and balances. Legal risk isnt a problem for exchange
traded contracts, however, its a real problem in OTC markets. This topic is best left to courts
and studied in law schools!
In their jargon-laded report, the regulators cited the need for appropriate oversight of
derivatives trading operations by boards of directors and senior management, and the need
for comprehensive internal control and audit procedures. They also urged national regulators
to ensure that firms and banks operate on a basis of prudent risk limits, sound measurement
procedures and information systems, continuous risk monitoring and frequent management
reporting.
21
22
Value-at-Risk
While most of these issues are beyond the scope of this book, let us briefly talk about a
recent development in risk monitoring that has achieved wide adoption. This technique
known as Value at risk (VaR), was pioneered by Dennis Weatherstone, former chairman of
the Wall Street firm J.P. Morgan. He wanted a short daily report summarizing the companys
global risk exposure and an estimate of potential losses over the next 24 hours. VaR provides
this measure. VaR using historical price observations statistically generates a statement like,
We are 99% confident that we will not lose more than $X million in the next 10 days.
Regulators now require all banks to report VaR, which helps them determine whether the
bank is keeping enough capital to offset the risks its exposed to. As with any innovation,
VaR has drawn the fancy and criticism of finance academics as well as practitioners. A single
number that measures something as elusive as risk has both protractors and detractorssee
Jorion (1996) for a good introduction to VaR.
A major criticism of VaR is that it neglects individual risk sources and takes a blackbox
approach to risk management. Let us now examine some major kinds of risks that may affect
businesses.
21
Companies like the Moodys and the Standard and Poor assess the credit risk of a company or a security
offering by assigning a credit rating. The highest rated issues and companies have the lowest chances of default
a default being defined as missing out or delaying on a single scheduled payment. HJM model provides a
way of taking such credit ratings and building them in the pricing model (Jarrow and Turnbull, 2000)
22 Jorion (2001) discusses how industry handles these risks.
Chapter 1, Page 29
AEM 421, Fall
Some Risks that Businesses Face

Think of yourself as the owner of a business. You probably face three kinds of risks
exchange rate risk, interest rate risk, and commodity price risk.
As discussed before, exchange rates fluctuate a lot more these days. It has been
happening since the breakdown of the Bretton Woods System of Gold-Exchange Standard in
1971. If substantial part of your business involves imports and exports or if you have
operations in other countries that send back profits, then exchange rate fluctuations can help
or hurt. This is a risk that you have to understand and hedge or not through exchange-rate
based derivatives.
No less important is interest rate risk. Businesses arent usually flushed with fundsit is
hard to find companies like Microsoft with cash holdings of twenty billion dollars or more.
Most companies find it hard to raise cash. Ups and downs in interest rates can thus raise or
lower your costs of funds and thus the cost of doing business. Interest rate based derivatives
offer many choices for hedging this risk.
Unless you are a finance company, your business is also exposed to fluctuations in
commodity prices. A rise in commodity prices may raise your cost of buying inputs and you
may not always be able to pass it on to your customers. This includes fuel prices and energy
costs. For example, if crude oil price goes up, so does the price of jet fuel and an Airlines
fuel expenses. Sometimes airlines levy a fuel surcharge from passengers, but it is unpopular
and frequently taken back. Another option is to hedge such risks by using oil-price based
derivatives.
In the next section you will see a snapshot of derivatives usage by Proctor & Gamble, a
blue-chip Company that is a component of the Dow Jones Industrial Average.
How a Blue Chip Company Uses Derivatives for Risk Management

SFAS (Statement of Financial Accounting Standards) No. 133, Accounting for
Derivative Instruments and Hedging Activities, as amended, requires U.S. Companies to
report all derivative instruments on the balance sheet at fair value and establishes criteria for
designation and effectiveness of hedging relationships. Take a look at the Form 10-K (Annual
Report) filed by the Cincinnati-based Proctor & Gamble, a giant company that owns some of
worlds best-known consumer products brands. You will find that P&G heavily uses
derivatives for risk management (see Insert 1-1 below for some excerpts on P&Gs
derivatives usage).
A careful reading of Insert 1-1 reveals several interesting characteristics of P&Gs risk
management activity:
P&G is exposed to the three categories of risks that we just mentioned.
P&G consolidates these risks and tries to naturally offset them, which means some risks
cancel each other. It then tries to hedge the rest with derivatives.
P&G does not hold derivatives for trading purposes.
Chapter 1, Page 30
AEM 421, Fall
P&G monitors derivative positions using techniques including market value, sensitivity
analysis and value at risk (VaR) modeling.
P&G uses interest rate swaps to hedge underlying debt obligations and enters into certain
currency interest rate swaps to hedge Company's foreign net investments.
P&G manufactures and sells its products in many countries. It mainly uses forwards and
options to manage the volatility associated with foreign currency purchases of materials
and other assets and liabilities created in the normal course of business (corporate policy
limits how much it can hedge).
P&G buys forwards and options to protect royalties and income from international
operations. It trades foreign currency swaps to hedge some intercompany financing
transactions.
P&G uses futures, options, and swaps to manage price volatility of raw materials.
P&G manages credit risk by not keeping all eggs in the same basketit spreads out the
risk by trading derivatives with a diversity of creditworthy counterparties.
P&Gs overall currency and interest rate exposures are such that the Company is 95%
confident that fluctuations in these variables (provided they dont deviate from their
historical behavior) would not materially affect its financial statements. P&G neither
expects significant risk from commodity hedging activity, nor from credit risk exposure.
How do we go about understanding and controlling these risks? Read on, for that is a
major purpose of this book.
Chapter 1, Page 31
AEM 421, Fall
INSERT 1-1
DERIVATIVES USE BY CONSUMER PRODUCTS GIANT
PROCTOR & GAMBLE COMPANY
23
EXCERPTS ON P&GS DERIVATIVES USAGE FROM THE FINANCIAL REVIEW

SECTION OF 10-K
HEDGING AND DERIVATIVE FINANCIAL INSTRUMENTS
The Company is exposed to market risks, such as changes in interest rates, currency
exchange rates and commodity prices. To manage the volatility relating to these exposures,
the Company nets the exposures on a consolidated basis to take advantage of natural offsets.
For the residual portion, the Company enters into various derivative transactions pursuant to
the Company's hedging policies. The financial impacts of these hedging instruments are
offset in part or in whole by corresponding changes in the underlying exposures being
hedged. The company does not hold or issue derivative financial instruments for trading
purposes. Note 6 to the consolidated financial statements includes a discussion of the
Company's accounting policies for financial instruments.
Derivative positions are monitored using techniques including market value, sensitivity
analysis and value at risk modeling. The tests for interest rate and currency rate exposures
discussed below are based on a Monte Carlo simulation Value at risk model using a one year
horizon and a 95% confidence level. The Model incorporates the impact of correlation and
diversification from holding multiple currency and interest rate instruments and assumes that
financial Returns are normally distributed. Estimates of volatility and correlations of market
factors are drawn from the RiskMetrics(TM) dataset as of June 30, 2001. In cases where data
is unavailable in RiskMetrics(TM) a reasonable proxy is included.
The Company's market risk exposures relative to interest and currency rates, as discussed
below, have not changed materially versus the previous reporting period. In addition, the
Company is not aware of any facts or circumstances that would significantly impact such
exposures in the near term.
23
These excerpts are taken from the Financial Review Section as well as Note 6 on Risk Management
Activities in the Form 10-K filed on 12 September 2001 with the U.S. Securities and Exchange Commission by
P&G This can be found by going to SECs website http://www.sec.gov/, clicking on Search for Company
Filings, typing in Procter & Gamble, and eventually clicking on 10-K filed on 12 September 2001.
Chapter 1, Page 32
AEM 421, Fall
INTEREST RATE EXPOSURE

Interest rate swaps are used to hedge underlying debt obligations. Certain currency interest
rate swaps are designated as hedges of the Company's foreign net investments.
Based on the Company's overall interest rate exposure as of and during the year ended June
30, 2001, including derivative and other instruments sensitive to interest rates, a near-term
change in interest rates, at a 95% confidence level based on historical interest rate
movements, would not materially affect the Company's financial statements.
CURRENCY RATE EXPOSURE
The Company manufactures and sells its products in a number of countries throughout the
world and, as a result, is exposed to movements in foreign currency exchange rates. The
Company's major foreign currency exposures involve the markets in Western and Eastern
Europe, Asia, Mexico and Canada. The primary purpose of the Company's foreign currency
hedging activities is to manage the volatility associated with foreign currency purchases of
materials and other assets and liabilities created in the normal course of business. Corporate
policy prescribes the range of allowable hedging activity. The Company primarily utilizes
forward exchange contracts and purchased options with maturities of less than 18 months.
In addition, the Company enters into certain foreign currency swaps with maturities of up to
five years to hedge intercompany financing transactions. The Company also utilizes
purchased foreign currency options with maturities of generally less than 18 months and
forward exchange contracts to hedge against the effect of exchange rate fluctuations on
royalties and income from international operations.
Based on the Company's overall currency rate exposure as of and during the year ended June
30, 2001, including derivative and other instruments sensitive to foreign currency
movements, a near-term change in currency rates, at a 95% confidence level based on
historical currency rate movements, would not materially affect the Company's financial
statements.
COMMODITY PRICE EXPOSURE
Raw materials used by the Company are subject to price volatility caused by weather, supply
conditions, political and economic variables and other unpredictable factors. The Company
uses futures, option and swap contracts to manage the volatility related to certain of these
exposures. Commodity hedging activity is not material to the Company's financial
statements.
EXCERPTS FROM NOTE 6 RISK MANAGEMENT ACTIVITIES
Chapter 1, Page 33
AEM 421, Fall
CREDIT RISK
Credit risk arising from the inability of a counterparty to meet the terms of the Company's
financial instrument contracts is generally limited to the amounts, if any, by which the
counterparty's obligations exceed the obligations of the Company. It is the Company's policy
to enter into financial instruments with a diversity of creditworthy counterparties. Therefore,
the Company does not expect to incur material credit losses on its risk management or other
financial instruments.
1.5
Summary
Derivatives are financial securities that derive their value from something else. A host of
factors has led to a surge in demand as well as a supply of derivatives in todays financial
markets.
In todays interconnected world, risks coming from different sources can make or break
businesses. Derivatives can both magnify risk (leverage and gambling) or reduce risk
(hedging). While gambling with derivatives remains common, most use derivatives to
remove some unwanted risk affecting their trade.
Stocks and bonds first trade in primary markets before hitting the secondary markets.
Derivatives on the other hand take birth, live, and die in secondary markets like an
exchange or an OTC market.
Exchanges have central locations where buyers and sellers gather to trade. Over-thecounter markets are diffused networks of buyers and sellers, brought together by
telecommunication connections.
Brokers match buyers and sellers and earn commissions for this service. Dealers trade on
their own account and survive by posting a bid-ask spread. The spread helps the dealer
defray order processing costs, maintain an optimum inventory, and protect herself when
trading with someone better informed than she is.
Hedgers use derivatives for risk reduction and the speculators accept risk with profit
expectations. Speculators can be further distinguished as scalpers, day traders, and
position traders on the basis of their trading strategies and how long they hold on to their
trades.
Along with market risk, the regulators are concerned about other sources of risk like
credit risk, liquidity risk, settlement risk, operations risk, and legal risk. Though
unglamorous, these factors can eat away profits and hamper the running of smooth
functioning derivatives markets.
1.6
Chapter 1, Page 34
AEM 421, Fall
Further Information, References, Questions and Problems
Information
You can find plenty of information on derivatives in academic journals, practitioner journals,
textbooks, scholarly books, research reports, newspapers, magazines, Internet websites, etc.
The top refereed finance journals like Journal of Derivatives, The Journal of Finance,
Journal of Financial and Quantitative Analysis, Journal of Financial Engineering,
Journal of Fixed Income, Journal of Futures Markets, Mathematical Finance, The
Review of Financial Studies, and Review of Derivatives Research, regularly publish
articles on derivatives. You will also find studies on derivatives in journals like
European Financial Management, Financial Analysts Journal, and Financial
Management.
The bibliography at the end of this book contains books on derivatives and peppers the
list with brief comments.
Brokerage and investment banking firms like Merrill Lynch, Goldman Sachs, J.P.
Morgan, and Salomon Smith Barney regularly bring out research reports on derivatives.
The Wall Street Journal, Investors Daily and several other business newspapers and
magazines frequently write about derivatives. Risk magazine has excellent research
articles as well as practitioners insights on derivatives.
A wealth of information is available on the Internetexchanges, government agencies,
companies and many other entities disseminate information through their websites. The
homepages for exchanges have market data, educational material, promotional materials,
and other relevant information. Type in an entity name or a keyword in a search engine
like Yahoo, and the websites will come popping up. Search engines also list interesting
websites under headings like Business, Finance, and Investing.
24
References
Jarrow, R. A., and S. Turnbull, 2000. Derivative Securities, 2nd edition. South Western
Publishing: Cincinnati, Ohio.
Jarrow, R., 2002. Modelling Fixed Income Securities and Interest Rate Options, 2nd edition.
Stanford University Press: Stanford, California.
Jorion, P., 1996. Value at Risk: The New Benchmark for Controlling Market Risk. Irwin
Professional Publishing.
24
Just as FDA (Food and Drug Administration) puts new medicines through rigorous clinical trials before
approval (so that you can think: That stuff must be safe, otherwise they would not have approved it), refereed
journals follow a process that tries to fairly evaluate research, making it safe for further consumption. The
authors send their paper to the editor of the journal, who removes the authors names from the article and sends
it to a scholar who acts as the referee. The editors decision to publish the paper heavily depends on the referees
report. In spite of flaws, this system of peer evaluation is the most objective system of judging the merits of
academic work.
Chapter 1, Page 35
AEM 421, Fall
Jorion, P., 2001. Financial Risk Manager handbook 2001-2002. GARP. John Wiley & Sons,
New York, New York.
Miller, M., 1986. Financial Innovation: The Last Twenty Years and the Next. Journal of
Financial and Quantitative Analysis 21, 459-471.
Smithson, C. W., C. W. Smith, Jr., and D. S. Wilford, 1995. Managing Financial Risk. Irwin
Professional Publishing, Burr Ridge, Illinois.
Questions and Problems on Chapter 1

1. What is the impact of the development of powerful, new computers on financial securities
and their markets?
2. What is a derivative security? Give an example of a derivative.
3. What are some of the major applications and uses of derivatives?
4. Evaluate the statement: hedging and speculation go hand in hand in the derivatives
market.
5. You announce to your roommate: These days, American businesses face more risk than
ever before. She thinks that you are talking about terrorism, global warming, pollution, and
what not. However, you are talking about two major U.S. policy changes that have made
exchange rates and interest rates more volatile than before.
a) Explain your statement to your roommate.
b) Explain to her why financial futures have replaced agricultural futures as the most actively
traded contracts.
6. Explain the following statements:
Derivatives are zero-supply securities. Derivatives are zero-sum games.
7. Distinguish between
a) a stock and a bond
b) speculation and hedging
c) an exchange and an OTC market
d) a broker and a dealer
e) a bid and an ask price
f) market order and limit order
Chapter 1, Page 36
AEM 421, Fall
g) spot and forward markets

h) volume and open interest
i) execution and settlement
8. U.S. Banks can borrow funds from the Fed (Federal Reserve Bank) by paying whats
called a discount rate. This interest rate is cheaper than other rates at which the bank can
borrow. However, if they start tapping this source of funds regularlythey will get a call
from a Fed official, who will politely ask, How are things at the bank and why are you
borrowing from us regularly? If the bank does not take the hint, the Feds will come down
and start examining their books.
a) What does this story tell you about the objectives of the banks (private entities) and
regulators?
b) The Securities and Exchange Commission (SEC) regulates the American stock markets.
However, the New York Stock Exchange (NYSE) members have committees, which carry
out a whole host of self-regulatory activities. NYSE members are profit-seeking
individualswhy would they self-regulate themselves, when regulations only raise their cost
of doing business? Does the above story provide any clue? What does self-regulation do to
the reputation of the marketplace?
9. What are the costs and benefits to a corn grower trading a forward or a futures contract? If
she is expecting a harvest in three months, should she buy or sell the derivative?
10. Why does the dealer offer to trade only a fixed amount at the bid and ask prices?
11. You are a dealer and post a price of $50.00 to $50.50 for a stock. The buy orders
outweigh sell orders, and your inventory is dwindling.
a) How would you adjust the bid and the ask if you believe in the inventory theory of
trading?
b) Whats the problem if you keep on raising the bid without adjusting the ask?
c) What would you do if you believe in the information theory of trading? Please explain
your actions.
12. There are many ways to trade. In the nineties, there was a proliferation of discount
brokerage firms in the U.S. They allow trading at bare bones commissions, but will only let
customers choose from a handful of order types. The traditional full-service brokerage firms
Chapter 1, Page 37
AEM 421, Fall
charge higher commissions, but allow customers to place trades in many different ways.
They also give personal advice and research reports. Well, everything has its price.
We define different order types, which can be used to trade stocks, bonds, futures, and
options. Unless specified, an order is placed as a day order, which, if not executed, cancels at
the end of the trading day. Or, you can instruct the broker to place it as a good-till-canceled
order (GTC order), which stays in the limit order book (a book where orders pending
execution are recorded) until cancelled.
Come up with examples for each of the following using YBM as the security traded, the
quoted share price being $100.00 to $100.10.
a) Odd lot trading is when the stocks are not traded in round lots (multiples of 100 shares).
b) A market order (MKT order) gets immediately executed at the best available price.
c) A limit order must be executed at a stated price or one thats more favorable (give
examples of limit-buy as well as limit-sell orders).
d) A stop order or a stop-loss order (STOP order) becomes a market order after a certain
price is reached. A stop-loss sell order is placed at a price lower than the current price, while
a start-gain order is placed at a price higher than the current price
e) A market-if-touched order (MIT order) requests execution at the best available price after a
trade occurs at the price shown on the order or at a better price.
f) A discretionary order (or market-not-held or disregard tape, DRT order) is a market order
but the filling broker can delay it in an attempt to get a better price.
g) A time-of-day order specifies execution at a specific time or interval of time.
h) A fill-or-kill order or a quick order (FOK order) must be immediately filled or its
canceled.
i) An all or none order must be executed in full.
13. It has been observed in many countries that when options exchange opened, the volume
fell in the stock exchange but so did the average stocks spread. Explain such a phenomena
using market microstructure insights.
14. When the international regulators in their 1994 report defined risk, what definition of risk
did they have in mind? How does this compare with the risk definition you learned when
studying the capital asset pricing model (CAPM) and other tenets of modern portfolio
theory?
Multiple Choice Question
Circle the correct answer in each of the following questions
15. Traders with superior information are most likely to trade in
a) stock market
b) bond market
c) options market
d) money market
Chapter 1, Page 38
AEM 421, Fall

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Derivatives Trading and Risk Management

Chapter 1 Derivatives Trading and Risk Management

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Financial Securities and Derivatives

Growing Financial Markets

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Example 1-1 Hedging and speculation in a derivative (forward contract) transaction

Derivatives have many uses. Consider some more examples:

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Markets and Trading

Primary and Secondary Markets

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Delivery date (May 15)

You agree to buy gold on May 15.

We can close-out our positions You buy my gold for $300.

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Exchanges and OTC Markets

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Major U.S. based OTC markets:

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Brokers and Dealers

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Example 1-4 Trading Stocks (see Figure 1-3)

Buyer of IBM shares

Huge order (e.g., Block trade)

Order reaches Specialist.

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

Order Placement Strategies

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

CONTINGENT (STRATEGIC) ORDERS (day or gtc orders)

Example 5-1 Order placement strategies in some hypothetical situations

Simplest is a market order

Jarrow, Turnbull, Chatterjea

Derivatives Trading and Risk Management

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Derivatives Trading and Risk Management

100.10 (Ask: if you buy immediately)

Place BUY orders below ask (generally)