CHAPTER 1
Futures Markets

In the mid-1800s, Chicago was the transportation and distribution center for agriculture products. Farmers in the Midwest transported and sold their products to wholesalers and merchants in Chicago, who often would store and later transport the products by either rail or the Great Lakes to population centers in the East. Because of the seasonal nature of grains and other agriculture products and the lack of adequate storage facilities, farmers and merchants began to use forward contracts as a way of avoiding storage costs and pricing risk. These contracts were agreements in which two parties agreed to exchange commodities for cash at a future date, but with the terms and the price agreed upon in the present. An Ohio farmer in June might agree to sell his expected wheat harvest to a Chicago grain dealer in September at an agreed-upon price. This forward contract enabled both the farmer and the dealer to lock in the September wheat price in June. In 1848, the Chicago Board of Trade (CBT) was formed by a group of Chicago merchants to facilitate the trading of grain. This organization subsequently introduced the first standardized forward contract, called a "to-arrive" contract. Later, it established rules for trading the contracts and developed a system in which traders ensured their performance by depositing good-faith money to a third party. These actions made it possible for speculators as well as farmers and dealers who were hedging their positions to trade their forward contracts. By definition, futures are marketable forward contracts. Thus, the CBT evolved from a board offering forward contracts to the United States' first organized exchange listing futures contracts-a futures exchange.

Introduction to Futures and Options Markets

Futures and options contracts on stock, debt, and currency, as well as such hybrid derivatives as swaps, interest rate options, caps, and floors, are an important risk-management tool. Farmers, portfolio managers, multinational businesses, and financial institutions often buy and sell derivatives to hedge positions they have in the derivative's underlying asset against adverse price changes. Derivatives also are used for speculation. Many investors find buying or selling options or taking futures positions an attractive alternative to buying or selling the derivative's underlying security. Finally, many institutional investors, portfolio managers, and corporations use derivatives for financial engineering, combining their debt, equity, or currency positions with different derivatives to create a structured investment or debt position with certain desired risk-return features.

This book is an exposition on derivatives, describing the markets in which derivatives are traded, how they are used for speculating, hedging, and financial engineering, and how their prices are determined. Part 1 examines the markets, strategies, and pricing of futures and forward contracts, while Parts 2 and 3 focus on options contracts and pricing. Part 4, in turn, examines the swap market.

Overview of Futures Markets

As new exchanges were formed in New York, London, Singapore, and other large cities throughout the world, the types of futures contracts grew from grains and agricultural products to commodities and metals and finally to financial futures: futures on foreign currency, debt securities, and security indexes. Because of their use as a hedging tool by financial managers and investment bankers, the introduction of financial futures in the early 1970s led to a dramatic growth in futures trading. The financial futures market formally began in 1972 when the Chicago Mercantile Exchange (CME) created the International Monetary Market (IMM) division to trade futures contracts on foreign currency. In 1976, the CME extended its listings to include a futures contract on a Treasury bill. The CBT introduced its first futures contract in October 1975 with a contract on the Government National Mortgage Association (GNMA) pass-through, and in 1977, it introduced the Treasury bond futures contract. The Kansas City Board of Trade was the first exchange to offer trading on a futures contract on an equity index, when it introduced the Value Line Composite Index (VLCI) contract in 1983. This was followed by the introduction of the Standard & Poor's (S&P) 500 futures contract by the CME and the New York Stock Exchange (NYSE) index futures contract by the New York Futures Exchange (NYFE).

Whereas the 1970s marked the advent of financial futures, the 1980s saw the globalization of futures markets with the openings of the London International Financial Futures Exchange (LIFFE) in 1982, Singapore International Monetary Market in 1986, and the Toronto Futures Exchange in 1984. The increase in the number of futures exchanges internationally led to a number of trading innovations: electronic trading systems, 24-hour worldwide trading, and alliances between exchanges. Concomitant with the growth in future trading on organized exchanges has been the growth in futures contracts offered and traded on the over-the-counter (OTC) market. In this market, dealers offer and make markets in more tailor-made forward contracts in currencies, indexes, and various interest rate products. The combined growth in the futures and forward contracts has also created a need for more governmental oversight to ensure market efficiency and to guard against abuses. In 1974, Congress created the Commodity Futures Trading Commission (CFTC) to monitor and regulate futures trading. In that legislation, Congress also allowed the creation of self-regulatory organizations, and in 1982, the National Futures Association (NFA), an organization of futures market participants, was established to oversee futures trading. Finally, the growth in futures markets led to the consolidation of exchanges. In 2006, the CME and the CBT approved a deal in which the CME acquired the CBT, forming the CME Group, Inc. With this and other consolidations, the major exchanges today offering derivatives include CBT/CME, Eurex, ICE, Hong Kong Futures Exchange, Singapore Exchange, Dubai Mercantile Exchange, Bolsa De Mercadorias & Futuros, and the Australian Stock Exchange. Exhibit 1.1 shows the Bloomberg CTM screen that lists the major exchanges trading futures and derivatives today.

EXHIBIT 1.1 Major Futures and Derivative Exchanges

Formally, a forward contract is an agreement between two parties to trade a specific asset at a future date with the terms and price agreed upon today. A futures contract, in turn, is a "marketable" forward contract, with marketability (the ease or speed in trading a security) provided through futures exchanges that not only list hundreds of contracts that can be traded but provide the mechanisms for facilitating the trades. Futures and forward contracts are known as derivative securities. A derivative security is one whose value depends on the values of another asset (e.g., the price of the underlying commodity or security). Another important derivative is an option. An option is a security that gives the holder the right, but not the obligation, to buy or sell a particular asset at a specified price on, or possibly before, a specific date.

Overview of Options Markets

Like the futures market, the US options market can be traced back to the 1840s when options on agriculture commodities were traded in New York. These option contracts gave the holders the right, but not the obligation, to purchase or to sell a commodity at a specific price on or possibly before a specified date. Like forward contracts, options made it possible for farmers or agriculture dealers to lock in future prices. In contrast to commodity futures trading, however, the early market for commodity options trading was relatively thin. The market did grow marginally when options on stocks began trading on the over-the-counter (OTC) market in the early 1900s. This market began when a group of investment firms formed the Put and Call Brokers and Dealers Association. Through this association, an investor who wanted to buy an option could do so through a member who either would find a seller through other members or would sell (write) the option himself.

The OTC option market was functional, but suffered because it failed to provide an adequate secondary market. In 1973, the CBT formed the Chicago Board Options Exchange (CBOE). The CBOE was the first organized option exchange for the trading of options. Just as the CBT had served to increase the popularity of futures, the CBOE helped to increase the trading of options by making the contracts more marketable. Since the creation of the CBOE, organized stock exchanges in the United States, most of the organized futures exchanges, and many security exchanges outside the United States also began offering markets for the trading of options. As the number of exchanges offering options increased, so did the number of securities and instruments with options written on them. Today, option contracts exist not only on stocks but also on foreign currencies, indexes, futures contracts, and debt and interest rate-sensitive securities.

In addition to options listed on organized exchanges, there is also a large OTC market in currency, debt, and interest-sensitive securities and products in the United States and a growing OTC market outside the United States. OTC debt derivatives are primarily used by...