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CHAPTER 10: DERIVATIVES

Topic One: What Is a ?

1. Overview. A. Derivatives are investments that derive value from an underlying asset or (e.g., , , stock , index, or a real asset, such as gold).

B. Derivatives can be used to reduce the risk of an underlying asset’s future , to speculate on the value of the underlying asset, or to an underlying asset.

C. The two categories of derivatives are options and forwards. (1) Options: A contract between a buyer and a seller: (a) The buyer has the right (but not the obligation) in the future to buy or sell an agreed-upon amount of an underlying asset at an agreed-upon price. (b) If the buyer wishes to his or her right, the seller must complete the transaction. (c) An owner of a call has the right to buy the underlying asset. (d) An owner of a has the right to sell the underlying asset.

(2) Forwards: Also contracts between a buyer and a seller. The buyer and seller are obligated to complete a transaction in the future for an agreed- upon amount of an underlying asset at an agreed-upon price.

2. Features Common to All Derivatives. A. Derivative agreements are contracts that set out the rights and obligations of the buyer and the seller.

B. Both parties to the contract must fulfill their contractual obligations or exercise their rights by the date, after which the contract is automatically terminated.

C. Each derivative contract includes a price or formula to determine the price of the asset to be bought or sold on the expiration date or before.

D. No up-front payment is required for forwards. To provide the seller with a sense of confidence that the terms of the contract will be fulfilled, the buyer can put up a performance or a good-faith deposit.

E. An options buyer makes a payment, called a premium, to the seller when the contract is drawn up. The buyer may then buy or sell the underlying asset at a preset price, on or before the contract expires.

F. Derivatives are a zero-sum game: every dollar lost by one party represents a dollar gained by the other.

3. Derivative Markets. A. Derivatives trade on over-the-counter (OTC) markets and exchanges. (1) Over-the-Counter (OTC) Derivatives (a) The OTC is made up mainly of financial institutions (e.g., ) trading with each other and with large corporate clients. (b) Transactions are made by dealers/brokers directly over the phone and computers, 24 hours per day, including weekends and holidays. (c) OTC derivatives can be more complex than exchange derivatives, as they are often custom-made to meet the needs of the client. (2) Exchange-traded Derivatives (a) A derivative exchange provides trading facilities via a trading floor or an electronic trading system. (b) Regulations for trading are made and enforced by the exchange. (c) This market was created due to standardization, risk, and liquidity issues present in the OTC market.

Comparison of OTC vs. Exchange-traded Derivatives OTC Exchange-traded Standardization and No standard contracts — Standardized contracts—no flexibility contracts customized to customization client need Privacy Completely private trades Trades are publicly known Liquidity and Contracts not liquid Contracts easily liquidated by offsetting taking offsetting market position risk High Low due to houses that guarantee contractual financial obligations Regulation Unregulated Regulated by their exchanges and government agencies

Topic Two: Types of Underlying Assets (For Exchange-traded Derivatives)

1. Commodities. A. Commodities are consumable: grains and seeds, livestock, lumber, fibre, food (e.g., orange juice, sugar), precious and industrial metals, and energy products (e.g., oil, natural gas).

B. Commodity futures and options are used: (1) By commodity producers, merchandisers, and processors, to protect against fluctuating commodity prices.

(2) By speculators, to profit from fluctuating commodity prices.

C. Commodity prices depend on supply and demand, agricultural production, weather, government policy, international trade, demographics, economics, and politics.

D. Most commodity derivatives are traded on exchanges.

2. Financials. A. Financial derivatives have financial assets underlying them.

B. Volatile interest and exchange rates, deregulation and competition among financial institutions, globalization, technological advances, and advancements in have all played a role in the recent growth of financial (and other) derivatives.

C. and Equity Indexes. (1) Equity options (i.e., individual stock options): (a) The principal type of . They trade on organized exchanges in the major trading nations (e.g., the Montreal Exchange).

(2) Equity index derivatives: (a) Based on equity indexes. (b) Settled by delivery instead of delivery of the underlying , thus eliminating the cost and complications of trading a quantity of stocks in the index. (c) Used by for hedging stock positions, adjusting portfolios, arbitraging comparable stock-combination contracts, and speculating on market direction. (d) In Canada, one index on which these derivatives are based is the S&P/TSX 60 Index. (e) Options on exchange-traded funds (e.g., iUnits S&P/TSX 60) are a recent type of listing; they require settlement by delivery of the underlying ETFs.

(3) Interest-rate derivatives (exchange-traded): (a) Interest-rate derivatives traded on an exchange are based on securities that are sensitive to interest-rate changes, not based on interest rates directly. (b) Underlying assets for these derivatives in Canada are GOC bonds and bankers’ acceptances, with futures options available on three-month bankers’ acceptances. (c) In Canada, interest-rate futures trade on the Montreal Exchange. (d) In the United States, underlying assets for these derivatives include Eurodollars, and treasury notes and bonds.

(4) Interest-rate derivatives (OTC-traded): (a) OTC-traded interest-rate derivatives are based on floating interest rates. (b) OTC contracts settle in cash.

(5) Currency derivatives: (a) Common underlying assets for these include the U.S. dollar, the Japanese yen, the British pound, the Euro, and the Swiss franc. (b) On organized exchanges, currency futures and options are commonly traded. On OTC markets, currency forwards and currency swaps are common. (c) Currency derivatives are not listed on any Canadian exchanges.

Topic Three: Why Investors Use Derivatives

1. Individual Investors. A. Individual investors mainly trade exchange-traded derivatives through a special account with a brokerage firm that must be registered to handle these accounts. (1) Options are more actively traded than futures.

B. These investors use derivatives to speculate and manage risk.

C. Investors must understand the risks of derivatives before investing, and should speculate only if they can handle the potentially large losses involved.

D. Investment advisors and representatives must have the following courses completed to become licensed before dealing with individual derivatives investors: (1) The CSI’s Derivatives Fundamentals Course (DFC), and (2) The Options Licensing Course (OLC or the Futures Licensing Course (FLC).

E. Individuals who purchase hedge funds and mutual funds that use derivatives are indirectly participating in derivatives.

2. Institutional Investors. A. Institutional investors that use derivatives include companies, managers of mutual funds, hedge funds, pension funds, etc. (1) They also use derivatives to speculate and manage risk. (2) Many institutional investors use derivatives to alter their asset allocation.

B. Unlike individual investors, they are able to trade OTC derivatives in addition to exchange-traded derivatives. (1) Costs associated with trading, including commissions, bid-ask spreads, and administrative fees can affect a decision to enter or leave a market. (2) Switching markets temporarily using derivatives may be more cost- effective than directly trading in the underlying assets.

3. Corporations and Businesses. A. Use derivatives to manage risks associated with interest rates, currency, and commodity prices.

B. The companies that use derivatives often: (1) Use borrowed funds. (2) Have international interests. (3) Consume or produce large amounts of commodities.

C. Corporations use hedging to manage risk while focusing on their primary business. (1) The purpose of hedging is to reduce the risk of losses from investments. Hedgers ―play both sides‖ by investing in derivatives that will benefit them in the opposite way as assets they are already invested in. (2) Hedging is useful for individuals or companies that rely on a certain asset as a part of their everyday business; by hedging with derivatives against the asset, they balance out the risk of loss. (3) In to protect against price decreases, the hedger can take a position in a or buy a put option on the asset. (a) For Example: A beef farmer has an interest in the price of beef increasing, but can offset the risk of it decreasing by buying derivatives that benefit from low beef prices. (4) In order to protect against price increases, the hedger can buy a forward contract or a on the asset. (a) For Example: A car- parts manufacturer benefits from low prices of metals, but can offset high metal prices by buying derivatives that pay off when metal prices are high. (5) Hedging can reduce—but does not eliminate—risk, so the company’s board of directors must be knowledgeable enough to decide when and how much to hedge.

4. Derivative Dealers. A. Derivative dealers are intermediary users of derivatives: they buy and sell derivatives, according to the demand of end users. (1) Individual investors, institutional investors, and corporations and business are end users of derivatives.

B. On OTC markets, derivative dealers take the opposite side to positions entered into by end users.

C. OTC derivative dealers in Canada include: (1) The ―big six‖ banks. (2) Canadian subsidiaries of large foreign banks. (3) Investment dealers. D. Exchange-traded derivative dealers in Canada include: (1) Banks. (2) Investment dealers. (3) Individuals.

Topic Four: Options

1. Overview. A. An option is a formal contract between the holder (i.e., the options buyer), and the seller, also known as the writer. The contract specifies the right, but not the obligation, to buy (call) or sell (put) a certain quantity of a security, at a stipulated price (the , or exercise price), until an expiration date.

B. The buyer of a call hopes that the price of the security will go up by an amount large enough to provide a profit when the option is sold.

C. The buyer of a put hopes that the price of the security will go down by an amount large enough to provide a profit when the option is sold.

D. The seller (i.e., the option writer) must buy or sell the underlying asset when the buyer wishes. The buyer has no further obligation to the seller after paying the option premium.

E. The expiration date of an OTC option is agreed upon by the counterparties. The expiration date of an exchange-traded option is determined by the exchange.

F. Options usually have short terms to expiration (e.g., nine months or less). Exchanges have recently started to list options with longer expirations, called -term Equity AnticiPation Securities (LEAPS), which offer the same risks and rewards as regular options.

G. The option premium is the price the buyer pays to purchase the option from the seller.

H. Option writers of exchange-traded options must maintain sufficient to cover transactions in their option account. This is not normally required in the OTC market.

2. Terminology. A. To be ―long‖ on either a call or a put is to have the expectation or hope that one will profit from a rise in the market price of the underlying interest.

B. To be ―short‖ on either a call or a put is to have the expectation or hope that one will profit from a fall in the market price of the underlying interest.

C. If the buyer is long, then the seller is always short, and vice versa.

D. The following chart illustrates the rights and obligations associated with option positions (calls [buys] and puts [sells]):

Holder or Buyer Writer or Seller Calls - Has the right to buy the - Has an obligation to sell the security until expiry. security. - At the strike price. - At the strike price. - Pays a premium ($). - Receives a premium ($). Puts - Has the right to sell the -Has an obligation to buy the security until expiry. security. - At the strike price. - At the strike price. - Pays a premium ($). - Receives a premium ($).

E. An option is described by a as its: ―underlying interest,‖ ―month of expiration,‖ ―strike price,‖ ―option type‖

Thus, a writer of an option to sell 100 TCB shares at a $10 strike price for June would state he or she wants to ―sell 100 TCB June 10 puts.‖

3. Options Trading. A. The size or amount of the underlying asset that one option contract represents is the option’s trading unit.

(1) There are a variety of trading units for options. In North America, the trading unit is always 100 shares for exchange-traded options.

B. An option’s premium quote is always for one unit. (1) The calculation of a contract’s total premium is: premium quote x option’s trading unit = total premium

(a) For example, for a North American exchange-traded option with a premium quote of $5:

$5.00 x 100 = $500.00

The total premium of the contract is $500.

C. A company has no say in whether there are options on its shares. Options are not used to raise capital.

D. European-style options (i.e., most index options) may be exercised only at the expiry date. American-style options (e.g., exchange-listed equity options) may be exercised at any time.

E. A new position in an option contract is an opening transaction.

F. There are three things that can occur before an option’s expiration date: (1) An offsetting transaction can be used to liquidate a position: (a) To offset a long position, the same type and number of contracts must be sold. (b) To offset a short position, the same type and number of contracts must be bought. (c) OTC options are offset only through negotiations by the parties.

(2) The option can be exercised by the option holder: (a) When the option is exercised, the seller is assigned the option. (b) The buyer of a call option buys the underlying asset from the writer at the strike price. (c) The buyer of a put option sells the underlying asset to the writer at the strike price. (3) The holder of the option can let it expire. (a) If not exercised on or before the expiration date, the option expires worthless.

G. Options are exercised only when they are in-the-money. (1) In-the-Money Calls: The market price of the underlying interest is above the strike price of the call (e.g., If ABC trades at $30 on the expiration date, ABC March 27 calls are considered to be ―in-the-money,‖ because the call can be exercised at $27 and the stock immediately sold at $30 for a profit). (2) In-the-Money Puts: The market price of the underlying interest is below the strike price of the put (e.g., ABC trades at $30 on ABC March 32 puts). (3) An option’s intrinsic value is its portion that is in-the-money. (a) The underlying asset price minus the strike price equals the intrinsic value of an in-the-money call option (e.g., ABC trades at $30. ABC March 27 calls. 30 – 27 = $3 intrinsic value). (b) The strike price minus the underlying asset price equals the intrinsic value of an in-the-money put option (e.g., ABC trades at $30. ABC March 32 puts. 32 – 30 = $2 intrinsic value). (c) An option with no intrinsic value has a strike price that matches the underlying asset price. This is known as an at-the-money put or call.

(4) Options trade for amounts greater than their intrinsic value before their expiry dates. This amount above the intrinsic value is the option’s time value. (a) The time value is the amount equal to the option’s premium, less the option's intrinsic value (e.g., ABC trades at $30. ABC March 27 calls at $4.75. Intrinsic value = $3.00. Time Value = $1.75). (b) The more time to expiration, the higher the time value. An option’s time value diminishes at an increasing pace as the expiration date approaches.

H. When the market price of the underlying interest is below the strike price of the call (e.g., ABC trades at $30. ABC December 31 calls), the option is an out-of- the-money call. (1) When the market price of the underlying interest is above the strike price of the put (e.g., ABC trades at $30. ABC December 28 puts), the option is an out-of-the-money put. (2) Out-of-the-money options are not exercised.

4. Option Exchanges. A. In Canada, options on stocks, stock indexes, financial futures, and exchange- traded funds are listed on the Montreal Exchange, and agricultural futures are listed on the ICE Futures Canada (formerly Winnipeg Commodity Exchange).

B. How to Read an Options Quote. (1) Option quote: Following is a sample of a derivative quotation for an option as it may appear in a financial newspaper.

Note: The superscript numbers refer to the explanations immediately following the quotation. They would not appear in the paper.

CDCC Equity Option Quotations 1Series 2C 3Bid 5Ask 6Last 7Vol 9Op Int 4 415.50 8Opt DAO Vol 420 Inc. 10Feb. 11$15.25 3.20 3.40 3.35 55 1600 11$15.25P 2.25 2.50 2.40 10 3100 10May 11$16.75 1.80 2.00 1.90 40 3300 11$16.75P 1.35 1.50 1.45 35 1090

10Aug. 11$19.00P 1.55 1.75 1.70 280 1010

Explanation (1) Name of company (i.e., the option’s underlying asset). (2) The currency the equity trades in. C = Canadian (3) The closing bid price for each option, expressed as a per- price. (4) The closing market price of the underlying equity. (5) The closing asking price for each option, expressed as a per-share price. (6) The price of the contract traded (also called the sale price), expressed as a per-share price. For example, $3.35 was the last price for the February calls. (7) The number of contracts traded that day (e.g., 55 contracts of the February calls representing 5,500 underlying shares [55 x 100]). (8) Total trading days volume in all series (55 + 10 + 40 + 35 + 280 = 420) (9) The . This is number of contracts outstanding that have not been closed out or exercised. The larger the number, the more liquid the series. (10) The expiration month of the option (e.g., February, May, August). (11) The exercise price (sometimes called strike price) of each series. P represents a put. When no letter appears, it is a call.

5. Options Strategies for Individual and Institutional Investors.

Buyer’s Expectation Writer’s Expectation

Call An alternative to buying the Selling the call option asset, offers investment guarantees the writer an leverage, and diversifies asset acceptable sale price at a allocation. future date.

Hopes the asset price goes Hopes the asset price goes up, and the call locks in the down, so the option will be future price at a guaranteed bought but not exercised— level, or that the option can be therefore, the writer keeps the sold directly into the market asset and earns income (the (long position). premium) (short position).

Put Can lock in a minimum selling Writer usually does not own price on asset owned by the the asset. buyer.

Hopes the asset price goes down, so the put will increase Hopes the asset price goes in value and can be resold for up, the put declines in value, a profit (short position). and is not exercised — therefore, the writer earns the premium income (long position).

A. Buying Call Options. (1) Buying calls to speculate. (a) For example: i. Jim buys 2 DAO January 25 calls at $3. This means that, for the premium of $600 ($3 x 100 shares x 2 options contracts), he has the option of buying 200 DAO shares at $25 before the January expiration date. ii. The decision to buy this option is based on the belief that DAO shares will trade above the total cost of the strike price ($25) plus the option premium ($3). iii. If the price of the shares increases to over $28, Jim can choose to sell the call options before they expire, for more than $3, and make a profit. iv. If the price of the shares decreases, however, Jim will have to decide whether to sell the options for a loss to redeem some of the premium paid, to hold on to the options in hopes that the price will rise prior to expiry, or to let the call options expire worthless and lose the amount of the premium. (2) Buying calls to manage risk. (a) For example: i. Teresa is planning to purchase 25,000 shares of DAO next June. To reduce the risk of an increasing share price between now and then, she buys 250 DAO June 25 call-option contracts. ii. The call option establishes that Teresa will not pay above $25 per share, plus the premium paid for the calls. iii. If DAO is trading at less than $25 per share, Teresa can let the call option expire worthless and purchase the shares in the market at the lower price.

B. Writing Call Options. (1) There are two types of call-option writers: (a) writers – own the underlying asset. (b) writers – do not own the underlying asset; therefore, have to buy the asset at market price if the option is exercised. (2) Covered call writing. (a) For example: i. Sara owns 300 DAO shares and believes the price will stay at $25 or decrease in the near future. She decides to write 3 DAO September 25 calls and sell them at $3.50. ii. If, as Sara suspects, the shares remain at a value of $25 or less, the option is unlikely to be exercised. In this case, Sara keeps her shares and makes a profit equal to the premium of $1,050 (300 shares x $3.50) paid by the buyer. iii. If the price rises above $25 and the buyer exercises the call (most likely at $28.50 or higher, because the buyer wants to redeem the premium), Sara will be forced to sell the shares at $25. She would receive $7,500 (300 x 25) plus the premium paid.

(3) Naked call writing. (a) For example: i. Lester writes 300 DAO September 25 calls at $3.50 as well, but he does not own these shares. Lester believes that the shares will expire at or below $25 and, therefore, will not be exercised. ii. If the shares are not exercised before September, Lester will make a profit of $1,050 (the premium paid by the buyer). iii. If the price of the stock goes to $30 and the buyer exercises the call option, Lester will have to buy the stock at its market price of $30. He would suffer a loss of $450 ($9,000 – [$7,500 buyers cost + $1,050 premium]).

C. Buying Put Options. (1) Buying puts to speculate. (a) For example: i. Travis buys 5 DAO December 25 puts for $2, with the belief that the shares are going to drop in price. A drop in the value of DAO stock is likely to mean an increase in the value of puts. ii. If the shares were trading at $21, Travis might choose to sell the put options for $4 for a profit of $2 per share or $1,000 total ($2 x 100 shares x 5 put options). iii. If the shares were trading at $28, Travis will have to either sell the puts at this price, hold on to them in hopes that the price will fall prior to expiry, or let the put options expire.

(2) Buying puts to manage risk. (a) For example: i. Nancy owns 500 shares of DAO, and she buys 5 DAO December 25 puts at $2 to secure her investment. ii. This is a married or hedge put, and it allows Nancy to sell the stock at $25 (strike price); the put contract makes the strike price the lowest selling price. iii. If the shares were trading at $21, Nancy would still be able to sell her shares for $25; however, she would have paid the $2 premium on top of that.

D. Writing Put Options. (1) A cash-secured put write is similar to a covered position. This involves setting aside the equivalent cash (often invested in a liquid, short-term, money-market security) for the amount of the strike price on a written put; if the put is assigned, the writer uses the cash (or sells the security) to buy the stock. (a) For example: i. Rachel writes 12 DAO May 25 puts at $2.50. She will receive a premium of $3,000 ($2.50 x 12 x 100). ii. As a cash-secured put writer, Rachel invests $30,000 ($25 x 100 x 12)—the amount of the strike price—in a T-bill, in case the buyer exercises the put option. (b) Cash-secured puts can be used to buy stocks at an effective price, determined by subtracting the premium amount from the strike price. (c) For Rachel, in the example above, the effective price is $22.50 ($25 – $2.50)

(2) A write requires that the writer buy the stock if the put is assigned, but the writer has not specifically set aside funds for this purpose. (a) For example: i. Sean writes 12 DAO May 25 puts at $2.50 and receives a premium of $3,000, but does not set aside the amount to cover the stock. ii. If the DAO shares expire at more than $25, they are not likely to be assigned, and Sean will keep the $3,000 premium. iii. If the DAO shares trade for less than $25, and the put buyer exercises the option, Sean will have to buy the shares at market value and may realize a loss. If the stock was assigned at $20.50, Sean would have a total loss of $2 per share or $2,400 (Sean pays $25/share – sold for $20.50/share = loss of $4.50 – $2.50 premium). (3) Put writers profit if the price of the stock stays the same or increases, because this tends to result in decreased put prices and the options are not likely to be assigned. If this is the case, the put writer keeps the premium payment and does not have to buy the underlying stock. (4) Cash-secured Put Writing. (5) Naked Put Writing.

6. Options Strategies for Corporations. A. Corporations do not use shareholder dollars to speculate in options. They do use options, however, to manage the risks of fluctuating interest or exchange rates and commodity prices. (1) Corporations use call option strategies to lock-in maximum future costs (a) For example, a Canadian auto manufacturer of Japanese cars knows that it will require a number of Japanese parts to be purchased in Yen in a few months’ time. Rather than buy the parts now, at today’s , the company would prefer to wait until the parts are needed and the exchange rates could be better. To avoid the risk of the exchange rate increasing, the company could buy a call option on the Yen, thus locking in the rate at the strike price plus the cost of the option. (2) Corporations use put option strategies to lock in minimum future prices (a) For example, in the summer, a Canadian grain corporation knows it will have a number of bushels of wheat to sell in the fall. Currently, wheat is selling for 0.50 per bushel. To ensure they will get no less than 0.50 per bushel when they are ready to sell, the corporation could buy a put option on wheat.

Topic Five: Forwards and Futures

1. Overview. A. A forward is a contract that covers the purchase and sale of a specified quantity of an underlying asset for future delivery at a certain price. (1) The buyer and seller are obligated to complete the transaction.

B. Forwards that trade over-the-counter (OTC) are known as forward agreements. (1) Forward agreements are most often based on and interest rates, though commodity forwards exist in small contracts. C. Forwards are mainly used by large corporations and institutional investors.

2. Futures. A. Futures are a type of forward that is more accessible to investors. (1) Future contracts are exchange-traded, and expire on the date set by the exchange on which the contract is listed. (2) Financial futures have an underlying financial asset (e.g., bonds). Commodity futures are based on an underlying physical asset (e.g., wheat). (3) As exchange-traded derivatives, the expiration dates, delivery locations, and number of assets per contract are standardized by the exchange. (4) Commodity futures may need to meet strict standards, including quality standards. (5) When a is entered into, no trade immediately takes place (i.e., the buyer does not pay the seller and the seller does not deliver the underlying asset). The contract establishes only that both parties agree to a certain price for the asset to be paid/delivered on a certain future date. (6) Actual futures deliveries are rare. Most often, parties offset positions before the expiration date. (7) Futures are delivered and paid for if they are held until their expiry date.

3. Cash-Settled Futures. A. Futures with undeliverable (or difficult to deliver) underlying assets (e.g., a stock index futures contract) are called cash-settled futures.

B. Delivery is made in cash, and the amount depends on the underlying asset’s performance between the contract’s start and its expiration date. (1) When the contract price is higher than the price of the underlying asset on the expiration date (i.e., prices have fallen), the buyer pays the seller. (2) When the contract price is lower than the price of the underlying asset on the expiration date (i.e., prices have risen), the seller pays the buyer.

4. Margin Requirements and Marking-to-Market. A. To ensure all financial obligations will be met, futures contracts require their buyers and sellers to deposit and sustain sufficient margin in their futures accounts. These margins are a good-faith deposit or a performance bond. They are meant to assure dealers that the financial obligations of the contract will be met.

B. Margins in futures trading are subject to minimums set by the exchange. There are two types of margin: (1) Initial margin (also called original margin)—required at the time the contract is made. (2) Maintenance margin—the minimum balance the party must maintain in a futures account while the contract is open.

C. A key feature of futures is that their trading gains and losses settle daily. This process is called marking-to-market.

D. At the end of a trading day, depending on the price change of the contract since the previous day, those in a long contract position make a payment to those in a short contract position and vice versa.

E. If a party’s settlement losses make their maintenance margin fall below the required amount, the party must add margin to the futures account.

5. Futures Exchanges. A. ICE Futures Canada (formerly Winnipeg Commodity Exchange) lists agricultural futures. The Montreal Exchange lists financial futures, including index futures, some Government of Canada (GOC) bonds, bankers’ acceptances, and the 30- day repo rate.

B. Reading a Futures Quotation (1) Futures quote: Following is a sample of a derivative quotation for a future as it may appear in a financial newspaper.

Note: The small numbers refer to the explanations immediately following the quotation. They would not appear in the paper.

Futures Quotations 2Contract High 3Contrac 4Month 5Open 6High 7Low 8Settled 9Change 10Open t Low 1 Interest 1 1Wheat 5000 bu., Cents Per Bushel 441 366 Mar 08 410 410 410 402 –12 3253 430 377 May 08 406 406 406 404 –7 88 400 330 July 08 395 395 397 392 –6 1357 11Est Sales 12Previous 13Open 14Change Sales Interest 2 2 39860 43295 122954 – 768

Explanation (1) Underlying interest. Prices are based on 5,000 bushels. (2) Contract’s highest price since it began trading. (3) Contract’s lowest price since it began trading. (4) Contract’s delivery month (e.g., March 2008). (5) That day’s opening price for the contract (e.g., the March 2008 contract opened at 410 or $4.10). (6) That day’s highest trade for the contract. (7) That day’s lowest trade for the contract. (8) That day’s closing price for the contract. (9) The difference between that day’s closing price and the previous day’s closing price (e.g., March 08 future closed down 12% from the previous day). (10) The open interest in the contract. (11) The trading day’s estimated volumes. (12) The previous trading day’s estimated volumes. (13) The number of futures open on the underlying interest. (14) The difference between the number of futures open that trading day versus the previous trading day.

6. Futures Strategies for Investors. A. Unlike options, futures do not involve puts or calls. They are simply long positions or short positions, so the number of futures strategies is limited.

B. Buying Futures. (1) Buying futures to speculate. (a) For example: i. Larry buys 8 crude oil July futures at $68 a barrel, for a contract worth $54,400 ($68 x 100 x 8). He deposited an initial margin of $500 per contract ($500 x 8 = $4,000). He intends to sell the futures when the price of crude oil goes up. ii. The margin required to purchase a future contract is small compared to the price of the underlying asset, which means that the leverage can be quite significant. iii. The price of crude oil goes up to $73, and Larry sells his futures. His margin was $4,000, which is still his, and his profit on the futures was $4,000 ($5 increase in value per barrel x 100 x 8). That is a profit of 100%. (b) However, this is risky, because, unlike the case with options, the buyer of a futures contract is obligated to buy the contract and could be forced to sell the contract at a loss should the price of the asset drop. (c) If the price of crude oil had dropped $5 per barrel (to $63), Larry would have suffered a loss of 100%.

(2) Buying futures to manage risk. (a) For example: i. Diane buys 8 crude oil July futures at $68 a barrel. The futures purchase is ensuring Diane that she will pay no more than $54,400. ii. To do this, Diane would not offset the contract while it is open, but let it expire and pay the agreed-upon price.

C. Selling Futures. (1) Selling futures to speculate. (a) For Example: i. Dave sells his Government of Canada (GOC) bond futures, expecting to profit from a predicted decrease in the bond price in the cash market. ii. If the bond price did decrease, Dave would buy back the bond futures at the lower price and make a profit. iii. However, if the Government of Canada (GOC) bond price increased, the price of bond futures would also increase, and Dave would either buy them back at a loss or wait in hopes that the price would go down before expiry.

(2) Selling futures to manage risk. (a) For example: i. Tammy owns Government of Canada (GOC) bonds that she wants to sell in the future. In order to lock in a minimum sale price, Tammy is selling futures on Government of Canada (GOC) bonds. ii. If the Government of Canada (GOC) bond price goes down, Tammy would have to deliver the Government of Canada (GOC) bonds at expiry, and she would receive the locked-in price.

7. Futures Strategies for Corporations. A. Like investors, corporations use futures to manage risk by buying and selling futures on assets to lock in purchase and sale prices respectively.

B. Example of how companies use futures for price protection: (1) In June 2007, Best Bread Bakery estimates it will require 75 tonnes of wheat to make flour in October 2007. The cash market price of wheat is currently $100 per tonne, and the October wheat futures price is $110 per tonne. Fearing a price increase, the bakery buys 3 October wheat futures at $110 (each contract has an underlying asset of 25 tonnes). (2) The rationale behind purchasing the futures is that, if the price of wheat goes up by October, the Best Bread Bakery will be guaranteed to pay no more than $110 per tonne for wheat. (3) However, although the bakery is protecting its purchase price, it may still decide to buy the wheat from its regular supplier prior to the expiration date of the futures contract. It may choose to sell off the futures rather than using them for the purchase. (4) Some reasons for this decision: (a) The bakery would like to avoid the expense of shipping the wheat from a different delivery location; its regular supplier may be less expensive. (b) The quality of the wheat that underlies the futures contract may be poorer than that of the bakery’s regular supplier. (c) It may need the wheat sooner than expected. (5) In addition to the benefits to the bakery of buying from its regular supplier, the futures contract is still beneficial when the bakery chooses to sell it rather than use it: if the price of the wheat increases, the bakery will sell its futures at the higher current price and make a profit, which it can put towards the purchase of the wheat.

Topic Six: Rights and Warrants

1. Overview. A. Rights, warrants, and call options give their holder the right to purchase additional stock at a set price until a certain date (the expiry date).

B. Unlike the case with options, rights and warrants are issued by a corporation to quickly and cost-effectively raise money, rather than to reduce risk.

C. Rights are normally short-term (e.g., four to six weeks).

D. Warrants tend to be issued with three to five years to expiration.

2. Rights. A. The issuing company may offer shareholders the opportunity to buy new shares in proportion to the number they already own. This privilege is called a right.

B. The subscription (also called offering) price is set below the current market price as an incentive to exercise the right. This also gives value to the right itself.

C. The company names a record date on which to close its books. On that date, all common shareholders on the company’s books receive the rights. (1) From the announcement date, up to and including the third business day prior to the record date, the shares trade cum rights (i.e., with the rights). (2) The shares trade ex rights (i.e., without the rights), starting two business days before the record date and until the expiry date.

D. To buy one new share, a specific number of rights are required and the subscriber is required to pay the subscription price.

E. A commission is not charged when the holder exercises rights.

F. Normally, a in the rights develops, and the rights can be sold on the listing exchange (usually the exchange where the underlying trades) by shareholders who do not want to exercise them.

G. Sample Timeline for Rights: (see next page)

May Sun Mon Tues Wed Thurs Fri Sat 1 2 3 4 5 6 7 Company Shares Shares Shares Shares announces trade trade trade trade cum May 11 cum rights cum rights cum rights rights (last record date day).

On this day, all common shareholders on books receive rights.

8 9 10 11 12 13 14 Shares trade Shares Record ex rights trade ex date (first day) rights

Shares will trade ex rights from today until expiry.

H. The price of the rights tends to fluctuate with the price of the common shares as they are affected by similar factors. Rights are not automatically exercised for the rights-holder. The holder has four choices: (1) Exercise any or all the rights and pay the subscription price. (2) Sell any or all the rights. There is not always a market. (3) Buy additional rights to exercise or trade later. (4) Let the rights expire. Once rights expire, they are worthless.

I. The intrinsic value of rights during the ex-rights period. (1) Like options, rights have intrinsic value. Rights have less time value, due to their short life. (2) The intrinsic value of a right in the ex-rights period is calculated as follows:

Market Price of Stock – Subscription Price Number of rights needed to subscribe for one share

(3) For example: TCB Inc. declares rights will be issued to its common shareholders. The rights are worth 1/10 of a share and are offered at a subscription price of $16. The expiry date is October 17.

On October 15, the shares are trading at $18.

Intrinsic value of rights = 18 – 16 10

= 2 10

= $0.20

Therefore, the rights are worth $0.20.

J. The intrinsic value of rights during the cum-rights period. (1) The intrinsic value of a right in the cum-rights period is calculated as follows:

Market Price of Stock – Subscription Price (Number of rights needed to buy one share) plus 1

(a) Using the information from the previous example on October 12 when the market price is $20. The theoretical intrinsic value of a right during the cum-rights period is: 20 – 16 = 4 = $0.36 10 10+1

(2) The theoretical intrinsic value is known as such because, during the cum-rights period, the rights do not trade individually.

K. Trading Rights. (1) Rights are automatically listed on the same the underlying common stock is listed on. Rights are traded until they expire. (2) Often rights trade above or below their intrinsic value because of supply and demand and costs to buy and sell. (3) Canadian trading practices require regular delivery; therefore, they must settle within three business days after the transaction. (4) If rights trade on the TSX Venture Exchange, three days before and on the expiry date a buyer can pay cash and take delivery of the rights on the day of the transaction. This is called trading on a cash basis. (5) The TSX has different settlement rules for rights in the days leading up to the expiry date: (a) Trades three days before the expiry date will settle one day before expiry. (b) Trades one and two days before expiry settle the next day for cash. (c) Trades made on the expiry date settle for cash that day. (d) The TSX stops trading for rights at noon of the expiry date. (e) For these types of short settlement periods, certificates must be delivered by the and be in the investment firm’s account in order to make a trade. (6) Rights often trade on a when-issued basis, because of their short life. This means that, between the time the rights are announced, and the time the rights are received, arrangements can be made between buyers and sellers. (7) Transactions following the actual either involve regular delivery or are made on a cash basis.

3. Warrants. A. Warrants are similar to call options, in that they give holders the right to purchase shares in a company at a set price for a set period of time. (1) However, unlike calls, warrants are issued by the companies themselves, and not by other investors.

B. Warrants that are attached to new issues of shares or are called sweeteners, because they make the issue more attractive.

C. Normally, warrants can be detached and traded separately, either immediately or after a specific period of time.

D. The expiration date of warrants is longer than rights, and can be up to several years.

E. Valuing Warrants. (1) The intrinsic value of a equals the market price of the common share minus the exercise price of the warrant. If this amount is negative or zero, then there is no intrinsic value. (a) For example, DAO Inc. is trading at $20, and the outstanding warrants have an exercise price of $15. The intrinsic value is $5. ($20 [market price of stock] – $15 [exercise price]). If DAO were trading at $14, and the exercise price was $15, the intrinsic value would be zero. (2) The time value of a warrant is the market price of the warrant less the intrinsic value. (a) For example, if DAO were trading at $14, and the warrant was trading at $5, the only value in the warrant would be the time value ($5 [market price of warrant] – 0 [intrinsic value]). If DAO increases to $18, and the warrant is trading at $5, it would have both a time value and an intrinsic value. The time value would be $2 ($5 – $3 [intrinsic value]). (3) The time value decreases as the expiry date approaches and is based on the speculative belief that the warrant will, at some time before expiry, have some intrinsic value.

F. Why Investors Buy Warrants. (1) Warrants are attractive because they provide the potential for leverage. (2) The market price of the warrant is usually much less than the market price of the underlying common stock, but the capital appreciation is usually the same (in absolute terms), resulting in a much greater percentage appreciation. (a) For example: i. A warrant has a market value of $5, with an exercise price of $15 on a common share trading at $20. If the common share rises to $30 a share, the warrant would rise to at least the intrinsic value of $15. This is an increase of 200% of the original price. The buyer of the common share would profit by $10 ($30 – $20), or 50%. (3) The reverse is also true: a decline in the price of the stock results in a much greater percentage capital loss to the holder of warrants.