DERIVATIVES & CONTRACTS

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1 DERIVATIVES & CONTRACTS (Derivati e Contratti di compravendita di titoli, future, materie prime) Abs Asset-backed Security. A financial instrument constructed by packaging a group of securities and then issuing a security whose purchaser has a claim against the cash flows generated by the original package. This process is known as securitization. Most asset-backed securities contain additional, complex features that give them option-like characteristics. The prepayment feature of a home mortgage is a good example. Originally designed for the mortgage market, asset-backed securities have also been constructed with packages of receivables, especially credit card receivables. In the mortgage area, the major types of ABS include mortgage pass-through securities and collateralized mortgage obligations. American-style option An option contract that can be exercised at any time from the date of purchase up to and including the expiration date. Most exchange-traded options are American-style. Call (1) An option pursuant to which the seller (writer) of the option is obligated to sell, and the holder of the option has the right but not the obligation to purchase, the underlying security at a specified price at any time until the option expires. (2) An option that gives the right to buy the underlying futures contract. Call option An option contract that gives its holder the right (but not the obligation) to purchase a specified number of shares of the underlying stock at the given strike price, on or before the expiration date of the contract.

2 CBOE Chicago Board Options Exchange. A Chicago-based securities exchange that revolutionized options trading by creating standardized, listed options in Before 1973, options were individually tailored and traded "overthe-counter" by a few put/call dealers. CBOE established a secondary market where options could be traded. The growth in the use of options propelled CBOE to become the world's largest options exchange, and the second largest securities exchange in the US. Today, CBOE captures the largest share of the US options market by trading more than 700,000 option contracts daily. CEC Commodities Exchange Centre. The location of five New York futures exchanges: Commodity Exchange, Inc. (COMEX); the New York Mercantile Exchange (NYMEX); the New York Cotton Exchange; the Coffee, Sugar and Cocoa Exchange (CSC); and the New York Futures Exchange (NYFE). CFTC Commodity Futures Trading Commission. A Federal agency charged and empowered under the Commodity Exchange Act of 1974 with regulation of futures trading in all commodities. Previously, futures trading had been regulated by the Commodity Exchange Authority of the US Department of Agriculture. The CFTC is composed of five commissioners, one of whom is designated as chairman, all appointed by the President subject to Senate confirmation, and is independent of all cabinet departments. Clearing member A member firm of a clearinghouse. Each clearing member must also be a member of an exchange. Not all members of an exchange, however, are members of a clearing organization. All trades of a non-clearing member must be registered with, and eventually settled through, a clearing member.

3 Clearinghouse An adjunct to a futures exchange through which transactions executed its floor are settled by a process of matching purchases and sales. A clearing organization is also charged with the proper conduct of delivery procedures and the adequate financing of the entire operation. CME Chicago Mercantile Exchange. A Chicago-based, not-for-profit corporation owned by its members. Its primary functions are to provide a location for trading futures and options, collect and disseminate market information, maintain a clearing mechanism and enforce trading rules. Commission house A firm that buys and sells future contracts for customer accounts. Commodity A commodity is food, a metal or another physical substance that investors buy or sell, usually via futures contracts. Commodity markets Domestic Commodity Markets CBOT COMEX CME CSCE IMM IOM GEM GLOBEX KCBT MGE MIDAM NYCE FINEX NYFE NYMEX Chicago Board of Trade Commodity Exchange of New York Chicago Mercantile Exchange Coffee, Sugar, Cocoa Exchange International Monetary Market International Options Market Global Emerging Market Global Electronic Exchange Kansas City Board of Trade Minneapolis Grain Exchange Mid-America Commodity Exchange New York Cotton Exchange Financial Instruments Exchange of New York New York Futures Exchange New York Mercantile Exchange

4 International Commodity Markets Deutsche Terminbourse Hong Kong Futures Exchange International Petroleum Exchange London Commodity Exchange London International Financial Futures Exchange London Metals Exchange Marche A Terme International De France Mercado De Futuros Financieros Montreal Stock Exchange Singapore International Monetary Exchange Swiss Options and Financials Futures Exchange Sydney Futures Exchange Tokyo International Financial Futures Exchanges Toronto Futures Exchange Winnipeg Commodity Exchange Frankfurt am Main, Germany Kowloon, Hong Kong London, England London, England London, England London, England Paris, France S.A., Barcelona, Spain Montreal, Quebec, Canada Singapore, Singapore Zurich, Switzerland Sydney NSW, Australia Tokyo, Japan Toronto, Ontario, Canada Winnipeg, Manitoba, Canada Commodity swap A swap in which at least one set of payments is based on the price of a commodity, such as oil. The other set of payments can be either fixed or determined by some other floating price or rate. While payments could be made by delivering actual units of the underlying commodity, in practice cash is exchanged instead. Commodity swaps are becoming increasingly common in the energy and agricultural industries, where demand and supply are both subject to considerable uncertainty. For example, heavy users of oil, such as airlines, will often enter into contracts in which they agree to make a series of fixed payments, say every six months for two years, and receive payments on those same dates as determined by an oil price index. Computations are often based on a specific number of tons of oil in order to lock in the price the airline pays for a specific quantity of oil, purchased at regular intervals over the two-year period. However, the airline will typically buy the actual oil it needs from the spot market. In most interest rate, currency and equity swaps, the variable payment is based on the price or rate on a specific day. However, in oil swaps it is common to base the variable payment on the average value of an oil index over a period of time, which could be weekly, monthly, quarterly, or the entire period between settlements. This feature removes the effects of an

5 unusually volatile single day and ensures that the payment will more accurately represent the value of the index. Average-price payoff structures are also found in other derivatives, particularly options. Counterparty risk (1) The risk that the other party to an agreement will default. (2) In an options contract, the risk to the option buyer that the option writer will not buy or sell the underlying as agreed. Currency hedging The simultaneous purchase and sale of matching forward currency contracts. This strategy is used to manage currency risk. Currency swap A swap in which the parties use two different currencies as the basis of their payments, for example, the US dollar and the Canadian dollar. Derivative instrument (1) A contract, such as an option or futures contract, whose price is derived from the price of the underlying financial asset. (2) A financial obligation that derives its precise value from the value of one or more other instruments (or assets) at that same point in time Derivative market A market for derivative instruments. Derivative security A financial security, such as an option, or future, whose value is derived in part from the value and characteristics of another security, the underlying security. Equity (1) The residual dollar value of a futures trading account, assuming its liquidation at the going market price. (2) The interest or value which an owner has in real estate over and above the mortgage against it.

6 Equity swap A swap in which at least one party s payments are based on the rate of return of an equity index, such as the S&P 500. The other party s payments can be based on a fixed rate, a non-equity variable rate, or even a different equity index. Equity swaps provide an easy and inexpensive means of reallocating a portfolio to a different equity sector. There are many ways to structure an equity swap. For example, the notional principal can be fixed or variable. A fixed notional principal would replicate the position of a portfolio that is rebalanced periodically to maintain the same dollar allocation to a particular asset class. A variable notional principal would reflect a portfolio that is not rebalanced, but whose allocations grow or recede due to changes in the relative market values of its asset classes. In addition, an equity swap can be set up so that one either absorbs or is hedged against the currency risk, depending upon the base currency used for the notational principal. Equity swaps can also be concentrated on specific industries, market sectors, or even individual stocks, though the latter is not common. Equity swaps do have a potentially greater downside risk than interest rate swaps, since equity returns, unlike interest rates, can be negative. Thus, if one market used in an equity swap goes down while the other goes up, the responsibility for both sides of the payments could fall on just one of the parties. European-style option An option that may be exercised only at the expiration date. FCM Futures Commission Merchant. A firm or person engaged in soliciting or accepting and handling orders for the purchase or sale of futures contracts, subject to the rules of a futures exchange and, who, in connection with such solicitation or acceptance of orders, accepts any money or securities to margin any resulting trades or contracts. An FCM must be licensed by the CFTC.

7 Forward contract An contract between two parties in which (a) the buyer agrees to pay the seller a sum of money on a future date in exchange for something in return; and (b) the parties reach their agreement without the involvement of a futures exchange or clearinghouse. Like a futures contracts, what the buyer receives could be an asset, a currency, an option, or a sum of money representing the value of an asset or currency. But unlike a futures contract, the agreement can contain non-standard terms and conditions, such as unusual quantities or expiration dates. More importantly, each party in a forward contract must agree to assume the credit risk of the other party. Depending on their perceptions of the credit risk, the parties might impose some type of collateral requirements, but they are unlikely to require margins or daily settlements of the type required on futures exchanges. Because of these features, forward contracts are generally not designed to be tradable; there is essentially no secondary market for them. When first established, a forward contract is neither an asset nor a liability. It is simply an agreement with an initial value of zero, since at the outset neither party pays anything to the other. A forward contract acquires a positive or negative value only after payment is made. Forward prices are obtained by taking the spot price and adding to it the cost of carry, which is the storage cost and the interest foregone minus any convenience yield or dividend/interest paid on the underlying instrument. This is similar to the way futures are priced. However, there are two major considerations that can lead to price differentials between forwards and futures: (a) Futures contracts will be marked to market daily, whereas forward contracts will not. (b) Forward contracts have credit risks that futures contracts do not. Futures A term used to designate all contracts covering the sale of financial instruments or physical commodities for future delivery on a commodity exchange.

8 Futures contract A standardized agreement to purchase or sell a defined amount of a particular security or commodity at a fixed price on a set future date. The buyer (or long) agrees to take delivery at expiration, while the seller (or short) agrees to deliver when the contract expires. The contract is subject to the terms and conditions established by a federally designated contract market upon which trading is conducted. Since futures contracts are transferable, they are themselves are often traded on the futures market. A futures contract differs from an option in that an option is a right to buy or sell, whereas a future is a promise to actually make a transaction. A future is part of a class of securities called derivatives, so named because such securities derive their value from the worth of an underlying investment. Futures option An option on a futures contract. Interest rate swap A binding agreement between counterparties to exchange periodic interest payments on some predetermined dollar principal, which is called the notional principal amount. Interest rate swaps are the most common type of swap Normally at each payment or "settlement date, the party who owes more pays the net amount; so at any given settlement date only one party actually makes a payment. The notional principal itself is never exchanged. Often one set of payments in an interest rate swap is determined by the Eurodollar (LIBOR) rate, while the other set is fixed at a rate that corresponds to the yield on a Treasury note of comparable maturity plus some additional basis points. However, other types of arrangements are possible, such as tying both sets of payments to different variable rates. The term structure of interest rates and the forward rates implied by the relationship between short and long term rates are critical factors in evaluating interest rate swaps.

9 The simplest interest swap is called the "plain vanilla" or "fixed for floating rate swap." For example, if a company has a floating rate loan of $10 million with a bank and believes that interest rates will rise, the company may enter into a fixed for floating rate swap with the bank. For the purposes of the swap, the existing loan principal becomes the notional principal. The company agrees to pay the bank a fixed rate of interest of 9%, on the notational principal according to a 3-year schedule of payments. In exchange, the bank agrees to pay the company interest at the LIBOR (Eurodollar) rate in effect six months prior to each settlement date. The company in effect buys a claim on a series of floating interest payments by agreeing to make fixed interest payments, giving the company the benefits of a fixed rate loan without incurring additional loan origination/conversion costs. Long position (1) An option position in which a person has executed one or more options trades with the net result being that the number of contracts bought exceeds the number of contracts sold. In such a case, the person is an "owner" or holder of options. (2) A position in which an individual owns securities. An owner of 1,000 shares of stock is said to be "long the stock." Margin call (1) A call from clearinghouse to a clearing member, or from a brokerage firm to a customer, to bring margin deposits up to a required minimum level. A demand for additional funds because of adverse price movement. (2) The amount of a margin call. Margin requirement - options The amount of cash an uncovered (naked) option writer is required to deposit and maintain to cover his daily position valuation and reasonably foreseeable intra-day price changes. Nominal price Price quotations on futures for a period in which no actual trading took place.

10 Notional principal amount In an interest rate swap, the predetermined dollar principal on which the exchanged interest payments are based. Option (1) An agreement that conveys the right, but not the obligation, to buy (receive) or sell (deliver) a specific property at a stipulated price and within a stated period of time. (2) An agreement that gives the buyer the right, but not the obligation, to buy or sell a security at a set price on or before a given date. Investors, not companies, issue options. Investors who purchase call options bet the stock will be worth more than the price set by the option (the strike price), plus the price they paid for the option itself. Buyers of put options bet the stock's price will go down below the price set by the option. An option is part of a class of securities called derivatives, so named because these securities derive their value from the worth of an underlying investment. A call is an option contract to buy (from the writer of the call) shares of stock at a stated price, expiring on the stated date. A put is an option contract to sell shares of stock at a stated price, expiring on a stated date. Options may be traded on the Chicago Board Options Exchange (CBOE), thereby providing standardization of securities option contracts and trading practices. Options contract A contract that, in exchange for the option price, gives the option buyer the right, but not the obligation, to buy (or sell) a financial asset at the exercise price from (or to) the option seller within a specified time period, or on a specified date (expiration date). Premium (1) The price of an options contract. (2) In futures trading, the amount the futures price exceeds the price of the spot commodity.

11 Put An option granting the right to sell the underlying futures contract. Opposite of a call. Put option A security that gives investors the right to sell (or put) a fixed number of shares at a fixed price within a given time frame. An investor, for example, might wish to have the right to sell shares of a stock at a certain price by a certain time in order to protect, or hedge, an existing investment. Reference rate A benchmark interest rate used to specify conditions of an interest rate swap or an interest rate agreement. The reference rate represents the minimum interest rate that investors will demand for investing in a non- Treasury security. Securitization The process of creating a pass-through, such as the mortgage passthrough security, by which the pooled assets become standard securities backed by those assets. Spot price The current market price of an actual physical commodity. Also called cash price. Stock index option An option in which the underlying is a common stock index. Stock option An option in which the underlying is the common stock of a corporation. Stock option contract A negotiable contract paid for in advance, which gives the purchaser the right to buy (call) or sell (put) usually 100 shares of the stock named in the contract at a fixed price during a fixed period, from 21 days to a year or more.

12 Strike index For a stock index option, the index value at which the buyer of the option can buy or sell the underlying stock index. The strike index is converted to a dollar value by multiplying by the option's contract multiple. Strike price The stated price per share for which underlying stock may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. Structured note A structured note, sometimes called "hybrid debt," is an intermediate term debt security, whose interest payments are determined by some type of formula tied to the movement of an interest rate, stock, stock index, commodity, or currency. Although structured notes are derivatives, they often do not include an option, forward or futures contract. Structured notes provide investors with an opportunity to take advantage of views not only about the direction of interest rates but the volatility, the range, the shape of the term structure (i. e., long term rates vs. short term rates), and the direction of commodity and equity prices. For example, consider an oil company with a poor credit rating that wants to borrow. It issues a note with the interest payments tied to the price of oil. As oil goes up, its cash flows increase and it finds it easier to make the interest payments. When oil prices go down, its interest burden is lower. There are a wide variety of structured notes, including inverse floaters and range notes. An inverse floater is a floating rate instrument whose interest rate moves inversely with market interest rates. Many structured notes, and particularly inverse floaters, have a leverage factor in which the rate adjusts by a multiple, such as 1.5 times LIBOR. Swap A contract between two parties in which the parties: (a) promise to make payments to one another on scheduled dates in the future, and (b) use different criteria or formulas to determine their respective payments.

13 Swaps are not guaranteed by any clearinghouse, and, therefore, are susceptible to default. Because of this, the contracting parties are sometimes required to post collateral or mark to market. Corporations and financial institutions are the primary users of swaps. Swaps are equivalent to a series of forward contracts, each with the same price. However, the structure of a swap can be far more efficient than a package of individual contracts. There are four classes of swaps defined by the type of their underlying instrument: interest rate, equity, currency, and commodity. Tender To offer for delivery against futures. Time value The portion of the premium that is based on the amount of time remaining until the expiration date of the option contract, such that the underlying components that determine the value of the option may change during that time. Time value is generally equal to the difference between the premium and the intrinsic value. Underlying The item of value that the parties agree to exchange in a derivative contract. Underlying security (1) For options, the security subject to being purchased or sold upon exercise of an option contract. For example, IBM stock is the underlying security to IBM options. (2) For depository receipts, the class, series and number of the foreign shares represented by the depository receipt.