Options, Futures, and Other Derivatives, 10th Edition John C. Hull, E book (Text Book )

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chapter 1

institutions, and investors throughout the world, lost a huge amount of money and the
world was plunged into the worst recession it had experienced in 75 years. Chapter 8
explains how securitization works and why such big losses occurred.
The way market participants trade and value derivatives has evolved through time.
Regulatory requirements introduced since the crisis have had a huge effect on the overthe-counter market. Collateral and credit issues are now given much more attention
than in the past.
Market participants have changed the proxy they use for the risk-free rate. They also
now calculate a number of valuation adjustments to reflect funding costs and capital
requirements, as well as credit risk. This edition has been changed to keep up to date
with these developments. Chapter 9 is now devoted to a discussion of how valuation
adjustments work and the extent to which they are theoretically valid.
In this opening chapter, we take a first look at derivatives markets and how they are
changing. We describe forward, futures, and options markets and provide an overview
of how they are used by hedgers, speculators, and arbitrageurs. Later chapters will give
more details and elaborate on many of the points made here.
1.1 EXCHANGE-TRADED MARKETS
A derivatives exchange is a market where individuals trade standardized contracts that
have been defined by the exchange. Derivatives exchanges have existed for a long time.
The Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and
merchants together. Initially its main task was to standardize the quantities and
qualities of the grains that were traded. Within a few years, the first futures-type
contract was developed. It was known as a to-arrive contract. Speculators soon became
interested in the contract and found trading the contract to be an attractive alternative
to trading the grain itself. A rival futures exchange, the Chicago Mercantile Exchange
(CME), was established in 1919. Now futures exchanges exist all over the world. (See
table at the end of the book.) The CME and CBOT have merged to form the
CME Group (www.cmegroup.com), which also includes the New York Mercantile
Exchange (NYMEX), and the Kansas City Board of Trade (KCBT).
The Chicago Board Options Exchange (CBOE, www.cboe.com) started trading call
option contracts on 16 stocks in 1973. Options had traded prior to 1973, but the CBOE
succeeded in creating an orderly market with well-defined contracts. Put option
contracts started trading on the exchange in 1977. The CBOE now trades options on
thousands of stocks and many different stock indices. Like futures, options have proved
to be very popular contracts. Many other exchanges throughout the world now trade
options. (See table at the end of the book.) The underlying assets include foreign
currencies and futures contracts as well as stocks and stock indices.
Once two traders have agreed on a trade, it is handled by the exchange clearing
house. This stands between the two traders and manages the risks. Suppose, for
example, that trader A agrees to buy 100 ounces of gold from trader B at a future
time for $1,250 per ounce. The result of this trade will be that A has a contract to buy
100 ounces of gold from the clearing house at $1,250 per ounce and B has a contract to
sell 100 ounces of gold to the clearing house for $1,250 per ounce. The advantage of
this arrangement is that traders do not have to worry about the creditworthiness of the
people they are trading with. The clearing house takes care of credit risk by requiring
2 CHAPTER 1
each of the two traders to deposit funds (known as margin) with the clearing house to
ensure that they will live up to their obligations. Margin requirements and the operation
of clearing houses are discussed in more detail in Chapter 2.
Electronic Markets
Traditionally derivatives exchanges have used what is known as the open outcry system.
This involves traders physically meeting on the floor of the exchange, shouting, and
using a complicated set of hand signals to indicate the trades they would like to carry
out. Exchanges have largely replaced the open outcry system by electronic trading. This
involves traders entering their desired trades at a keyboard and a computer being used
to match buyers and sellers. The open outcry system has its advocates, but, as time
passes, it is becoming less and less used.
Electronic trading has led to a growth in high-frequency and algorithmic trading.
This involves the use of computer programs to initiate trades, often without human
intervention, and has become an important feature of derivatives markets.