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Question description

details    Discuss the following derivative vehicles and strategies:

  • Puts

  • Calls

  • Straddles

  • Collars

  • Swaps

  • Futures

  • Covered call

    Be sure to address the following question in detail:     When would each be used?                 Materials from the course you can reference too…..



Derivative markets have become increasingly important in the ever-expanding global economy. The use of derivative instruments such as forward contracts, futures contracts, option contracts, and swaps have proliferated as the number of firms and investors has increased worldwide. The wide variety of different derivative instruments available for both hedging and speculative purposes expands every year.

Brief History

Futures markets initially developed in Chicago. This was because the city was a hub for the transportation of various foodstuffs, such as grain. In 1848, the Chicago Board of Trade was formed, and the first forward contract followed shortly. The contract quickly became popular with speculators. In 1874, the rival Chicago Produce Exchange was formed. In 1898, the name was changed to the Chicago Butter and Egg Board. Later, it became the Chicago Mercantile Exchange (CME), and this is where futures contracts began to gain their popularity.

Initially, the only futures contracts were based on commodities, such as various metals and agricultural products. During the 1970s, the CME began to offer futures contracts based on financial assets. These gained quickly in popularity. In 1977, the Chicago Board of Trade developed what is now the most successful contract ever created U.S. Treasury Bond Futures contracts.

In 1973, the Chicago Board of Trade created the Chicago Board Options Exchange (CBOE). This is where options on stocks began. Now options on a vast number of assets trade on a multitude of exchanges worldwide.

Futures Markets

In futures markets, a typical futures exchange is a corporation that is owned by members. These members are usually individuals and not other corporate entities. Like any corporation, the owners (members) choose a board of directors which, in turn, selects upper-level managers to manage the exchange.

One very important function of the management is to develop new, profitable futures contracts. Each contract has certain specifications associated with it. These include a contract size, a quotation limit, minimum price fluctuations, a contract grade, delivery terms, and trading hours for the contract. There are also daily price limits associated with most contracts.

There are several participants in futures market activity. Most of these participants fall under the category of a futures trader, which includes many subcategories. A hedger is a trader who happens to hold a position in the spot market and takes an opposite position in the futures market to reduce his or her risk. A speculator is one who does not hold a spot position but merely buys or sells futures contracts based on future price expectations. A speculator actually increases his or her risk by taking a position in a contract. Arbitrageurs are traders who look for riskless profit opportunities. They buy and sell futures contracts accordingly and help ensure the law of one price in a market. Many other participants exist, such as scalpers, spreaders, day traders, and position traders.

Options Markets

In options markets, options also trade on various organized and over-the-counter markets. There are two basic types of options: call options and put options. A call option gives the buyer the right to buy an underlying asset at a fixed price, which is called the exercise price or the strike price. A put option gives the buyer the right to sell an underlying asset at the exercise or strike price. Calls are said to be "in the money" if the price of the underlying asset exceeds the strike price, "at the money" if the asset price equals the strike price, and "out of the money"if the price of the underlying asset is lower than the strike price. Puts are said to be in the money if the asset price is less than the strike price, at the money if the asset price equals the strike price, and out of the money if the price of the asset exceeds the strike price.

Each option contract is for 100 options. For example, if this was a call option on a stock, the call contract represents the right to purchase 100 shares of the stock at the exercise price. Options have set expiration dates that follow various cycles: January, February, and March cycles. Similar to futures contracts, there are both position limits and exercise limits on options. A position limit sets the maximum quantity of options that an investor can hold on one side of the market. Exercise limits set the maximum number of options that an investor can exercise on any 5 consecutive business days.


Types of Derivatives

A put option is a contract that gives the owner the right—but not the obligation—to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date. Often, puts are purchased as a portfolio hedge to protect against a down market.

A call option is a contract that gives the owner the right—but not the obligation—to buy a specified amount of an underlying security at a specified price within a specified time.

A straddle is an options strategy with which the investor holds a position in both a call and a put with the same strike price and expiration date.

A collar is a protective options strategy that is implemented after a long position in a stock has experienced substantial gains. It is created by purchasing an out-of-the-money put option while simultaneously writing an out-of-the-money call option.

A swap is the exchange of one security for another to change the maturity (bonds), to change the quality of issues (stocks or bonds), or because investment objectives have changed. This can also include currency swaps and interest rate swaps.

A financial future is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. The profits and losses of a futures contract depend on the daily movements of the market for that contract and are marked to market daily.

A covered call is an options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This strategy can generate extra income, but the investor may have the investment “called away” and lose the investment to the investor who purchased the call.


Article: Everything Hedging


Hedging involves the use of derivatives. Derivatives are financial instruments that derive their value from changes in the value of related assets such as foreign currency (Radebaugh, Gray, & Black, 2006). There are three types of derivatives used in hedging: forward contracts, future contracts, and options.

Forward contract is a contract to buy or sell a specified amount of an asset at a specified price at a specified future date (Radebaugh, Gray, & Black, 2006). The current price for the asset is called the spot price, and the price specified in the forward contract is the forward price. The initial value of the forward contract is zero and does not require an initial outlay of cash.

Assume one contracts with an oil price speculator to purchase one barrel of oil for $100 in 3 months. Further assume that 3 months from now, oil is trading at $110 per barrel. Because one locked the price at $100 per barrel, the oil price speculator contracted with will either deliver one barrel of oil at $100 or settle the contract. Settling the contract means the oil price speculator would pay $10 to settle the contract (remember, there is no initial outlay of cash for the contract). One would take the $10, and the $100 he or she would have paid anyway for the oil, and purchase the barrel of oil worth $110.

Futures contracts (sometimes called futures) have essentially the same characteristics as a forward contract but are more standardized to allow them to trade more easily in markets (Arditti, 1995). Perhaps the best and most amusing example of futures trading is in the movie Trading Places with Eddie Murphy (playing Billie Ray, a street con man) and Dan Aykroyd (playing Winthorpe, a sophisticated commodities trader). The two characters are looking to trade frozen concentrated orange juice (FCOJ) futures which hinge on how the orange harvest is. In other words, there is a greater reliance on frozen concentrated orange juice (FCOJ) if the orange harvest is bad. Billie Ray and Winthorpe, in an effort to thwart the bad guys (the Duke Brothers), acquire inside information regarding the orange crop report that indicates the orange harvest is better than the Duke Brothers anticipated. Winthorpe and Billie Ray first sell FCOJ futures at roughly $1.45 per unit, a price inflated by some underhanded dealings of the Dukes. When the price falls as a result of the release of the real crop report indicating a good harvest, Winthorpe and Billie Ray buy futures at roughly $0.22 per unit. Thus, for every future unit they had previously sold at $1.45, they purchase a matching amount for only $0.22, resulting in a profit of more than $1.20 per unit (over 545%) (Folsey, Harris, & Weingrod, 1983).

An option is a right—not an obligation—to either buy (call option) or sell (put option) a specified amount of an asset at a specified price for some specific future date. The specified price is called the strike price or the exercise price one has to pay for an option. Because this is not an obligation, rather a right, one will exercise the option only if it makes sense.

Types Of Derivatives

The following chart outlines types of derivatives (Beams, Clement, & Anthony, 2008):



Hedge on net asset or liability position

Hedge of an Identifiable Commitment

Hedge of Net Investment in a Foreign Entity


Investment. To speculate changes in exchange rates.

Eliminate gains/losses resulting from exchange rate changes

Lock-in purchase or sale of goods that must be paid in a foreign currency

Eliminate fluctuations in net value of the investment due to exchange rate changes

Types of Adjustment





Statement on which reported

Income statement

Income statement

Income statement

Balance Sheet

Recognition of gains and losses

Recognize currently in net income, based on change in forward exchange rate

Recognize currently in net income, but are offset by related gains and losses of the net asset or liability position

Defer until transaction date

Adjustment to the translation adjustment in the equity section of the balance sheet

Treatment of premiums and discounts (Deferred exp)


Amortize ratably over the life of the contract

Amortize ratably over the life of the contract or defer and treat as an adjustment of purchase/sales price

Amortize ratably over the life of the contract or defer and treat as an adjustment of translation adjustment in the equity section of the balance sheet

Speculative Foreign Contracts

Foreign currencies are also commodities—just as Billie Ray and Winthorpe’s frozen concentrated orange juice was a commodity. Consequently, companies can invest in foreign currency commodities for speculative purposes. Forward contracts held for speculative purposes are valued at the forward rate throughout the life of the contract. Gains and losses result from changes between initial forward rate and subsequent forward rates and are recognized in the reported income of the period. There is no recognition for premiums or discounts. The following is an example of a speculative foreign contract:

On 11/01/20X8 a U.S. company purchases a 90 day future contract for 500,000 Eurodollars.

Spot rate on 11/01/20X8


90-day forward rate on 11/01/20x8


30-day forward rate on 12/31/20X8


Spot rate on 02/01/20X9


The day contract is signed 11/01/20X8

Euros due from broker (500,000 X .0107)


Contract payable to broker


To record contract at the 90-day forward rate

Balance sheet date 12/31/20X8

Euros due from broker (500,000 X (.0108 -.0107))



Exchange gain


To recognize gain due to change in current forward rate

Date contract is due

Contract payable due to broker (100,000 x .0107)




To record payment to broker at the contract price

Cash (value of euro received at current spot rate)


Euros due from broker (5,350+50)


Exchange gain (500,000 X (.0107 - .0106)


To record receipt of cash value of €100,000 at the current spot rate

Hedge On Net Asset or Net Liability Position

When a company sells a product or purchases a product from a foreign company, the value of the accounts receivable or payable can fluctuate based on the exchange rate. Consequently, the hedge is used to buy or sell foreign currency for a specific date to offset the fluctuation. This is called a forward exchange (Fischer, Cheng, Taylor, 2008). 

Hedge of an Identifiable Commitment

An identifiable foreign currency commitment is a contract that will result in a foreign currency transaction at a future date. This differs from forward exchanges with exposed net asset positions in that it is only a commitment to purchase foreign currency and not an actual purchase. The FASB treats this type of hedge in a special way. Gains and losses resulting from forward contracts on identifiable foreign currency commitments should be deferred and treated as an adjustment if two requirements are met—the foreign currency transaction is designated as a hedge of a foreign currency commitment, and the foreign currency commitment is firm (Fischer, Cheng, Taylor, 2008).

Cash Flow Hedge of an Anticipated Foreign Currency Transaction

In this type of cash flow hedge, the transaction has not occurred, and no contract has been signed. In this scenario, a U.S. company projects that it will need foreign currency for a future transaction. The hedge is used as an attempt to minimize the variability of the exchange rate. Domestic companies that regularly purchase products or services from a foreign vendor can use this quite effectively. If the terms of the transaction are not fixed, and if specified requirements reflected in SFAS 133 are met, than this hedge can qualify for cash flow hedge treatment. The income earned on the foreign currency derivative investment used in a cash flow hedge will create an Other Comprehensive Income column (Beams, Clement, & Anthony, 2008). In the case of the option, the change in the intrinsic value of the hedge is categorized as Other Comprehensive Income. The Other Comprehensive Income will offset any exchange losses. The change in the time value of the option is the cost of the hedge. Gains and losses are deferred until the item being hedged actually affects income. Discounts or premiums on these forward contracts must be amortized over the life of the contract.

Documentation Requirements

SFAS 133 requires formal documentation of the hedging relationship at the inception of the hedge, generally on the date the forward contract is entered into. The hedging company must prepare the document that identifies the hedged item, the hedging instrument, the nature of the risk being hedged, how the hedging instrument’s effectiveness will be assessed, and the risk management objective and strategy for undertaking the hedge (Hoyle, Schaefer, & Doupnik, 2008).


Arditti, F. D. (1995). Derivatives: A comprehensive resource for options, futures, interest swaps, and mortgage securities. Boston: Harvard Business School Press.

Beams, F. L., Clement, R. P., & Anthony, J. H. (2008). Advanced accounting (10th ed.). Upper Saddle River, NJ: Prentice Hall.

Fischer, P. M., Cheng, R. H., & Taylor, W. J. (2008). Advanced accounting (10th ed.). Cincinnati, Ohio: South-Western College.

Folsey, G. (Producer), Harris, T. (Writer), & Weingrod, H. (Writer). (1983). Trading places [Motion picture]. United States: Paramount Pictures.

Radebaugh, L. H., Gray, S. J., Black, E. L. (2006). International accounting and multinational enterprises (6th ed.). Hoboken, NJ: Wiley.


What is a Put Option?

The following link opens an instructional video that describes puts to hedge a portfolio.


What is a put option? [Video]. (2011, September 28). Retrieved from


Virtual Trading

The following link opens an interactive site to practice trading options without risking money.


Virtual options trading. (n.d.). Retrieved from the CBOE Web site:


Virtual Stock Exchange

The following link opens an interactive site where you can practice stock and option trading.


Virtual stock exchange games. (2013). Retrieved from the Wall Street Journal Web site:

Resource Links

·  Options Industry Council
Web page with option definitions

CBOE is a source for options trading information.

·  WSJ Exposed
Wall Street Journal article is about corporate hedging.

·  Investors Seek More Transparency on Corporate Hedging, Derivatives Exposures
This article discusses corporate disclosures on hedge accounting.

·  A Beginner's Guide to Hedging
This article discusses fundamental hedging techniques.

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