Iordachi Victoria, dr., conf. univ. - Tranzacii bursiere, curs de lecii Theme 3. Forward transactions with primary securities.

(6/6hs)

2013

3.1. Essence of forward transactions. Forward markets for transactions with primary securities were created at London International Financial Futures Exchange (LIFFE), Marche A Terme International de France (MATIFE) and Deutsche Termin Burse (DTB). A forward contract is an agreement between two parties to buy or sell an asset at a certain future time (maturity) for a certain price (forward price) agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today with respecting the contractual obligations of both parties today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. Forward transactions have the following primary securities as underlying assets: shares, bonds, treasury bills etc. At maturity the value of these securities is delivered/received that was the object of negotiation at the moment of contracts conclusion. This peculiarity creates the difference between the futures contract, where exactly the contract represents the object of negotiation. Forward contracts with primary securities can take the following forms: 1) Transactions with strict deadline/maturity: Reglement mensuel (RM) transactions (French); 2) Margin transactions; 3) Conditional transactions: A prime; Stellage. Forward transactions suppose the conclusion of transactions with securities at stock exchanges, which will be liquidated at a certain date in the future at a fixed price. The price (the rate), maturity and other provisions are stipulated in t he agreement at the moment of the transactions initiation. Forward transactions, generally, are divided into: 1) Transactions with regulated maturity (la termen ferm): Au reglement mensuel (cu reglementare lunara). 2) Margin transactions. 3) Conditional transactions: Premium 1

Iordachi Victoria, dr., conf. univ. - Tranzacii bursiere, curs de lecii Stellage

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3.1.1. Transactions with strict maturity/deadline: Au reglement mensuel (RM) transactions. Transactions with strict deadline suppose definite liabilities for both parties (the buyer and seller) from the moment of contracts conclusion, while the moment of accomplishing these liabilities is delayed (takes place at a certain day in future). Peculiarities of transactions with strict deadline are: The clients submit their orders to buy and sell on any date at stock exchange. Liquidation takes place on a certain trading day at the end of reporting month. The buyer assumes to pay at maturity the value of required securities, while the seller deliver assets at maturity. The clients can submit uncovered orders, keeping this position until the moment of transaction liquidation. The buyer should put a covering (guarantee) on the account of brokerage company, while the seller a guarantee in form of securities. The value of guarantee varies between 20-40% and is fixed by stock exchange authorities. The buyer/seller should negotiate a fix quantity of securities (5, 20, 25, 50, 100 or 500). Intervention of clients on this market ca have a real purpose: the buyer is willing to purchase securities and to resell them at maturity, while the seller can sell securities that he does not possess and repurchase them until maturity to honor his obligations. Liquidation of position can be done by means of reporting by buyer or seller, meaning the maturitys prolongation until the liquidation day of the next month at the stock exchange. In conclusion of the above mentioned things, RM transactions suppose that a transaction is concluded at stock exchange in one day, and is executed (liquidated) at the stock exchange at a fixed day in each month, called the liquidation day. Buyers can purchase assets, without possessing liquidity at the moment of the contracts conclusion and the seller can deliver assets without their physical possession. On the other hand, the buyer of assets becomes their owner from the moment of the transactions conclusion, so the owner of dividends. The stock exchange establishes the assets which can be traded au reglement mensuel, and the most active assets, with a constantly high demand and supply. At the same time, the stock exchange establishes the minimal number of assets for which contracts can be concluded (minimum 5,10,25,50 or 100 assets). As a rule, the higher is the nominal value of stocks, the less is the minima l number of assets (standard volume of assets). This is the ma in feature that differentiates au reglement mensuel transactions and au comptant trasactions (in which the contract is concluded without the establishment of a minimal (standard) number of assets). The operator should deposit a covering (fr. 2

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couverture), by choosing among: cash funds or treasury bills (the most liquid and safe securities), representing 20% from the contracts value; securities with fixed income (bonds) or gold, representing 20% from the contracts value; securities with variable income (sto cks) - the value of guarantee should represent 40% from the contracts value. This covering represent the same role as in case of margin trading at American stock exchanges. So, within RM transactions, honoring of contractual liabilities can be done through: 1. Contracts liquidation; 2. Settlement of balances supposes the possibility for the buyer to make an opposite direction operation at liquidation date (T1) or before liquidation (but with the same maturity (T2 =T1)). This means that forward bid transaction (order to buy securities) is followed by a forward ask transaction (selling them), while selling of assets is followed by their buying. These transactions do not suppose real movement of assets, but only capital changing. 3. Reporting the transaction. One interesting feature of forward transactions (RM transactions) is that these transactions can be reported, if the prices evolution is not proper for the investors expectations. This implies the contracts prolongation until the further liquidation. Report is analyzed as a double direction transaction at the stock exchange: An operation with maturity and liquidation at the current month An operation with maturity and liquidation in the next month. In order to be able to report a transaction, the investor has to find a counter-part, someone who possesses funds and who accepts to buy securities at the liquidation date instead of him (the investor), but with the engagement to re-sell him back at the following maturity date (next liquidation date established at the stock exchange). For this credit (of money) the investor (reportant) pays the interest called report to the reporter (reportor). The investor (reportantul) practically sells to the reporter his stocks at this rate (compensation rate), and then buys back the same securities from the reporter at the liquidation date at the same rate, plus the interest (the report). Three situations are common in practice: a) The situation when the number of buyers who report (those who are not willing to receive assets) exceed the number of sellers (those who are not willing to deliver assets). In this situation, the buyers must find creditors, who are willing to lend funds until the further liquidation. The credits are guaranteed by assets, which at further liquidatio n will be returned at the price fixed at the reporting day called compensation rate. So, these reportings are done with a payment of a fee to the buyer (the one who is interested in postponing), called report tax . 3

Iordachi Victoria, dr., conf. univ. - Tranzacii bursiere, curs de lecii For those who possess excess funds, report investment is advantageous because: It is a short-term investment; It is guaranteed with the value of assets; It implies a high efficiency rate in comparison with the term.

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b) The situation when the number of sellers who report (the assets which are not delivered) exceed the number of buyers who report; the sellers must borrow assets in order to be able to report their position until the further liquidation. These assets borrowing from third parties are done by means of a deport taxs paying. c) The situation when the number of reported purchases is equal with the number of reported sales, when there is neither payment of report tax, nor payment of deport tax; the reporting is done at parity. The advantages of forward market transactions are: High rate of revenue rendering due to speculations; Due to inverse operations, certain positive margins can be obtained; At the moment of contract conclusion, there is no need in the presence of funds or assets, the investor must only possess a minimum deposit co vering amount (margin); Leverage effect in case of a correct prediction, the smaller is the margin, the higher is the revenue; Avalanche effect the successive orders repeating from the first main order. The profit gained at each new transaction is added at the initial margin, so in this way it is created the possibility to conclude more transactions, with a higher quantity of assets, the profit being increased until the maturity.

3.1.2. Conditional transactions Within the conditional transactions with primary securities only the buyer has the right to decide weather to execute or not the contract (prime transaction), or to choose the position of the seller or the buyer at maturity date (stellage transaction). I. Prime transactions Within the prime transac tions, the buyer, at the day of the contracts liquidation (at the day of the prime outcry), can either deliver the payment for assets, or abandon the contract, paying the prime to the seller. So, two particular elements appear: the contracts covering (the margin) is represented by the primes amount (the prime is the amount of money agreed at the beginning, which will be paid by the buyer at maturity, in case if the contract is not executed); 4

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risk assumed by the operator, when he works uncovered is limited by the primes amount. At Paris Stock Exchange, prime transactions have three successive maturities on the RM market, starting from the first month (for example, for a contract concluded in March, three maturities, that could be selected by operator would be March, April, May). The day of primes outcry is the stock exchange day before the liquidation date. The bid price at a prime transaction is higher than the RM rate, as the buyer, who has alternatives has to compensate the advantage that is granted to him by the seller, by price difference. The price different is called ecart. The level of prime is called dont and is fixed by the Counsel of Stock Exchange (Le Conseil des Bourses). The price of the contract (also called the exercise price) depends on the stocks rate (which is associated with three donts for each of the primes maturities), the contracts maturity and the markets estimated tendency. Table 3.1.1 Example of quoting at Paris Stock Exchange for some company shares Maturity June July August Price 1050 1150 1250 Dont Dont Dont 25 25 25 Prime 50 50 50 75 75 75

For example (see Table 3.1.1), within a trading session, the primes quotation at Paris Stock Exchange for the companys stocks is presented in Table. A prime transaction to purchase 100 stocks with maturity in June, means that the investor accepts to receive stocks at the end of June by paying 1050 FF/stock, or to abandon the contract, paying the seller 50FF/stock. One of the directions to use prime transactions is speculation. In this case, the buyer anticipates an increase in price and expects to be able to give an order to sell stocks in the day of primes outcry. Suppose an investor, anticipating the increase in price of stocks X, purchase a prime contract with maturity in June, at 1050 dont 50. As coverage, he will transfer 5000FF (50FF*100stocks) which is the level of prime and fixes an exercise price of 1050. The further attitude of the investor depends on the evolution of rate of X stocks until the day of primes outcry. So, there can be the following possibilities (see figure 3.1.1): a) If the price of X stocks reaches 1150FF during the outcry in June, the investor purchases the stocks and accepts the contracts execution. He will pay 1050FF*100 = 105000FF and wil l get

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100 X assets, which at present are quoted at 115000FF. as a result, the investor has a gross profit in value of 10000FF (115000-105000). b) If the price is 950FF, the investor abandons the prime and abandons the contract, loosing the prime in value of 5000FF. If he did not proceed to this, the loss would be higher than the prime. He would buy stocks at 1050FF/stock, but the market price (MP) is 950, loosing 100FF/stock, which is higher than 50FF/stock.

Profit of prime contract

Primes step

950

1000

1050

Loss

1025

1050

Current rate

Figure 3.1.1. Graphical representation of buying a premium contract

Source. Made by authors c) If the MP is 1025FF, the investor executes the contract, as the loss is only 25FF/stock (10501025), instead of 50FF/stock as prime. The general rule is that if the price at the day of primes outcry is lower than the prime step 1 , the investor executes the contract, having less losses than the prime. If at the day of primes outcry, the rate is lower than the prime step, the operator abandons the contract, paying the prime (limits his loss at the value of prime). At a current price, which is between the prime step and the contracts price the investor executes the contract, loosing less than the value of prime. The investor also can also make an arbitrage operation. In this case, the bid prime operation is associated with a put RM operation, which allows the operator to increase his profit as a result of prime operation, with the condition to make the sale at a superior price. If, for example, together with the bid
1

Prime step the difference between the contracts price and the prime

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prime operation for 100 stocks X at 1050FF/stock with maturity in July, the investor also concludes a put RM operation with maturity in July, at 110FF/stock, he will get a profit of (1100FF-1050FF)*100 = 5000FF, as at maturity, at outcry, he will accept the first contract (receiving 100 stocks at 1050FF) and will immediately liquidate the RM contract (delivering stocks at 1100FF). Such prime operations are possible only when there exist disequilibrium between supply and demand on the market, in terms of time and space. These opportunities are temporary and disappear by using arbitrage techniques. If it is anticipated a decrease in price, the operator can make a coverage operation (hedging). Lets suppose he sells 100 X stocks (RM operation) with maturity in July for 1050FF. in conditions of a bear market, he earns a profit, as prices decrease. In order to hedge against the risk of prices increase, at the same time, he purchases 100 X stocks with prime at 1065FF dont 50. if the market increases and the prices rose to 1100FF, he looses at the RM sell (1050-1100)FF*100stocks = -5000FF, but gains at the prime operation (1100-1065)FF*100stocks = 3500FF and reduces his loss. II. Stellage operations Stellage is a conditional contract that supposes the right of a buyer to choose the operat ions direction, taking into consideration two prices established in the contract, called les bornes de stellage (limits of stellage). Stellages comprise characteristics of firm transactions with the conditional ones. The seller of a stellage appreciates that till maturity the rate of securities will be stable, while the seller of the stellage anticipates a rates fluctuation of the traded asset (appreciation or depreciation). Stellage is a firm transaction, as the operator has the obligation to execute the contract. The operator who purchased the stellage has the right to choose at maturity his position, according to the evolution of price. He can become the assets buyer at the highest price stipulated in the contract, or the seller at the lowest price stipulated in the stellage. The stellage comprises two rates, separated by an ecart . The inferior and superior limits are called the stellages bornes. The stellage transaction is concluded for a 6 month period. If until maturity the market price of stocks doesnt significantly fluctuate, the buyer of the stellage will suffer losses. At any price situated within the stellages bornes, irrespective the adopted position, the operator will suffer losses. The figure 3.1.2 represents a stellage for stock XXX, with the bornes 1050/950 FF/stock. This contract allowes the buyer at maturity to declare himself either the buyer at price 1050FF, or seller, at price 950FF.

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(+)

Seller

Buyer

1000 950 1050

Current rate

(-)

Figure 3.1.2. Graphical representation of buying a stellage contract Source. Made by authors

3.1.3. Technique of margin transactions

Buying on margin is borrowing money from a broker to purchase s hares. Thus, margin transactions suppose buying primary securities on credit, by means of brokerage company. Margin trading allows the client to buy more shares than he'd be able to normally. To trade on margin, it is required to open a margin account. This is different from a regular cash account, in which the investor can trade using his own money on the account. By law, the clients broker is required to obtain his signature to open a margin account. The margin account may be part of a standard account opening agreement or may be a completely separate agreement. Once the account is opened and operational, the investor can borrow up to 50% of the purchase price of a stock . This portion of the purchase price that the investor deposits, is known as the initial margin. The client can keep his loan as long as it is necessary, provided he fulfills his obligations: First, when he sells the stock in a margin account, the proceeds go to the brokerage company against the repayment of the loan until it is fully paid. Second, there is also a restriction called the maintenance margin, which is the minimum account balance that the investor must maintain before the broker will

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force him to deposit more funds or sell stock to pay down the loan. When this happens, it's known as a margin call . Borrowing money isn't without its costs. Regrettably, marginable securities in the account are collateral. The client must pay the interest on his loan. The interest charges are applied to his account unless he decides to make payments. Over time, the investors debt level increases as interest charges accrue against him. As debt increases, the interest charges increase, and so on. Therefore, buying on margin is mainly used for short-term investments. The longer the investor holds an investment, the greater the return that is needed to break even. Not all stocks qualify to be bought on margin. The Central Authority of Capital Market in each country may regulate which stocks are marginable. Individual brokerages can also decide not to margin certain stocks, so you should check what restrictions exist on your margin account. Advantages of margin transactions are: Amplifying the volume of securities transactions through additional demand (based on the credit received by buyers from brokers) and additional supply (through short selling); Amplifying positive financial results of clients according to weight of debt in the total value of transaction; Diversification of securities portfolio by investors access to a greater number of securities; Possibilities to trade any type of securities, but in practice, most frequently are used ordinary shares. The mechanism of margin transaction for the buyer is presented in Figure 3.1.3. Client - buyer

Stock Exchange

Clearing house

5 Stock Exchange company 9 2 6 8 9 Bank 7

Iordachi Victoria, dr., conf. univ. - Tranzacii bursiere, curs de lecii Figure 3.1.3. Mechanis m of margin transaction for the buyer Source. Made by authors

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1. The buyer submits a bid order (order to buy) at a stock exchange company and deposits an initial margin. 2. The Stock Exchange company opens an account for the client. 3. The broker executes the order at the stock exchange. 4. The stock exchange notifies the clearing house on the orders execution. 5. The clearing house delivers the broker purchased securities and he makes payment on behalf of the client from the amount of granted credit, representing the difference between the market value of purchase securities and initial margin. 6. The Stock Exchange company keeps securities as collateral for the credit granted and the buyer has an uncovered (long) position. 7. The Stock Exchange company is borrowed from a bank using as guarantee securities. 8. The bank ensures financing. 9. After opening the long position, the brokerage company registers daily fluctuations in price of purchase securities until the moment of position liquidation by the buyer. The main characteristics of any margin transaction are: Operation involves granting credit in money or securities; Initiation of transaction starts by depositing a certain amount of money by the client, which represents initial margin that is intangible for the who le duration of transaction; The broker as creditor requires a coverage that is composed of purchased securities; Transaction cost is represented by interest rate related to credit as well as refinancing interest rate used by broker; The debtor is able to diminish his debt by additional transfers on the account. Dividends resulted from purchased shares that remain blocked within the guarantee deposit created at the brokerage company, also diminish the debt; Securities that are blocked within the guarantee deposit are subjected to a daily actualization according to evolution of market price. This operation is called marking to market . Trading on margin, considering its specific regulations, imposes defining some technical elements like: Initial margin is fixed by market regulations and represents the deposit created by the client in form of cash money or blocked securities. Maintenance margin the clients own capital initially fixed at a minimal level that should be maintained during the whole duration of transaction. Market regulations suppose that the 10

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current relative margin should be maintained at x% from the market value of securities for the whole period of account opened at the brokerage company. Collateral is the counter value of purchased securities that are placed as guarantee at the broker for the granted credit. Absolute margin the difference between the value of collateral and the clients debt. Returnable margin ratio between absolute margin and market value of the existent securities on the clients account at the end of each trading day. Margin call additional guarantee required by broker to the client when the maintenance margin gets lower than the initial limit. Margin is determined by equation 3.1.1:

(3.1.1) Where: M is the margin, V is the market value of the securities, L is the brokers loan. The ratio is expressed as a percentage. The lowest initial margin, or the margin at the time of the purchase, is 50%. After the purchase of the stock on margin, there is a maintenance margin below which the margin is not allowed to fall. On the New York Stock Exchange, the maintenance margin is 25%, but brokers can set their own margins (30% is common). If the margin falls below the maintenance margin, the broker calls for additional cash from the investor. If the money does not come within the specified time, the broker immediately sells the stock. Other characteristics of margin transactions are : 1) The client can perform multiple orders in base of borrowed funds from margin account. The account registering of transactions are done: On the accounts credit cash (assets) covering by the client; revenue from asstes sales; dividends from stocks; On the accounts debit market value of assets bought on margin; interest on credit granted by broker. Example: A client gives his broker an order to buy 200 stocks X at rate $100, in base of a margin account of $10000 (initial margin). The broker executes the order, buying on margin; in 5 days, he receives the assets 11

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and makes the payment to clearing house, borrowing the client the difference amount from the contracts value. The broker does not deliver the assets to his client, but retains them as collateral for the granted credit funds. In 30 days, the stocks price goes up till $110. The client gives the broker the order to liquidate his long position, and to sell securities at market price. So the client obtains a profit of $2000 (commission and interest is not considered). 2) Due to the fact the margin transactions are based on borrowed funds, a leverage factor appears, providing the investor all advantages and disadvantages of leverage. Lower margin requirements allow the investor to borrow more, increasing the percentage of gain or loss on investment, when the stock price increases or decreases. The leverage factor equals 1/percent margin. Thus, as an example, if the margin is 50%, the leverage factor is 2. Therefore, when the rate of return on the s tock is plus or minus 10%, the return on the investors equity is plus or minus 20%. If the margin declines to 33%, it could be borrowed more (67%) and the leverage factor is 3 (1/.33). The following example shows how borrowing by using margin affects the distribution of your returns before commissions and interest on the loan: Assume you acquired 200 shares of a $50 stock for a total cost of $10.000. A 50 percent initial margin requirements allowed you to borrow $5000, making your initial equity $5000. If the stock price increase by 20% to $60 a share, the total market value of your position is $12000 and your equity is now $7000 or 58% ($7000/$12000). 3) One of the characteristics of transactions on margin, is their regulation and supervision by law of the states authority, especially the establishment of margin and its compliance supervision . The maintenance margin is the required proportion of the investors equity in the total value of the stock; the maintenance margin protects the broker if the stock price declines. At present, in USA the minimum maintenance margin specified at Federal Reserve is 25%, but individual brokerage firms can dictate higher margins for their customers. If the stock price declines to the point where the investors equity drops below 25% of the total value of the position, the account is considered undermargined and the investor will receive a margin call to provide more equity. If the client does not respond in time with the required funds, the stock will be sold to pay off the loan. The time allowed to meet the margin call varies between investment firms and is affected by market conditions. Under volatile market conditions, the time allowed to respond to a margin call can be shortened drastically. Given a maintenance margin of 25%, when the investor buys on margin it should be considered how far the stock price can fall before a margin call will be received. The computation for our example is as follows: if the price of the stock is P and you own 200 shares, the value of the position is 200P and the equity in the account is 200P - $5000 (the brokers loan).

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The percentage margin is (200P - $5000)/200P. To determine the price, P, that is equal to 25% (0,25), we use the computation: (200P - $5000)/200P = 0,25 200P - $5000 = 50P P = $33,3 Therefore, when the stock price declines to $33,3 (from the original cost of $50), the equity value is exactly 25%; so if the stock goes below $33,3, the investor will receive a margin call. 3.1.4. Short sales technique A short sale is generally the sale of shares that the investor does not own (or that he will borrow for delivery). Short sellers believe the price of the stock will fall, or are seeking to hedge against potential price volatility in securities that they own. If the price of the stock drops, short sellers buy the stock at the lower price and make a profit. If the price of the stock rises, short sellers will incur a loss. Short selling is used for many purposes, including to profit from an expected downward price movement, to provide liquidity in response to unanticipated buyer demand, or to hedge the risk of a long position in the same security or a related security. Example of a short sale. An investor believes that there will be a decline in the stock price of Company A. Company A is trading at $60 a share, so the investor borrows shares of Company A at $60 a share and immediately sells them in a short sale. Later, Company A's stock price declines to $40 a share, and the investor buys shares back on the open market to repla ce the borrowed shares. Since the price is lower, the investor profits on the difference -- in this case $20 a share (minus transaction costs such as commissions and fees). However, if the price goes up from the original price, the investor loses money. Unlike a traditional long position when risk is limited to the amount invested shorting a stock leaves an investor open to the possibility of unlimited losses , since a stock can theoretically keep rising indefinitely. Typically, when the operator sells short, his brokerage firm loans him the stock. The borrowed stock comes from either the firm's own inventory, the margin account of other brokerage firm clients, or another lender. As with buying stock on margin, the brokerage firm will charge interest on the loan, and the operator is subject to the margin rules. If the borrowed stock pays a dividend, the operator must pay the dividend to the person or firm making the loan. Although the vast majority of short sales are legal, abusive short sale practices are illegal. For example, it is prohibited for any person to engage in a series of transactions in order to create actual or apparent active trading in a security or to depress the price of a security for the purpose of inducing the 13

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purchase or sale of the security by others. Thus, short sales affected to manipulate the price of a stock are prohibited (other details on short sales are given in Textbox 3.1.1 from Annex 3.1.1). In a "naked" short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a "failure to deliver" or "fail"). Failures to deliver may result from either a short or a long sale. There may be legitimate reasons for a failure to deliver. For example, human or mechanical errors or processing delays can result from transferring securities in physical certificate rather than book-entry form, thus causing a failure to deliver on a long sale within the normal three-day settlement period. A fail may also result from naked short selling. For example, market makers who sell short thinly traded, illiquid stock in response to customer demand may encounter difficulty in obtaining securities when the time for delivery arrives. Naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules. Indeed, in certain circumstances, naked short selling contributes to market liquidity. For example, broker-dealers that make a market in a security generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to purchase or arrange to borrow the security, a market maker engaged in bona fide market making, particularly in a fast- moving market, may need to sell the security short without having arranged to borrow shares. The stages of realizing short sales are given in figure 3.1.4: Brokerage company B2
5 1 3 8 2

SE
7 4

Client

3a 6

Brokerage company B1

Clearing house

Figure 3.1.4. Short sales scheme : realizing stages Source. Made by authors 1. the client gives a short sale order, 2. the broker concludes the contract and executes the order. From now on the client becomes the seller of assets that he does not possess (or possesses but doesnt want to execute the contract 14

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with them). The assets will be borrowed from the third party in order to fulfill obligations (short position) 3. the broker borrows assets on behalf of the client from the brokerage company and informs that this credit is done for his client (3a) 4. the broker executes the contract delivers assets towards the compensation house, according to maturity terms. As seller receives the counter value for assets at the rate from the contract. 5. the counter value is deposited as a guarantee for assets credit. This way, the client executed the contract at SE but remains indebted by assets and has a frozen assets account. 6. at proper moment, the client gives the order to buy the respective assets 7. the order is executed at SE 8. the assets are returned to the creditor. This way the client makes a covering of his short position, closing his assets account. As a result, the operation consists in two opposite stock exchange transactions concluded in different moments (moments 2 and 7). The ratio for the client is the following: he could buy the assets due at lower rate in order to return them, thus obtaining a profit. The conditions in which the credit is granted depend on the ratio between the supply and demand of assets and liquidity at that period of time. If the assets are rare on the market and the broker cannot obtain them easily, the assets will be borrowed with a prime pro rata temporis owed by the short seller. If the liquidity is scarce, then the creditor will grant assets to the debtor by also paying an interest for amount of money that is owned as guarantee until the cred its liquidation (moments 5-8). Usually, the interest is a little above the current market interest rate. As a result, the following rule is well known among the traders: the bow pays the interest, while the bear not : the investor working on a long (the bow) expects a rise in the price, he borrows money on a margin, paying interest for credit money and receiving dividends for assets. The investor working on a short (the bear) doesnt pay the interest, as borrowing assets and guaranteeing assets with cash, he has a position of a creditor of money funds. One of the main characteristics of transaction is marking to market 2 : all the time the borrowed assets should be guaranteed by a cash amount equal to the current market value of these assets. In this case two situations appear:

Process of daily revaluation of a security to reflect its current market value instead of its acquisition price or book

value. Also called marked to market or marking to market.

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When the assets rate falls down, the value of guarantee becomes higher than the value of borrowed assets and the creditor broker should transfer the difference on the account of the debtor client. When the assets rate goes up, the guarantee becomes insufficient and the debtor broker requires his client new cash transfers (margin call).

3.2. Price creation on forward market

Forward price - the price specified in a forward contract for a specific commodity. The forward price makes the forward contract have no value when the contract is written. However, if the value of the underlying commodity changes, the value of the forward contract becomes positive or negative, depending on the position held. Forwards are priced in a manner similar to futures. As with a futures contract, the first step in pricing a forward is to add the spot price to the cost of carry 3 (interest forgone, convenience yield, storage costs and interest/dividend received on the underlying). However, unlike a futures contract, the price may also include a premium for counterparty credit risk, and there is not daily marking- to-market to minimize default risk. If there is no allowance for these credit risks, then the forward price will equal the futures price. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. The value of a forward position at maturity depends on the relationship between the delivery price (K) and the underlying price ST at that time (see Figure 3.2.1). For a long position this payoff is: fT = ST For a short position, it is: fT = K ST

3 Cost of carry - expenses incurred while a position is being held; for examp le, interest on securities bought on margin, dividends paid on short positions, and other expenses.

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Iordachi Victoria, dr., conf. univ. - Tranzacii bursiere, curs de lecii

2013

Figure 3.2.1. Value of a forward position at maturity Source. Made by authors Example . Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agr ee on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. Forward price of stocks is determined by relation 3.2.1:
PF Ps 1 Rd t 365

whe re,

(3.2.1)

PF forward price, PS SPOT price, Rd interest rate on deposits; t- period of time untill the liquidation of forward contract If the dividends for stocks are paid during the contracts period, the price should be adjusted by the value of dividends, because when buying the contract, the investor does not receive dividends. 17

Iordachi Victoria, dr., conf. univ. - Tranzacii bursiere, curs de lecii

2013

a) Lets examine the case when the dividends are paid at the moment of the contracts liquidation:
PF Ps 1 Rd t 365 Div

3.2.2

Where Div dividend in absolute value If we use percentage rate of dividends, then:
PF Ps 1 Rd d t 365

3.2.3

Where d percentage rate of the dividend for one year Example: Spot price of stock 1000 m.u., interest rate on deposit 2-%, dividend rate 10%. Determine the forward price of the contract, if the maturity of the contract is 182 days.
F= 1000 1

0 ,2

0 ,1

182 365

=1049,86 u.m.

b) The dividend is paid at a certain moment during the contracts duration: In this case the buyer looses not only the dividend, but also the percentage from its reinvesting until the moment of the contracts liquidation. F= S 1 Where: Rd2 interest rate on deposit for t2 period Rd1,2 interest rate on deposit for t2 -t1 period
Rd
2

t2 365

Div 1

Rd

2 ,1

t 2 t1 365

3.2.4

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Iordachi Victoria, dr., conf. univ. - Tranzacii bursiere, curs de lecii

2013
Annex 3.1.1

Textbox 3.1.1. Short sales. The first rule of investing: buy low and sell high. If you haven't actually bought anything, get someone to lend it to you first, then sell it high and buy it back once the price has dropped. That's the first rule of short-selling sell high, buy back low, and pocket the difference and it 's a trick that has been hastening market crashes for at least 400 years. Short sellers see an overvalued stock that they ass ume will drop in price, so they borrow some shares fro m a brokerage firm and sell them immediately, at the still-inflated price. If the price drops, they buy back the shares and return them to the lender. If the price rises, the seller still buys them and ends up taking a loss. It's basically old fashioned trading, except in reverse. And because short sellers profit when the price falls, they are often blamed for driving a stock down. On Sept. 19, fo llowing one of the most turbulent weeks in stock markets' history, the Securities and Exchange Co mmission (SEC) banned short sales of 799 financial co mpanies for just that reason. But defenders of short-selling say the practice doesn't cause a market to crash, it merely accelerates the fall. It's a little b it like ripping off a Band-Aid: you can do it the slow way o r the fast way, but there's still going to be an in jury underneath. While regular trading fills the market with people who only want their stocks to go up and will do anything to ensure that it happens short selling creates people who want the market to go down, and therefore (its defenders say) does a better job at keeping the market honest. Short sellers were the first to discover problems at Enron, WorldCo m and Bear Stearns. As Vanderbilt University economics professor Peter Rousseau puts it, "It's always good to have people on both sides." Crit ics, however, say that when short sellers pile into a particular stock, their borrowed 'sell' orders can swamp the market forcing the price to plu mmet. Shorts are most visible when any kind of speculative bubble starts to burst. They existed in the Netherlands in 1637, when the escalating price of tulip bulbs suddenly plummeted. (The Dutch, in fact, were the first to ban shorting, back in 1610, when they decided it probably wasn't a good idea to sell so mething you didn't own). They were around in 1773, when England realized that its South Sea Company had falsely inflated its own stock price. And they were there 1929, when they helped give Wall Street and America a great big wake-up call. More recently, short selling has been blamed for helping precipitate the Asian financial crisis of the late 1990s; billionaire financier George Soros famously netted more than $1 billion by shorting the British pound in 1992. There's also something called naked short selling, wh ich is a short sale that occurs before the seller has actually borrowed the stock. If the seller can't borrow the shares in time, it's called a "failure to deliver" a practice that has been illegal since the SEC was founded in 1934, although investors have long found a way around the ban. So me failures are accidents; a computer glitch here, an unexpected difficulty there. But many are done on purpose, when the seller has no intention of following through with the deal. This does reduce a stock's price all these people are selling, but no one is buying because there's not actually anything to buy and has been illegal since the SEC was founded in 1934, although investors have long been able to find wa ys around the ban. If short selling is the sale of something you don't own, naked short selling is the sale of something that may not even exist. Victims of naked shorting can see thousands of phantom stocks trade hands every day, and there's not much they can do about it. Every time a market crashes, short selling is blamed because even legitimate short transactions with stocks that actually exist drive prices down faster. The London Stock Exchange banned short sales in 1787 to protect banking stocks after a large bank collapsed. After the 1929 crash, President Hoover publicly railed against short selling. New Yo rk State Attorney General Andrew Cuomo did the same thing last week, calling short sellers "looters after a hurricane." Then came the SEC's Sept. 19 ban, which pushed the Dow Jones Industrial Average up 370 points, even as market analysts called the move little but an ineffective and ill -advised band-aid. As short sellers would argue, they were merely pricking a bubble that was going to burst any way.

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