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Derivatives- I

Mapping to Curriculum
Reading 60: Derivative Markets and Instruments Reading 61: Forward Markets and Contracts

Reading 62: Future Markets and Contracts

This files has expired at 30-Jun-13 Expect around 6 questions in the exam from todays lecture

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Key Concepts
Difference Between OTC And Exchange Traded Contracts Payoffs of Futures and Forwards FRAs Margins Types of Futures

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Introduction
What are the fundamental assets trading in the market?

1. 2. 3. 4.

Stocks Bonds Commodities Currency

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What Is A Derivative?

D Derivative

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A
A Underlying, a fundamental asset For example, a Stock, Bond, Currency, Commodity

The value of D changes as A moves

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Derivatives Payoff

Non-Linear Payout Linear Payout Y-axis Profit/Loss on (D)

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X-axis Value of Underlying (A)

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Types Of Derivatives

Derivatives

Linear (Have Linear Payoffs)

Non-Linear (Have Non-Linear Payoffs)

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Forwards/Future s (D)

Options (D)

Swaps, Exotics (D2)

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Definition
Derivative: It is a financial instrument whose value is derived (hence the name derivative) from the value on an underlying asset Underlying asset: It can be stocks, indices, bonds, commodities, currency, rates, etc.

Main types of derivatives (explained later): Forwards and Futures Swaps Options Exotics

Exchange traded: Traditionally open-outcry system Switching to electronic trading Contracts are standardized Example: - Europe: Liffe: http://www.liffe.com - US: Chicago Board of Trade http://www.cbot.com

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Trading Types: Exchange traded Over the Counter

Over the counter (OTC):

A computer- and telephone-linked network of dealers Contracts can be non-standard

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Difference Between OTC And Exchange Traded Contracts

Over the Counter (OTC)
Instruments are Customized Counter-party can be another company Mark-to-Market is not done. Cash is only exchanged at contract expiry. Low Liquidity

Exchange Traded
Instruments are Standardized The exchange is the counterparty Mark-to-Market Everyday (profit/loss is calculated and settled on a day to day basis) High Liquidity

High Counter-party risk No counter-party risk This files has expired at 30-Jun-13 A dealer market with no central trading location Backed by a clearinghouse Unregulated Market No active secondary market Regulated Market Active Secondary Market

Instruments: Swaps, Exotics

Instruments: Futures, Options

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Forward contract - Example

You need a laptop, one year from now. The current price of a laptop is $1000.

You have 3 options, to fulfill your requirement: 1. Buy it now at $1000, and use it after a year 2. Buy it a year from now at the market price prevailing one year from now (unknown price). 3. Enter into an agreement with the vendor so as to purchase the laptop a year from now at a price of $1000.

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In each of the three scenarios, what would be your profit/loss if the price of the laptop after one year is: 1. $500 2. $1000 3. $1500

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Forward contract - Example

Taking the Third Scenario, If you locked a fixed price of $1000 for a laptop after one year, your profit and loss would look like:

Agreed upon Price of Laptop (X=strike)

1000
1000 1000

Price of Laptop (S=spot)

500
1000

Profit and Loss from the Buyers Perspective (S-X)

-500
0

1500 This files has expired at 500 30-Jun-13

The Profit and Loss from the vendors point of view:

Agreed upon Price of Laptop (X=strike)

1000 1000 1000

Price of Laptop (S=spot)

500 1000 1500

Profit and Loss from the Buyers Perspective (X-S)

500 0 -500

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Forward contract - Example

Payoff from Buyers Perspective Payoff from Sellers Perspective

500

0 -500

500

This 1000 files 1500 has expired at 0 30-Jun-13 500

Slope of the line is 1

500

1000

1500

-500

Slope of the line is -1

This is a Zero-Sum Game

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Characteristics Of Forward Markets

Contract whereby parties are committed: To buy (sell) An underlying asset At some future date (maturity) At a delivery price (forward price) set in advance

When contract is initiated: No cash flow

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Forward price such that PV of the contract zero Forward contracts: It is private & customized Forward contract the risk of default is a concern For forward contracts, losses accumulate until the end of the contract Forward contract are generally designed to held till expiration

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Characteristics Of Forward Markets

The party which agrees to buy the specified asset is said to take a long position, and the party which agrees to sell the specified asset is said to take a short position.

Customization, difficulty of closing out positions, low liquidity

Forward contracts are subject to default Netting multiple transactions with the same counterparty lowers default risk. Forward contract is nearly always constructed with the idea that the participants will hold on their positions

This until the contract expires

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The possibility exists that any of the participants may wish to terminate the position prior to expiration

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Forward Contract: Example

Underlying asset: Gold Spot price: Maturity: Size of contract: Forward price: Profit/Loss at maturity $980 / ounce 6-month 100 ounces $990 / troy ounce

Spot price Buyer (long) Seller (short)

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950 970 990 0 0 1010 -4,000 +4,000 -2,000 +2,000 +2,000 -2,000

1030 +4,000 -4,000

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Forward Contract: Example

Long Position Long Position

Gain/Loss

Gain/Loss

$990

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$990

ST

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Agenda
Derivative Markets and Instruments Forward Markets and Contracts Future Markets and Contracts

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Settlement Of A Forward Contract

A position in a forward contract can be settled depending on the type of contract:

Deliverable forward contract: Settled by delivering the underlying asset on expiry of the contract
Cash settlement: Under this method the party which is on the loss side of the contract pays the amount of the loss to the other party terminate the contract The person who has a obligation to purchase the asset as per the contract(long position) pays the person who has a obligation to sell the asset(short position) if the prevailing price is lower than the contracted price This files has expired at 30-Jun-13 Exchange for Physicals:
Settled ex-pit settled off the exchange Negotiate the terms of Transaction

Terminating the position before expiration: This can be done by entering into another contract which is opposite to the current contract. The time period of the new contract should be equal to the time left till expiration of the current contract. This can be done in one of the following ways:
Cash: This can be done when the loss making party pays the counterparty thus settling and terminating the account. Derivative: Getting into an offsetting transaction. If you are long a contract that you wish to terminate, short the same contract to square off your position. If this short position is taken with the same counterparty, it eliminates counter party risk.
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Example: Contract Termination By Offsetting

Consider 3 Companies, Company A, Company B, and Company C. Forward contract - expiry of June 2nd, 2012, underlying - the S&P 500 index, fixed price = $1,300 B and A entered into this forward contract with B as the long position and A as the short position. Now B, feeling he took a wrong call, squared off the position by getting into a similar contract with C, taking the short position in that contract. If at contract expiry, the index is at $1,350, B gains $50 in its contract with A, but loses $50 in its contract with C. His net profit and loss should be 0. However, in case party A defaults, Bs net profit/loss becomes -$50.

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A B
S L

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Dealer Versus End User

The end users are typically corporations who want to hedge their risks. Dealers are like the market makers for forward contracts and include banks and other Non banking financial companies. Dealers may enter into contracts with other dealers to hedge their own outstanding positions.

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Forwards On Equity And Bonds

For Equity Forward Contracts the underlying asset is a stock. Such contracts can be settled by cash or by delivery of the stock.

One can also have a forward contract whose underlying is the stock index. Such contracts are only settled in
cash Forward on zero coupon bonds or coupon paying bonds are the same as Equity Forward contracts. But as bonds have a fixed life, the forward contract on bonds must expire before the underlying bonds mature

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Effect of Dividends
Equity forwards typically have payoffs based only on price of the equity or level of index. Thus dividends are not taken into account at settlement. An exception to this is the forwards on the S&P 500 Total Return Index, which includes dividends.

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Example
T-bills are usually quoted at a discount to face value. This discount is annualised to arrive at the settlement price

Example:
$10 million face value T-bills with 100 days to maturity, priced at 2% discount. Compute the dollar amount to be paid by long to settle the T-bill Solution: 2% * (100/360) = 0.556%

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$ settlement price = (1 0.556%)*10 million = $9,944,444

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Eurodollar Time Deposit Market

Euro Dollar time deposit refers to Dollar denominated deposits outside US The rate of interest at which banks borrow funds from other banks in the London interbank market is called LIBOR(London Interbank Offered Rate) Quoted as annualized rate based on a 360 day year LIBOR is published by the British Bankers Association on a daily basis LIBOR is the most popular benchmark for short term interest rates Equivalent Euro rate is called Euribor

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Forward Rate Agreement(FRA)

For a notional amount N, in a Pay Fixed, Receive Floating 3-by-9 FRA agreement:
Fixed Rate Decided: 5.5% 180 day LIBOR = 5% Receive: Fixed =5.5% Pay: 180 day LIBOR = 6% Value of contract to floating payer: N*(5-5%-6%)*180/360

Start of an FRA agreement

Reference period for borrowing

T=0

T=3 m T=9m FRA Period/Duration This files has expired at 30-Jun-13

Expiry/Settlement

Payment tothe Long at Expiry Notional

(Rate at Settlement - FRA Rate) (days/360) 1 (Rate at Settlement days/360)

It is derived from 2 forward contracts, one long, one short Forward contract to borrow (long) or lend (short) at a pre-specified rate A typical FRA is where interest at a predetermined rate, RK is exchanged for interest at the market rate A 3-by-9 FRA means a180 day LIBOR starting 90 days from now
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FRA Example
FRA that Settles in 30 days

$1 million notional
Based on 90-day LIBOR Forward rate of 5% Actual 90-day LIBOR at settlement is 6%

Solution:

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(6% - 5%) * (90/360)* $1m = $2,500 PV: 2,500 / (1 + (90/360)*6%) = $2,463

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Currency Forward Contracts

Used by banks and corporations to manage foreign exchange risk.

For example, if you are located in the USA and know you are going to receive 500 Million Yen in 3 Months, a currency forward can hedge the risk of future currency fluctuations. You can enter into a currency forward that gives you a 80Yen/$ in 3 months on a notional amount of 500 Million Yen.

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Characteristics Of Futures
A futures contract is an agreement between two parties in which one party, the buyer, agrees to buy from another party, the seller, an underlying asset or other derivative, at a future date at a price agreed on today.

Characteristics of Futures: Standardization: Major difference between forwards & futures is that futures contracts have standardized contract terms

This has expired Futures contracts specify the files quality & quantity of goods thatat can 30-Jun-13 be delivered, delivery time & the manner
of delivery Uniformity promotes market liquidity

Clearinghouse: Each exchange has clearinghouse

It guarantees that traders will honor their obligations Act as buyer to evry seller & seller to every buyer

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Agenda
Derivative Markets and Instruments Forward Markets and Contracts Future Markets and Contracts

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Distinguish Between Forward Contract & Future Contract

Fundamentally, Futures are similar to Forward contracts. They differ on the following aspects:

FORWARDS Not traded on exchanges Are private agreements between two parties and are not as rigid in their stated terms and conditions Credit risk is high High customization This files has Settlement at the end of contract and on a specific date Mostly used by hedgers that want to remove the volatility of the underlying, hence delivery/cash settlement usually takes place

FUTURES Traded on exchanges Standard contracts Clearing house and daily mark to market reduces credit risk Settlement can occur over a range expired at 30-Jun-13 of dates Usually closed out before maturity and hardly any deliveries happen

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Mechanics Of Future Markets

Investor : You Broker : Goldman Sachs Trader : Specialist Exchange : NYSE

Clearing House Member

Clearing House: Options Clearing Corporation

Clearing house margin If not the broker a clearing house member has to be a member of the clearing 30-Jun-13 house. Clearing margin : Just like a margin account with a broker, members have an account with the clearing house No maintenance margin Account balance to be maintained at all times = number of contracts * original margin

Specifications of a contract Asset: If asset is a commodity, exchange specifies the asset in This complete detail: grade, quality, size, shape, colour, etc Contract size: The amount of the asset to be delivered Delivery arrangement: place of delivery Delivery month

Margins Margin account.: investor deposits a certain amount of money with the broker in the files has expired margin account Initial margin: the initial amount deposited in the margin account Maintenance margin: is somewhat below the initial margin. The minimum amount after which a margin call is sent to the investor. After margin call investor has to top his margin account to the initial margin

at

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Margins, Its Calculation & Interpretation

Example: Consider a long position of a DJIA futures contract. For simplicity sake, the market lot is one contract. The current level of the DJIA is 13,000. I enter into a long forward position at the current level. The required initial margin is $300 and the maintenance margin is $220. Compute the margin balance for this position after:
$50 decrease in price on Day 1 $50 decrease in price on Day 2 $50 decrease in price on Day 3
300 250 Margin EOD 0 Margin EOD 1, 3 Margin EOD 2 before variation Margin

Solution:

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0

Day

Opening Balance
$300 $250 $300

Price
$1,300.00 $1,250.00 $1,200.00 $1,150.00

Daily Change
0 ($50.00) ($50.00) ($50.00)

Gain/Loss
0 ($50) ($100) ($150)

Balance
$300 $250 $200 $250

Variation Margin

0 (Purchase) $300 1 2 3

100

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Margins, Its Calculation & Interpretation

In the stock market, margin means that a loan is made. In the futures market, margin is the amount of money that must be put into an account by a party opening up a futures position. Initial Margin Requirement the amount a futures trader is required to put up at the initiation of the contract. This payment can be viewed as collateral. Both the buyer and seller of a futures contract must deposit margin.

This files has expired atand 30-Jun-13 Clearing house marking to market results in gains and losses the account balance must remain above the maintenance margin requirement. Mark to market prices is done at the settlement price which represents an average of the final trades of the day. The additional margin that is deposited to fulfill the maintenance margin requirement is called variation margin.

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Marking To Market
Marking to market: Marking to market involves adjusting the margin account to reflect the change in the price of the underlying security The exchange imposes price limits within which the future contracts can be traded. If a contract has a daily price limit of five cents, and it is current price is $2.50, then the contract has made a limit move If the contract price hits above $2.55 the contract has said to be limit up

This files expired 30-Jun-13 If the contract price hits below $2.45 thehas contract has said toat be limit down
As no trade will take place the price is said to have locked limit

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Margins, Its Calculation & Interpretation

Example: Consider a long position of five wheat contracts, each of which covers 5000 bushels. Assume a contract price is $1.00 & that each contract requires an initial margin deposit of $150 & maintenance margin of $100. The total initial margin required for the 5-contract trade is $750. Maintenance margin for the account is $500. Compute the margin balance for this position after:
2-cent decrease in price on Day 1 1-cent increase in price on Day 2 1-cent decrease in price on Day 3

Solution: Day 0 (Purchase) 1 2 3

This files has expired at 30-Jun-13 Opening Price/Bushel Daily Gain/Loss Balance Balance Change
$750 $750 $750 $1000 $1.00 $0.98 $0.99 $0.98 0 -$0.02 +$0.01 -$0.01 0 -$500 +$250 -$250 $750 $250 $1000 $750

Variation Margin $500

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Termination Of Futures Contract

Future contracts can be terminated in any one of the following ways: Delivery: A short can terminate the contract by delivering the goods, & a long can terminate the contract by accepting delivery & paying the contract price to the short Cash settlement: Here, the futures account is marked-to-market based on the settlement price on the last day of trading Closeout, Reverse or offsetting trade: similar to exiting a forward contract prior to expiration but other

has expired side of the position isThis held by files the clearinghouse

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Exchange of physicals: E.g.: pit (outside exchange) transaction

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Types Of Futures
Characteristic Underlying T. Bill Futures 90-day T. Bill T. Bond Futures Bonds with maturities over 15 years $100,000 Eurodollar Futures 90-day LIBOR Stock Index Futures Stock Index Currency Futures Foreign Exchange Rate Depends on currency: MXP500,000 EUR125,000 USD/unit

Face Value

$1 Million

$1 Million

Depends on value of contract and multiplier and index level

Price Quote

100-annualized This files discount on T.Bill in percent Cash

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Cash Cash

100-annualized

Settlement

Cheapest to Deliver Bond (depends on conversion factor) 1/32nds of the face value = $3125

Minimum Change

1 tick = 0.01% => $25

Depends on value of contract and multiplier and index level 250 for the S&P 500

Depends on currency: MXP=>USD 50 EUR=>USD 12.5

Multiplier

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Five Minute Recap

Over the Counter (OTC) Instruments are Customized Counter-party can be another company Exchange Traded Instruments are Standardized The exchange is the counterparty

Mark-to-Market is not done. Cash is only exchanged at contract expiry.

Low Liquidity High Counter-party risk A dealer market with no central trading location Unregulated Market

Mark-to-Market Everyday (profit/loss is calculated and settled on a day to day basis)

High Liquidity No counter-party risk Backed by a clearinghouse Regulated Market Terminating an open derivatives position before expiration: Cash Derivative Offsetting Trade Exchange of Physicals

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Active Secondary Market
Instruments: Futures, Options
Receive: Fixed =5.5% Pay: 180 day LIBOR = 6% Value of contract to floating payer: N*(5-5%-6%)*180/360

No active secondary market

Instruments: Swaps, Exotics
Fixed Rate Decided: 5.5% 180 day LIBOR = 5% Start of an FRA agreement

Reference period for borrowing

T=0

FRA Period/Duration

T=3 m

T=9m Expiry/Settlement

Payment tothe Long at Expiry Notional

(Rate at Settlement - FRA Rate) (days/360) 1 (Rate at Settlement days/360)

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