Financial Derivatives

Introduction to Derivatives

Hull et al: Chapters 1 & 2

1. Course Overview
• In this unit, we provide an in-depth examination of the
following derivatives:
– Options;
– Futures;
– Forwards; and,
– Swaps.
• We examine these instruments on a range of underlying
commodities including stocks, interest rates and foreign
exchange.
• We also look at more exotic instruments such as
weather and electricity derivatives.

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2. Lecture Overview
• In this lecture we will:
– Recap the basics of forward, futures and options
contracts;
– Revisit the concepts of hedging, speculation and
arbitrage; and
– Discuss the mechanics of futures and forward
markets.
• It would be a good idea to review your
Foundations of Finance notes to ensure you are
familiar with all of the terminology pertaining to
futures, forwards and options contracts. We will
only discuss this prerequisite material briefly.

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3. The Nature of Derivatives
• A derivative is an instrument whose value
depends on the values of other more basic
underlying variables.
• Examples of derivative contracts include:
forward; futures; and, options contracts.

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4. In What Ways are Derivatives Used

• Derivatives can be used to:

– Hedge risks;
– Speculate;
• take a view on the future direction of the market
– Lock in an arbitrage profit;
– Change the nature of a liability; and,
– Change the nature of an investment without
incurring the costs of selling one portfolio and
buying another.

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5. Forwards and Futures Contracts
• A futures/forward contract is an
agreement to buy or sell an asset at a
certain time in the future for a certain
price.
• By contrast in a spot contract there is an
agreement to buy or sell the asset
immediately (or within a very short period
of time).

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5. Forwards and Futures Contracts
• The future/forward prices for a particular
contract is the price at which you agree to
buy or sell the underlying asset.
• It is determined by supply and demand in
the same way as a spot price.

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5. Forwards and Futures Contracts
• In a forward or futures contracts:
– The party that has agreed to buy has a long
position. They have a final payoff of St-F.
– The party that has agreed to sell has a short
position. They have a final payoff of F- St.

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5. Forwards and Futures Contracts
• Example of a forward/futures contract:
– It is January and an investor enters into a long
futures contract on COMEX to buy 100 oz of
gold @ $1,200 in April
– If in April the spot price of gold ends up being
$1,215 per oz, what is the investor’s profit?
• As the investor is the long position, the payoff from
the contract is ST-F, which equals ($1215-
$1200)x100=$1,500.

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5. Forwards and Futures Contracts
• Some important points about Futures and
Forward contracts:
– The initial value of the contract is zero.
– No money changes hands when forward and futures contracts
are first negotiated & the contract is settled at maturity.
– Forward contracts are similar to futures except that they trade in
the over-the-counter market. Futures contracts on the other
hand are exchange traded instruments.
• In Australia, futures contracts are traded on the Australian Securities
Exchange (ASX).
– In addition, if you recall from Foundations of Finance,
intermediate gains or losses are posted each day during the life
of the futures contract.
• This feature is known as marking to market.
• The intermediate gains or losses are given by the difference between
today’s futures price and yesterday’s futures price.
• These monies are transferred between the margin accounts of contract
parties.

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5. Forwards and Futures Contracts
• Some important points about Futures and Forward contracts
(continued):
– The forward/futures price for a contract is the delivery price that
would be applicable to the contract if were negotiated today (i.e., it
is the delivery price that would make the contract worth exactly
zero).
– In other words, it would make no difference whether you entered
into the forward contract to receive the asset in 6 months from
now, or bought the asset today and stored it for 6 months. The
cost of either strategy would be identical.
– The forward price may be different for contracts of different
maturities.

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5. Forwards and Futures Contracts
• Some important points about Futures and
Forward contracts (continued):
– Examples of futures markets:
• ASX (http://www.asx.com.au)
• Chicago Board of Trade
• Chicago Mercantile Exchange
• LIFFE (London)
• Eurex (Europe)
• BM&F (Sao Paulo, Brazil)
• TIFFE (Tokyo)
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5. Forwards and Futures Contracts
– Profit from a long forward/futures position:
Profit

Price of Underlying
at Maturity

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5. Forwards and Futures Contracts
– Profit from a short forward/futures position:
Profit

Price of Underlying
at Maturity

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5. Forwards and Futures Contracts
– Convergence of Futures to Spot:

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b)

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5. Forwards and Futures Contracts
• Some important points about Futures and Forward
contracts (continued):
– As the delivery month of a futures contract is approached, the futures
price converges to the spot price of the underlying asset. When the
delivery price is reached, the futures price equals, or is very close to the
spot price.
– If the futures price is above the spot price during the delivery period,
traders will have an arbitrage opportunity, and will short the futures
contract, buy the asset and make delivery. This will force the futures
price to fall and converge to the spot price.

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5. Forwards and Futures Contracts
• Some important points about Futures and
Forward contracts (continued):
– If the futures price is below the spot price during the
delivery period, companies wanting to acquire the
asset would enter into a long position in the futures
contract and wait for delivery to be made. As they do
so, the futures price will tend to rise, until the futures
and spot prices converge.

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5. Forwards and Futures Contracts
Key Features of Forward/Futures Contracts:
FORWARDS FUTURES
Private contract between 2 parties Exchange traded
Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at maturity Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity

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5. Forwards and Futures Contracts
• Margin Accounts
– As noted previously in the lecture, futures contracts
involve a margin account.
– A margin is cash or marketable securities deposited
• by an investor with his or her broker.
– The balance in the margin account is adjusted to
reflect daily settlement.
– Margins minimize the possibility of a loss through a
default on a contract.

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5. Forwards and Futures Contracts
• Closing Out of a Futures Position
– Closing out a futures position involves entering
into an offsetting trade.
• For example, if you hold a long position in wool, to
close it out you would take a short position on wool
on the same quantity with the same maturity date.
• Most futures contracts are closed out before
maturity.

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5. Forwards and Futures Contracts
• Closing Out of a Futures Position (continued)
– If a contract is not closed out before maturity, it is
usually settled by delivering the assets underlying
the contract.
• When there are alternatives about what is delivered, where it is
delivered, and when it is delivered, the party with the short position
chooses.
– Some contracts (for example, those on stock indices
and Eurodollars) are settled in cash.
– The terms of the contract will stipulate whether there
is physical or cash settlement.

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5. Forwards and Futures Contracts
• Some futures terminology:
– Open interest: the total number of contracts
outstanding.
• Equal to number of long positions or number of short
positions.
– Settlement price: the price just before the final bell
each day.
• Used for the daily settlement process.
– Volume of trading: the number of trades in 1 day.

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5. Forwards and Futures Contracts
• Regulation of Futures Markets
– Designed to protect the public interest.
– Regulators try to prevent questionable
trading practices by either individuals on the
floor of the exchange or outside groups.

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6. Option Contracts
• A call option is an option to buy a certain
asset by a certain date for a certain price
(the strike price).
• A put option is an option to sell a certain
asset by a certain date for a certain price
(the strike price).

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6. Option Contracts
• The person in the long position of either a call or
put option is the holder of the option.
– They make the choice as to whether the option
is exercised or not.
– For this privilege they must pay an option premium to
the writer.
• The person in the short position of either a call
or put option is the writer of the option.
– They are obliged to fulfil the terms of the option
contract if the holder exercises it.
– In return they receive an option premium from the
holder.

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6. Option Contracts
• If someone is long in a call option:
– They have the right, but not the obligation to buy the
underlying asset to the person who is short in the call
option for a specified price. If they choose to exercise
the option, the payoff will be St-X.
• If someone is short in a call option:
– They are obligated to sell the underlying asset for the
specified price to the person in the long position if the
holder decides to exercise the option. If the option is
exercised by the holder, the payoff to the writer is –
(St-X).

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6. Option Contracts
• If someone is long in a put option:
– They have the right, but not the obligation to sell the
underlying asset to the person who is short in the put
option for a specified price. If they choose to exercise
the option, the payoff is X-St.
• If someone is short in a put option:
– They are obligated to buy the underlying asset for the
specified price from the person in the long position if
the holder decides to exercise the option. If the
holder decides to exercise the option, the payoff to
the writer will be –(X-St)

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6. Option Contracts
• Options can be either exchange traded, or
traded on an OTC market. Examples of options
exchange markets are:
– ASX (http://www.asx.com.au)
– Chicago Board Options Exchange
– American Stock Exchange
– Philadelphia Stock Exchange
– LIFFE (London)
– Eurex (Europe)

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6. Option Contracts
• Another way to distinguish between
options is whether they are American or
European in nature:
– An American options can be exercised at any
time during its life, up to and including the
expiry date; and,
– A European option can be exercised only at
the expiry date.

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6. Option Contracts
• Options contracts differ from forward and futures
contracts in a number of ways:
– A futures/forward contract gives the holder the
obligation to buy or sell at a certain price;
– An option gives the holder the right but not
the obligation to buy or sell at a certain price;
– In return for this right, the holder must pay an option
premium to the writer; and,
– Options can be both OTC and exchange traded,
whereas forward contracts are OTC and futures
contracts are exchange traded instruments.

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7. Types of Market Traders
• There are three main types of market participants:
1. Hedgers want to avoid exposure to adverse movements in the
price of an asset.
• As such, they will have a position in both the derivative, and the
underlying asset.
2. Speculators take a position in the market betting that either the
price of an asset will go up, or it will go down.
• If they are correct they will make large gains, but if they are wrong
they have the potential to make enormous losses.
• Some of the largest trading losses in derivatives have occurred
because individuals who had a mandate to hedge against risks
switched to being speculators.
3. Arbitrageurs attempt to lock in a riskless profit by
simultaneously entering into transactions in two or more
markets.

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7. Types of Market Traders
• An Example of Arbitrage:
– Suppose that:
• The spot price of gold is US$1090;
• The quoted 1-year futures price of gold is US$1195;
• The 1-year US$ interest rate is 5% per annum; and,
• The cost of storage is 2% per annum.

• Is there an arbitrage opportunity?

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7. Types of Market Traders
• If the spot price of gold is S & the futures price is for a contract
deliverable in T years is F, then:
F = S (1+r+q )T
where r is the 1-year (domestic currency) risk-free rate of
interest, and q is the cost of storage.
• In our example, S=1090, T=1, r=0.05 and q=0.02 so that:

F = 1090(1+0.05+0.02)1 = 1166.30

• Here F = 1195 but S0(1 + r+q)T = 1166.30. Hence we should take a

short position in the futures contract (which is relatively overvalued)
and take a long position in physical commodity (which is relatively
undervalued), making an arbitrage profit of $28.70 per ounce.

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8. Conclusion
• In today’s lecture we have had a broad
overview of forward, futures and options
contracts.
• In next week’s lecture, we will focus on
forward and futures contracts in greater
detail, with a particular emphasis on
hedging strategies and the determination
of forward and futures prices.

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