Derivatives Summary Notes

Week 1: Introduction

What is a derivative?
- A derivative is a financial instrument whose value depends on (or derives from) the value of
other, more basic, underlying values.
o Interest rate, foreign exchange, and equity derivatives
o Credit derivatives
o Electricity derivatives
o Weather derivatives
o Insurance derivatives
- Futures, forwards, options

Exchange Traded Markets

- Chicago Board of Trade (CBOT): established in 1948
o Initially used to trade grains -> Speculators soon started trading contracts as
opposed to the grain itself
- Chicago Mercantile Exchange (CME): established in 1919
- CME and CBOT merged to form CME Group, includes New York Mercantile Exchange (NYME)
- Traditionally ‘open-outcry system’
o Traders physically meet on the floor of the exchange to shout and hand signal to
indicate trades they would like to carry out
- Electronic trading
o Algorithmic trading: use of computer programs to initiate trades, often without
human interactions
o Reduce costs
o Improve trade execution speed
o Create an environment less prone to manipulation
- Over-the-counter markets (OTC)
o Decentralised market, without a physical location where market participants trade
 Trade with one another through various communication modes such as
telephone, email and proprietary electronic trading systems.
Communication methods are often recorded in the instance of phone calls
o Trades are usually between two financial institutions or between a financial
institution or between a financial institution and one of its clients (typically a
corporate treasurer or fund manager)
o Financial institutions act as a market maker (quote bid and ask price)
o Non-standardised contracts -> negotiate mutually attractive deal
o Credit risk, counter-party risk
 Counter-party risk: where one party defaults before the completion of the
trade and will not make future payments required of them by contract
 Credit risk: Risk of possibility from borrower’s failure to repay a loan or meet
contractual obligations
What are Forward Contracts?
- Spot contract: agreement to buy/sell an asset today
- Forward contract: agreement to buy/sell an asset at specified time in the future for a certain
price
- Traded in the OTC market
o Long Position: the party that agrees to buy
o Short position: the party that agrees to sell
- Forward price: the delivery price that would be applicable to the contract that negotiated
today
o The delivery price will make the contract worth exactly zero today
o Forward price may be difference for contracts of different maturities

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 - Profit and loss of long and short position

o
o For long position
 If the price of the underlying asset is greater than the price at the breakeven
point, the asset will make a profit
 This is because you are buying the asset at the agreed price of K
(intercept of the X-Axis), but is actually valued at St where spot price
at maturity is greater than the agreed price of purchase.
 Thus, right side of the long position graph is profit while any point
on the left is loss
 Therefore, profit is calculated as:
Profit = St – K
Where St = spot price and K= agreed underlying price
o For Short position
 If the price of the underlying asset at maturity is less than agreed price from
the forward contract, the asset will make a profit
 Similar to the long position, the asset makes a profit because
investors are obligated to pay for the agreed price rather than the
market spot rate at maturity. Thus, if the market price is actually less
than the spot price, the asset will make a profit
 Therefore, profit is calculated as:
Profit = K – St

What are Futures Contracts?

- Futures contracts: agreement to buy or sell an asset at a certain time in the future for a
certain price
- Similar to forward contract but traded on an exchange rather than OTC
- Standardised contract
- Margin requirement
o Having a margin account with capital in order to participate in trading
What are options?
- Options: financial security that gives the holder the right to buy or sell a specified quantity of
a specified asset at a specified price on or before a specified date
- American Option: can be exercised at any time during its life
- European Option: can only be exercised at maturity
- Traded on both OTC and exchange markets
- Call option: option to buy
o Price of call option decreases as strike price increases
o Price of call option more valuable as their time to maturity increases
- Put option: option to sell
o Price of put option increases as strike increases
o Price of put option more valuable as their time to maturity increases
- Buyer/holder/long position: has the right
o Pay premiums
o Buy a call = long a call
- Seller/writer/short position: has the obligation
o Receive premiums
o Sell a call = write a call = short a call
- Long call: right to buy
- Short call: obligation to sell
- Long put: right to sell
- Short put: obligation to buy

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Types of Traders
- Hedgers: Reduce risk from potential future movements in a market variable

o
- Speculators: bet on future direction of a market variable

o
- Arbitrageurs: take offsetting positions in two or more instruments to lock in a profit
o Achieving riskless profits by exploiting price differences on two or more markets
o Transaction costs – the only thing that affects the amount of profit achieved
o Markets react to supply and demand by arbitrageurs and arbitrage opportunities
disappear
- All provide necessary market liquidity
Week 2: Mechanics of Future Markets
Futures contracts
- Exchange traded
- The vast majority of contracts do not lead to delivery (i.e. are closed before maturity)
- Closing out a futures position involves entering into the opposite trade of the original one
- Specifications:
o The asset
 Commodity – grades of the commodity
 Financial assets
o Contract size – the amount of the asset that has to be delivered under one contract
o Delivery arrangement: the price tends to be higher for delivery locations that are
relatively far from the main source of the commodity
o Delivering months – the precise period during the month when delivery can be
made
o Price quotes – how prices will be quoted. In the US, crude oil futures prices are
quoted in dollars and cents
o Position limits – prevents speculators from exercising undue influence on the market

Convergence of Futures to Spot

- As the delivery period for a futures contract is approached, the futures price converges to
the spot price of the underlying asset
- When the delivery period is reached, the futures price equals or is very close to the spot
price

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- If futures price>spot price, arbitrage opportunity arises
o Short the future contract
o Buy the asset at spot price
o Make delivery - https://www.investopedia.com/terms/p/physicaldelivery.asp
o Profit = futures price – spot price
o Futures price will fall as traders sell futures
Margins
- Margin – fund deposited by an investor with broker
- Initial margin – the amount that must be deposited at the time the contract is entered
- Daily settlement (or market to market) – at the end of each trading day, the margin account
is adjusted to reflect the investor’s gain or loss
- The investor is entitled to withdraw any balance in the margin account in excess of the initial
margin
- If the margin account falls below the maintenance margin, the investor receives a margin
call and is expected to top up the margin account to the initial margin level by the end of the
next day. Otherwise, risk getting their account closed out
- Most brokers play investors interest on the balance of the margin account
- Other than cash, investor can usually deposit securities with the broker
o Treasury bills (shares) are usually accepted in lieu of cash at 90% (50%) of their face
(market) value
- Margin requirement depends on:
o The objective of the trader (Hedger vs speculator)
 Speculators have higher risk so they require a higher margin
o The variability of the price of the underlying asset

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o Clearing house acts as the intermediary in futures transactions
o Guarantees the performance of the parties to each transaction
o Brokers who are not members themselves must channel their business through a
member
o The main task: keep track all transactions that take place during a day and calculate
net positions of each of its members
o Credit risk

Market Quotes
- Open/high/low: the three types of prices achieved in trading during the day
- Settlement price: the price just before the final bell each day
o Used for calculating daily gains and losses and margin requirements
- Volume: the number of contracts traded
- Open interest: the number of contracts outstanding
o Number of long or short position
 -

Market Patterns
- Markets where the futures price is an increasing function of the time to maturity are known
as normal markets
- Markets where the futures price decreases with the maturity of futures contract are known
as inverted markets

Delivery
- Very few futures contracts that are entered lead to delivery of the underlying asset
- Most contracts are closed out early
- If contract is not closed before maturity, it is usually settled by delivering the assets
underlying in 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 financial futures are settled in cash because it is inconvenient or impossible to deliver
the underlying asset

Types of traders
- The two main types of traders:
o Futures commission merchants (FCMs) follows the instructions of their clients and
charge a commission
o Locals are trading on their own account
- Can be hedgers, speculators, or arbitrageurs
- Speculators can be classified as:
o Scalpers: watching for very short-term trends
o Day traders: hold positions for less than one trading day
o Position traders: holds positions for much longer periods of time
Forwards vs futures contracts

Hedging
- Objectives of hedging
o Hedging is used to reduce risk of adverse price movements in an asset
o Perfect hedge: completely removes the risk
 Risk does not necessarily mean zero loss, but rather the uncertainty of the
asset
 Thus, a perfect hedge moves the uncertainty
o A long (short) futures hedge is appropriate when you know you will purchase (sell)
an asset in the future and want to lock in the price
- Long hedge example
o You know that you need to buy 100,000 pounds of copper in may
o Spot price = $4.7/pound
o Futures price for May delivery = $4.5/pound
o Contract size = 25,000/contract
o Solution: take a long position in 4 (=100,000/25,000) May Futures contracts
 If copper price in May = $4.55/pound
 Pay for copper -4.55*100,000 = -$455,000
 Profit on futures = 100,000*(4.55-4.50) = $5,000
 Total payoff = -455,000 + 5,000 = -$450,000
 If copper price in May = $4.35/pound
 Pay for copper: -4.35*100,000 = -$435,000
 Loss on futures = 100,000*(4.35-4.50)=-$15,000
 Total pay off = -435,000 – 15,000 = -$450,000
 - Short hedge example
o A US company expects to receive £1 in May
o Today, this is equivalent to 1M*1.75 = $1.75M
o Futures price of £ for May delivery today is 1.80$/£
o The company can short futures contract for £1M to be delivered in May
 Exchange rate in May = 1.70$/£
 1M£ sold for $1.7M
 Profit on futures = 1M*(1.80-1.70)=$0.1M
 Total payoff = 1.85 – 0.5M = $1.80M
 Exchange rate in May = 1.85$/£
 1M£ sold for $1.85M
 Loss on futures = 1M*(1.80-1.85) = -$0.5M
 Total payoff = 1.85-0.5M = $1.80

Arguments for and against Hedging

- For
o Most companies are in the business of manufacturing, or retailing or wholesaling, or
providing a service
o These companies have no skill or expertise in predicting variables such as interest
rates, exchange rates, and commodity prices
- Against
o Shareholders are usually well diversified and can make their own hedging decisions
o A company who does not hedge can be expected to have consistent profit margins,
but a company who hedges can expect to have fluctuations in the profit margin

o
Basis Risk
- In practise, the hedger hardly removes all risks arising from the price of the asset: some
reasons are:
o The asset to be hedged may not be exactly the same as the underlying asset of
futures contracts
o Uncertain as to the exact date when the asset will be bought and sold
o May require the futures contracts to be closed before its delivery month
- These problems give rise to basis risk
- Basis = spot price – futures price = S-F
- Basis risk arises because of the uncertainty about the basis when the hedge is closed out
o E.g maccas need to sell orange juice, goes to market but finds no orange juice
future. They can find most similar product in the financial market, e.g. No orange
juice future but there is orange future. The future price movement for orange juice
movement and orange future movement may not be perfectly correlated. This may
create the imperfect hedge
- Example
o Assume that a hedge is put in place time t1 and closed at t2
o Define
 F1: futures at time 1
 F2: futures at time 2
 S1: spot price at time 1
 S2: spot price at time 2
 B1: basis at time 1
 B2: basis at time 2
 B1 = s1-f1
 B2 = s2-f2
o The value of F1 is known at time t1
o If b2 were also known at this time, a perfect hedge would result
o The basis risk is the uncertainty associated with b2, i.e. uncertainty between s2 and
f2
o If the basis strengths (i.e. increases) unexpectedly, the hedger’s position improves; if
the basis weakens (i.e. decreases) unexpectedly, the hedger’s position worsens

Choosing contracts
- When there is no futures contract on the asset being hedged, choose the contract whose
futures price is most highly correlated with asset price
o This known as cross hedging
- Choose a delivery month that is as close as possible to, but later than, the end of the life of
the hedge
o Basis risk increases as the time difference between hedge expiration and the
delivery month increases
 o Delivery months are March, June, September and December. For hedge expirations
in February, the March contract will be choses

Cross hedging
- Cross hedging occurs when the asset underlying the futures contract is different from the
asset which price is being hedged
- The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of
the exposure
- Hedge ratio = size of the futures position /size of exposure
o Same asset: hedge ratio =1
- The hedger should choose a value for the hedge ratio that minimize the hedge position

Optimal Hedge Ratio

Optimal number of contracts

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- Example
o A firm expects to sell 200,000 pounds of bacon in June 2016 and needs to hedge it.
o The closest contract: pork bellies futures traded on CME, for 40,000 pounds each
o Sigma(bacon) = 0.15, sigma(pork bellies)=0.2, correlation=0.8
o H*=0.8*0.15/0.2=0.6
o N=200,000*0.6/40,000 = short 3 futures contracts
o Delivery months: feb,mar,July,aug ->choose July as closest
WEEK 3: Determination of Forward and Futures Prices
Investment vs Consumption assets
- Investment assets: assets held by significant numbers of investors solely for investment
purposes
o E.g. stock, bonds, gold, silver
 Do not have to be held exclusively for investment
 Silver and gold for example has a number of industrial uses, also known as
investment commodities
- Consumption assets: assets held primarily for consumption purposes
o e.g. copper, oil, pork bellies
- Use arbitragers arguments to determine the forward and futures prices of an investment
asset but not for consumption assets

Short Selling
- Short selling involves selling assets you do not own
- Possible for some but not all investment assets
- Your broker borrows securities from another client and sell them in the market in the usual
way
o Later you must buy the securities back, so they can be replaced in the account of the
client
o The investor takes a profit if the stock price has declined and a loss if it has risen
o You must pay dividends and other benefits the owner of the securities should
receive on the shares
o Margin account is kept with the broker to guarantee that you do not walk away from
your obligations

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Forward Pricing