A person resident in India is permitted to enter into a contract in a commodity exchange or market outside India to hedge price risk

in commodities imported / exported, domestic transactions, freight risk, etc., through the Authorised Dealer Category - I (AD Category I) banks. The role of Authorised Dealer banks here is primarily to provide facilities for remitting foreign currency amounts towards margin requirements from time to time, subject to verification of the underlying exposure. 1. Who can hedge? A person resident in India, who has a commodity exposure and faces risks due to volatile commodity prices, can hedge the price risk in the International Commodity Exchanges/Markets, using hedging products such as, futures and options, which are exchange traded and Over the Counter (OTC) derivatives as permitted by the Reserve Bank from time to time. Prior approval from the Reserve Bank / an AD Category - I bank is required. 2. What are the hedging facilities available to oil companies? The Reserve Bank, through the approval/delegated routes, has permitted following facilities for oil price hedging: Hedging of exposures arising from import of crude oil and export of petroleum products based on underlying contracts. Hedging of exposures arising from import of crude oil based on past performance up to 50 per cent of the volume of actual imports during the previous year or 50 per cent of the average volume of imports during the previous three financial years, whichever is higher. Hedging of inventory up to 50 per cent of the volumes in the quarter preceding the previous quarter. Hedging of exposures arising from domestic purchase of crude and sale of petro products on the basis of underlying contracts. Hedging of exposures on import / export of jet fuel and domestic purchase of jet fuel by users i.e., domestic airline companies. 3. Which are the entities permitted to hedge oil price risk? Domestic oil refining and marketing companies are permitted to hedge their price risk on crude oil and petroleum products on overseas exchanges/ markets to modulate the impact of adverse price fluctuations. Domestic users of aviation turbine fuel (ATF) are also permitted to hedge their price risk on ATF in overseas exchanges / OTC markets. 4. What are the commodities, other than petroleum and petroleum products, which could be hedged in international exchanges? The Reserve Bank has permitted companies to hedge price risk on import/ export in respect of any commodity (except gold, silver, platinum) in the international commodity exchanges/ markets under the delegated route. The eligible company interested in hedging price risk in respect of its import/ export may apply to any AD Category-I bank.

The Reserve Bank has also permitted companies listed on a recognised Stock Exchange to hedge the price risk in respect of domestic purchases and sales of aluminium, copper, lead, nickel and zinc under the delegated route. The eligible company interested in hedging price risk in respect of above commodities may apply to any AD Category-I bank. 5. What are the hedging facilities permitted for entities in Special Economic Zones (SEZs)? AD Category-I banks are permitted to allow entities in Special Economic Zones to undertake hedging transactions in the overseas commodity exchanges/markets to hedge their commodity price risk on import/export. Such transactions are permitted only when the unit in the SEZ is completely isolated from financial contacts with its parent or subsidiary in the mainland or within the SEZs as far as import/export transactions are concerned. 1. What is a freight derivative? A freight derivative is a financial instrument whose value is derived on the future levels of freight rates, such as "dry bulk" carrying rates and oil tanker rates. Freight derivatives are used mainly by end users such as ship owners and large ware houses, suppliers such as oil refining and marketing companies to manage risk and hedge against price volatility in the supply chain. 2. Which are the entities permitted by RBI to hedge freight risk? Oil refining and marketing companies, shipping companies and other companies which have substantial overheads on account of freight component, are permitted to hedge the freight risk in international exchanges/OTC markets on the basis of the underlying exposures. The oil and shipping companies are permitted to hedge through the delegated route i.e. through AD Category -I banks and other corporates having freight exposures are permitted to hedge after obtaining prior approval from the Reserve Bank. . Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes. Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. For instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position. How hedging is done In this type of transaction, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale. The futures market also has substantial participation by speculators who take positions based on the price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profits whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and futures remain correlated.

Example - case of steel An automobile manufacturer purchases huge quantities of steel as raw material for automobile production. The automobile manufacturer enters into a contractual agreement to export automobiles three months hence to dealers in the East European market. This presupposes that the contractual obligation has been fixed at the time of signing the contractual agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing steel prices. In order to hedge against price risk, the automobile manufacturer can buy steel futures contracts, which would mature three months hence. In case of increasing or decreasing steel prices, the automobile manufacturer is protected. Let us analyse the different scenarios: Increasing steel prices If steel prices increase, this would result in increase in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes profit in the futures transaction. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means that he faces a corresponding loss in the physical market. But this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position. Decreasing steel prices If steel prices decrease, this would result in a decrease in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes losses in the futures transaction. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means that he faces a corresponding gain in the physical market. The loss in the futures market is offset by his gains in the physical market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position. This results in a perfect hedge to lock the profits and protect from increase or decrease in raw material prices. It also provides the added advantage of just-in time inventory management for the automobile manufacturer. Understanding the meaning of buying/long hedge A buying hedge is also called a long hedge. Buying hedge means buying a futures contract to hedge a cash position. Dealers, consumers, fabricators, etc, who have taken or intend to take an exposure in the physical market and want to lock- in prices, use the buying hedge strategy. Benefits of buying hedge strategy: To replace inventory at a lower prevailing cost. To protect uncovered forward sale of finished products.

The purpose of entering into a buying hedge is to protect the buyer against price increase of a commodity in the spot market that has already been sold at a specific price but not purchased as yet. It is very common among exporters and importers to sell commodities at an agreed-upon price for forward delivery. If the commodity is not yet in possession, the forward delivery is considered uncovered. Long hedgers are traders and processors who have made formal commitments to deliver a specified quantity of raw material or processed goods at a later date, at a price currently agreed upon and who do not have the stocks of the raw material necessary to fulfill their forward commitment. Understanding the meaning of selling/short hedge A selling hedge is also called a short hedge. Selling hedge means selling a futures contract to hedge. Uses of selling hedge strategy. To cover the price of finished products. To protect inventory not covered by forward sales. To cover the prices of estimated production of finished products. Short hedgers are merchants and processors who acquire inventories of the commodity in the spot market and who simultaneously sell an equivalent amount or less in the futures market. The hedgers in this case are said to be long in their spot transactions and short in the futures transactions. Understanding the basis Usually, in the business of buying or selling a commodity, the spot price is different from the price quoted in the futures market. The futures price is the spot price adjusted for costs like freight, handling, storage and quality, along with the impact of supply and demand factors. The price difference between the spot and futures keeps on changing regularly. This price difference (spot - futures price) is known as the basis and the risk arising out of the difference is defined as basis risk. A situation in which the difference between spot and futures prices reduces (either negative or positive) is defined as narrowing of the basis. A narrowing of the basis benefits the short hedger and a widening of the basis benefits the long hedger in a market characterized by contango - when futures price is higher than spot price. In a market characterized by backwardation - when futures quote at a discount to spot price - a narrowing of the basis benefits the long hedger and a widening of the basis benefits the short hedger. However, if the difference between spot and futures prices increases (either on negative or positive side) it is defined as widening of the basis. The impact of this movement is opposite to that as in the case of narrowing.

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. Support for this pricing relationship is based upon the argument thatarbitrage opportunities would materialize if there is a divergence between the value of calls and puts. Arbitrageurs would come in to make profitable, riskless trades until the put-call parity is restored. To begin understanding how the put-call parity is established, let's first take a look at two portfolios, A and B. Portfolio A consists of a european call option and cash equal to the number of shares covered by the call option multiplied by the call's striking price. Portfolio B consist of a european put option and the underlying asset. Note that equity options are used in this example. Portfolio A = Call + Cash, where Cash = Call Strike Price Portfolio B = Put + Underlying Asset

It can be observed from the diagrams above that the expiration values of the two portfolios are the same. Call + Cash = Put + Underlying Asset Eg. JUL 25 Call + $2500 = JUL 25 Put + 100 XYZ Stock If the two portfolios have the same expiration value, then they must have the same present value. Otherwise, an arbitrage trader can go long on the undervalued portfolio and short the overvalued portfolio to make a riskfree profit on expiration day. Hence, taking into account the need to calculate the present value of the cash component using a suitable risk-free interest rate, we have the following price equality:

Put-Call Parity and American Options Since American style options allow early exercise, put-call parity will not hold for American options unless they are held to expiration. Early exercise will result in a departure in the present values of the two portfolios. Validating Option Pricing Models The put-call parity provides a simple test of option pricing models. Any pricing model that produces option prices which violate the put-call parity is considered flawed.

. Put/Call parity

C - P = S -X + i - d Where: C = Call option price P = Put option Price S = Stock price X = exercise price i = cost of carry d = present value of dividends This relationship between the Put, Call and stock prices originally appeared in a paper by Hans Stoll entitled "The Relationship Between Put and Call Prices" in 1969. The formula was developed for European options (those are the ones that can't be exercised early) but it also applies pretty well to American options. The reason is because unless one of the options is really deep in the money or the

dividend is extremely large, the value of the early exercise component in the American style options is generally small and doesn't have much impact on the formula. In my opinion, it is very important that you understand this basic relationship between Puts, Calls and Stock. I am constantly amazed when I talk to people who have been trading options for any significant length of time and I realize that they don't know there is a connection between the prices. I guess on one level that's okay, it helps me pay my son's college tuition! Let's see how to calculate the i and d terms, and then we will apply the formula to some examples. The cost of carry, i, is calculated by multiplying the risk free rate of return by the exercise price times the number of days to expiration divided by 365. For our purposes, this risk free rate is what you can get on an investment with only a minute possibility of default, such as short term CD's. Traders, I know have recently been using about 5%, although after the last 2 rate cuts, perhaps a lower rate like 4.5% may be more appropriate. To calculate the d, we must take into account any dividends that are being paid prior to expiration and calculate their present value. All that means is we must divide the dividend amount by (1 + risk free interest rate) raised to a power. That power is the time to expiration divided by 365. By the way, since the dividend amount is usually small relative to the stock price and with interest rates being as low as they currently are, most traders just use the actual dividend amount instead of the present value of the dividend, in the formula. It has a minimal effect on the prices. Let's say we know the following about XYZ stock and options: It's trading @ $52, and doesn't pay a dividend There are 37 days to Jan expiration The Jan 50 Call is trading @ 5.50 My risk free rate of return is 5% The question is, how much should the Jan 50 Put be trading for? First, calculate i as .05 x 50 x (37/365) = .25 We also know that d = 0, so our equation becomes; C-P=S-X+i-d Or 5.50 - P = 52 - 50 + .25 - 0 5.50 - P = 2.25 Finally, we get P = 3.25

Monte Carlo methods for option pricing

In mathematical finance, a Monte Carlo option model uses Monte Carlo methods to calculate the value of an option with multiple sources of uncertainty or with complicated features.[1] The term 'Monte Carlo method' was coined by Stanislaw Ulam in the 1940s. The first application to option pricing was by Phelim Boyle in 1977 (for European options). In 1996, M. Broadie and P. Glasserman showed how to price Asian options by Monte Carlo. In 2001 F. A. Longstaff and E. S. Schwartz developed a practical Monte Carlo method for pricing American-style options.

Methodology
In terms of theory, Monte Carlo valuation relies on risk neutral valuation.[1] Here the price of the option is its discounted expected value; see risk neutrality and Rational pricing: Risk-neutral valuation. The technique applied then, is (1) to generate several thousand possible (but random) price paths for the underlying (or underlyings) via simulation, and (2) to then calculate the associated exercisevalue (i.e. "payoff") of the option for each path. (3) These payoffs are then averaged and (4) discounted to today. This result is the value of the option.[2] This approach, although relatively straightforward, allows for increasing complexity:

An option on equity may be modelled with one source of uncertainty: the price of the underlying stock in question.[2] Here the price of the underlying instrument that it follows a geometric Brownian motion with constant drift So: , where and volatility is usually modelled such .

is found via a random sampling from a normal

distribution; see furtherunder BlackScholes. (Since the underlying random process is the same, for enough price paths, the value of a european option here should be the same as under Black Scholes).

In other cases, the source of uncertainty may be at a remove. For example, for bond options [3] the underlying is a bond, but the source of uncertainty is the annualized interest rate (i.e. the short rate). Here, for each randomly generated yield curve we observe a different resultant bond price on the option's exercise date; this bond price is then the input for the determination of the option's payoff. The same approach is used in valuing swaptions,[4] where the value of the underlying swap is also a function of the evolving interest rate. (Whereas these options are more commonly valued using lattice based models, for path dependent interest rate derivatives such as CMOs simulation is the primary technique employed.[5]) For the models used to simulate the interest-rate seefurther under Short-rate model; note also that "to create realistic interest rate simulations" Multifactor short-rate models are sometimes employed.[6]

Monte Carlo Methods allow for a compounding in the uncertainty.[7] For example, where the underlying is denominated in a foreign currency, an additional source of uncertainty will be the exchange rate: the underlying price and the exchange rate must be separately simulated and then combined to determine

the value of the underlying in the local currency. In all such models, correlationbetween the underlying sources of risk is also incorporated; see Cholesky decomposition: Monte Carlo simulation. Further complications, such as the impact of commodity prices or inflation on the underlying, can also be introduced. Since simulation can accommodate complex problems of this sort, it is often used in analysing real options [1] where management's decision at any point is a function of multiple underlying variables.

Simulation can similarly be used to value options where the payoff depends on the value of multiple underlying assets [8] such as a Basket option or Rainbow option. Here, correlation between assets is likewise incorporated.

As required, Monte Carlo simulation can be used with any type of probability distribution, including changing distributions: the modeller is not limited to normal or lognormal returns;[9] see for example DatarMathews method for real option valuation. Additionally, the stochastic process of the underlying(s) may be specified so as to exhibit jumps or mean reversion or both; this feature makes simulation the primary valuation method applicable to energy derivatives.[10] Further, some models even allow for (randomly) varying statistical (and other) parameters of the sources of uncertainty. For example, in models incorporating stochastic volatility, the volatility of the underlying changes with time; see Heston model.

[edit]Application

As can be seen, Monte Carlo Methods are particularly useful in the valuation of options with multiple sources of uncertainty or with complicated features, which would make them difficult to value through a straightforward BlackScholes-style or lattice based computation. The technique is thus widely used in valuing path dependent structures like lookback- and Asian options [9] and in real options analysis.[1][7] Additionally, as above, the modeller is not limited as to the probability distribution assumed. [9] Conversely, however, if an analytical technique for valuing the option existsor even a numeric technique, such as a (modified) pricing tree [9]Monte Carlo methods will usually be too slow to be competitive. They are, in a sense, a method of last resort;[9] see further under Monte Carlo methods in finance. With faster computing capability this computational constraint is less of a concern.

Valuation of options From Wikipedia, the free encyclopedia

This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. (December 2009) Further information: Option: Model implementation

In finance, a price (premium) is paid or received for purchasing or selling options. This price can be split into two components. These are: Intrinsic Value Time Value Contents [hide] 1 Intrinsic Value 2 Time Value 3 Pricing models 4 References [edit]Intrinsic Value

If the market value is more than the strike price, then a call option is 'In the Money'. The difference between the two is called the Intrinsic Value. In simple words, it is the value by which is already available in the market. If you are holding NIFTY 5000 Call (Bullish/Long) option and NIFTY is at 5050 level then you already have 50 Rs advantage even if the option expires today. These 50 Rs is the intrinsic value of option. Conversely if you are holding a put option and NIFTY is below strike price then your option has an intrinsic value equalling the difference between the strike price and NIFTY value. So, Intrinsic Value = Current Stock Price Strike Price (Call Option) = Strike Price Current Stock Price (Put Option) [edit]Time Value

The option premium is always greater than intrinsic value. This extra money is for the risk which the option writer/seller is undertaking. This is called the Time Value. Time value is the amount the option trader is paying for a contract above its intrinsic value, with the belief that prior to expiration the contract value will increase because of a favourable change in the price of the underlying asset. Obviously, the longer the amount of time until the expiry of the contract, the greater the time value. So, Time Value = Option Premium Intrinsic Value

There are many factors which determine Option Premium. These factors affect the premium of the option with varying intensity. Some of these factors are listed here: Price of the underlying: Any fluctuation in the price of the underlying (stock/index/commodity) obviously has the largest impact on premium of an option contract. An increase in the underlying price increases the premium of call option and decreases the premium of put option. Reverse is true when underlying price decreases. Strike price: How far is the strike price from spot also has an impact on option premium. Say, if NIFTY goes from 5000 to 5100 the premium of 5000/5100 strike will change a lot compared to a contract with strike of 5500 or 4700. Time till expiry: Lesser the time to expiry, option premium follows the intrinsic value more closely. On the expiry date Time Value approached zero. Volatility of underlying: Underlying security is a constantly changing entity. The degree by which its price fluctuates can be termed as volatility. So a share which fluctuates 5% on either side on daily basis is said to have more volatility than lets say a stable blue chip shares whose fluctuation is more benign at 2-3%. Volatility affects calls and puts alike. Higher volatility increases the option premium because of greater risk it brings to the seller. Apart from above, other factors like bond yield (or interest rate) also affect the premium. This is due to the fact that the money invested by the seller can earn this risk free income in any case and hence while selling option; he has to earn more than this because of higher risk he is taking. Sometimes dividend payment by an underlying is also factored in to the premium as it affects the cost of buying those shares directly rather than buying the option.[1] .. Put-Call Parity And Arbitrage Opportunity An important principle in options pricing is called a put-call parity. It says that the value of a call option, at one strike price, implies a certain fair value for the corresponding put, and vice versa. The argument, for this pricing relationship, relies on the arbitrage opportunity that results if there is divergence between the value of calls and puts with the same strike price and expiration date. Arbitrageurs would step in to make profitable, risk-free trades until the departure from put-call parity is eliminated. Knowing how these trades work can give you a better feel for how put options, call options and the underlying stocks are all interrelated. Adjustments for American Options This relationship is strictly for European-style options, but the concept also applies to American-style options, adjusting for dividends and interest rates. If the dividend increases, the puts expiring after the ex-dividend date will rise in value, while the calls will decrease by a similar amount. Changes in interest rates have the opposite effects. Rising interest rates increase call values and decrease put values. The Synthetic Position

Option-arbitrage strategies involve what are called synthetic positions. All of the basic positions in an underlying stock, or its options, have a synthetic equivalent. What this means is that the risk profile (the possible profit or loss), of any position, can be exactly duplicated with other, but, more complex strategies. The rule for creating synthetics is that the strike price and expiration date, of the calls and puts, must be identical. For creating synthetics, with both the underlying stock and its options, the number of shares of stock must equal the number of shares represented by the options. To illustrate a synthetic strategy, let's look at a fairly simple option position, the long call. When you buy a call, your loss is limited to the premium paid while the possible gain is unlimited. Now, consider the simultaneous purchase of a long put and 100 shares of the underlying stock. Once again, your loss is limited to the premium paid for the put, and your profit potential is unlimited if the stock price goes up. Below is a graph that compares these two different trades. If the two trades appear identical, that's because they are. While the trade that includes the stock position requires considerably more capital, the possible profit and loss of a long-put/long-stock position is nearly identical to owning a call option with the same strike and expiration. That's why a long-put/long-stock position is often called a "synthetic long call." In fact, the only difference between the two lines, above, is the dividend that is paid during the holding period of the trade. The owner of the stock would receive that additional amount, but the owner of a long call option would not Arbitrage Using Conversion and Reversals We can use this idea of the synthetic position, to explain two of the most common arbitrage strategies: the conversion and the reverse conversion (often called a reversal). The reasoning behind using synthetic strategies for arbitrage is that since the risks and rewards are the same, a position and its equivalent synthetic should be priced the same. A conversion involves buying the underlying stock, while simultaneously buying a put and selling a call. (The long-put/short-call position is also known as a synthetic short stock position.) For a reverse conversion, you short the underlying stock while simultaneously selling a put and buying a call (a synthetic long stock position). As long as the call and put have the same strike price and expiration date, a synthetic short/long stock position will have the same profit/loss potential as shorting/owning 100 shares of stock (ignoring dividends and transaction costs). Remember, these trades guarantee a profit with no risk only if prices have moved out of alignment, and the put-call parity is being violated. If you placed these trades when prices are not out of alignment, all you would be doing is locking in a guaranteed loss. The figure below shows the possible profit/loss of a conversion trade when the put-call parity is slightly out of line. This trade illustrates the basis of arbitrage - buy low and sell high for a small, but fixed, profit. As the gain comes from the price difference, between a call and an identical put, once the trade is placed, it doesn't matter what happens to the price of the stock. Because they basically offer the opportunity for free money, these types of trades are rarely available. When they do appear, the window of opportunity lasts for only a short time (i.e. seconds or minutes). That's why they tend to be executed primarily by market makers, or floor traders, who can spot these rare opportunities quickly and do the transaction in seconds (with very low transaction costs). (For related reading, see Trading The Odds With Arbitrage.)

Conclusion A put-call parity is one of the foundations for option pricing, explaining why the price of one option can't move very far without the price of the corresponding options changing as well. So, if the parity is violated, an opportunity for arbitrage exists. Arbitrage strategies are not a useful source of profits for the average trader, but knowing how synthetic relationships work, can help you understand options while providing you with strategies to add to your options-trading toolbox. .

Bettering Your Portfolio With Alpha And Beta

When an investor separates a single portfolio into two portfolios, an alpha portfolio and a beta portfolio, he or she will have more control over the entire combination of risks to which he or she is exposed. By individually selecting your exposure to alpha and beta, you can enhance returns by consistently maintaining desired risk levels within your aggregate portfolio. Read on to learn how this can work for you.

The ABCs Before we start, you'll need to understand a few key terms and concepts, namely alpha, beta, systematic risk and idiosyncratic risk.

Beta - The return generated from a portfolio that can be attributed to overall market returns. Exposure to beta is equivalent to exposure to systematic risk. The alpha is the portion of a portfolio's return that cannot be attributed to market returns, and is thus independent from market returns.

Alpha - The return generated based off of idiosyncratic risk. Systematic Risk - The risk that comes from investing in any security within the market. The level of systematic risk that an individual security possesses depends on how correlated it is with the overall market. This is quantitatively represented by beta exposure.

Idiosyncratic Risk - The risk that comes from investing in a single security (or investment class). The level of idiosyncratic risk an individual security possesses is highly dependent on its own unique characteristics. This is quantitatively represented by alpha exposure. (Note: A single alpha position has its own idiosyncratic risk. When a portfolio contains more than one alpha position, the portfolio will then reflect each alpha position's idiosyncratic risk collectively.)

The Beta Exposure Component What is it? A portfolio that is constructed of multiple equities will inherently have some beta exposure. Beta exposure in an individual security is not a fixed value over a given period of time. This translates to systematic risk that cannot be held at a steady value. By separating the beta component, an investor can keep a controlled set amount of beta exposure in accordance with his or her own risk tolerance. This helps enhance portfolio returns by producing more consistent portfolio returns.

Alpha and beta expose portfolios to idiosyncratic risk and systematic risk, respectively; however, this is not necessarily a negative thing. The degree of risk to which an investor is exposed is correlated to the degree of potential return that can be expected. Find out more about risk in How Risky Is Your Portfolio?, Personalizing Risk Tolerance and Determining Risk And The Risk Pyramid.

How do you choose exposure? Before you can choose a level of beta exposure, you must first choose an index that you feel represents the overall market. The overall equity market is usually represented by the S&P 500 Index. This is the most widely used index to gauge market movement, and has a wide variety of investment options.

If you feel the S&P 500 does not accurately represent the market as a whole, there are plenty of other indexes that you will find that may suit you better. There is a limitation however, as many of the other indexes do not have the wide variety of investment options that the S&P 500 does. This usually limits individuals to using the S&P 500 index to obtain beta exposure.

Now you must choose a desired level of beta exposure for your portfolio. If you invest 50% of your capital in an S&P 500 index fund and keep the rest in cash, your portfolio has a beta of 0.5. If you invest 70% of your capital in an S&P 500 Index fund and keep the rest in cash, your portfolio beta is 0.7. This is because the S&P 500 represents the overall market, which means that it will have a beta of 1. Choosing a beta exposure is highly individual, and will be based on many factors. If a manager was benchmarked to some sort of market index, that manager would probably opt to have a high level of beta exposure. If the manager was aiming for an absolute return, he or she would probably opt to have a rather low beta exposure.

Ways of Obtaining Beta Exposure There are three basic ways to obtain beta exposure: buy an index fund, buy a futures contract or buy some combination of both an index fund and futures contracts.

There are advantages and disadvantages to each option. When using an index fund to obtain beta exposure, the manager must use a large amount of cash to establish the position. The advantage, however, is that there is no limited time horizon on buying an index fund itself. When buying index futures to obtain beta exposure, an investor only needs a portion of the cash to control the same sized position as buying the index itself. The disadvantage is that one must choose a settlement date for a futures contract, and this turnover can create higher transaction costs. (Read more about indexes in Index Investing.)

The Alpha Component For an investment to be considered pure alpha, its returns must be completely independent from the returns attributed to beta. Some strategies that exemplify the definition of pure alpha are things like: statistical arbitrage, equity neutral hedged strategies, selling liquidity premiums in the fixed-income market, etc.

Some portfolio managers use their alpha portfolios to buy individual equities. This method is not pure alpha, but rather the manager's skill in equity selection. This creates a positive alpha return, but it is what is referred to as "tainted alpha". It is tainted because of the consequential beta exposure that goes along with the purchase of the individual equity, which keeps this return from being pure alpha.

Individual investors trying to replicate this strategy will find the latter scenario of producing tainted alpha to be the preferred method of execution. This is due to the inability to invest in the professionally run, privately owned funds (casually called hedge funds) that specialize in pure alpha strategies. (To learn more about hedge funds, see Introduction To Hedge Funds - Part One, Part Two and A Brief History Of The Hedge Fund.)

There is something of a debate on how this alpha portfolio should be allocated. One methodology states that a portfolio manager should make one large alpha "bet" with the alpha portfolio's capital set aside for alpha generation. This would result in the purchase of a sole individual investment and it would use the entire amount of capital set within the alpha portfolio.

There is some dissent among investors though, because some say a single alpha investment is too risky, and a manager should hold numerous alpha positions for risk diversification purposes. (Keep reading about alpha in Understanding Volatility Measurements.)

Putting It All Together Some might question why you would want to have beta exposure within a portfolio. After all, if you could fully invest in pure alpha sources and expose yourself solely to the uncorrelated returns through exposure to pure idiosyncratic risk, wouldn't you do so? The reason lies in the benefits of passively capturing gains over the long term that have historically occurred with beta exposure.

In order to have more control over the total risk to which an investor is exposed in an aggregate portfolio, he or she must separate this portfolio into two portfolios: an alpha portfolio and a beta portfolio. From here the investor must decide what level of beta exposure would be most advantageous. The excess capital from this decision is then put to use in a separate alpha portfolio to create the best alpha-beta framework.

Read more: http://www.investopedia.com/articles/07/alphabeta.asp#ixzz1oAbVQd00

Using Interest Rate Parity To Trade Forex Interest rate parity refers to the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of interest rate parity is that hedged returns from investing in different currencies should be the same, regardless of the level of their interest rates.

There are two versions of interest rate parity:

1. Covered Interest Rate Parity 2. Uncovered Interest Rate Parity Calculating Forward Rates Forward exchange rates for currencies refers to exchange rates at a future point in time, as opposed to spot exchange rates, which refers to current rates. An understanding of forward rates is fundamental to interest rate parity, especially as it pertains to arbitrage. The basic equation for calculating forward rates with the U.S. dollar as the base currency is: Forward Rate = Spot Rate X (1 + Interest Rate of Overseas country) (1 + Interest Rate of Domestic country) Are binary options right for you? Find out today with a free demo at www.pfgbest.com/binaryoptions Forward rates are available from banks and currency dealers for periods ranging from less than a week to as far out as five years and beyond. As with spot currency quotations, forwards are quoted with a bid-ask spread. Consider U.S. and Canadian rates as an illustration. Suppose that the spot rate for the Canadian dollar is presently 1 USD = 1.0650 CAD (ignoring bid-ask spreads for the moment). One-year interest rates (priced off the zero-coupon yield curve) are at 3.15% for the U.S. dollar and 3.64% for the Canadian dollar. Using the above formula, the one-year forward rate is computed as follows: 1 USD = 1.0650 X (1 + 3.64%) = 1.0700 CAD (1 + 3.15%) The difference between the forward rate and spot rate is known as swap points. In the above example, the swap points amount to 50. If this difference (forward rate spot rate) is positive, it is known as a forward premium; a negative difference is termed a forward discount. A currency with lower interest rates will trade at a forward premium in relation to a currency with a higher interest rate. In the example shown above, the U.S. dollar trades at a forward premium against the Canadian dollar; conversely, the Canadian dollar trades at a forward discount versus the U.S. dollar. Can forward rates be used to predict future spot rates or interest rates? On both counts, the answer is no. A number of studies have confirmed that forward rates are notoriously poor predictors of future spot rates. Given that forward rates are merely exchange rates adjusted for interest rate differentials, they also have little predictive power in terms of forecasting future interest rates.

Covered Interest Rate Parity According to covered interest rate parity, forward exchange rates should incorporate the difference in interest rates between two countries; otherwise, an arbitrage opportunity would exist. In other words, there is no interest rate advantage if an investor borrows in a low-interest rate currency to invest in a currency offering a higher interest rate. Typically, the investor would take the following steps: 1. Borrow an amount in a currency with a lower interest rate. 2. Convert the borrowed amount into a currency with a higher interest rate. 3. Invest the proceeds in an interest-bearing instrument in this (higher interest rate) currency. 4. Simultaneously hedge exchange risk by buying a forward contract to convert the investment proceeds into the first (lower interest rate) currency. The returns in this case would be the same as those obtained from investing in interest-bearing instruments in the lower interest rate currency. Under the covered interest rate parity condition, the cost of hedging exchange risk negates the higher returns that would accrue from investing in a currency that offers a higher interest rate. Covered Interest Rate Arbitrage Consider the following example to illustrate covered interest rate parity. Assume that the interest rate for borrowing funds for a one-year period in Country A is 3% per annum, and that the one-year deposit rate in Country B is 5%. Further, assume that the currencies of the two countries are trading at par in the spot market (i.e., Currency A = Currency B). An investor: Borrows in Currency A at 3%. Converts the borrowed amount into Currency B at the spot rate. Invests these proceeds in a deposit denominated in Currency B and paying 5% per annum. The investor can use the one-year forward rate to eliminate the exchange risk implicit in this transaction, which arises because the investor is now holding Currency B, but has to repay the funds borrowed in Currency A. Under covered interest rate parity, the one-year forward rate should be approximately equal to 1.0194 (i.e., Currency A = 1.0194 Currency B), according to the formula discussed above. What if the one-year forward rate is also at parity (i.e., Currency A = Currency B)? In this case, the investor in the above scenario could reap riskless profits of 2%. Here's how it would work. Assume the investor: Borrows 100,000 of Currency A at 3% for a one-year period. Immediately converts the borrowed proceeds to Currency B at the spot rate.

Places the entire amount in a one-year deposit at 5%. Simultaneously enters into a one-year forward contract for the purchase of 103,000 Currency A. After one year, the investor receives 105,000 of Currency B, of which 103,000 is used to purchase Currency A under the forward contract and repay the borrowed amount, leaving the investor to pocket the balance - 2,000 of Currency B. This transaction is known as covered interest rate arbitrage. Market forces ensure that forward exchange rates are based on the interest rate differential between two currencies, otherwise arbitrageurs would step in to take advantage of the opportunity for arbitrage profits. In the above example, the one-year forward rate would therefore necessarily be close to 1.0194. Uncovered Interest Rate Parity Uncovered interest rate parity (UIP) states that the difference in interest rates between two countries equals the expected change in exchange rates between those two countries. Theoretically, if the interest rate differential between two countries is 3%, then the currency of the nation with the higher interest rate would be expected to depreciate 3% against the other currency. In reality, however, it is a different story. Since the introduction of floating exchange rates in the early 1970s, currencies of countries with high interest rates have tended to appreciate, rather than depreciate, as the UIP equation states. This well-known conundrum, also termed the "forward premium puzzle," has been the subject of several academic research papers. The anomaly may be partly explained by the "carry trade," whereby speculators borrow in lowinterest currencies such as the Japanese yen, sell the borrowed amount and invest the proceeds in higher-yielding currencies and instruments. The Japanese yen was a favorite target for this activity until mid-2007, with an estimated $1 trillion tied up in the yen carry trade by that year. Relentless selling of the borrowed currency has the effect of weakening it in the foreign exchange markets. From the beginning of 2005 to mid-2007, the Japanese yen depreciated almost 21% against the U.S. dollar. The Bank of Japan's target rate over that period ranged from 0 to 0.50%; if the UIP theory had held, the yen should have appreciated against the U.S. dollar on the basis of Japan's lower interest rates alone. The Interest Rate Parity Relationship Between the U.S. and Canada Let us examine the historical relationship between interest rates and exchange rates for the U.S. and Canada, the world's largest trading partners. The Canadian dollar has been exceptionally volatile since the year 2000. After reaching a record low of US61.79 cents in January 2002, it rebounded close to 80% in the following years, reaching a modern-day high of more than US$1.10 in November 2007. Looking at long-term cycles, the Canadian dollar depreciated against the U.S. dollar from 1980 to 1985. It appreciated against the U.S. dollar from 1986 to 1991 and commenced a lengthy slide in 1992, culminating in its January 2002 record low. From that low, it then appreciated steadily against the U.S. dollar for the next five and a half years.

For the sake of simplicity, we use prime rates (the rates charged by commercial banks to their best customers) to test the UIP condition between the U.S. dollar and Canadian dollar from 1988 to 2008. Based on prime rates, UIP held during some points of this period, but did not hold at others, as shown in the following examples: The Canadian prime rate was higher than the U.S. prime rate from September 1988 to March 1993. During most of this period, the Canadian dollar appreciated against its U.S. counterpart, which is contrary to the UIP relationship. The Canadian prime rate was lower than the U.S. prime rate for most of the time from mid-1995 to the beginning of 2002. As a result, the Canadian dollar traded at a forward premium to the U.S. dollar for much of this period. However, the Canadian dollar depreciated 15% against the U.S. dollar, implying that UIP did not hold during this period as well. The UIP condition held for most of the period from 2002, when the Canadian dollar commenced its commodity-fueled rally, until late 2007, when it reached its peak. The Canadian prime rate was generally below the U.S. prime rate for much of this period, except for an 18-month span from October 2002 to March 2004. Hedging Exchange Risk Forward rates can be very useful as a tool for hedging exchange risk. The caveat is that a forward contract is highly inflexible, because it is a binding contract that the buyer and seller are obligated to execute at the agreed-upon rate. Understanding exchange risk is an increasingly worthwhile exercise in a world where the best investment opportunities may lie overseas. Consider a U.S. investor who had the foresight to invest in the Canadian equity market at the beginning of 2002. Total returns from Canada's benchmark S&P/TSX equity index from 2002 to August 2008 were 106%, or about 11.5% annually. Compare that performance with that of the S&P 500, which has provided returns of only 26% over that period, or 3.5% annually. Here's the kicker. Because currency moves can magnify investment returns, a U.S. investor invested in the S&P/TSX at the start of 2002 would have had total returns (in terms of USD) of 208% by August 2008, or 18.4% annually. The Canadian dollar's appreciation against the U.S. dollar over that time frame turned healthy returns into spectacular ones. Of course, at the beginning of 2002, with the Canadian dollar heading for a record low against the U.S. dollar, some U.S. investors may have felt the need to hedge their exchange risk. In that case, were they fully hedged over the period mentioned above, they would have foregone the additional 102% gains arising from the Canadian dollar's appreciation. With the benefit of hindsight, the prudent move in this case would have been to not hedge the exchange risk. However, it is an altogether different story for Canadian investors invested in the U.S. equity market. In this case, the 26% returns provided by the S&P 500 from 2002 to August 2008 would have turned to negative 16%, due to the U.S. dollar's depreciation against the Canadian dollar. Hedging exchange

risk (again, with the benefit of hindsight) in this case would have mitigated at least part of that dismal performance. The Bottom Line Interest rate parity is fundamental knowledge for traders of foreign currencies. In order to fully understand the two kinds of interest rate parity, however, the trader must first grasp the basics of forward exchange rates and hedging strategies. Armed with this knowledge, the forex trader will then be able to use interest rate differentials to his or her advantage. The case of U.S. dollar/Canadian dollar appreciation and depreciation illustrates how profitable these trades can be given the right circumstances, strategy and knowledge. .. Binomial options pricing model In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for the valuation of options. The binomial model was first proposed by Cox, Ross and Rubinstein (1979). Essentially, the model uses a discrete-time (lattice based) model of the varying price over time of the underlying financial instrument. In general, binomial options pricing models do not have closed-form solutions. [edit] Use of the model The Binomial options pricing model approach is widely used as it is able to handle a variety of conditions for which other models cannot easily be applied. This is largely because the BOPM is based on the description of an underlying instrument over a period of time rather than a single point. As a consequence, it is used to value American options that are exercisable at any time in a given interval as well as Bermudan options that are exercisable at specific instances of time. Being relatively simple, the model is readily implementable in computer software (including a spreadsheet). Although computationally slower than the BlackScholes formula, it is more accurate, particularly for longer-dated options on securities with dividend payments. For these reasons, various versions of the binomial model are widely used by practitioners in the options markets For options with several sources of uncertainty (e.g., real options) and for options with complicated features (e.g., Asian options), binomial methods are less practical due to several difficulties, and Monte Carlo option models are commonly used instead. When simulating a small number of time steps Monte Carlo simulation will be more computationally time-consuming than BOPM (cf. Monte Carlo methods in finance). However, the worst-case runtime of BOPM will be O(2n), where n is the number of time steps in the simulation. Monte Carlo simulations will generally have a polynomial time complexity, and will be faster for large numbers of simulation steps. Monte Carlo simulations are also less susceptible to sampling errors, since binomial techniques use discrete time units. This becomes more true the smaller the discrete units become.

[edit] Method The binomial pricing model traces the evolution of the option's key underlying variables in discretetime. This is done by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates. Each node in the lattice represents a possible price of the underlying at a given point in time. Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). The value computed at each stage is the value of the option at that point in time. Option valuation using this method is, as described, a three-step process: price tree generation, calculation of option value at each final node, sequential calculation of the option value at each preceding node.

STEP 1: Create the binomial price tree

The tree of prices is produced by working forward from valuation date to expiration. At each step, it is assumed that the underlying instrument will move up or down by a specific factor ( tree (where, by definition, either be or and . ). So, if or ) per step of the

is the current price, then in the next period the price will

The up and down factors are calculated using the underlying volatility, , and the time duration of a step, , measured in years (using the day count convention of the underlying instrument). From the condition that the variance of the log of the price is , we have:

The above is the original Cox, Ross, & Rubinstein (CRR) method; there are other techniques for generating the lattice, such as "the equal probabilities" tree. The Trinomial tree is a similar model, allowing for an up, down or stable path. The CRR method ensures that the tree is recombinant, i.e. if the underlying asset moves up and then down (u,d), the price will be the same as if it had moved down and then up (d,u) here the two paths merge or recombine. This property reduces the number of tree nodes, and thus accelerates the computation of the option price. This property also allows that the value of the underlying asset at each node can be calculated directly via formula, and does not require that the tree be built first. The node-value will be:

Where [edit]STEP

is the number of up ticks and

is the number of down ticks.

2: Find Option value at each final node

At each final node of the tree i.e. at expiration of the option the option value is simply its intrinsic, or exercise, value. Max [ ( ), 0 ], for a call option

Max [ (

), 0 ], for a put option: Where is the strike price and is the spot price of the underlying asset at the period.

[edit]STEP

3: Find Option value at earlier nodes

Once the above step is complete, the option value is then found for each node, starting at the penultimate time step, and working back to the first node of the tree (the valuation date) where the calculated result is the value of the option. In overview: the binomial value is found at each node, using the risk neutrality assumption; see Risk neutral valuation. If exercise is permitted at the node, then the model takes the greater of binomial and exercise value at the node. The steps are as follows: (1) Under the risk neutrality assumption, today's fair price of a derivative is equal to the expected value of its future payoff discounted by the risk free rate. Therefore, expected value is calculated using the option values from the later two nodes (Option up and Option down) weighted by their respective probabilitiesprobability p of an up move in the underlying, and probability (1-p) of a down move. The expected value is then discounted at r, the risk free rate corresponding to the life of the option. The following formula to compute the expectation value is applied at each node: Binomial Value = [ p Option up + (1-p) Option down] exp (- r t), or

where is the option's value for the node at time ,

is chosen such that the related binomial distribution simulates the geometric Brownian motion of the underlying stock with parameters r and , is the dividend yield of the underlying corresponding to the life of the option. It follows that in a risk-neutral world futures price should have an expected growth rate of zero and therefore we can consider Note that for to be in the interval the following condition on has to be for futures.

satisfied

(Note that the alternative valuation approach, arbitrage-free pricing, yields identical results; see delta-hedging.) (2) This result is the Binomial Value. It represents the fair price of the derivative at a particular point in time (i.e. at each node), given the evolution in the price of the underlying to that point. It is the value of the option if it were to be heldas opposed to exercised at that point. (3) Depending on the style of the option, evaluate the possibility of early exercise at each node: if (1) the option can be exercised, and (2) the exercise value exceeds the Binomial Value, then (3) the value at the node is the exercise value.

For a European option, there is no option of early exercise, and the binomial value applies at all nodes.

For an American option, since the option may either be held or exercised prior to expiry, the value at each node is: Max (Binomial Value, Exercise Value). For a Bermudan option, the value at nodes where early exercise is allowed is: Max (Binomial Value, Exercise Value); at nodes where early exercise is not allowed, only the binomial value applies.

In calculating the value at the next time step calculatedi.e. one step closer to valuationthe model must use the value selected here, for Option up/Option down as appropriate, in the formula at the node.

[edit] Discrete dividends In practice, the use of continuous dividend yield, , in the formula above can lead to significant mispricing of the option near an ex-dividend date. Instead, it is common to model dividends as discrete payments on the anticipated future ex-dividend dates. To model discrete dividend payments in the binomial model, apply the following rule:

At each time step, , calculate , for all where is the present value of the -th dividend. Subtract this value from the value of the security price at each node (, ). [edit] Relationship with BlackScholes

Similar assumptions underpin both the binomial model and the BlackScholes model, and the binomial model thus provides a discrete time approximation to the continuous process underlying the BlackScholes model. In fact, for European options without dividends, the binomial model value converges on the BlackScholes formula value as the number of time steps increases. The binomial model assumes that movements in the price follow a binomial distribution; for many trials, this binomial distribution approaches the normal distribution assumed by BlackScholes.

In addition, when analyzed as a numerical procedure, the CRR binomial method can be viewed as a special case of the explicit finite difference method for the BlackScholes PDE; see Finite difference methods for option pricing.[citation needed]

In 2011, Georgiadis shows that the binomial options pricing model has a lower bound on complexity that rules out a closed-form solution.[1] .

Option (finance)

In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike).[1]The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfil the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset. An option which conveys the right to buy something at a specific price is called a call; an option which conveys the right to sell something at a specific price is called aput. The reference price at which the underlying asset may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless.[1] In return for assuming the obligation, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised. An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other over-the-counter options are customized ad hoc to the desires of the buyer, usually by an investment bank.[2][3]
[edit]Contract

specifications

Every financial option is a contract between the two counterparties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:[4]

whether the option holder has the right to buy (a call option) or the right to sell (a put option) the quantity and class of the underlying asset(s) (e.g., 100 shares of XYZ Co. B stock) the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise

the expiration date, or expiry, which is the last date the option can be exercised the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount

the terms by which the option is quoted in the market to convert the quoted price into the actual premium the total amount paid by the holder to the writer

[edit]Types

The Options can be classified into following types:

[edit]Exchange-traded

options

Exchange-traded options (also called "listed options") are a class of exchange-traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing housewith fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include:[5][6]

stock options, bond options and other interest rate options stock market index options or, simply, index options and options on futures contracts callable bull/bear contract

[edit]Over-the-counter

Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: 1. interest rate options 2. currency cross rate options, and 3. options on swaps or swaptions.

[edit]Other

option types

Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.
[edit]Option

styles

Main article: Option style Naming conventions are used to help identify properties common to many different types of options. These include:

European option an option that may only be exercised on expiration. American option an option that may be exercised on any trading day on or before expiry. Bermudan option an option that may be exercised only on specified dates on or before expiration. Barrier option any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised.

Exotic option any of a broad category of options that may include complex financial structures.[7] Vanilla option any option that is not exotic.

[edit]Valuation

models

Main article: Valuation of options The value of an option can be estimated using a variety of quantitative techniques based on the concept of risk neutral pricing and using stochastic calculus. The most basic model is the BlackScholes model. More sophisticated models are used to model the volatility smile. These models are implemented using a variety of numerical techniques.[8] In general, standard option valuation models depend on the following factors:

The current market price of the underlying security, the strike price of the option, particularly in relation to the current market price of the underlying (in the money vs. out of the money),

the cost of holding a position in the underlying security, including interest and dividends, the time to expiration together with any restrictions on when exercise may occur, and an estimate of the future volatility of the underlying security's price over the life of the option.

More advanced models can require additional factors, such as an estimate of how volatility changes over time and for various underlying price levels, or the dynamics of stochastic interest rates. The following are some of the principal valuation techniques used in practice to evaluate option contracts.
[edit]BlackScholes

Main article: BlackScholes Following early work by Louis Bachelier and later work by Edward O. Thorp, Fischer Black and Myron Scholes made a major breakthrough by deriving a differential equation that must be satisfied by the price of any derivative dependent on a non-dividend-paying stock. By employing the technique of constructing a risk neutral portfolio that replicates the returns of holding an option, Black and Scholes produced a closedform solution for a European option's theoretical price.[9] At the same time, the model generates hedge parameters necessary for effective risk management of option holdings. While the ideas behind the Black Scholes model were ground-breaking and eventually led to Scholes and Merton receiving the Swedish Central Bank's associated Prize for Achievement in Economics (a.k.a., the Nobel Prize in Economics),[10] the application of the model in actual options trading is clumsy because of the assumptions of continuous (or no) dividend payment, constant volatility, and a constant interest rate. Nevertheless, the BlackScholes model is still one of the most important methods and foundations for the existing financial market in which the result is within the reasonable range.[11]
[edit]Stochastic

volatility models

Main article: Heston model

Since the market crash of 1987, it has been observed that market implied volatility for options of lower strike prices are typically higher than for higher strike prices, suggesting that volatility is stochastic, varying both for time and for the price level of the underlying security. Stochastic volatility models have been developed including one developed by S.L. Heston.[12] One principal advantage of the Heston model is that it can be solved in closed-form, while other stochastic volatility models require complex numerical methods.[12] See also: SABR Volatility Model
[edit]Model

implementation

Further information: Valuation of options Once a valuation model has been chosen, there are a number of different techniques used to take the mathematical models to implement the models.
[edit]Analytic

techniques

In some cases, one can take the mathematical model and using analytical methods develop closed form solutions such as BlackScholes and the Black model. The resulting solutions are readily computable, as are their "Greeks".
[edit]Binomial

tree pricing model

Main article: Binomial options pricing model Closely following the derivation of Black and Scholes, John Cox, Stephen Ross and Mark Rubinstein developed the original version of the binomial options pricing model.[13] [14] It models the dynamics of the option's theoretical value for discrete time intervals over the option's life. The model starts with a binomial tree of discrete future possible underlying stock prices. By constructing a riskless portfolio of an option and stock (as in the BlackScholes model) a simple formula can be used to find the option price at each node in the tree. This value can approximate the theoretical value produced by Black Scholes, to the desired degree of precision. However, the binomial model is considered more accurate than BlackScholes because it is more flexible; e.g., discrete future dividend payments can be modeled correctly at the proper forward time steps, and American options can be modeled as well as European ones. Binomial models are widely used by professional option traders. TheTrinomial tree is a similar model, allowing for an up, down or stable path; although considered more accurate, particularly when fewer timesteps are modelled, it is less commonly used as its implementation is more complex.
[edit]Monte

Carlo models

Main article: Monte Carlo methods for option pricing For many classes of options, traditional valuation techniques are intractable because of the complexity of the instrument. In these cases, a Monte Carlo approach may often be useful. Rather than attempt to solve the differential equations of motion that describe the option's value in relation to the underlying security's

price, a Monte Carlo model uses simulation to generate random price paths of the underlying asset, each of which results in a payoff for the option. The average of these payoffs can be discounted to yield an expectation value for the option.[15] Note though, that despite its flexibility, using simulation for American styled options is somewhat more complex than for lattice based models.
[edit]Finite

difference models

Main article: Finite difference methods for option pricing The equations used to model the option are often expressed as partial differential equations (see for example BlackScholes PDE). Once expressed in this form, a finite difference model can be derived, and the valuation obtained. A number of implementations of finite difference methods exist for option valuation, including: explicit finite difference, implicit finite difference and the Crank-Nicholson method. A trinomial tree option pricing model can be shown to be a simplified application of the explicit finite difference method. Although the finite difference approach is mathematically sophisticated, it is particularly useful where changes are assumed over time in model inputs for example dividend yield, risk free rate, or volatility, or some combination of these that are not tractable in closed form.
[edit]Other

models

Other numerical implementations which have been used to value options include finite element methods. Additionally, various short rate models have been developed for the valuation of interest rate derivatives, bond options and swaptions. These, similarly, allow for closed-form, lattice-based, and simulation-based modelling, with corresponding advantages and considerations.
[edit]Risks

As with all securities, trading options entails the risk of the option's value changing over time. However, unlike traditional securities, the return from holding an option varies non-linearly with the value of the underlying and other factors. Therefore, the risks associated with holding options are more complicated to understand and predict. In general, the change in the value of an option can be derived from Ito's lemma as:

where the Greeks

and

are the standard hedge parameters calculated from an option , and are unit changes in the underlying's

valuation model, such as BlackScholes, and

price, the underlying's volatility and time, respectively. Thus, at any point in time, one can estimate the risk inherent in holding an option by calculating its hedge parameters and then estimating the expected change in the model inputs, , and ,

provided the changes in these values are small. This technique can be used effectively to understand and manage the risks associated with standard options. For instance, by offsetting a holding in an option with the quantity of shares in the underlying, a trader can form a delta neutral portfolio

that is hedged from loss for small changes in the underlying's price. The corresponding price sensitivity formula for this portfolio is:

[edit]Example

A call option expiring in 99 days on 100 shares of XYZ stock is struck at $50, with XYZ currently trading at $48. With future realized volatility over the life of the option estimated at 25%, the theoretical value of the option is $1.89. The hedge parameters , , , are (0.439, 0.0631,

9.6, and 0.022), respectively. Assume that on the following day, XYZ stock rises to $48.5 and volatility falls to 23.5%. We can calculate the estimated value of the call option by applying the hedge parameters to the new model inputs as:

Under this scenario, the value of the option increases by $0.0614 to $1.9514, realizing a profit of $6.14. Note that for a delta neutral portfolio, whereby the trader had also sold 44 shares of XYZ stock as a hedge, the net loss under the same scenario would be ($15.86).
[edit]Pin

risk

Main article: Pin risk A special situation called pin risk can arise when the underlying closes at or very close to the option's strike value on the last day the option is traded prior to expiration. The option writer (seller) may not know with certainty whether or not the option will actually be exercised or be allowed to expire worthless. Therefore, the option writer may end up with a large, unwanted residual position in the underlying when the markets open on the next trading day after expiration, regardless of their best efforts to avoid such a residual.
[edit]Counterparty

risk

A further, often ignored, risk in derivatives such as options is counterparty risk. In an option contract this risk is that the seller won't sell or buy the underlying asset as agreed. The risk can be minimized by using a financially strong intermediary able to make good on the trade, but in a major panic or crash the number of defaults can overwhelm even the strongest intermediaries.
[edit]Trading

The most common way to trade options is via standardized options contracts that are listed by various futures and options exchanges. [16] Listings and prices are tracked and can be looked up byticker symbol. By publishing continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and execute

transactions. As an intermediary to both sides of the transaction, the benefits the exchange provides to the transaction include:

fulfillment of the contract is backed by the credit of the exchange, which typically has the highest rating (AAA),

counterparties remain anonymous, enforcement of market regulation to ensure fairness and transparency, and maintenance of orderly markets, especially during fast trading conditions.

Over-the-counter options contracts are not traded on exchanges, but instead between two independent parties. Ordinarily, at least one of the counterparties is a well-capitalized institution. By avoiding an exchange, users of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In addition, OTC option transactions generally do not need to be advertised to the market and face little or no regulatory requirements. However, OTC counterparties must establish credit lines with each other, and conform to each others clearing and settlement procedures. With few exceptions,[17] there are no secondary markets for employee stock options. These must either be exercised by the original grantee or allowed to expire worthless.
[edit]The

basic trades of traded stock options (American style)

These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging. An option contract in US markets usually represents 100 shares of the underlying security.[18]
[edit]Long

call

Payoff from buying a call.

A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just purchase the stock itself. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium (price) paid, he will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire

worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can control (leverage) a much larger number of shares.
[edit]Long

put

Payoff from buying a put.

A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid, he will profit. If the stock price at expiration is above the exercise price, he will let the put contract expire worthless and only lose the premium paid.
[edit]Short

call

Payoff from writing a call.

A trader who believes that a stock price will decrease can sell the stock short or instead sell, or "write," a call. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.
[edit]Short

put

Payoff from writing a put.

A trader who believes that a stock price will increase can buy the stock or instead sell, or "write", a put. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price at expiration is above the exercise price, the short put position will make a profit in the amount of the premium. If the stock price at expiration is below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock. A benchmark index for the performance of a cash-secured short put option position is the CBOE S&P 500 PutWrite Index (ticker PUT).
[edit]Option

strategies

Main article: Option strategies

Payoffs from buying a butterfly spread.

Payoffs from selling a straddle.

Payoffs from a covered call.

Combining any of the four basic kinds of option trades (possibly with different exercise prices and maturities) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several. Strategies are often used to engineer a particular risk profile to movements in the underlying security. For example, buying a butterfly spread (long one X1 call, short two X2 calls, and long one X3 call) allows a trader to profit if the stock price on the expiration date is near the middle exercise price, X2, and does not expose the trader to a large loss. An Iron condor is a strategy that is similar to a butterfly spread, but with different strikes for the short options offering a larger likelihood of profit but with a lower net credit compared to the butterfly spread. Selling a straddle (selling both a put and a call at the same exercise price) would give a trader a greater profit than a butterfly if the final stock price is near the exercise price, but might result in a large loss. Similar to the straddle is the strangle which is also constructed by a call and a put, but whose strikes are different, reducing the net debit of the trade, but also reducing the risk of loss in the trade. One well-known strategy is the covered call, in which a trader buys a stock (or holds a previously-purchased long stock position), and sells a call. If the stock price rises above the exercise price, the call will be exercised and the trader will get a fixed profit. If the stock price falls, the call will not be exercised, and any loss incurred to the trader will be partially offset by the premium received from selling the call. Overall, the payoffs match the payoffs from selling a put. This relationship is known as put-call parity and offers insights for financial theory. A benchmark index for the performance of a buy-write strategy is the CBOE S&P 500 BuyWrite Index (ticker symbol BXM).

[edit]Historical

uses of options

Contracts similar to options are believed to have been used since ancient times. In the real estate market, call options have long been used to assemble large parcels of land from separate owners; e.g., a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and might not unless he can buy all the plots in the entire parcel. Film or theatrical producers often buy the right but not the obligation to dramatize a specific book or script. Lines of credit give the potential borrower the right but not the obligation to borrow within a specified time period. Many choices, or embedded options, have traditionally been included in bond contracts. For example many bonds are convertible into common stock at the buyer's option, or may be called (bought back) at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the loan early, which corresponds to a callable bond option. In London, puts and "refusals" (calls) first became well-known trading instruments in the 1690s during the reign of William and Mary.[19] Privileges were options sold over the counter in nineteenth century America, with both puts and calls on shares offered by specialized dealers. Their exercise price was fixed at a rounded-off market price on the day or week that the option was bought, and the expiry date was generally three months after purchase. They were not traded in secondary markets. Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher Thales of Miletus. On a certain occasion, it was predicted that the season's olive harvest would be larger than usual, and during the off-season he acquired the right to use a number of olive presses the following spring. When spring came and the olive harvest was larger than expected he exercised his options and then rented the presses out at much higher price than he paid for his 'option'.[20][21]

..

Futures contract
From Wikipedia, the free encyclopedia

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties -- the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease. Note that the contract itself

costs nothing to enter; the buy/sell terminology is a linguistic convenience reflecting the position each party is taking (long or short). In many cases, the underlying asset to a futures contract may not be traditional commodities at all that is, for financial futures the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also. The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (since any gain or loss has already been previously settled by marking to market). A closely related contract is a forward contract. A forward is like a futures in that it specifies the exchange of goods for a specified price at a specified future date. However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. Nor is the contract standardized, as on the exchange. Unlike an option, both parties of a futures contract must fulfill the contract on the delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. The difference in futures prices is then a profit or loss.
[edit]Origin

Aristotle described the story of Thales, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or poor and because the olive press owners were willing to hedge against the possibility of a poor yield. When the harvest time came, and many presses were wanted concurrently and suddenly, he let them out at any rate he pleased, and made a large quantity of money.[1]

The first futures exchange market was the Djima Rice Exchange in Japan in the 1730s, to meet the needs of samurai whobeing paid in rice, and after a series of bad harvestsneeded a stable conversion to coin.[2] The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward contracts in 1864, which were called futures contracts. This contract was based on grain trading and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around the world.[3] By 1875 cotton futures were being traded in Mumbai in India and within a few years this had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion.[4]
[edit]Standardization

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.

The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.

The currency in which the futures contract is quoted. The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing point -- the location where delivery must be made.

The delivery month. The last trading date. Other details such as the commodity tick, the minimum permissible price fluctuation.

[edit]Margin

To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%15% of the contract's value. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin. Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange.

If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as variation margin, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day. Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closedout the client is liable for any resulting deficit in the clients account. Some U.S. exchanges also use the term maintenance margin, which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term initial margin and variation margin. The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets). A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level. Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he does not want to be subject to margin calls. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit. Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchanges perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.
[edit]Settlement

- physical versus cash-settled futures

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration

Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires. [5] Cash settled futures are those that, as a practical matter, could not be settled by delivery of the referenced item - i.e. how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. ICE Brent futures use this method.

Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures contract stops trading, as well as the final settlement price for that contract. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading months. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.
[edit]Pricing

When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is determined via arbitrage arguments. This is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. agricultural crops after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist for example on crops before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date) - the futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract.
[edit]Arbitrage

arguments

Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply, or may be freely created. Here, the forward price represents the expected future value of the underlying discounted at the risk free rateas any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away. Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r.

or, with continuous compounding

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.
[edit]Pricing

via expectation

When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be applied, as the arbitrage mechanism is not applicable. Here the price of the futures is determined by today's supply and demand for the underlying asset in the futures. In a deep and liquid market, supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship.

By contrast, in a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known ascornering the market), the market clearing price for the futures may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down.
[edit]Relationship

between arbitrage arguments and expectation

The expectation based relationship will also hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability. In other words: a futures price is martingale with respect to the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity.
[edit]Contango

and backwardation

The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as contango. The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as backwardation.
[edit]Futures

contracts and exchanges

Contracts There are many different kinds of futures contracts, reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities, securities (such as single-stock futures), currencies or intangibles such as interest rates and indexes. For information on futures markets in specific underlying commodity markets, follow the links. For a list of tradable commodities futures contracts, see List of traded commodities. See also the futures exchange article.

Foreign exchange market Money market Bond market Equity market Soft Commodities market

Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Although contract trading began with traditional commodities such as grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates. Exchanges Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbrse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 90 futures and futures options exchanges worldwide trading to include:
[6]

CME Group (formerly CBOT and CME) -- Currencies, Various Interest Rate derivatives (including US Bonds); Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork, Cattle, Butter, Milk); Index (Dow Jones Industrial Average); Metals (Gold, Silver), Index (NASDAQ, S&P, etc.)

IntercontinentalExchange (ICE Futures Europe) - formerly the International Petroleum Exchange trades energy including crude oil, heating oil, gas oil (diesel), refined petroleum products, electric power, coal, natural gas, and emissions

NYSE Euronext - which absorbed Euronext into which London International Financial Futures and Options Exchange or LIFFE (pronounced 'LIFE') was merged. (LIFFE had taken over London Commodities Exchange ("LCE") in 1996)- softs: grains and meats. Inactive market in Baltic Exchange shipping. Index futures include EURIBOR, FTSE 100, CAC 40, AEX index.

South African Futures Exchange - SAFEX Sydney Futures Exchange Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures) Tokyo Commodity Exchange TOCOM Tokyo Financial Exchange - TFX - (Euroyen Futures, OverNight CallRate Futures, SpotNext RepoRate Futures)

Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures) London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel, tin and steel IntercontinentalExchange (ICE Futures U.S.) - formerly New York Board of Trade softs: cocoa, coffee, cotton, orange juice, sugar

New York Mercantile Exchange CME Group- energy and metals: crude oil, gasoline, heating oil, natural gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium

Dubai Mercantile Exchange Korea Exchange - KRX Singapore Exchange - SGX - into which merged Singapore International Monetary Exchange (SIMEX)

ROFEX - Rosario (Argentina) Futures Exchange NCDEX - National Commodity and Derivatives Exchange, India

[edit]Codes

Most Futures contracts codes are four characters. The first two characters identify the contract type, the third character identifies the month and the last character is the last digit of the year. Third (month) futures contract codes are

January = F February = G March = H April = J May = K June = M July = N August = Q September = U October = V November = X December = Z

Example: CLX0 is a Crude Oil (CL), November (X) 2010 (0) contract.
[edit]Who

trades futures?

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper", while they have no practical use for or intent to actually take or make delivery of the underlying asset. In other words, the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract.
[edit]Hedgers

Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivativeproducts will use financial futures or equity index futures to reduce or remove the risk on the swap. Those that buy or sell commodity futures need to be careful. If a company buys contracts hedging against price increases, but in fact the market price of the commodity is substantially lower at time of delivery, they could find themselves disasterously non-competitive.
[edit]Speculators

Speculators typically fall into three categories: position traders, day traders, and swing traders (swing trading), though many hybrid types and unique styles exist. With many investors pouring into the futures markets in recent years controversy has risen about whether speculators are responsible for increased volatility in commodities like oil, and experts are divided on the matter. [7] An example that has both hedge and speculative notions involves a mutual fund or separately managed account whose investment objective is to track the performance of a stock index such as the S&P 500 stock index. The Portfolio manager often "equitizes" cash inflows in an easy and cost effective manner by investing in (opening long) S&P 500 stock index futures. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. This also preserves balanced diversification, maintains a higher degree of the percent of assets invested in the market and helps reduce tracking error in the performance of the fund/account. When it is economically feasible (an efficient amount of shares of every individual position within the fund or account can be purchased), the portfolio manager can close the contract and make purchases of each individual stock. The social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences, from a hedger to a speculator, for example.
[edit]Options

on futures

In many cases, options are traded on futures, sometimes called simply "futures options". A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. Futures are often used since they are delta one instruments. Calls and options on futures may be priced similarly to those on traded assets by using an extension of the Black-Scholes formula, namely Black's formula for futures. Investors can either take on the role of option seller/option writer or the option buyer. Option sellers are generally seen as taking on more risk because they are contractually obligated to take the opposite futures position if the options buyer exercises his or her right to the futures position specified in the option. The price of an option is determined by supply and demand principles and consists of the option premium, or the price paid to the option seller for offering the option and taking on risk. [8]
[edit]Futures

contract regulations

All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the United States government. The Commission has the right to hand out fines and other punishments for an individual or

company who breaks any rules. Although by law the commission regulates all transactions, each exchange can have its own rule, and under contract can fine companies for different things or extend the fine that the CFTC hands out. The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment that has more than 20 participants. These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and noncommercial open interest. This type of report is referred to as the 'Commitments of Traders Report', COT-Report or simply COTR.
[edit]Definition

of futures contract

Following Bjrk[9] we give a definition of a futures contract. We describe a futures contract with delivery of item J at the time T:

There exists in the market a quoted price F(t,T), which is known as the futures price at time t for delivery of J at time T.

The price of entering a futures contract is equal to zero. During any time interval amount , the holder receives the . (this reflects instantaneous marking to market)

At time T, the holder pays F(T,T) and is entitled to receive J. Note that F(T,T) should be the spot price of J at time T.

[edit]Nonconvergence This section may contain original research. Please improve it by verifying the claims made and adding references. Statements consisting only of original research may be removed. More details may be available on the talk page. (April 2008)

Some exchanges tolerate 'nonconvergence', the failure of futures contracts and the value of the physical commodities they represent to reach the same value on 'contract settlement' day at the designated delivery points. An example of this is the CBOT (Chicago Board of Trade) Soft Red Winter wheat (SRW) futures. SRW futures have settled more than 20 apart on settlement day and as much as $1.00 difference between settlement days. Only a few participants holding CBOT SRW futures contracts are qualified by the CBOT to make or receive delivery of commodities to settle futures contracts. Therefore, it's impossible for almost any individual producer to 'hedge' efficiently when relying on the final settlement of a futures contract for SRW. The trend is for the CBOT to continue to restrict those entities that can actually participate in settling commodities contracts to those that can ship or receive

large quantities of railroad cars and multiple barges at a few selected sites. TheCommodity Futures Trading Commission, which has oversight of the futures market in the United States, has made no comment as to why this trend is allowed to continue since economic theory and CBOT publications maintain that convergence of contracts with the price of the underlying commodity they represent is the basis of integrity for a futures market. It follows that the function of price discovery, the ability of the markets to discern the appropriate value of a commodity reflecting current conditions, is degraded in relation to the discrepancy in price and the inability of producers to enforce contracts with the commodities they represent.[10]
[edit]Futures

versus forwards

While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price, they are different in two main respects:

Futures are exchange-traded, while forwards are traded over-the-counter.

Thus futures are standardized and face an exchange, while forwards are customized and face a non-exchange counterparty.

Futures are margined, while forwards are not.

Thus futures have significantly less credit risk, and have different funding.
[edit]Exchange

versus OTC

Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties. Thus:

Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being over-the-counter.

In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearing house.

[edit]Margining

For more details on Margin, see Margin (finance). Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). Forwards do not have a standard. They may transact only on the settlement date. More typical would be for the parties to agree to true up, for example, every quarter. The fact that forwards are not margined daily means that, due to movements in the price of the underlying

asset, a large differential can build up between the forward's delivery price and the settlement price, and in any event, an unrealized gain (loss) can build up. Again, this differs from futures which get 'trued-up' typically daily by a comparison of the market value of the future to the collateral securing the contract to keep it in line with the brokerage margin requirements. This true-ing up occurs by the "loss" party providing additional collateral; so if the buyer of the contract incurs a drop in value, the shortfall or variation margin would typically be shored up by the investor wiring or depositing additional cash in the brokerage account. In a forward though, the spread in exchange rates is not trued up regularly but, rather, it builds up as unrealized gain (loss) depending on which side of the trade being discussed. This means that entire unrealized gain (loss) becomes realized at the time of delivery (or as what typically occurs, the time the contract is closed prior to expiration) - assuming the parties must transact at the underlying currency's spot price to facilitate receipt/delivery. The result is that forwards have higher credit risk than futures, and that funding is charged differently. In most cases involving institutional investors, the daily variation margin settlement guidelines for futures call for actual money movement only above some insignificant amount to avoid wiring back and forth small sums of cash. The threshold amount for daily futures variation margin for institutional investors is often $1,000. The situation for forwards, however, where no daily true-up takes place in turn creates credit risk for forwards, but not so much for futures. Simply put, the risk of a forward contract is that the supplier will be unable to deliver the referenced asset, or that the buyer will be unable to pay for it on the delivery date or the date at which the opening party closes the contract. The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. This means that there will usually be very little additional money due on the final day to settle the futures contract: only the final day's gain or loss, not the gain or loss over the life of the contract. In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, further limiting credit risk in futures. Example: Consider a futures contract with a $100 price: Let's say that on day 50, a futures contract with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures contract costs $90. This means that the "mark-to-market" calculation would requires the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin"). This money goes, via margin accounts, to the holder of the other side of the future. That is, the loss party wires cash to the other party.

A forward-holder, however, may pay nothing until settlement on the final day, potentially building up a large balance; this may be reflected in the mark by an allowance for credit risk. So, except for tiny effects of convexity bias (due to earning or paying interest on margin), futures and forwards with equal delivery prices result in the same total loss or gain, but holders of futures experience that loss/gain in daily increments which track the forward's daily price changes, while the forward's spot price converges to the settlement price. Thus, while under mark to market accounting, for both assets the gain or loss accrues over the holding period; for a futures this gain or loss is realized daily, while for a forward contract the gain or loss remains unrealized until expiry. Note that, due to the path dependence of funding, a futures contract is not, strictly speaking, a European-style derivative: the total gain or loss of the trade depends not only on the value of the underlying asset at expiry, but also on the path of prices on the way. This difference is generally quite small though. With an exchange-traded future, the clearing house interposes itself on every trade. Thus there is no risk of counterparty default. The only risk is that the clearing house defaults (e.g. become bankrupt), which is considered very unlikely. .

Differences Between Futures & Stock Options - Introduction

Futures and stock options are the two most widely publicized leveraged derivative instrument in the world today. In fact, futures and options are the two most widely used hedging instrument in the world as well. This have inevitably led many investors into thinking that futures and stock options are the same thing. In fact, there have been laymen investors referring to both instruments collectively as "Options Futures". Nothing can be further from the truth. Futures and options are two different things and futures trading really has nothing to do with options trading. Futures and options serve different needs in the capital market and will forever be important elements on their own in every well diversified portfolio. Even though futures and options are two different things, even since the invention of options on futures, that is, options with futures as their underlying asset, this distinction has been greatly blurred and made it all the more confusing for beginners to futures and options trading. This tutorial shall explain what futures and options are and their main differences.

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Differences Between Futures & Stock Options - What exactly are Futures?
Like stock options, a futures contract is an agreement between a buyer and seller of an underlying asset. In a futures contract, the buyer agrees to buy and the seller agrees to sell the underlying asset at a price agreed upon now at a future date. Like stock options, futures contracts are standardized contracts and traded publicly in an exchange. Up to this point, a futures contract sounds a lot like a call option, right? Well, that's just about where the similarity ends. Buyers of the futures contracts put up a fraction of the price of the underlying asset when the contract is entered upon. This upfront payment is like the downpayment you pay when buying a house, which means that the futures contract itself does not come with a premium. Buyers and sellers of futures contracts are also Obligated to fulfill the futures contract agreement upon expiration but not buyers and sellers of options contracts. Because of this obligation, both parties are exposed to unlimited liability when prices move against their favor. In futures trading, price differences are settled daily, which means that if prices move against your favor, you may be required to topup your trading account in what is commonly known as a "Margin Call". This also means that as long as prices continue to move against your favor day after day, you will be required to topup every single day. This is the unlimited liability that we talked about in the last paragraph and is also why so many futures traders go broke every quickly if prices should move suddenly against them.

Differences Between Futures & Stock Options - What exactly is Stock Options Trading?
Stock options trading is the trading of stock options. Stock options are financial instruments that give you the right to buy or sell certain shares in the stock market. Using the 2 kinds of stock options; Call Options and Put Options, options traders are able to profit when the underlying stock goes up or down and even when it is trading sideways. In options trading, all you can lose is the amount of premium paid towards buying the stock options when prices move against your favor. If you buy a contract of call options for $100, all you can lose is $100 if the stock move against your favor. This is unlike the unlimited liability facing futures traders. This is also what makes options trading safer than futures trading for most beginners. Read more about Stock Options.

Differences Between Futures & Stock Options - Comparison

Here's a comparison of some of the main differences between Futures and Stock Options:

Premium

While you pay a fee called the "premium" when buying stock options, there are no premiums to be paid in a futures contract. The initial amount of money (known as "Initial Margin") paid when you buy a futures contract is a fraction of

the price paid for the underlying stock.

Obligations

Buyers of stock options are not obligated to exercise the rights to buy the underlying stock at all while buyers of futures contracts are obligated to buy the underlying stock from the seller of that contract upon expiration.

Liability

Buyers of futures contracts are exposed to unlimited liability should prices move against them while buyers of stock options lose only the amount of money used to purchase those stock options. Only writers of stock options are exposed to unlimited liability, not buyers.

Expiration

Buyers of futures contracts are obligated to buy the underlying asset (for physically delivered futures contracts) upon expiration of the contract no matter what price the underlying asset is. Buyers of options contracts can allow the options to expire worthless if the options are out of the money.

Versatility

Options trading is a lot more versatile than futures trading as the unique combination of call options and put options along with the premium on each contract made it possible for options strategies that profit in all directions. Apart from arbitraging, futures trading is basically single directional (you make money only when price moves in one direction). By now, it should be clear that futures and stock options trading are two totally different things with their own trading characteristics. Futures trading is an important risk management and speculative technique while options trading has evolved to become a stand-alone strategic investment. Futures should never be made a replacement for stock options trading and stock options trading cannot replace Futures as well. Both trading instruments serves different purposes and should find their place in every well diversified portfolio.

What are the Differences between a Futures and a Forward Contract?

Although a Futures Contract is similar to a Forward Contract in that both are agreements to trade on a set future date, there are some significant differences. Fututres contracts are highly standardized, while each Forward contract is personalized and unique. Futures are settled at the end on the last trading date of the contract with the settlement price; whereas, the Forwards are settled at the start with a forward price.

The profit or loss on a Futures position is exchanged in cash every day. With the Forwards contract, the profit or loss is realized only at the time of settlement so the credit exposure can keep increasing. The Futures contract does not specify to whom the delivery of a physical asset must be made; in a Forwards contract it is clearly specified who recieves the delivery. Futures are traded on an exchange, while Forwards are traded over-the-counter.