1.

Introduction

What are Derivatives?

• Derivatives are zero net supply bilateral

contracts deriving their values from some
underlying asset, reference rate, or index.
 1.2

Examples of Derivatives
• Futures Contracts
• Forward Contracts
• Swaps
• Options
 1.3

Ways Derivatives are Used

• To hedge risks
• To speculate (take a view on the
future direction of the market)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment
without incurring the costs of selling
one portfolio and buying another
 1.4

Forward Contracts
• Obligates one party to buy (the long position) and the
other party to sell (the short position) an asset or
commodity in the future for an agreed-upon price.
• Physical delivery contract
• Cash-settled contract
• Trade only in an over-the-counter (OTC) market
• communication among traders is over the phone
• Examples:
• buy 5,000 oz. of gold @ US$400/oz. in one year
• sell £1,000,000 @ 1.5000 US$/£ in six months
• earn a 4% rate of interest on a US$ deposit for a 3-
month period starting in six months
 1.5
How a Forward Contract Works
• The contract is a private agreement between
two counterparties
• Normally, the price in the contract is chosen
so that the contract’s initial market value is
zero
– => no money changes hands when first
negotiated & the contract is settled at maturity
– Think about a forward contract as the decision to
delay the sale or purchase of an asset three
months, for example, from today.
 1.6

Futures Contracts
• Like a forward:
– Obligates one party to buy (the long position) and
the other party to sell (the short position) an asset
or commodity in the future for an agreed-upon
price.
• Physical delivery contract
• Cash-settled contract
• Unlike a forward:
– Trade on a futures exchange and are subject to daily
settlement
• Evolved out of forwards and possess many of the
same characteristics
 1.7

Exchanges Trading Futures

• Chicago Board of Trade
• Chicago Mercantile Exchange
• LIFFE (London)
• Eurex (Europe)
• BM&F (Sao Paulo, Brazil)
• TIFFE (Tokyo)
• and many more (see list at end of book)
 1.8

Options
• An option gives its owner the right to
purchase or sell an asset on or before some
date in the future.

– Call versus Put options

– American and European Options

– Physical delivery versus cash-settled options

 1.9

Exchanges Trading Options

• Chicago Board Options Exchange
• American Stock Exchange
• Philadelphia Stock Exchange
• Pacific Exchange
• LIFFE (London)
• Eurex (Europe)
• and many more (see list at end of book)
 1.10

Main Differences between Options and

Futures: Hedging Strategies
Feature Futures Options
(or Forwards)
Type of strategy Symmetric Asymmetric

Up-front costs $0.00 Option premium

Flexibility Less than option More than futures

Contract obligation Obligated to buy or Have the right to

w.r.t. transacting sell at buy or sell at
predetermined price predetermined price

OTC vs. Exchange-Traded Derivatives:
Contract Characteristics
Exchange-Traded
• Terms specified by “listing
agents” (i.e. exchange)
• The main non-standard
item in most exchange-
traded derivatives is the
price, which is determined
in the market place
– Pure open outcry (CME)
– Physical delivery mkt (CBOE)
– Electronic dealer market
(AMEX)
– Electronic limited order book
(Sydney Futures Exch.)
1.11
OTC
• Specific terms defined
exclusively by the two
counterparties
• General terms set forth in
pro forma documentation
called “master
agreements”
– Can be customized through
annexes to master agreements
 1.12
OTC vs. Exchange-Traded Derivatives:
Market Characteristics
Exchange-Traded OTC
• Organized market with • Deals are negotiated in
specific and detailed opaque “market”
trading rules • Dealer market where
• Exchange defines the brokers and dealers make
rules of the game and two-way markets
enforces them • Sometimes brokered
• Highly transparent • Often lacks
“transparency”, esp. for
• Quotes and prices are customized and new
available very rapidly by transaction prices
numerous services • “Plain vanilla” products
are more standardized
 1.13

Types of Traders
• Hedgers
– mainly interested in protecting themselves against
adverse price changes
– want to avoid risk
• Speculators
– hope to make money in the markets by betting on
the direction of prices
– “accept” risk
• Arbitrageurs
– arbitrage involves locking into riskless profit by
simultaneously entering into transactions in two or
more markets
 1.14
Hedging Examples
• A US company will pay £10 million for
imports from Britain in 3 months and
decides to hedge using a long position
in a forward contract
• An investor owns 1,000 Microsoft
shares currently worth $73 per share. A
two-month put with a strike price of $63
costs $2.50. The investor decides to
hedge by buying 10 contracts
 1.15
Speculation Example
• An investor with $4,000 to invest feels
that Amazon.com’s stock price will
increase over the next 2 months. The
current stock price is $40 and the price
of a 2-month call option with a strike of
45 is $2
• What are the alternative strategies?
 1.16

Arbitrage Example

• A stock price is quoted as £100 in

London and $172 in New York
• The current exchange rate is 1.7500
• What is the arbitrage opportunity?
 1.17
1. Gold: An Arbitrage
Opportunity?
• Suppose that:
– The spot price of gold is US$390
– The quoted 1-year futures price of gold is
US$425
– The 1-year US$ interest rate is 5% per
annum
• Is there an arbitrage opportunity?
 1.18
2. Gold: Another Arbitrage
Opportunity?
• Suppose that:
– The spot price of gold is US$390
– The quoted 1-year futures price
of gold is US$390
– The 1-year US$ interest rate is
5% per annum
• Is there an arbitrage opportunity?
 1.19

The Futures Price of Gold

If the spot price of gold is S & the futures price is
for a contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
In our examples, S=390, T=1, and r=0.05 so that
F = 390(1+0.05) = 409.50
 1.20

Derivative Resources on the Web

• Exchange information
• Futures Exchange or Gov’t Agency Internet
Site

and contract • New York Mercantile Exchange

specifications are •
http://www.nymex.com
Kansas City Board of Trade
available for all major •
http://www.kcbt.com
Chicago Mercantile Exchange
exchanges •
http://www.cme.com
Chicago Board of Trade
http://www.cbot.com
• Chicago Board Options Exchange
http://www.cboe.com

• Real-time pricing and • Minneapolis Grain Exchange

http://www.mgex.com
volume data • New York Cotton Exchange
http://www.nyce.com
• Coffee, Sugar & Cocoa Exchange
http://www.csce.com
• CFTC

• Educational tools http://www.cftc.gov

 1.21
Forward, Futures, and Swaps
• The first section of the course will cover
forward, futures and swaps.
• Relevant Chapters in Textbook (4th edition)
– Mechanics of Futures and Forward Markets (Ch.
2)
– The Determination of Forward and Futures Prices
(Ch. 3)
– Hedging Strategies using Futures (Ch. 4)
– Interest-Rate Futures (Parts of Ch. 5)
– Swaps (Ch. 6)