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Derivatives

Topic #4

Futures Contracts

An agreement to buy or sell an asset at a certain time in the future for a certain price

Long and Short positions Futures price This eliminates the risk for both participants Exchanges:

CBOT (1848) Chicago Mercantile Exchange (1874) London Financial Futures and Options Exchange Eurex Over the counter

Profits from Futures Contracts

0

STK

0

STK

Profit Profit

Long Position Short Position

TS K TK S

Contract Specifications

The underlying asset Commodity: exact specification of the quality and

the available alternatives Financial: exact specification, usually without any

flexibility Contract size - depends on the likely user Delivery arrangements

Location Packaging

Contract Specifications

Delivery months Commodity: usually allows some flexibility Financial: usually is very specific

Price quotes Price movement limits

Designed to stabilize the prices Position limits Futures and Spot Prices

Forward Contracts

Just like Futures, but not traded on an exchange

Options Contracts

Call (Put) options - the right, but not the obligation, to buy (sell) an asset

Exercise (strike) price Expiration date (maturity) European vs. American option Each contract is for 100 shares Participants:

Buyers of calls or puts Sellers of calls or puts (i.e. writing an option)

Options Markets

Put and Call Brokers and Dealers Association Case by case basis First over-the-counter market

CBOE and many other exchanges Recent over-the-counter markets

Large transactions Contracts tailored to specific needs

Other Derivatives

Interest-rate caps If the interest rate on a floating rate loan exceeds

the cap, the seller of the cap provides the difference

Convertible bonds At expiration the bonds can be converted into stock

Weather derivatives Real Estate Price Indices

Hedging

If you need to make a future foreign currency payment

If you are going to receive a future foreign currency payment

In general: if you need to deliver or get some asset or commodity in the future

Hedging using options Futures fix the future price, while options provide

insurance at some upfront cost

Speculating

Expose yourself to price movements Spot vs. Futures transactions Spot vs. Options transactions Arbitrage

Lock-in a riskless profit Hard to come by Absence of arbitrage enhances market efficiency