derivatives & future contracts(1)

7/30/2019 Derivatives & Future Contracts(1)

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Introduction to Derivatives (1) Definition of derivatives

A security whose price is dependent upon or derived

from one or more underlying assets. The derivativeitself is merely a contract between two or more parties.Its value is determined by fluctuations in theunderlying asset


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Introduction to Derivatives (2) Common types:

Futures

Forward Forward

Swap

Underlying asset

Agricultural products, poultry, mining resources,currency, financial instruments (interest rate, index),carbon, etc


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Introduction to Derivatives (3) Type of Trader

Hedger : reduce risk from potential future movement

Speculator : bet on the future direction for gain Arbitrageur : take offsetting positions in two or more

instruments to lock in profit


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Introduction to Derivatives (4) Important Terms

Spot price : the price for immediate delivery

Future price : price for delivery some time in the future Long future position: someone who agreed to buy

Short future position: someone who agreed to sell


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Future Markets (1) Definition :

An agreement to buy or sell an asset at a certain in thefuture for a certain price

Referred to by its delivery month, i.e. July corn futurescontracts = contract of buying / selling corn for Julydelivery

Most of futures contracts is not delivered but close outposition prior to delivery period


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Future Markets (2) Closing position : enter opposite trade to the original one

that opened the position

ie. May 6 : long 5 July 12 corn futures contract

July 20 : short (selling) 5 July 12 corn future


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Future Markets (3) Specification of Future Contract

Specific asset, contract size, place and time of delivery

Will be determined by the Exchange before the contracttraded

Contract size must be big enough to cover admin costbut small enough to attract small hedger

Delivery time: usually the whole month, with certainmax delivery date


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Future Markets (4) Convergence of future price to spot price

as delivery time approached, future price converge tospot price

i.e. in delivery date if future price > spot price, arbitragerwill :

Sell (short) a future contract, buy the asset, make delivery

Will do that continuously until future price decline same to

spot price


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Future Markets (5) The operation of Margin

Margin needed to cease out credit risk

Margin account : account to hold the margin deposit Initial margin : amount must be deposited 1st time

Daily settlement / marking to market:

practice to revaluing an instrument to reflect the current

value Margin call , maintenance margin


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Future Markets (6) Example:

June 5, buy 2 Dec gold future contract

Price : $ 900 / ounce 1 contract size : 100 ounce. Total = 200 ounce

Initial margin : $2000/contract

Maintenance margin : 75% from initial margin /

contract


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Future Market (7)Day Future

PriceDaily gain /

lossCumulative

gain/lossMargin acc

balanceMargin call

900 4000

Jun 5 897 (600) (600) 3400Jun 6 896.10 (180) (780) 3220

Jun 9 898.20 420 (360) 3640

Jun 10 897.10 (220) (580) 3420

Jun 11 896.70 (80) (660) 3340

Jun 12 895.40 (260) (920) 3080

Jun 13 893.30 (420) (1340) 2660 1340

Jun 16 893.60 60 (1280) 4060

Jun 17 891.80 (360) (1640) 3700


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Future Market (8) Clearing House

Intermediary in future transactions

Guarantees each parties to fulfill its obligations Deals with brokers

Brokers must maintain margin account with clearinghouse = clearing margin

Daily settlement to fulfill original margin everyday


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Future Market (9) Quotation

Price

Settlement Price Open interest : total number of contracts outstanding


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Future Market (10) Delivery

Most contracts close out early

Delivery might be taken place by hedger, but maybeexpensive

Decided by seller (short position)

Seller notify broker which notify clearing house which

notify buyer (long position) First day of notice day : first day notice can be submitted

to exchange


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Future Market (11) Last notice day: last day notice can be submitted to

exchange

Last trading day: usually a few days before last notice

day

To avoid risk of having to take delivery, long positiontrader must close position before first notice day


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Future Market (12) Cash settlement

For financial futures (interest rate, stock index) aresettled in cash because inconvenient / impossible todeliver


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Forward Contract Forward contract:

Agreement to buy or sell an asset at a certain time in thefuture for a certain price

Similar to future contracts

Traded in the over-the-counter market : telephone-and-computer linked network of dealers

Typically entered by two financial institutions orfinancial institutions and one of its client


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Forward Market (2) Exposed to credit risk

Very popular for the foreign exchange

The contract size, delivery date and price according tomutual agreement

The profit / loss of forward and futures contract shouldbe similar, otherwise arbitrage will occur

Size of forward market can be 10x compared to futuresmarket


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Forward Market (3)Forward FuturesPrivate contract between 2 parties Traded on Exchange

Not standardize Standardize contract

Usually one specific delivery date Range of delivery dateSettled on end of contract Settled daily

Delivery / final cash settlement usuallytakes place

Contract usually closed out prior tomaturity

Some credit risk Virtually no credit risk


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derivatives & future contracts(1)

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