Download - 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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