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I. Derivavesa. A derivave is a nancial instrument whose value depends on (or derives from) the values of other, more

basic, underlying variables.

b. i.e. a stock opon, value is dependent on the price of the stockc. commodies are not derivavesd. Uses of derivaves:

i. Risk managementii. Speculaon

iii. Regulatory arbitragee. Example: use of derivaves for risk management

i. A corn farmer enter into a contract which makes a payment when the price of corn is low, thisreduces the risk of loss hedging

f. Example: use of derivaves in speculaoni. If you want to bet that the S&P 500 stock index will be between 1300 and 1400 one year from

today, derivaves can be constructed to let you do that.

g. Uses of derivave securies for regulatory arbitrage:i. Derivaves are oen used to eliminate the risk of price uctuaon while sll maintaining

physical possession of the stock

ii. Using derivaves, the owner of the stock can defer taxes on the sale of the stock, or retain vongrights, without the risk of holding the stockh. Traded on the derivaves exchange or OTC markets

i. Futures markets June 2004 noonal amount of outstanding posions $53 trillion ii. OTC June 2004 noonal amount of $220 trillion

i. Derivave exchangesi. A market where individuals trade standardized contracts that have been dened by the

exchange

1. CBOE, CBOT (Chicago Board of Trade), CME (Chicago Mercanle Exchange)j. Futures exchange (market) central nancial exchange where people can trade standardized futures

contracts; that is, a contract to buy specic quanes of a commodity or nancial instrument at a

specied price with delivery set at a specied me in the future

i. These contracts fall under the broad category of derivavesii. Instruments are priced according to the movement of the underlying asset (stock, physical

commodity, index, etc.)

k. OTC marketsi. Telephone and computer-linked network of dealers

ii. Trades are done usually between two nancial instuons or between a nancial instuon andone of its clients

iii. Financial instuons oen act as market makers for the more commonly traded instruments(always prepared to quote both a bid price and ask (oer) price)

iv. PROS: the terms of a contract do not have to be those specied by an exchange. Marketparcipants are free to negoate any mutually aracve dealv. CONS: there is usually some credit risk in an OTC trade small risk that the contract will not be

honored

II. Forward Contractsa. An agreement to buy or sell an asset for a certain me in the future at a certain price b. Long posion party agrees to buy the underlying asset on a certain specied future date for a certain

specied price

c. Short posion party agrees to sell the asset on the same date for the same price

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d. Example: July 20, 2007 US Corporaon will pay $1 million in 6 months (1/20/08) and wants to hedgeagainst exchange rate moves; Answer: the company can agree to buy $1 million in 6 months forward at

an exchange rate of 2.0489.

i. The company has the long forward contract on GBP, it has commied to buy 1 million from thebank for $2.0489 million

ii. The bank has the short forward contract on GBP, it has commied that on January 20, 2008, itwill sell 1 million for $2.0489 million

e. Calculang future payoi. It depends on the purchase price and the future price of the asset

ii. The payo from a long posion is St K; where K is the delivery price and St is the spot price ofthe asset at maturity of the contract.

f. Pricing a forward contracti. Consider a stock that pays no dividend that is worth $60; you can borrow or lend money for 1

year at 5%; what should the 1-year forward price of the stock be?

ii. The price is $60 5% = $631. If the forward price is more than this, say $67, you could borrow $60, buy one share of

the stock, and sell it forward for $67

III. Futures Contractsa. An agreement between two pares to buy or sell an asset at a certain me in the future for a certainprice. Dierent from forward contracts these are normally traded on an exchange.b. This is a standardized contract between two pares to buy or sell a specied asset of standardized

quanty and quality at a specied future date at a price agree today.

c. Example:i. September 1st, the December futures price of gold is quoted as $680

1. This is the price at which traders can agree to buy or sell gold for December delivery IV. Opons

a. The buyer of the opon gains the right, but not the obligaon, to engage in some specic transacon onthe asset.

b. The seller incurs the obligaon to fulll the transacon if so requested by the buyerc. The originator of the opon collects a premium from the buyer for wring the opond. Call opon gives the holder the rights to buy the underlying asset by a certain date (date of maturity)

for a certain price (strike price).

i. The buyer of a call opon wants the price of the underlying instruments to rise in the future,thus they can exercise the opon and sell the underlying instrument for a prot.

e. Put opon the buyer acquires a short posion by purchasing the right to sell the underlying instrumentto the seller of the opon for the strike price during a specied period of me.

i. Buyer will pay seller a premium for this opon and the seller is obligated to buy the underlyinginstrument from the buyer at the strike price, regardless of current market value.

f. American opons can be exercised at any me up to the expiraon date (most opons are American) typically trade on exchanges

g. European opons can be exercised only on the expiraon date itself typically trade OTC h. The price of a call opon decreases as the strike price increases; the price of a put opon increases as

the strike price increases.

i. Opons tend to become more valuable as their me to maturity increases V. Who trades derivaves?

a. Hedgers used to reduce the risk that they face from potenal future movements in a market variable b. Speculators used to bet on the future direcon of a market variable c. Arbitrageurs used to take an oseng posion in two or more instruments to lock in a prot.

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i. Arbitrage involves locking in a riskless prot by simultaneously entering into transacons in twoor more markets

VI. Example:a. Suppose it is October and a speculator considers that a stock is likely to increase in value over the next 2

months to $27; the stock price is currently $20, and a 2-month call opon with a strike price of $22.50 is

currently selling for $1.

i. Payo from purchasing 100 shares: 100 (27 20) = $7001. If stock fell to $15 however, loss is 100 (15 20) = ($500)

ii. Purchasing 100 contracts of call opon: 100 (27 20) = $700 100 = $6001. If price falls loss would be $100 premium paid for the right to buy

b. A stock is traded on both the NYSE and London Stock Exchange stock price in NY is $200 and 100 inLondon at a me when the exchange rate is $2.0300 per pound

i. An arbitrageur could simultaneously buy 100 shares of the stock in New York and sell them inLondon to obtain a prot of 100 *($2.03 100) - $200+ = $300

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Chapter 2 Mechanics of Futures Markets

I. Typical transacon of futures and forwardsa. Buyers: On March 5th a trader in NY might call a broker with instrucons to buy 5,000 bushels of corn for

delivery in July of the same year; the broker would immediately issue instrucons to a trader to buy

(take a long posion in) one July corn contract.

b. Sellers: a trader in Kansas might instruct a broker to sell 5,000 bushels of corn for July delivery; thisbroker would then issue instrucons to sell (take a short posion in) one corn contract; a price would be

determined and the deal would be done.

c. Closing out a posion means entering into the opposite trade to the original one. This is dierentthan delivery. The majority of contracts do not lead to delivery.

II. Contractsa. When developing a new contract, the exchange must specify in some detail, the exact nature of the

agreement between the two pares.

i. The underlying asset when the asset is a commodity such as corn it is important to specifythe grade or grades of the commodity that are acceptable (i.e. Corn: No. 2 Yellow

ii. Contract size species the amount of the asset that have to be delivered under one contract(under law instruments with a face value of 100k are delivered

iii. Delivery agreement the place where delivery will be made (exchange -licensed warehouses)iv. Delivery months precise period during the month when delivery can be madev. Price quotes daily price movement limits are specied by the exchange.

vi. Price limits and posions limit down and limit upIII. Ensuring contracts are honored

a. If investors contact each other directly one may try to back out of a posion b. Margins security deposits required from a futures or opons trader

i. Margin accountii. Inial margin amount required to be collateralized in order to open a posion

iii. Maintenance margin amount required to be kept in collateral unl the posion is closed generally lower than the inial requirement allows the price to move against the margin

without immediately forcing a margin call

iv. Example: futures price has dropped from $600 to $597, the investor has lost 200 3 = $600because the 200 ounces of December gold, which the investor contracted to buy at $600, can

now be sold for $597.

1. The balance in the margin account would be reduced by $600v. Margin call if the balance in the margin account falls below the maintenance margin, the

investor must top up the margin account to the INITIAL MARGIN level the next day. The extra

funds deposited are known as a variaon margin. If the investor doesnt comply the broker

closes out the posion

c. REVIEW TEXT TABLE 2.1 likely test quesond. Clearinghouse a rm that guarantees the performance of the pares in an exchange -traded derivaves

transacon

i. Keep track of all transacons that take place during a day, so that it can calculate the net posionof each of its members.

ii. The clearinghouse member is required to maintain a margin account with the clearing house(clearing margin)

iii. The clearinghouse takes the opposite posion of each side of a trade, when two pares agree onthe terms of a transacon the clearinghouse sits in the middle and acts as both the buyer and

the seller.

iv. Exists to ensure that transacons happen as planned and ensure the smooth funconing ofnancial markets

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e. Net margins when the gross basis is used, the number of contracts equals the sum of the long andshort posions; when the net basis is used, these are oset against each other

i. Example: suppose a clearinghouse member has two clients: one with a long posion in 20contracts, the other with a short posion in 15 contracts.

1. Gross margining would calculate the clearing margin on the basis of 35 contracts2. Net margining would calculate the clearing margin on the basis of 5 contracts. (Most

exchanges use this!)

f. Collateralizaon in an aempt to reduce credit risk, the over-the-counter market is now imitang themargining system adopted by exchanges with a procedure known as collateralizaon.

i. How it works: consider two parcipants in the over-the-counter market, company A andcompany B, with an o/s OTC contract. They could enter into a collateralizaon agreement where

they value the contract each day. If from one day to the next the value of the contract to

company A increases, company B is required to pay company A cash equal to this increase

g. LTCMi. The investment strategy was known as convergence arbitrage

ii. Example: two bonds, X and Y, issued by the same company that promised the same payos, withX being less liquid (less acvely traded market places a value on liquidity) than Y

1. As a result the price of X would be less than the price of Y. LTCM would buy X, short Y,and wait, expecng the prices of the two bonds to converge at some future me

iii. Strategy for collateralizaon: when the interest rates increased, the company expected bothbonds to move down in price by about the same amount, so that the collateral it paid on bond X

would be about the same as the collateral it received on bond Y. It is therefore expected that

there would be no signicant oulow of funds as a result of its collateralizaon agreements

iv. Liquidity crisis! Russia defaulted on debt in 1998. One result was that investors valued liquidinstruments more highly than usual and the spreads between the prices of the liquid and illiquid

instruments in LTCMs porolio increased dramacally. The prices of the bonds LTCM had

bought went down and the prices of those it had shorted increased.

1. LTCM lost ~$4 billion because it was highly leveraged and unable to make the paymentsrequired under the collateralizaon agreements

IV. Wall Street Journala. Explain Table 2.2, the commodity futures quotes

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i. The rst three numbers in each row show the opening price, highest price achieved in tradingduring the day, and lowest price.

1. For March 2007, copper on Jan 8th, 2007; the opening was 253.50 cents per pound andduring the day was between 247.00 and 258.95 cents.

ii. Fourth number is the selement price price used to calculate daily gains and losses and marginrequirements. (price immediately before bell signaling end of trading for the day)

iii. The nal column shows the open interest for each contract total # of contracts o/s b. Normal markets markets where the selement prices increase with the maturity of the contract c. Inverted markets markets where the selement prices decrease (this is when the current or ST

contract prices are higher than the LT contracts (usually occurs because a good is currently in short

supply which drives up the price)

d. Backwardaon the market condion wherein the price of a forward or futures contract is tradingbelow the expected spot price at contract maturity. NEED BETTER DEFINITION

e. Contango? LOOK THIS UP!V. Delivery

a. The decision on when to deliver is made by the party with the short posion, the exchange then choosesa party with a long posion to accept delivery

b. Commodity case example: usually means accepng a warehouse receipt in return for immediatepayment

c. When a contract is seled in cash, all o/s contracts are declared closed on a predetermined day i. the nal selement price is set equal to the spot price of the underlying asset at either the

opening or close of trading on that day

VI. Tradersa. Brokers following instrucons of their clients and charge a commission for each trade b. Locals trading on their own accountc. Speculators

i. Scalpers watching for very ST trends and aempt to prot from small changes in the contractprice. Usually only hold posion for a few minutes

ii. Day traders hold posion for

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i. Investor group takes a huge long futures posion and also tries to exercise some control over thesupply of the underlying commodity

ii. As the maturity of the futures contracts is approached, the investor group does not close out itsposion so that the number of contracts o/s for delivery may exceed the amount of commodity

available for delivery.

iii. The holders of the short posions realize that they will nd it dicult to deliver and becomedesperate to close out their posions

iv. RESULT: large rise in both futures and spot prices v. Regulators respond by increasing margin requirements, imposing stricter posion limits or

prohibing trades that increase a speculators open posion and requiring market parcipants to

close out their posions. (i.e. Silver Squeeze and Hunt Brothers)

IX. Accounng Principlesa. Accounng standards require changes in the market value of a futures contract to be recognized when

they occur unless the contract qualies as a hedge

b. If the contract is not a hedge, gains or losses are generally recognized for accounng purposes in thesame period in which the gains or losses from the item being hedged are recognized. (Hedge Accounng)

i. Raonale: if the company is hedging the purchase of 5,000 bushels of corn in Feb. 2008, theeect of the futures contract is to ensure that the price paid is close to 250 cents per bushel.

The accounng treatment reects that this price is paid in 2008.c. Example: consider a company with a December year end; In Sept. 2007 it buys a March 2008 corn

futures contract and closes out the posion at the end of Feb. 2008. Suppose that the futures prices are

250 cents per bushel when the contract is entered into, 270 cents per bushel at the end of 2007, and 280

cents per bushel when the contract is closed out. The contract is for delivery of 5,000 bushels.

i. Non-hedge accounng: gains are 5,000 (2.7 2.5) = $1000 in 2007 and $500 in 2008.ii. Hedge accounng: the enre gain of $1,500 is realized in 2008 for accounng purposes

X. Forward contracts vs. futures contracts

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Chapter 3