Introduction Futures & Forward Markets Chapter 1 & 2

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Definition of Derivatives
An instrument whose value depends on the values of other more basic underlying variables Underlying variables () :
Commodity Financials Others : weather, trade of permission, etc.
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Examples of Derivatives
Forwards () Futures () Swaps () Options () Synthetic Contracts () : options on futures, swaption, portfolio insurance, . . .
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Usage of Derivatives
Hedging () Speculation () Arbitrage () Others :
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
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(1) Futures
An agreement to buy or sell a certain quantity of an asset at a certain time in the future for a certain price Similar to down payment () Spot[Cash] contract : an agreement to buy or sell the asset immediately (or within a very short period of time)
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Futures Price
Price at which you agree to buy or sell Determined by supply and demand in the same way as a spot price Specified as :
Quantity Price (futures/delivery price) Time (maturity/delivery data)

Example : KOSPI200_futures.bmp
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Specification of Futures Contract

Underlying asset Contract size Delivery arrangement Delivery months Price quotes Daily price movement limits Position limits Example : SPEC_KTB.bmp
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Examples of Futures
Agreement to:
buy 100 oz. of gold @ $400/oz. in Dec. (COMEX) sell 62,500 @ 1.5000 $/ in Mar. (CME) sell 1,000 bbl. of oil @ $20/bbl. in Apr. (NYMEX)

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Types of Position
Long position () : a party that has agreed to buy Short position () : a party that has agreed to sell

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Types of Traders
Hedgers Speculators Arbitrageurs
Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators. (See Chapter 21)
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Example of Hedging
A US company will pay 10 million for imports from Britain in 3 months It decides to hedge using a long position in a forward contract Why does this company do this?

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Example of Speculation
An investor with $4,000 to invest feels that Amazon.coms 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 is the investors profit?
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Example of Arbitrage
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?

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Exchanges Trading Futures

KOFEX (Korea Futures Exchange) TIFFE, TOCOM (Tokyo) CBOT (Chicago Board of Trade) CME (Chicago Mercantile Exchange) LIFFE (London) Eurex (Europe) and many more . . .
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Electronic Trading
Traditionally traded using the open outcry system () Currently replaced by electronic trading () where a computer matches buyers and sellers

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Offsetting or Delivery
Offsetting () : closing out a position before maturity
Most contracts are closed out before maturity

Delivery () : if not closed out before maturity

Physical delivery () Cash settlement ()
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Delivery Process
Seller can initiate delivery process :
Day 1 (position day) : shorts broker notifies Board of Trading Clearing Corp Day 2 (notice day) : Board matches seller with oldest long position Day 3 (delivery day) : buyers broker gives check, gets ownership receipts

Most futures are cash-settled or closed out with an offsetting trade

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Clearing House Function

Default risk : a counter party incapable of fulfilling his/her obligation
Clearing House buys sells Ms. Long buys Mr. Short
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sells

Margins
Margin account : cash or marketable securities deposited by an investor with broker Balance adjusted to reflect daily settlement Minimizing the possibility of a loss through a default on a contract
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Marking-to-Market
Initial margin () : a security deposit to open a futures position Maintenance margin () : if balance below it, it must be topped up Settlement price () : the price
just before the final bell each day used for the daily settlement process
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Margin Call (1)

Initial margin = $200/cont. Maintenance margin = $160/cont.

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Margin Call (2)

Situation :
Long position in 2 Dec. gold futures on Jun. 5 contract size : 100 oz. futures price : $400 margin requirement : $2,000/cont. ($4,000 in total) maintenance margin : $1,500/cont. ($3,000 in total)
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Possible Outcome
Futures Price (US$) 400.00 5-Jun 397.00 . . . . . . 13-Jun 393.30 . . . . . . 19-Jun 387.00 . . . . . . 26-Jun 392.30 (600) . . . (420) . . . (1,140) . . . 260 (600) . . . (1,340) . . . (2,600) . . . (1,540) Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) Margin Account Margin Balance Call (US$) (US$) 4,000 3,400 . . . 0 . . .

Day

2,660 + 1,340 = 4,000 . . . < 3,000 . . 2,740 + 1,260 = 4,000 . . . . . . 5,060 0

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Trading Volume & Open Interest

Trading volume () : the number of trades in 1 day Open interest () : the total number of contracts outstanding
equal to number of long positions or number of short positions

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Relationship O.I. & T.V.

O.I. : stock variable T.V. : flow variable
Long A D E B C Total Short B C D A E Contracts 1 2 2 1 2 O.I. 1 3 3 2 0 T.V. 1 2 2 1 2 8
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Basis
Basis F(t) S(t) = FP SP deviations from usual basis patterns may open up profit opportunities at maturity (t =T), F(T) = S(T)
FP,SP F(t)
basis

S(t)

time

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Convergence of Futures to Spot

Contango
FP SP FP

Backwardation

SP

Time

Time

(a)

(b)
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Over-The-Counter (OTC)
An important alternative to exchanges Telephone and computer-linked network of dealers who do not physically meet Between financial institutions, corporate treasurers, and fund managers
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(2) Forwards
Popular on currencies and interest rates Futures
Exchange traded Standardized Unknown traders Terms fixed Settled daily No default risk

Forwards
Private OTC Customized Two parties Terms negotiable Settled at end of contract Default risk
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Forward Price
The delivery price applicable to the contract if were negotiated today
it is the delivery price that would make the contract worth exactly zero)

May be different for contracts of different maturities

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Examples of Forwards
Agreement to:
buy 100 oz. of gold @ $400/oz. in Dec. sell 62,500 @ 1.5000 $/ in Mar. (), ,

Difference :
Forwards : settled only on delivery date Futures : settled daily over the period until delivery date
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Pay-Off of Long Forward

Profit

Price of Underlying at Maturity

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Pay-Off of Short Forward

Profit

Price of Underlying at Maturity

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FX Quotes for GBP

Contract Spot 1-month forward 3-month forward 6-month forward Bid 1.5118 1.5127 1.5144 1.5172 Offer 1.5122 1.5132 1.5149 1.5178

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(3) Options
Call option : an option to buy a certain asset by a certain date for a certain price Put option : an option to sell a certain asset by a certain date for a certain price Strike[Exercise] price ()
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American vs European Options

American options : can be exercised at any time during its life European options : can be exercised only at maturity KOFEX : European type only Example : KOSPI200_options.bmp
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Example : Cisco Options

00/05/08, Stock Price = 62.75
Strike Price 50 65 80 Jul. Call 16.87 7.00 2.00 Oct. Call 18.87 10.87 5.00 Jul. Put 2.69 Oct. Put 4.62

8.25 10.62 17.50 19.50

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Exchanges Trading Options

KOFEX (Korea Futures Exchange) CBOE (Chicago Board Options Exchange) American Stock Exchange LIFFE (London) Eurex (Europe) and many more
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Futures/Forwards vs. Options

A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price What is difference?
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Assignment
Ch.1 (p.15) : 1-20. to 1-22. Ch.2 (p.39) : 2-24. to 2-27. Trading Simulation
Initial endowment : 100 million Won KOSPI200 (long or short) Calculate weekly Initial/maintenance margin changes, gains/losses, net profits Based on Wednesday Closing Price
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