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Lecture 1 - Course Overview

FINM2002 Derivatives
FINM7041 Applied Derivatives
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1. Course Overview
This course builds upon the knowledge
you have developed in Foundations of
Finance.
The unit provides in-depth coverage of
options, futures, forwards and swaps on a
range of underlying commodities including
stocks, interest rates, foreign exchange as
well as more exotic instruments such as
weather and electricity derivatives.
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1. Course Overview
At the completion of this unit students are
expected to have a good understanding of
how derivative instruments are priced,
traded and used.
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2. Lecture Overview
In this lecture we will:
Recap the basics of forward, futures and options
contracts;
Revisit the concepts of hedging, speculation and
arbitrage; and
Discuss the mechanics of futures and forward
markets.
It would be a good idea to review your Foundations of
Finance notes to ensure you are familiar with all of
the terminology pertaining to futures, forwards and
options contracts. We will only discuss this
prerequisite material briefly.
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3. The Nature of Derivatives
A derivative is an instrument whose value
depends on the values of other more basic
underlying variables.
Examples of derivative contracts include
forward, futures and options contracts.



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4. In What Ways are Derivatives Used
Derivatives can be used to:
hedge risks;
speculate (take a view on the future direction
of the market);
lock in an arbitrage profit;
change the nature of a liability; and,
change the nature of an investment without
incurring the costs of selling one portfolio and
buying another.
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5. Forwards and Futures Contracts
A futures/forward contract is an
agreement to buy or sell an asset at a
certain time in the future for a certain
price.
By contrast in a spot contract there is an
agreement to buy or sell the asset
immediately (or within a very short
period of time).
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5. Forwards and Futures Contracts
The future/forward prices for a particular
contract is the price at which you agree to
buy or sell the underlying asset.
It is determined by supply and demand in
the same way as a spot price.
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5. Forwards and Futures Contracts
In a forward or futures contracts:
The party that has agreed to buy has a long
position.
They have a final payoff of S
t
-F.
The party that has agreed to sell has a
short position.
They have a final payoff of F- S
t
.

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5. Forwards and Futures Contracts
Example of a forward/futures contract:
It is January and an investor enters into
a long futures contract on COMEX to
buy 100 oz of gold @ $1,200 in April
If in April the spot price of gold ends up
being $1,215 per oz, what is the
investors profit?
As the investor is the long position, the
payoff from the contract is S
T
-F, which
equals ($1215 - $1200) x 100 = $1,500.
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5. Forwards and Futures Contracts
No money changes hands when forward and futures contracts
are first negotiated & the contract is settled at maturity.
The initial value of the contract is zero.
Forward contract are similar to futures except that they trade in
the over-the-counter market. Futures contracts on the other
hand are exchange traded instruments. In Australia, futures
contracts are traded on the Australian Securities Exchange
(ASX).
In addition, if you recall from Foundations of Finance,
intermediate gains or losses are posted each day during the
life of the futures contract. This feature is known as marking
to market. The intermediate gains or losses are given by the
difference between todays futures price and yesterdays futures
price. These monies are transferred between the margin
accounts of contract parties.
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5. Forwards and Futures Contracts
The forward/futures price for a contract is the
delivery price that would be applicable to the contract
if were negotiated today (i.e., it is the delivery price
that would make the contract worth exactly zero).
In other words, it would make no difference whether
you entered into the forward contract to receive the
asset in 6 months from now, or bought the asset
today and stored it for 6 months. The cost of either
strategy would be identical.
The forward price may be different for contracts of
different maturities.
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5. Forwards and Futures Contracts
Examples of futures markets:
ASX (http://www.asx.com.au)
Chicago Board of Trade
Chicago Mercantile Exchange
LIFFE (London)
Eurex (Europe)
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
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5. Forwards and Futures Contracts
Profit from a long forward/futures position:
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Profit
Price of Underlying
at Maturity
5. Forwards and Futures Contracts
Profit from a short forward/futures position:
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Profit
Price of Underlying
at Maturity
5. Forwards and Futures Contracts
Convergence of Futures to Spot:
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Time Time
(a) (b)
Futures
Price
Futures
Price
Spot Price
Spot Price
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5. Forwards and Futures Contracts
As the delivery month of a futures contract is
approached, the futures price converges to the spot
price of the underlying asset. When the delivery price is
reached, the futures price equals, or is very close to the
spot price.
If the futures price is above the spot price during the
delivery period, traders will have an arbitrage
opportunity, and will short the futures contract, buy
the asset and make delivery. This will force the futures
price to fall and converge to the spot price.
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5. Forwards and Futures Contracts
If the futures price is below the spot
price during the delivery period,
companies wanting to acquire the asset
would enter into a long position in the
futures contract and wait for delivery to be
made. As they do so, the futures price
will tend to rise, until the futures and
spot prices converge.
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5. Forwards and Futures Contracts
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Private contract between 2 parties Exchange traded
Non-standard contract Standard contract
Usually 1 specified delivery date Range of delivery dates
Settled at maturity Settled daily
Delivery or final cash
settlement usually occurs
Contract usually closed out
prior to maturity
FORWARDS FUTURES
Key Features of Forward/Futures Contracts:
5. Forwards and Futures Contracts
As noted previously in the lecture, futures
contracts involve a margin account.
A margin is cash or marketable securities
deposited by an investor with his or her broker.
The balance in the margin account is adjusted
to reflect daily settlement.
Margins minimize the possibility of a loss
through a default on a contract.
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5. Forwards and Futures Contracts
Closing out a futures position involves
entering into an offsetting trade. For example, if
you hold a long position in wool, to close it out
you would take a short position on wool on the
same quantity with the same maturity date.
Most futures contracts are closed out before
maturity.
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5. Forwards and Futures Contracts
If a contract is not closed out before maturity,
it is usually settled by delivering the assets
underlying the contract. When there are
alternatives about what is delivered, where it is
delivered, and when it is delivered, the party
with the short position chooses.
Some contracts (for example, those on stock
indices and Eurodollars) are settled in cash.
The terms of the contract will stipulate whether
there is physical or cash settlement.
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5. Forwards and Futures Contracts
Some futures terminology:
Open interest: the total number of contracts
outstanding.
equal to number of long positions or
number of short positions.
Settlement price: the price just before the final bell
each day.
used for the daily settlement process.
Volume of trading: the number of trades in 1 day.
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5. Forwards and Futures Contracts
Regulation of futures markets is
designed to protect the public interest.

Regulators try to prevent questionable
trading practices by either individuals on
the floor of the exchange or outside
groups.
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6. Option Contracts
A call option is an option to buy a
certain asset by a certain date for a
certain price (the strike price).

A put option is an option to sell a
certain asset by a certain date for a
certain price (the strike price).

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6. Option Contracts
The person in the long position of either a call or
put option is the holder of the option. They
make the choice as to whether the option is
exercised or not. For this privilege they must
pay an option premium to the writer.
The person in the short position of either a call
or put option is the writer of the option. They
are obliged to fulfil the terms of the option
contract if the holder exercises it. In return
they receive an option premium from the
holder.
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6. Option Contracts
If someone is long in a call option:
They have the right, but not the obligation to buy the
underlying asset to the person who is short in the
call option for a specified price.
If they choose to exercise the option, the payoff will
be S
t
-X.
If someone is short in a call option:
They are obligated to sell the underlying asset for
the specified price to the person in the long position
if the holder decides to exercise the option.
If the option is exercised by the holder, the payoff to
the writer is (S
t
-X).
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6. Option Contracts
If someone is long in a put option:
They have the right, but not the obligation to sell the
underlying asset to the person who is short in the
put option for a specified price. If they choose to
exercise the option, the payoff is X-S
t
.

If someone is short in a put option:
They are obligated to buy the underlying asset for
the specified price from the person in the long
position if the holder decides to exercise the option.
If the holder decides to exercise the option, the payoff
to the writer will be (X-S
t
)
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6. Option Contracts
Options can be either exchange traded, or traded on
an OTC market. Examples of options exchange
markets are:
ASX (http://www.asx.com.au)
Chicago Board Options Exchange
American Stock Exchange
Philadelphia Stock Exchange
LIFFE (London)
Eurex (Europe)

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6. Option Contracts
Another way to distinguish between
options is whether they are American or
European in nature:
An American options can be exercised at
any time during its life, up to and including
the expiry date; and,
A European option can be exercised only at
the expiry date.
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6. Option Contracts
Options contracts differ from forward and
futures contracts in a number of ways:
A futures/forward contract gives the holder the
obligation to buy or sell at a certain price;
An option gives the holder the right but not the
obligation to buy or sell at a certain price;
In return for this right, the holder must pay an option
premium to the writer; and,
Options can be both OTC and exchange traded,
whereas forward contracts are OTC and futures
contracts are exchange traded instruments.
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7. Types of Market Traders
There are three main types of market participants:
Hedgers want to avoid an exposure to adverse movements in
the price of an asset. As such, they will have a position in both
the derivative, and the underlying asset.
Speculators take a position in the market betting that either the
price of an asset will go up, or it will go down. If they are correct
they will make large gains, but if they are wrong they have the
potential to make enormous losses. Some of the largest trading
losses in derivatives have occurred because individuals who had
a mandate to hedge against risks switched to being speculators.
Arbitrageurs are a third important group of participants in
derivatives markets. Arbitrage involves locking in a riskless
profit by simultaneously entering into transactions in two or more
markets.
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7. Types of Market Traders
An example of arbitrage:
Suppose that:
The spot price of gold is US$1090
The quoted 1-year futures price of
gold is US$1195
The 1-year US$ interest rate is 5%
per annum
The cost of storage is 2% per
annum.
Is there an arbitrage opportunity?
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7. Types of Market Traders
If the spot price of gold is S & the futures price is for a contract
deliverable in T years is F, then

F =S (1+r+q )
T

where r is the 1-year (domestic currency) risk-free rate of interest,
and q is the cost of storage.
In our example, S = 1090, T = 1, r = 0.05 and q = 0.02 so that:
F = 1090(1+0.05+0.02)
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= 1166.30
Here F = 1195 but S0(1 + r+q)T = 1166.30. Hence we should take a
short position in the futures contract (which is relatively
overvalued) and take a long position in physical commodity
(which is relatively undervalued), making an arbitrage profit of
$28.70 per ounce.
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8. Conclusion
In todays lecture we have had a broad
overview of forward, futures and options
contracts.
In next weeks lecture, we will focus on
forward and futures contracts in greater
detail, with a particular emphasis on
hedging strategies and the determination
of forward and futures prices.
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