Introduction to Derivatives

Introduction to Derivatives

1. Futures Contracts

   • Buyer pay small deposit (2-5%); so market knows they have some money
   • Price paid for asset in future relates to price currently paid in spot maret
   • Features
     • Contract specification: what, how much, where, how, when, price
       • What = Asset
       • How much = contract size (# units of underlying asset/contract)
       • Where/how = delivery arrangement
       • When = delivery month
       • Delivery price
       • Position limits
         • Not < minimum # contracts, not > maximum # contracts
         • Min/max decided by exchange
           • Don't want anyone taking excessively large positions; prevent destabilisation of market
     • Wide range of underlying assets (Not limited to list)
       • Agricultural & other commodities - CBOT, CME
       • Natural resources - NYMEX
       • Foreign currencies - PHLX
       • T-bills & Eurodollars - CME
       • T-bonds - CBOT
       • Equities - ASX200, S&P 500 - CME
         • Single stock futures
     • Exchange traded anonymously
       • Not futures contract unless traded on organised exchange
       • Contract b/w parties replaced w/ separate contracts w/ intermediary (clearinghouse)
         • After entering contract, counter-party is exchange itself, not other person; obligation to clearinghouse
       • Clearinghouse is long and short
       • Clearinghouse monitors credit risk
       • Open outcry system or electronic platform
       • If other party cannot fulfil contract, exchange finds someone who can; eliminates counter-party risk
     • Settled daily
   • Opening Futures Positions
     • Call broker/enter contract via online trading account
     • No initial payment, except bid-ask spreads, commissions and margins
       • Bid-ask spreads & commissions - financial market transactions
       • Margins - deposits in futures markets
     • Specify price today at which transactions will take place in future
       • Buyer pay seller futures price; seller delivers asset
         • Long position = receive asset
     • When opening futures account, also open margin account
       • Put money in margin account when you trade
   • Closing Out Future Positions
     • Take Delivery
       • <2% of futures contracts lead to delivery
         • Expensive - storage costs, transport
         • Inconvenient - speculators
       • Not closed out before maturity, settled by delivering underlying assets
       • If alternative options available, choice lies w/ party w/ short position
     • Reverse Position
       • Enter into contract opposite of original contract
         • First commit to deliver (buy) asset, then commit to buy (deliver) -> cancel out if same size
       • Before expiration (i.e. delivery), can close out
         • No more obligation
       • Profit/loss determined by change in futures price between date of entering contract and closing out
   • Positions
     • Long (receive/buy) vs short (deliver/sell)
     • Payoffs
       • Short
         • Profit when spot price decreases
         • Payoff = Futures - Spot
       • Long
         • Profit when spot price increases
         • Payoff = Spot - Futures
   • Margin Accounts
     • Reduces risk of default; futures exchanges require parties to post margin
     • Margin = leverage on the position
     • Initial margin & maintenance margin
     • Marking to market
       • Adjusting margin accounts daily to reflect gains/losses
       • Balance < maintenance margin, holder of account gets margin call to post additional margin (or position closed out)
       • Determine difference b/w today's & yesterday's settlement prices
         • Difference = +ve, long position's account is credited
         • Difference = -ve, short is credited from long's account
   • Futures Prices Quotes
     • Open interest = total # of contracts outstanding = # long/short positions
       • Indicates liquidity of contract
     • Settlement price = $P just before the final bell each day
       • Used for daily settlement process
     • Volume of trading = # of trades/day

2. Spot Contract

   • Buy/sell asset immediately -> pay 'now'

3. Nature of Derivatives

   • Derivative securities = instrument whose payoff/value depends on the values/prices of other variables -> underlying assets
   • Derives value from value of another asset
   • Underlying asset = asset underlying the futures contract

4. Derivatives Trading

   • Exchanges
     • Products & trading terms standardised
     • Increasingly replacing traditional trading using the open outcry system with electronic trading where comp matches buyers & sellers
       • Submit order; counter-party submits same order but opposite side
     • If one party honours their obligation, will get what they want, even if other party does not fulfil their obligation
   • Over-The-Counter (OTC) Markets
     • Alternative to exchanges
     • Telephone/comp-linked network of dealers who do not physically meet
     • Trade usually b/w financial institutions, corporate treasurers & fund managers
     • Contract flexibility, private market, relatively unregulated
       • Can debide w/ counter-party about quantity & variety of underlying asset
       • If one party does not fulfil their obligation, other party does not get what they want
     • Credit risk
   • 3 Reasons (Use motives to differentiate)
     • Hedge Risks
       • Price insurance; estimate price uncertainty
       • Still have quantity risk
     • Speculate
       • Allow more leverage
       • Can take bigger position in futures market w/ smaller initial outlay due to small deposit
       • Making a bet on future direction of market value; taking on risk
         • Unlike hedging, which is used to eliminate price risk
     • Arbitrage Profit
       • Asset traded in multiple markets
       • Can buy derivatives cheaper in one market and sell at higher price in another market simultaneously
       • Profit at no risk/free lunch
         • Unlike speculation
   • Users/Purpose
     • Hedging
       • Treasury/Risk Management departments; consumers/investors hedging FX, interest rate, etc.
       • Wants to lower risk profile; limit risk
     • Speculation
       • Speculators/position traders engaging in leveraged bets
     • Arbitrage
       • Pty trading groups/desks exploiting mispricing across related securities
         • Check same asset selling for same price across markets; if not, arbitrage opportunity
     • Hedge funds/financial institutions trade derivatives for all 3 reasons
   • Misuse
     • Can do many things w/ derivatives, so if you're not doing what you're meant to do & no monitoring, disasters could occur
       • If meant to use for hedging/arbitrage but switch to speculation, large losses can result
     • Nothing complicated needs to occur, just needs to be hidden