Introduction to Derivatives

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2 Introduction to Derivatives Copyright 2018 Oliver Publishing All rights are reserved, including the right of reproduction in whole, or in part, without the express written permission of Oliver Publishing Inc. ISBN: Published by: Oliver Publishing Inc. 151 Bloor Street West, Suite 800 Toronto, Ontario M5S 1S4 Tel: (416) Fax: (416) Toll Free: Printed and bound in Canada

3 TABLE OF CONTENTS OVERVIEW 4 Definition 4 Options 5 Forwards and Futures 5 Differences Between Exchange-Traded Derivatives And OTC Derivatives 6 Types of Underlying Interests 7 Uses for Derivatives 8 Risk and Cost Reduction 9 Risks and Trading Issues 10 FUTURES 12 Types of Forwards 12 Organized Futures Exchanges 13 Buying and Selling a Futures Contract 14 Reading a Futures Quotation Page 15 Exchanges and Clearing Houses 16 Futures Pricing 17 Arbitrage 18 Hedging 19 Speculation 21 Fundamental Analysis 22 Technical Analysis 23 EXCHANGE-TRADED OPTIONS 24 Option-Based Contracts 24 Why Buy an Option? 26 Why buy a call? 27 Why buy a put? 27 Reading Quotations 29 Options Pricing 30 Intrinsic Value 30

4 Time Value 30 Volatility of the Underlying Interest 31 Essential Option Strategies 32 Bullish Option Strategies 32 Bearish Option Strategies 34 SWAPS 36 Swap Dealer s Function 36 Types of Swaps 36 RISK, ACCOUNTING AND TAXATION ISSUES 40 Types of Risk 40 Measuring Risk 41 Internal Control and Monitoring to Reduce Risk 42 Limits on Risk-Taking 43 Accounting, Disclosure, Taxation 43 Taxation 44

5 Definition 1 OVERVIEW Derivatives are financial products that are unique, in that they are derived from and based on another financial product. These products include: stocks; bonds; foreign currencies or exchange rates; indexes such as stock-markets, prices, rates, or credit indexes; commodities, such as lumber; or even events like a change in the weather, interest rates, or credit ratings. Common Features For every buyer of a derivative, there is a seller on the other side of the contract. These are called the counterparties. The purchase or sale of a derivative involves a contractual agreement between these buyers and sellers to either buy or sell the underlying interest, at a specific price, either within a specific time period or at a specific future date. Derivatives have a market price, and this price fluctuates, depending on the market price of the underlying interest. The derivative contract is terminated on the expiry date. With some derivative contracts, a performance bond, called margin, is required when the derivative contract between the buyer and seller is established. This is meant to guarantee that the contract will be honoured. With other derivatives, the buyer makes an immediate payment to the seller when the contract is established. This is called the premium. The premium is a payment for the right to either buy or sell the underlying interest (depending on the type of derivative), at a pre-agreed price, before the expiry date. The effect of leverage (either positive or negative) must be considered when buying or selling derivatives. Since large dollar amounts of the underlying interest may be bought (or sold, depending on the type of derivative) using relatively small amounts of money, the effect of leverage can result in significant capital gains or losses. A ratio of 40:1 is not uncommon, compared to 3:1 for other investment products. While the owner of the derivative can determine whether or how much leverage they want to use, very aggressive use of leverage must be monitored and controlled.

6 Chapter 1: Overview Because there is always a buyer or a seller on either side of the contract, any profit that one side of the contract makes is exactly offset by the identical loss to the other side. This is called a zero-sum game. Options The buyer of an option has bought the right but not the obligation to either purchase or sell (depending on which type of option was bought) the underlying interest to which the option applies. The risk to the buyer is limited to the amount of the premium. Options can either be traded on exchanges or over the counter (OTC). The seller has sold the right and is obliged to either purchase or sell (depending on which type of option was sold) the underlying interest to which the option applies, if the buyer exercises their right. Thus, the writer carries the burden of risk, in exchange for which they are paid a premium. The seller is also called the option writer. There are two types of options: calls and puts. Both calls and puts can be bought and sold. A call option is a right or an obligation to buy the underlying asset, while a put option is a right or an obligation to sell the underlying asset. Rights and Obligations of Call and Put Buyers and Sellers CALL PUT Buyer Right to Buy Right to Sell Seller Obligation to Sell Obligation to Buy The premium is the cost of the option, paid by the buyer to the seller to compensate the seller for their risk. It is set by supply and demand for the option, which in turn is calculated by the market price of the underlying interest and the exercise price of the option. The exercise price is the price at which the underlying interest may be bought (for a call) or sold (for a put), if the buyer exercises their right. The expiry date is the date the option expires. If the option is not exercised on or before the expiry date, the option expires worthless. Therefore, the seller gets to keep the premium. Purchasing an option is rather like purchasing insurance, and may be used as a planning strategy to manage risk by guaranteeing the future value of an asset. Forwards and Futures A forward contract obliges the buyer to buy and the seller to sell a specific quantity of an underlying interest, at an agreed-upon price, at a specific time in the future, which is called the delivery date. An exchange-traded forward is called a future. The downside of a forward is that it obliges both parties to complete the transaction unless they agree to cancel it. Differences Between Options and Forwards Options are rights that are purchased by paying a premium. The buyer has the right to exercise but no obligations. The seller has the right to keep the premium paid but is obligated to either deliver the underlying asset or accept delivery of the underlying asset. With forwards, both sides have obligations, and have little or no initial cost. The buyer of a forward does not have to pay a premium to the seller when the forward contract is established. 6

7 Chapter 1: Overview Call options have value if the market price of the underlying interest is above the exercise price, and put options have value if the market price is below the exercise price. However, the value of the option does not typically change dollar for dollar with the change in the market price of the underlying interest as it is made up of intrinsic value as well as time value. On the other hand, forwards have value that corresponds with the change in the market price of the underlying interest. Differences Between Exchange-Traded Derivatives And OTC Derivatives Exchange-Traded Derivatives The organized exchanges provide standardization and liquidity, and some would say more fairness and transparency, that is not found in the over-the-counter (OTC) market. Default risk is not a major concern as a clearing house (such as the Canadian Derivatives Clearing Corporation known as CDCC) guarantees the obligations of both sides of the contract, and the contract itself. Over-the-Counter Derivatives There are two types of forward-based (OTC) derivatives that trade forward agreements and swap agreements. The most popular forward agreements are based on foreign exchanges (foreign-exchange agreements) or interest rates (forward-rate agreements). A major feature of OTC derivatives, making them more complex, is that every aspect of the contract can be customized with special features by the buyer or the seller (e.g., a swap agreement). The most common swap is the interest-rate swap, in which two investors swap two different interest rates with each other (e.g., a fixed rate for a floating-rate loan payment). A swap agreement differs from a regular forward contract in two ways: An underlying interest is not delivered. Instead, the buyer and seller exchange the difference between their respective interests. As a result, only one of the investors actually makes the (net) payment. The swap contract is effectively a series of forward contracts that are packaged together. There is not one delivery and one payment, as there would be with a forward contract, but rather a series of exchanges of cash flows at future times, with the dates specified in the contract. A knock-out feature is often included with an OTC option. With this feature, the option expires if the underlying interest falls to or below the exercise price prior to expiry. Other special OTC features are caps, floors, barriers, and compound options. A relatively new type of OTC derivative is the contract for differences (CFD). Limited to Canadian accredited investors, CFDs track the fair value of an underlying interest (e.g., stocks, indexes, commodities, treasuries). Settlement is made in cash. CFDs have no fixed expiry date or contract size. Contrasts Flexibility: The terms, conditions, underlying interests, expiry, contract size, and other features may all be customized for an OTC derivative. Exchange-traded derivatives do not have this flexibility. Underlying interests, contract size, expiry, and other features are standardized by the exchange. Privacy: Only the buyer and seller to the OTC derivatives contract have knowledge about the contract. All aspects of all exchange-traded derivatives are a matter of public record. 7

8 Chapter 1: Overview Liquidity: The downsides of customization and privacy are that OTC derivatives are not easy to sell to a third party. Selling a derivative or offsetting a position (taking the opposite of an established position) in an exchange is easy. Risk: Because of the private nature of OTC derivatives, default and credit risk can be a concern. This is not a consideration for exchange-traded derivatives as the exchanges guarantee and the clearing houses verify all transactions. Clearing houses guarantee the financial obligation of the contract through a system of performance bonds, called margin, which must be posted by those entering into the contract. Accounting: Whereas OTC derivatives are settled on the expiry date, exchange-traded derivatives are accounted for on a daily basis, called marking to market, and margin accounts are adjusted accordingly, giving the net value of the transaction. Regulation: OTC-traded contracts are private and unregulated. Since exchange-traded contracts are public, they are regulated. Regulation has negative and positive aspects. On the one hand, lack of regulation permits far greater creativity and innovation in the OTC market. On the other hand, regulation in the organized exchanges guarantees fairness, transparency, and an efficient secondary market. Delivery: OTC derivatives usually result in delivery at expiry. The underlying interest of an exchange-traded derivative is rarely delivered in actuality. Commission: OTC commissions are typically hidden in the price whereas any commission on an exchange-traded derivative is disclosed. Types of Underlying Interests The two major types of underlying interests for derivatives are commodities and financial assets. Producers, merchandisers, and processors of commodities use commodities derivatives to guarantee future prices, either for consumption or for investment purposes. In Canada, financial derivatives trade on the Montréal Exchange (MX). Commodity futures used to trade on the Winnipeg Commodities Exchange now trade on ICE in the US. The largest derivatives market in the US is the CME Group, which owns and operates The Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT), and the New York Mercantile Exchange and Commodity Exchange (COMEX). The other major player is the Chicago Board Options Exchange (CBOE) which is owned by the Cboe Global Markets. An OTC derivative can be created on any underlying asset if the two parties agree. Types of Commodities Type Examples Exchanges Agricultural products Grains and oilseeds (wheat, corn, soybeans, canola) Chicago Board of Trade (CBOT) ICE Futures (formerly Winnipeg Commodity Exchange) Livestock and meat (pork bellies, hogs, live cattle, feeder cattle) Forest, fibre, and food contracts (lumber, cotton, orange juice, sugar, cocoa, coffee) Chicago Mercantile Exchange (CME) Coffee, Sugar, and Cocoa Exchange Chicago Mercantile Exchange (CME) New York Cotton Exchange 8

9 Chapter 1: Overview Types of Commodities Type Examples Exchanges Precious and Industrial Metals Gold, silver, platinum, copper, aluminium, lead, nickel New York Mercantile Exchange (NYMEX) London Metal Exchange Energy Products Crude oil, heating oil, gasoline, natural gas, propane New York Mercantile Exchange International Petroleum Exchange Types of Financial Derivatives Type Examples Exchanges Equity Individual stocks, ETFs Chicago Board Options Exchange (CBOE) Philadelphia Stock Exchange International Securities Exchange Bourse de Montréal Interest-rate Instruments Foreign Currencies Treasury bills, Eurodollars, Treasury notes, bonds (U.S.), bankers acceptances, Government of Canada bonds (Can), London Interbank Offered Rate (LIBOR), Treasury bonds (OTC) U.S. dollar, British pound, Japanese yen, Swiss franc, euro Bitcoin Chicago Mercantile Exchange (CME) Chicago Board of Trade (CBOT) Bourse de Montréal Eurex Euronext.liffe Chicago Mercantile Exchange (CME) International Monetary Market Philadelphia Stock Exchange Montréal Exchange Stock Indexes Other S&P 500, S&P/TSX 60 volatility indexes Credit, weather, and emissions derivatives Montréal Exchange CBOE ICE Uses for Derivatives Derivatives are used by companies and financial institutions to: Reduce risk; Reduce costs; and Facilitate market entry and exit. Other investors use derivatives for: Yield enhancement; Speculation; and Arbitrage. Creators of ETFs use swaps in the creation of synthetic, leveraged, and inverse ETFs. 9

10 Risk and Cost Reduction Chapter 1: Overview Risk Reduction or Hedging Derivatives are used by financial institutions, manufacturers, mining and natural-resource companies, farmers, retailers, and governments to: Manage risk due to volatility in exchange rates, interest rates and commodity prices; Reduce costs; Enter and exit markets; Improve yields; Speculate; and Engage in arbitrage. Mitigating cash-flow volatility as part of a risk-reduction plan, also called hedging, is the most common use of derivatives. Because derivatives can be bought or sold immediately, derivatives can be used to manage and adjust for specific risks on an ongoing basis. The logic of hedging is that, by taking a position using a derivative at a substantially lower cost than owning an asset outright, the trader can mitigate the risk of either holding or planning to hold the asset by taking a position opposite to the primary position. Although it may seem counterintuitive, the decision not to hedge can turn a producer into a speculator because of the uncertainty of future prices. Hedging rarely eliminates all risk associated with an investment. For example, the correlation between the quantity and quality of the hedge may not perfectly match the quantity or quality of the primary position. The risk added to a hedge by imperfectly correlated positions is called basis risk. Another consideration is that the complete elimination of all risks may be prohibitively expensive and thus reduce or eliminate profit as well. The decision to buy a forward, an option, an OTC or an exchange-traded product is complex. It involves such considerations as the hedger s take on the future, their specialized needs, or the likelihood they may wish to withdraw from the contract in the future due to changing circumstances. Cost Reduction Hedgers can use derivatives to reduce the cost of new or existing debt by utilizing the principle of comparative advantage. This is accomplished by means of interest rate or currency swaps in which the buyer and the seller exchange financial interests, each of which is of value to the other. Market Entry and Exit Commissions, bid-ask spreads, and other administrative costs can be very expensive, especially if the trader is trading in and out of markets often or trading large volumes, both of which can cause the market price to rise or fall dramatically. Derivatives can enable a trader to control a block of assets far in excess of the actual cash outlay. Yield Enhancement Derivatives can be used, on a speculative basis, to enhance the returns earned on a portfolio by selling an interest in the investment assets one already owns. If correctly and carefully executed, the premium earned on the options can enhance the portfolio s yield by locking in the portfolio s current value without actually 10

11 sacrificing any value. Chapter 1: Overview Speculation In general, speculation using derivatives is inconsistent with the goal of risk management because it increases rather than reduces risk. Speculators trade on the future direction of commodities, currencies, stocks, bonds, and other securities, as well as derivatives. By trying to predict the direction of the market, they hope to profit from someone with the opposite belief. Due to the principle of the zero-sum game, in the long term such strategies tend to be selfdefeating. Although derivatives can facilitate speculation, the leverage involved also vastly increases the risk (and, of course, the potential reward). This is especially true of forwards, which, as contractual obligations, cannot be allowed to simply expire, as is the case with options. Arbitrage Advanced dealers and traders use derivatives for arbitrage. An arbitrage opportunity arises when the derivative is traded at different prices in two or more separate markets. The arbitrageur buys a derivative at the lower price in one market and almost immediately sells it at the higher price in the other market, thereby locking in the profit with nearly no risk. The actual risk in arbitrage is a function of the amount of time that passes between the buy and the sell, during which time the price may change. Creation of ETFs Synthetic, leveraged and inverse ETFs are created using derivatives such as swaps rather than purchasing the assets the ETFs are tracking. These ETFs are less transparent and have increased counterparty risk in comparison to other ETFs. Swaps increase tracking errors as well as the costs of ETFs passed on to the investor. The use of swaps also increases the flexibility for the ETF creator. Risks and Trading Issues The main risk of derivatives is not inherent in the use of derivatives themselves but in the ease with which a trader can intentionally or unintentionally use leverage, which is potentially far greater than with other investments. This risk is magnified when derivatives are used for speculation rather than risk management. Because derivative investing is a zero-sum game, it is not realistic to expect that one can consistently beat the market. The use of derivatives must be incorporated into a comprehensive risk-management program, with explicit objectives and effective limits on risk, acceptable types of derivatives and maximum permitted positions. These restrictions must apply to the entire derivative portfolio and to each individual trader. Trading decisions must be subject to monitoring and control by overseers who are not involved in trading and who do not benefit from trading activities either directly or indirectly. The monitoring and reporting system should be explicit, accurate, objective and efficient. Users and Uses Globally, open interest in exchange-traded futures and options were estimated to be USD 33,669 billion in December OTC derivations, as of 2016 were estimated to be USD 552,925 billion for financial derivatives, USD 1,770 billion 11

12 Chapter 1: Overview for commodity contracts and USD 11,977 billion for credit derivatives. Most companies use derivatives for risk management rather than speculation. The following table summarizes the correlation between company types and types of derivatives used: Global Correlation of Type of Company to Type of Derivative (all correlations positive) Company Type Derivative Type Commodity price hedgers No preference Firms with higher leverage Interest-rate derivatives Firms with higher proportions of foreign assets, Foreign-exchange derivatives sales, and income Utilities Interest-rate derivatives Utilities, oil, mining, steel, chemicals Commodity-price derivatives Use of derivatives by companies tends to be greater in countries with larger local-currency derivative markets, such as the US. Additional Resources Visit the International Accounting Standards Board 12

13 2 FUTURES A forward is a contract or agreement made between a buyer and a seller that requires the buyer to take delivery of the underlying interest and pay for it and the seller to deliver the underlying interest and take the pre-agreed payment for it. All forwards have a buyer and a seller, an expiry date, and a formula explaining how the payment is to be made. These features are negotiated when the two parties enter into the contract. As mentioned earlier, forwards can trade on an exchange. They are then known as futures. Prepayment or a premium is not required when the contract or agreement is made. At the time of the contract or agreement, a performance bond called margin is required for exchange-traded futures but not typically for the OTC forward markets. Thus, forwards can be more highly leveraged than futures. Types of Forwards Exchange-Traded Futures Contracts Financial Futures (e.g., interest rate, currency, equity futures) Commodity Futures (e.g., gold, soybeans, crude oil) Over-the-Counter (OTC) Forward Agreements Forward-Rate Agreements (FRAs) (based on interest rates) Foreign-Exchange Agreements (based on currencies) Foreign-Commodity Agreements Swaps Interest rates Foreign-exchange Credit-related Commodity-based Equity-based Trading in forwards and futures is considered to be a zerosum game, as the buyer s gain is the seller s loss and vice versa. The amount of gain or loss varies continuously with the fair value of the underlying interest.

14 Characteristics Chapter 2: Forwards and Futures A forward agreement is a private, customized, legally binding contract between a buyer and a seller to buy and sell an underlying interest at a specific price on an expiry date. The price at which the buyer agrees to buy and the seller agrees to sell is the exercise price. All aspects of this agreement can be negotiated. There is no standardization. The buyer of the contract is said to be long as they believe that the price will rise, whereas the seller is called short as they believe that the price will fall (or are hedging against that risk). Since the exercise price and the market price are the same when the forward contract is transacted, the fair value of the forward at inception is zero. Thus, no fees apply. The payout is simply the intrinsic value at expiry. Buyer: Payout = Market Price Exercise Price Seller: Payout = Exercise Price Market Price In actuality, forward agreements are generally transacted by a third-party dealer (e.g., an investment bank), which acts as agent between buyer and seller, selling and buying the forward agreements to and from the buyer and seller in two separate transactions. Five Differences between a Forward Agreement and a Futures Contract Contract size: Because futures contracts trade on an exchange, they are standardized. This means that the size of a contract may not exactly correspond to the needs of a buyer. For example, silver contracts trade in standard contracts of 5,000 troy ounces. Standard contract sizes are reported in the financial press, as well as by exchanges. Delivery date: Also due to standardization, the delivery date set by the exchange may not exactly match the buyer s personal needs. Using forwards eliminates this issue as the two parties can agree on a date that works for both of them. Mark to market: The mark-to-market accounting system, explained below, means that the net difference between the buyer s and the seller s interest is settled daily, whereas OTC contracts are settled when the contract expires. The final net payout is the same, but the timing of the cash flows differs. Offsetting transaction: If a buyer or a seller wants to reverse (offset) their position, the exchanges have better liquidity compared with OTC transactions, meaning that either one can acquire an opposite or offsetting position easily. It can be quite difficult to find a counterparty when you are trying to offset an OTC forward. Guarantee: All transactions within an exchange are guaranteed by the exchange or the clearing house, which means that futures contracts are essentially risk free. This is not true of the OTC market. Organized Futures Exchanges Futures markets carefully regulate the trading activities that they facilitate. Futures contracts must be approved and listed for trading by the appropriate regulatory authority. In Canada this is the provincial securities commission. In the United States it is the Commodity Futures Trading Commission (CFTC). To calm markets, the exchanges set limits on the amount by which the price can rise or fall during a single daily trading session. If the price falls by an amount equal to the daily trading limit, the contract is said to be limit down. If it rises by an equal amount, it is said to be limit up. 14

15 Chapter 2: Forwards and Futures What Exchanges Regulate and Standardize Contract size (quantity) Maximum daily price limits Deadline days Maximum price fluctuations Delivery locations (delivery place) Price increments Delivery months Quality (grade) Delivery standards Settlement Delivery time Terms and conditions Margin requirements Tradeable months Marking to market Trading hours Maturity Underlying interest(s) Although in theory trading may continue at these limits, in practice trading usually comes to a halt. This puts traders who are out of the money in a very precarious situation, especially if the limits last for several days. Most exchanges use one of the following approaches to lessen this risk: limits are increased by 150% to improve liquidity; limits are removed entirely for futures contracts trading in their delivery month; some exchanges have abolished limits altogether. Buying and Selling a Futures Contract In fact, most futures contracts are terminated before the expiry date through an offsetting trade. This is done by the long independently selling the contract and the short independently buying back the contract. The payout is the difference between the offsetting transaction and the original entry price. As long as the contract is offset before the first delivery day that is near the end of the month before the delivery month, there is no need for the investor to think about delivery. For example, if the long position receives a notice on October 24, he is expected to deliver between November 1 and November 30. As long as he closes out his long position before November 1, he will not be obligated to deliver. Contracts that have not been offset prior to this first delivery date are subject to physical delivery (with the exception of stock-index futures, which are cash delivered). If there is delivery: the seller controls the delivery process: time, location, and grade; the delivery process begins with the first delivery day. Shorts notify the clearing corporation of their intention to deliver, and longs are notified by the clearing corporation that they must take delivery. Exchanges notify the buyers and sellers that their first delivery day is approaching. Then they can close out their respective positions and, if they want to maintain the position, roll over into a new contract further into the future. Investors are encouraged to close out before delivery. One method of doing this is to increase margin requirements on and after the first delivery day. Cash Settlement Some futures contracts are cash settled. These are called cash-settled futures contracts. A stock-index futures contract is an example of a cash-settled contract. The buyer or seller with the negative payout compensates the investor with the positive payout in cash. 15

16 Margin and Marking to Market Chapter 2: Forwards and Futures Margins on futures transactions differ from stock margins in that stock margins represent loans by a broker, whereas futures margins are good-faith deposits or performance bonds. Both the long and the short must maintain margin. Minimum margin requirements are set by the exchange or the clearing house. Original margin is the margin required by the original terms of the futures transaction. Maintenance margin is the minimum amount that must be maintained in the account as long as the futures position exists. This amount is lower than the original margin. Futures use a marking to market system. This system calculates the daily profit or loss for the position. This profit or loss is added to the account. If the position has lost money that day, the money is deducted from the margin in the account. If the client s margin in the account goes below the minimum maintenance margin amount, the client must put more money into the account. If the position has increased in value, this amount is added to the already existing margin amount. Futures Trading and Leverage In the context of futures trading, leverage may be defined as the ratio of the capital required to control an underlying interest relative to the fair value of the underlying interest. In the world of equities, a security can be bought with margin ranging from 30% to 80% (3:1 to 1.25:1). However, in the world of futures trading, where margin requirements vary from 3% to 10% (33:1 to 10:1), the risk to the investor is far greater if the fair value of the underlying interest moves in the wrong direction. Reading a Futures Quotation Page A futures quotation page of the type found in a daily newspaper or exchange website would typically include the following information: Name of asset Delivery month of the contract Current trading session Open: opening price expressed in U.S. dollars High Low Last Most recent settlement price: the average of the prices of trades made towards the end of the session, specified by the exchange s Pit Committee Point change: the difference between the current and previous day s settlement price Estimated volume Previous trading session Settle Volume Open interest: number of outstanding contracts Futures traders evaluate the technical strength or weakness of a market by analyzing the open interest (pending orders) and volume figures, as well as price trends. 16

17 Chapter 2: Forwards and Futures Size of the Contract and Underlying Interest Value The fair value of the underlying interest per contract is calculated by multiplying the contract size by the price. Contract sizes are usually published in the financial press. Additional Resources Find futures quotations online: Exchanges and Clearing Houses Exchanges An order to buy or sell a futures contract is first communicated to the trading floor of the futures exchange where that contract is listed, and then to the area of the floor where that specific contract is traded, called the pit. The buying and selling is done through an open-outcry auction process (i.e., verbal and hand signals are used). Computerized auction market systems are growing in popularity, despite some initial resistance. Canada, for example, has completely electronic trading floors. In order to trade on the exchange, the member firm (or brokerage firm) must be registered. There are two types of registered floor traders: locals primarily trade for their own accounts and floor brokers fill orders for customers. Exchange Functions Open Auction Forum The essential function of an exchange is to provide the communications infrastructure, physical or electronic, for buying and selling futures contracts through an auction system, as well as a publication, monitoring, and enforcement system that guarantees fair and competitive markets. Contract Development An exchange s new-products committee is responsible for evaluating the economic viability of proposals for offering new types of futures contracts and submitting them to the regulatory authorities for approval, as well as for redesigning or delisting existing products. Clearing House Functions The clearing house is established by the exchange to handle financial settlements. It may be a department of the exchange or an independent company. The following table shows the names of the clearing houses associated with three major Canadian exchanges: Canadian Futures Exchanges and Associated Clearing Houses Exchange Clearing House Bourse de Montréal Canadian Derivatives Clearing Corporation Natural Gas Exchange NGX ICE Futures ICE Clear, Inc. 17

18 Guaranteeing Performance Chapter 2: Forwards and Futures The clearing house guarantees the financial obligations for both sides of every transaction and thus maximizes the efficiency and integrity of the exchange by acting as seller to every buyer and as buyer to every seller. This is called the principle of substitution. Clearing houses are able to guarantee buyers and sellers financial transactions by deriving financing from three main sources: margin requirements; guarantee deposits; fees for services. Clearing The clearing house matches the trades that are submitted by the member firms, either on behalf of their clients or for their own accounts. The clearing house verifies the accuracy of all transactions, ensures that there is a buyer for every seller and a seller for every buyer, verifies that the original margin is received, and then correlates all positions so that they balance. Handling Deliveries The clearing house takes the role of ensuring that all deliveries are completed without problems; for example, when the clearing house receives notification of an intention to make delivery, it in turn notifies the member firms with long positions, usually on a first-in, first-out basis (i.e., the member firms with the oldest long positions are notified first; this practice is referred to as FIFO). The clearing house is not required to take on the obligation of delivery if one side does not satisfy the conditions of delivery. Additional Resources Visit the Canadian Derivatives Clearing Corporation: Visit the Natural Gas Exchange: Futures Pricing Overview Whereas expectations concerning the future value of a commodity do figure highly in determining futures prices in some markets, in others (e.g., gold) the main basis of futures prices is a concept called cost of carry. Cash Market / Futures Market The cash market is a market in which assets are traded for immediate delivery with payment in cash. The cash market is not an exchange but rather a loose network of buyers and sellers who keep in touch with each other by telephone and electronically. The price at which cash trades take place is called the market price, and this varies according to the grade and location of the commodity. Since this is an OTC market, the buyers and sellers take upon themselves the risk of each other s default. 18

19 Chapter 2: Forwards and Futures Since the futures market represents an obligation to buy and/or sell an underlying interest, the futures price will be similar to the current market price of the underlying interest. The essential difference between the two markets is timing. Cash markets are immediate; futures markets are deferred. Cost of Carry The cost of carry is the opportunity cost of carrying (i.e., holding) an underlying interest (e.g., storage, financing, and insurance costs for a period of time). In a normal market, the fair value of a futures contract is equal to the market price plus the cost of carry for the term of the contract. If a mispricing were to occur, it would be quickly corrected by arbitrage (defined below). Thus, in a normal market the futures price rises with time, since the cost of carry also rises. This is due to the increase in the period of time during which the underlying interest is held. Basis The basis is the difference between the market price (i.e., the fair value at which the underlying interest is trading in the futures market) and the futures price. Normal Market In a normal market, the futures price is higher than the market price and the basis widens as prices rise, or narrows as prices fall. A normal market occurs when supplies of a commodity are plentiful. An inverted market occurs when the futures price is lower than the market price and the basis widens as prices fall, or narrows as prices rise, contrary to a normal market. An inverted market occurs when supplies of a commodity are scarce. Arbitrage Arbitrage (simultaneously buying an asset in one market and selling it in another with the intention of making a profit from the price difference) is the mechanism by which the market aligns futures prices with market prices plus carrying costs for the term of the contract, called the time to expiry. If futures prices deviate from market prices plus carrying costs to a degree sufficient to justify the transaction costs (e.g., commissions, bidask spreads, etc.) of the arbitrage itself, the arbitrageurs will move in to either buy or sell, thereby bringing the futures price back into line with the fair value. For futures contracts to trade close to fair value, arbitrage must be cheap and easily executed. Cash-and-Carry Arbitrage Cash-and-carry arbitrage occurs when a future is overpriced relative to the underlying interest. The arbitrageur sells the futures and buys the underlying interest. At expiry, they deliver the relatively underpriced asset and keep the difference as their profit. Arbitrage is a form of speculation that is nearly risk free. Arbitrage opportunities are infrequent and short-lived, leading to George Soros s famous quip that arbitrageurs do not live very long. Arbitrage is a highly specialized institutional technique that is not readily accessible to ordinary investors. Reverse Cash-and-Carry Arbitrage Reverse cash-and-carry arbitrage occurs when a future is underpriced relative to the underlying interest. The arbitrageur buys the future and borrows, then sells, the underlying interest. At expiry, the relatively underpriced asset is delivered and the difference is kept as profit. The reverse cash-and-carry arbitrage involves the additional expense of leasing the borrowed underlying interest and the opportunity cost of providing collateral on the one hand, while earning interest on the borrowed asset and avoiding the cost of storage and insurance on the other. 19

20 Chapter 2: Forwards and Futures Because reverse cash-and-carry arbitrage is more expensive than direct cash-and-carry arbitrage, there is a downward pressure on futures prices that results in futures prices being more readily underpriced than overpriced. Four Conditions of Arbitrage Four conditions facilitate arbitrage: the ability to short sell; plentiful supply of the underlying interest; storability; stable supply and demand. Financial futures meet all of the conditions for making arbitrage easy to implement. Ironically, as a result, financial futures (e.g., equities and currencies) tend to trade close to cost of carry. Grains, oil seeds, and crude oil, because they are seasonal, do not lend themselves to easy arbitrage, and thus their prices tend to deviate from a strict cost-of-carry basis. With these types of commodities, the expectations of the market become a crucial factor in pricing. The additional cost of owning a physical asset that is in short supply is called the convenience yield. The addition of the convenience yield to the cost of carry can result in volatile prices and inverted markets. Backwardation An inverted futures market occurs when the price for the futures contract falls significantly below the market price. This typically occurs when there is a shortage in the underlying interest in the cash market that bids the market price up to the point where the market price is greater than the futures price. As supply shrinks, the demand moves to the nearest delivery date, pushing up these futures prices over futures prices for later delivery dates. This occurs if the buyers believe that the shortage will be short-lived. If supply is short in November, for example, this will push up futures prices in December, which causes futures prices in January to increase as well. Inversions can occur during periods of normal supply (as opposed to periods of shortage), for example, in anticipation of a new grain harvest. This means that the market puts a short-term premium on the market price of the commodity, believing that the supply will be relieved with the next harvest (i.e., the supply becomes limited during the winter and early spring, but will be replenished during the summer harvest). If an asset cannot be borrowed, reverse cash-and-carry arbitrage is not possible and, therefore, the degree to which futures prices can trade below the fair value is theoretically without limit. Convergence The technical term for the narrowing of the basis as it approaches expiry in a normal market is called convergence. Convergence reflects the gradual decline of the cost of carry. Hedging Types Futures markets enable participants to either reduce (or eliminate) or take on risk. Reducing or eliminating risk is called hedging, assuming risk is called speculation. 20

21 Chapter 2: Forwards and Futures Two types of risk are: the risk of owning an asset and the risk of expecting to own an asset in the future. Short Hedge A short hedge sells an interest that the hedger owns or expects to own in the future, thus locking in the selling price of the asset in the future. Hedges are generally offset towards the end of the contract to avoid delivery. In most cases, futures hedges are used as a risk-management strategy to control prices, not as a means of delivery. A corn farmer is worried that when it is time to deliver his crop, the price of corn will have fallen. He sells a corn future in October at US$375. At expiry, in December, corn is trading at US$350. He has made a profit of $25 calculated as $375 - $350 on the futures he sold. Although he will only be able to sell his corn at $350, the profit from the futures has increased his income by $25 and locked in the price of his corn at $375. Long Hedge A long hedge buys an interest that the hedger expects to buy in the future, thus locking in the purchase price of the asset in the future. A national bakery is concerned about the price of wheat due to a drought in the west. The drought could drive up the price of the wheat due to short supply. The CFO decides to buy wheat futures. He pays US$560 per contract. When the futures contract expires the price of wheat is $655, a difference of $95. His contract was marked to market each day. As the price increased so did the value of his contract. He can choose to sell his contract (what typically happens) and buy the wheat on the open market or accept delivery of the wheat. Either way, the price for his company is $560 profit from the futures, calculated as $650 - $95. When futures prices and market prices narrow to the point that they are identical when the contract expires, this is called a perfect hedge. A perfect hedge occurs if two preconditions are met: Maturity match: the hedger s holding period must be equal to the time to expiry of the contract; Asset match: the asset that the hedger holds must be identical to the underlying interest of the contract. If the foregoing conditions are not met, a perfect hedge is still possible, but less likely. An imperfect hedge exposes the hedger to basis risk, which is the risk of an unexpected change in the difference between the market price and the futures price (i.e., the basis). In the example above, the bakery might have needed to buy wheat in January but the futures they bought do not expire until February. Or the type of wheat they prefer to make their bread is not the type of wheat the futures contract is based on. One way of effecting a perfect hedge, even if the expiry and/or the asset do not match, is by offsetting the futures contract prior to its expiry and before the basis deviates from the hedger s expectation. For example, if the hedger feels that prices for oil futures will increase to $70, the hedger will close out the position just as the prices are reaching $70, before the prices go above $70. Imperfect Hedges An imperfect hedge is defined as a hedge in which the basis changes in a way that is inconsistent with the hedger s expectations. An imperfect hedge makes sense only if the basis risk (i.e., the probability of an unexpected change in the basis), is less than the market risk (i.e., the risk of being unhedged). An unexpected change in the basis can be caused by changes in the supply-demand equilibrium, which can result in a temporary deviation from the market price. 21

22 Chapter 2: Forwards and Futures A cross-hedge may be used when a futures contract based on the underlying interest is not available. A crosshedge is based on an asset that is correlated to but not identical with the underlying interest. A cross-hedge also introduces basis risk into the hedge. Optimal Hedge Ratio Where considerations of an expiry or asset mismatch make expectations uncertain, and thus increase the basis risk, the optimal hedge ratio can be used to calculate the best number of contracts to buy to adjust for the historical or expected price relationship between the futures contract and the underlying interest. If the market price is expected to rise relative to the futures price, the number of contracts should be increased. If futures prices are expected to be more volatile than the market price, the number of contracts should be decreased. The optimal hedge ratio is a function of the standard deviation of the market price, the standard deviation of the futures price, and the coefficient of correlation between the asset to be hedged and the underlying interest. Optimal Hedge Ratio = Correlation Coefficient (Standard Deviation of Market Price Standard Deviation of Futures Price) The number of contracts required is multiplied by the optimal hedge ratio to arrive at an adjusted figure. For example, a national flour producer prefers a certain type of wheat for its flour that it sells to bakeries for bread products. However, there are no futures trading on this type of wheat. So, it will implement an imperfect hedge by buying Chicago Wheat Futures. To create the hedge, the CFO of the company will use the correlation coefficient between the two types of wheat, and the standard deviation of the market prices of the required wheat as well as standard deviation of the futures prices. Using the following information: Correlation Coefficient = Standard Deviation of Market Price = Standard Deviation of Futures Price = The CFO calculates a hedge ratio of:.9071 x (0.0275/0.0358) = The national flour producer should hedge by taking a position in Chicago Wheat futures that corresponds to 69.68% of its exposure. The wheat future has a contract unit of 5,000 bushels. The flour producer needs 2,000,000 bushels. They need to buy 400 x.6968 = or 279 contracts. Statistical Recap: Standard deviation (σ) is the degree to which a value deviates from the mean of the distribution. Correlation coefficient is the degree to which two variables are correlated. Speculation What Attracts Speculators? Unlike hedgers, who seek to avoid risk, speculators are risk-seekers. They assume the risk that hedgers are trying to avoid, thereby increasing market liquidity. Speculation is the process of seeking to derive a profit by assuming risk. Four main conditions facilitate speculation in the futures markets: Easy entry and exit: Assuming a position in a futures market is simple, quick, and easy. Trading can be 22

23 Chapter 2: Forwards and Futures accomplished online through a discount broker or on the telephone. Low margins facilitate trading. Variety of opportunities: Futures markets give access to assets and trading strategies (e.g., spreads) that small investors would not be able to trade otherwise. Mini-contracts (i.e., fractions as low as one-tenth of a regular contract) are affordable and liquid. Leverage: Leverage as low as 3% enables a speculator to control a large block of assets with little money down. Emotion: Speculative trading in the futures markets challenges the speculator to understand the market better than the trader on the other side of the transaction. For many speculators this is a source of satisfaction. Types of Speculator Locals ( scalpers ): work on the trading floor; have a short time horizon for maintaining positions (e.g., minutes); look for small price differentials within short periods of time; trade frequently; make (or lose) small amounts per trade; depend on volume to make a living. Day traders: take positions for no longer than one trading session; liquidate positions by the end of the day; look for small price moves, but larger than the locals; are risk averse; avoid taking positions on or around days when major economic reports are expected. Position traders: utilize time horizon of weeks or months; profit from longer-term price trends; tend to be well financed and able to withstand short-term price fluctuations. Spreaders: identify situations where the price relationship between two related underlying interests has deviated from the norm (typically, one asset is underpriced and the other is overpriced); buy the underpriced contract and at the same time sell the overpriced contract, then wait until the price relationship reverts to the norm. There are four types of spreads: Intramarket spreads (called calendar or time spreads) involve buying and selling futures contracts on the same underlying interest but with different expiry dates. Intercommodity spreads take two different-but-related futures contracts that may or may not trade on the same exchange; involve buying the underpriced and selling the overpriced and waiting for the price relationship to revert to the norm, then liquidating both contracts (e.g., buying treasury notes and selling treasury bonds is called notes over bonds (NOB)). Intermarket spreads involve buying and selling futures contracts on the same underlying interest but executing them on different exchanges. Commodity product spread involves buying and selling a futures contract in a commodity (e.g., soybeans) and a by-product of the commodity (e.g., soybean meal). Managed Futures Investor: uses futures to diversify equity and bond portfolios. There are three types: Managed accounts: for an investor who wants some exposure to the futures markets and is willing to give trading authority to a trading advisor. Managed futures fund: a mutual fund that invests in the futures markets. There are several types of managed futures (mutual) funds, depending on the investor s objectives. Commodity pools: funds that are available only to sophisticated investors; typically have a high minimum investment and are sold as a limited partnership. 23