Examples of Derivative Securities: Futures Contracts

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1 Finance Derivative Securities Lecture 1 Introduction to Derivatives Examples of Derivative Securities: Futures Contracts Agreement made today to: Buy 5000 bushels of US$4.50/bushel on December 2, 2016 (Globex CBOT) Futures pay in the future but decide now how much to pay A futures contract is an agreement to buy or sell a specified quantity of a specified asset at a specified time in the future for a specified price (delivery price) Buyer needs to pay only a small fraction (2-5%) of the delivery price as deposit 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) pay now. The Nature of Derivatives: What are they? A derivative security is an instrument (or contract) whose payoff and, thus, value depends on the values (or, prices) of one or, more other variables (referred to as underlying assets). I.e. such a security derives its value from the value of another (traded or not) asset Ø Examples of underlying (or, primary assets): commodities, stocks, bonds, interest rates, live cattle, weather, etc. Derivatives Trading: Exchanges Products and trading terms are standardised Traditionally derivative contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers Derivatives Trading: Over-the-Counter (OTC) Markets Important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers Contract flexibility (as opposed to standardised), private market, relatively unregulated Credit risk as opposed to an exchange Hedging example A farmer with wheat in the field knows that the crop will be ready for sale in December.

2 Q: What can he do? 1) Wait until December, then sell the wheat in the spot market (sales price uncertain) 2) Sell (go short) Wheat Futures for December delivery (sales price predetermined) Through the futures contracts the farmer locks in the price at which he delivers the wheat. Futures can be a form of insurance (or, hedging) Speculation Example In July an investor with $20,000 feels that the price of wheat will increase over the next 2 months. The current spot price is $4.00 per bushel and the futures price for the September contract (i.e., expiring in 2 months) is $4.20 1) Buy Spot 5000 bushels of Wheat put the $20,000 down now 2) Buy (long) wheat futures no money down, except a 5% deposit Futures allow more leverage Arbitrage example A stock price is quoted as 100 euros in London and 182 dollars in New York The current exchange rate is Three Reasons for Trading Derivatives 1) To hedge risks (= insurance) 2) To speculate (=take a view on the future direction of a market value) 3) To lock in an arbitrage profit (=free lunch) Who uses derivatives & for what purpose? 1) Treasury/Risk Management departments hedging FX, interest rate, raw material price risk, firm-wide risk (hedging) 2) Proprietary trading groups/desks exploiting mispricing across related securities (arbitrage) 3) Speculators (position traders) engaging in leveraged bets (speculation) 4) Hedge funds trade derivatives for all three reasons. Derivatives Misuse When a trader has a mandate to use derivatives for hedging or arbitrage, but then switches to speculation, large losses can result. Financial distress occurs when you speculate but you should be arbitraging or hedging. Futures Contract Specification: what, how much, where, how, when, price Available on a wide range of underlying assets Exchange traded Settled Daily Futures: Contract Specification

3 The asset (what) The contract size (how many units of the underlying per contract) The delivery of the arrangement (where, how) The delivery month (when) The delivery price Position limits such as how many contracts you can go long or short, limiting excessive speculative/risky positions. Futures: Underlying Agricultural and other commodities (CBOT, CME) Natural resources (NYMEX) Foreign currencies (PHLX) T-bills and Eurodollars (CME) T-bonds (CBOT) Equities (ASX 200, S&P 500 CME) single stock futures Futures: Exchange trading The contract between the two parties is replaced with separate contracts with an intermediary (the clearinghouse). The clearinghouse is both long and short. The clearinghouse has to monitor credit risk Open outcry system or electronic platform Opening Futures Positions To open a position you call your broker or enter into the contract via online trading account Contracts are referred to by their delivery price Ø e.g long May WTI (oil futures) No initial payment, except bid-ask spreads, commissions and margins Price agreed upon today is the price at which transactions will take place in the future Closing Out Futures Positions Two options: take delivery or reverse a position Most contracts don t lead to delivery (less than 2%) - Inconvenient (speculators) - Expensive (storage costs, transport) Reversing a position - Enter into a contract that is opposite of the original contract Ø Example: March 6: long 1 July corn. April 12: short 1 July corn Ø Profit or loss is determined by the change in the futures price between March 6 & April 12 Delivery If a futures contract is not closed out before maturity, it is settled by delivering the asset 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.

4 A few contracts (for example, those on stock indices) are necessarily (i.e., always) settled in cash Terminology: Long & Short The that has agreed to receive (buy) the underlying asset through the derivative contract acquires a long position on the underlying The party that has agreed to deliver (sell) the underlying through the derivative contract acquires a short position on the underlying Payoffs to Long and Short Positions Long: 1) Generally used to describe the buyer of the underlying 2) Long Positions agree to receive an asset at today s futures 3) Long profits when spot price increases 4) Payoff = Spot Futures Short: 1) Generally used to describe the seller of the underlying 2) Short positions agree to deliver an asset at today s futures price 3) Short profit when spot price decreases 4) Payoff = Futures Spot Margin Accounts To reduce the risk of default, futures exchanges require parties to post margin In practice, a trader posts the margin (cash or liquid securities) with a broker through whom they trade. The broker in turn places the margin with the clearinghouse Margin leverage on the position. Only about 5% of the value of a contract is required Initial margin Maintenance margin: say 75% of initial margin Margins and Marking-to-Market The payoff profiles are snapshots of the contract at maturity In reality, a cash exchange between parties takes place at the end of each day (daily settlement) Margin accounts are adjusted daily to reflect gains and losses (marking to market) If the balance in the margin account dips below the maintenance margin, the holder of the account gets a margin call Must post additional margin or the position is closed out Marking to Market The difference between today and yesterday s settlement prices is determined. If the difference is positive, then the long position s account is credited If negative, short is credited from long s account

5 Example of Marking to Market An investor takes a long position in 2 December gold futures contracts on June 5. Ø contract size is 100 oz. Ø futures price is US$400 Ø margin requirement is US$2,000/contract (US$4,000 in total) Ø maintenance margin is US$1,500/contract (US3,000 in total) Ø when your balance goes below $3,000 you have to replenish the initial margin Futures Price Quotes Open interest: the total number of contracts outstanding is equal to the number of long or short positions. Indicates liquidity of the contract Settlement Price: the price just before the final bell each day. This is used for the daily settlement process Volume of trading: the number of trades in 1 day. Convergence of Futures Price to Spot Price As futures approaches expiration, futures price converges to the spot price. Otherwise there s an arbitrage opportunity. Example: Assume futures is above the spot at maturity FT>ST Sell overvalued security and buy undervalued one Arbitrageurs sell (short) a futures contract, buy the asset, and make the delivery This continues until prices are equal (subject to transaction costs) Forward Contracts A forward contract is an OTC agreement to buy or sell a certain quantity of a certain asset at a certain time in the future for a certain price Forward contracts are very similar to futures except that they trade in the OTC market Profit/loss profiles are the same as for futures There is NO daily settlement. At the end of the life of the contract one party buys the asset for the agreed price from the other party Forward contracts are (more) popular on currencies and interest rates Forward vs. Futures Contracts Private contract between two parties (OTC) v traded on the exchange Not standardised v standardised Usually one specified delivery date v range of delivery dates Settled at end of contract v settled daily Delivery or final settlement usual v usually closed out prior to maturity Some credit risk v virtually no credit risk/counterparty risk