Financial Markets & Institutions Introduction to derivatives. Futures and forwards. Slides by Emilia Garcia-Appendini
The Nature of Derivatives A derivative is an instrument whose value depends on the values of other variables Examples: Futures contracts Forward contracts Options Swaps Credit derivatives
How derivatives are used To hedge risks Reduce risks from potential future movements in a market variable To speculate To bet on the future direction of a market variable To lock in an arbitrage profit Take offsetting positions in two instruments of same risk level but different prices To change the nature of an asset or a liability For example, its duration
Futures Contracts A futures 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)
Futures Contracts (cont) Available on a wide range of underlying assets Traded in an exchange The contract terms are standardized by the exchange Specifications need to be defined: Exactly what can be delivered, The contract size (i.e. how much of the asset will be delivered d in one contract) t) Where it can be delivered, & When it can be delivered
Some future exchanges Chicago Board of Trade (CBT) Chicago Mercantile Exchange (CME) London International Financial Futures Exchange (LIFFE) Mercato Italiano dei Futures (MIF) Mercado Español de Futuros y Forwards (MEFF) Europe Exchange (Eurex); Euronext Bolsa de Mercadorias y Futuros (BM&F, Sao Paulo, Brazil) Tokyo International Financial Futures Exchange (TIFFE, Tokyo)
Example: Orange Juice futures contract of the NY Cotton Exchange US Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than 13 to 1 and not more than 19 to 1, with factors of color and flavor each scoring 37 points or higher and 19 for defects, with a minimum score of 94.
Example: CBT Interest rate futures T-bond Underlying asset: Any long-term US Treasury bond that has a maturity of greater than 15 years and is not callable within 15 years Instruments must have a face value of $100 000
Interest rate futures quotes from the WSJ (Columns show month, open, high, low, settle, change, lifetime low, and open interest, respectively)
Terminology The party that has agreed to buy has a long position The party that has agreed to sell has a short position
Example January: an investor enters into a long futures contract on COMEX (Commodity Exchange, NY) for 100 oz of gold @ $300 in April April: the price of gold is $315 per oz What is the investor s profit? Answer: $15/oz x 100oz= $1500
Profits/Losses from a Long Futures Position Profit Agreed price Price of Underlying at Maturity
Profits/Losses from a Short Futures Position Profit Agreed price Price of Underlying at Maturity
What happens in an exchange Exchanges provide a mechanism for people who want to buy or sell assets in the future to trade with each other Example: In March, a NY investor wants to buy 5000 bushels of corn to be delivered in July The investor s broker communicates these instructions to the CBOT At the same time, an investor in Kansas issues instructions ti to sell 5000 bushels of corn for July Instructions passed on to CBOT The price of the futures contract will be determined by supply and demand
How trades are done in an exchange Traditionally futures 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
Futures contracts: in practice The vast majority of futures contracts that are initiated do not lead to delivery Reason: It is costly to take delivery in the terms of a futures contract Investors typically close out their positions prior to delivery To close out a position, enter in an offsetting one. For example: If on April you entered a long position for 4 July crude futures contracts, you would close out your position on June by shorting 4 July crude futures contract
Delivery If a futures 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. Af few contracts t (for example, those on stock indices and Eurodollars) are settled in cash
Futures contracts and credit risk: Margins Futures contracts are protected against default by 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 If future price moves against investor s position, the margin balance is reduced by the same amount If the margin account diminishes to a given threshold ( maintenance margin ), investor is asked to inject new funds ( margin call )
Example of a Margin Account An investor takes a long position in 2 December gold futures contracts on June 5 contract size is 100 oz. futures price is US$400 / oz margin requirement is US$2,000/contract (US$4,000 in total) maintenance margin is US$1,500/contract (US$3,000 in total)
The margin account
Convergence of futures to spot As the delivery month of a futures contract t is approached, the futures price converges to the spot price of the underlying asset When the delivery date is reached, the futures price equals the spot price Case (a): If at delivery date the futures price F were above the spot price S, an investor could: Sell a futures contract and collect F Buy the asset and pay S Deliver the purchased asset. Total earnings: F-S
Convergence of futures to spot (cont) All investors would detect the same arbitrage opportunity The increased demand for spot asset in case would reduce the spot price The decreased d demand d for the futures would increase the futures price The process of increase/decrease of prices would stop when F=S A similar mechanism would operate if at delivery date the futures price F were below the spot price S (Case b). In this case, investors would: Buy a futures contract and pay F Get the asset delivered Sell the asset and collect S Total earnings: S-F>0
Convergence of futures to spot (cont) Futures Price Spot Price Spot Price Futures Price (a) Time (b) Time
Widely Traded Financial Futures Contracts
Widely Traded Financial Futures Contracts
Forward Contracts A forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a certain price Forward contracts are similar to futures except that they trade in the over-the-counter t market They are private agreements between two parties At the end of the life of the contract one party buys the asset for the agreed price from the other party Usually there is no daily settlement (no margin account), hence credit risk may be an issue
Over-the Counter Markets The over-the counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are recorded to avoid disputes Trades are usually between financial institutions, corporate treasurers, and fund managers
Collateralization in OTC Markets The OTC market is beginning to imitate the margining system with collateralization Under a collateralization agreement, OTC contracts are valued regularly with a pre-agreed valuation Suppose company A and company B have an OTC contract If the value increases from one day to the other for company A, then company B must pay a collateral equal to this increase and company A receives this increase
Forward vs Futures Contracts FORWARDS Private contract between 2 parties Not standardized FUTURES Exchange traded Standard contract Usually 1 specified delivery date Settled at maturity Delivery or final cash settlement usually occurs Range of delivery dates Settled daily Contract usually closed out prior to maturity Some credit risk Virtually no credit risk
Spot and forward quotes for the USD/GDP exchange rate Bid (Buy) Offer (Sell) Spot 1.6281 1.6285 1-month forward 1.6248 1.6253 3-month forward 1.6187 1.6192 6-month forward 1.6094 1.6100
Profit from a Long Forward Position Profit Agreed price Price of Underlying at Maturity
Profit from a Short Forward Position Profit Agreed price Price of Underlying at Maturity