Derivatives: Future

Financial & Commodity

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Derivatives

Derivative is a financial instrument whose value depends on /is derived from the value of some other financial instrument, called the underlying asset

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INTRODUCTION
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded

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Standardized contract Standard underlying instrument Standard quantity and quality Standard timing of such settlement (The date and the month of delivery)

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Structure of a futures contract:

Seller (has short position) is obligated to deliver the commodity or a financial instrument to the buyer (has long position) on a specific date This date is called settlement, or delivery , date

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Example

A sells the futures contract of Reliance Industries stock to B. Quantity is 200 shares, price is Rs. 3200 and the expiry date is 3 months away. Now, after 3 months, irrespective of the market price of the stock of Reliance Industries, A would deliver 200 shares of Reliance Industries to B at Rs. 3200.

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 In futures trading, this is done through the clearing corporation

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TERMINOLOGY
Spot price: The price at which an underlying asset trades in the spot market. Futures price: The price that is agreed upon at the time of the contract for the delivery of an asset at a specific future date Contract cycle: It is the period over which a contract trades. Expiry date: is the date on which the final settlement of the contract takes place. Contract size: The amount of asset that has to be delivered under one contract. This also called as the lot size.
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 Basis: Basis is defined as the futures price minus the spot price. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

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 2,125.70 (spot price)

Prev. Close Open 2,164.70 Low 2,115.15 Close 2122.85 High 2,171.35 2,164.70

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Traded Volume (contracts) Traded Value (lacs) Underlying value Market Lot Open Interest

34,346 91,523.50 2,119.50 125 39,56,000

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Evolution
Bombay Cotton Trade Association in Calcutta in 1875. Future trading in oil seeds was started with the setting up of Gujrati Vyapari Mandali in 1900. Future market in Bullion began at Mumbai in 1920. In 1952 Govt. passed the Forward contract Regulation Act which controls forward & future contracts. During 1960-1970 govt. suspended trading in several commodities. Two committees were appointed

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Traders in future market

Hedger Speculators Arbitragers

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Arbitragers

Riskless trding

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Speculators

An investor who is willing to take a risk by taking future position with the expectation to earn profit Forecast the future economic condition 7 decide which position to be taken that will yield profit if forecast is realized.
Fundamental analyst Technical analyst

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DERIVATIVE
A derivative is a financial instrument that derives or gets it value from some real good or stock.
It is in its most basic form simply a contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date.

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DERIVATIVE
Derivatives offer the same sort of leverage or multiplication as a mortgage. For a small amount of money, the investor can control a much larger value of company stock then would be possible without use of derivatives. This can work both ways, though. If the investor purchasing the derivative is correct, then more money can be made than if the investment had been made directly into the company itself. However, if the investor is wrong, the losses are multiplied instead.

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DERIVATIVE
Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. hedge risks; reflect a view on the future behavior of the market, speculate; lock in an arbitrage profit; change the nature of a liability; change the nature of an investment;

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HEDGING & SPECULATION

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging.

Derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

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HEDGING
Wheat

Wheat Farmer

Forward Contract Cash

Miller

Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat.

there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract.

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HEDGING
Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract.

The individual or institution has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract.

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SPECULATION
Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.

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EXAMPLE 1 (SOURCES OF RISK)

Suppose that a British investor holds a number of 10 year US T-Notes, and wants her investment to expire on the 1st December 01. The face value of the notes is $10m, and at the current market prices they are worth $10.38m. The exchange rate today is 1.4726$ / . Therefore, if she decides to liquidize the notes now, the investor would receive $ 7.049m. There are two sources of risk in this setting: Exchange rate risk and interest rate risk.

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EXAMPLE 2 (EXCHANGE RATE RISK)

The British pound might keep rising against the dollar. This is illustrated in figure. In this case, the value of the investment will decline. The investor examines the futures markets, and observes that the quote for a $ / Pounds exchange rate future that expires on the 1st December 01 is 1.4834$ / Pounds. By selling futures worth $10.38m she will ensure a payment of

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EXAMPLE 2 (EXCHANGE RATE RISK)

The above does not describe the perfect hedge position! Since the investor keeps the money in the 10y note until next year, she will enjoy the interest and the possible coupons, offered through that year. The right amount to be converted would be the one that will include those payments. But what is this value? The actual value of the notes will depend on the short rates that will be in place next year. This gives rise to the interest rate risk.

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EXAMPLE 3 (INTEREST RATE RISK)

If the US rates go up during the next year, the value of the investment will decline -the bond prices will fall. How can the investor hedge against this kind of risk? By selling TNote futures. Setting up the portfolio for this hedge is not as easy for the investor as it sounds. Unlike the FX futures contract, there is no 10y T-Note futures contract available that expires on the 1st Dec 01. She investigates a bit more and collects some similar instruments that might be helpful: these are described in the following table.

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EXAMPLE 3 (INTEREST RATE RISK)

Unfortunately, the instruments on the 10y TNote do not have the appropriate maturity, whereas the instruments that have the correct maturity have a different underlying. Using the 30y T-Bond will not hedge perfectly, the risk that remains from such situations is called the basis risk.

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TYPES OF DERIVATIVES
Over-the-counter (OTC) derivatives Exchange-traded derivatives (ETD)

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OVER-THE-COUNTER (OTC) DERIVATIVES

These are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary.
Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties.

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EXCHANGE-TRADED DERIVATIVES (ETD)

These are those derivatives products that are traded via specialized derivatives exchanges or other exchanges.

A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee.

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DERIVATIVE CONTRACT TYPES

Forwards/Futures Options Swaps

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FORWARDS/ FUTURES
Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardized contract written by the parties themselves.

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FORWARD CONTRACTS
The most basic forward contract. It is a contract negotiated between two parties for the delivery of a physical asset (e.g., oil or gold) at a certain time in the future for a certain price fixed at the inception of the contract. No actual transfer of ownership occurs in the underlying asset when the contract is initiated. Instead, there is simply an agreement to transfer ownership of the underlying asset at some future delivery date.

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FORWARD CONTRACTS EXAMPLE

Seller

100 OUNCES $ 400/OZ The party that has agreed to buy has a long position. The party that has agreed to sell has a short position.

Buyer

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Seller

FUTURE CONTRACTS
It is essentially a forward contract that is traded on an organized financial exchange

EXCHANGE

Buyer

Futures markets began with grains, such as corn, oats, and wheat, as the underlying asset. Financial futures are futures contracts based on a financial instrument or financial index. Foreign currency futures are futures contracts calling for the delivery of a specific amount of a foreign currency at a specified future date in return for a given payment of U.S. dollars. Interest rate futures take a debt instrument, such as a Treasury bill (T-bill) or Treasury bond (T-bond), as their underlying financial instrument.
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FUTURE CONTRACTS
With these kinds of contracts, the trader must deliver a certain kind of debt instrument to fulfill the contract. In addition, some interest rate futures are settled with cash. Financial futures also trade based on financial indexes. For these kinds of financial futures, there is no delivery, but traders complete their obligations by making cash payments based on changes in the value of the index.

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FUTURE & FORWARD

A futures contract is a forward contract traded on an organized exchange. Biggest problems traders face in using forward contracts: credit risk exposure the difficulty of searching for trading partners, the need for an economical means of exiting a position prior to contract termination

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CREDIT RISK EXPOSURE

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CREDIT RISK EXPOSURE

Marking to market creates a difference in the way futures and forward contracts allow traders to lock in prices. With a forward contract, the price of the asset exchanged at delivery is simply the price specified in the contract. With a futures contract, the buyer pays and the seller receives the spot price prevailing at the delivery date.

If this is so, then how is the price locked in?

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CREDIT RISK EXPOSURE

The gains and losses on a futures position are recognized daily so that over the life of the futures contract the accumulated profits or lossescoupled with the spot price at deliveryyield a net price corresponding with the futures price quoted at the time the futures position was established. Futures exchanges use a clearinghouse to serve as the counterparty to all transactions.

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SEARCHING PARTNERS
A second problem with a forward contract is that the heterogeneity of contract terms makes it difficult to find a trading partner.

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EXITING A POSITION
A third and related problem with a forward contract is the difficulty in exiting a position, short of actually completing delivery.

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DIFFERENCES BETWEEN FORWARDS & FUTURES CONTRACTS

Forwards Futures

Primary market
Secondary market Contracts Delivery

Dealers
None Negotiated Contracts expire

Organized Exchange
the Primary market Standardized Rare delivery

Collateral
Credit risk Market participants

None
Depends on parties Large firms

Initial margin, markthe-market

None [Clearing House] Wide variety
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OPTIONS

An option is the right to buy or sell, for a limited time, a particular good at a specified price.
For example, if IBM is selling at $120 and an investor has the option to buy a share at $100, this option must be worth at least $20, the difference between the price at which you can buy IBM ($100) through the option contract and the price at which you could sell it in the open market ($120).

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OPTIONS

Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset.
The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date.

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OPTIONS

Options give the party with the long position one extra degree of freedom: she can exercise the contracts if she wants to do so; whereas the short party have to meet the delivery if they are asked to do so. This makes options a very attractive way of hedging an investment, since they can be used as to enforce lower bounds on the financial losses. In addition, options offer a very high degree of gearing or leverage, which makes them attractive for speculative purposes too.

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OPTIONS

Prior to 1973, options of various kinds were traded over-the-counter.

In 1973, the Chicago Board Options Exchange (CBOE) began trading options on individual stocks. Since that time, the options market has experienced rapid growth, with the creation of new exchanges and many kinds of new option contracts.

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CALL AND PUT OPTIONS

call option gives the owner the right to buy a particular asset at a certain price, with that right lasting until a particular date. Ownership of a put option gives the owner the right to sell a particular asset at a specified price, with that right lasting until a particular date.

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SWAPS

Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

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THE MARKET PARTICIPANTS

Three kinds of dealers engage in market activities: Hedgers speculators Arbitrageurs
Each type of dealer has a different set of objectives

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HEDGERS

Hedging includes all acts aimed to reduce uncertainty about future [unknown] price movements in a commodity, financial security or foreign currency. This can be done by undertaking forward or futures sales or purchases of the commodity security or currency in the OTC forward or the organized futures market. Alternatively, the hedger can take out an option which limits the holder's exposure to price fluctuations.

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SPECULATORS
Speculation involves betting on the movements of the market and try to take advantage of the high gearing that derivative contracts offer, thus making windfall profits. In general, speculation is common in markets that exhibit substantial fluctuations over time. Normally, a speculator would take a ``bullish'' or ``bearish'' view on the market and engage in derivatives that will profit her if this view materializes. Since in order to buy, say, a European call option one has to pay a minute fraction of the possible payoffs, speculators can attempt to materialize extensive profits.

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ARBITRAGE
In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: Striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit.

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ARBITRAGEURS
A person who engages in arbitrage is called an arbitrageursuch as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

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