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High Liquidity
Most of the futures markets offer high liquidity, especially in case of currencies, indexes, and
commonly traded commodities. This allows traders to enter and exit the market when they
wish to.
Simple Pricing
Unlike the extremely difficult Black-Scholes Model-based options pricing, futures pricing is
quite easy to understand. It's usually based on the cost-of-carry model, under which the
futures price is determined by adding the cost of carrying to the spot price of the asset.
2. Explain theta and strategy for buying and selling based on theta
Theta is a measure of the rate of decline in the value of an option due to the passage
of time. It can also be referred to as an option's time decay. If everything is held constant,
the option loses value as time moves closer to the maturity of the option.
There are ways to profit from time decay. One of the most effective strategies that
aims to do this is the Iron Condor or individual credit spreads. These strategies give the
ability to capture time decay with a set amount of risk. The theta on the option sold will be
higher than the thetas on the option purchased.
3. Explain call-put parity
Put-call parity is a principle that defines the relationship between the price of
European put options and European call options of the same class, that is, with the same
underlying asset, strike price, and expiration date.
Put/call parity shows the relationship that has to exist between European put and
call options that have the same underlying asset, expiration, and strike prices.
Put/call parity says the price of a call option implies a certain fair price for the
corresponding put option with the same strike price and expiration (and vice versa).
When the prices of put and call options diverge, an opportunity for arbitrage exists,
enabling some traders to earn a risk-free profit.
where:
C = price of the European call option
PV(x) = the present value of the strike price (x), discounted from the value on the expiration
date at the risk-free rate
P = price of the European put
S = spot price or the current market value of the underlying asset
4. History of options
The very first account of options was mentioned in Aristotle's book named "Politics",
published in 332 B.C. Yes, Before Christ! That's how far back human has used the concept of
buying the rights to an asset without necessarily buying the asset itself, yes, an option or
what we call in finance as a "Contingent Claim". Aristotle mentioned a man named Thales of
Miletus who was a great astronomer, philosopher and mathematician. Yes, Thales was one
of the seven sages of ancient greece. By observing the stars and weather patterns, Thales
predicted a huge olive harvest in the year that follows. Understanding that olive presses
would be in high demand following such a huge harvest, Thales could turn a huge profit if he
owned all of the olive presses in the region, however, he didn't have that kind of money.
Instead, Thales thought of a brilliant idea. He used a small amount of money as deposit to
secure the use of all of the olive presses in the region, yes, a CALL OPTION with olive presses
as the underlying asset! As Thales expected, harvest was plentiful and he sold the rights to
using all of these olive presses to people who needed them, turning a big fortune.
By controlling the rights to using the olive presses through an option (even though he didn't
name it "option" then), Thales had the right to either use these olive presses himself when
harvest time came (exercising the options) or to sell that right to people who would pay
more for those rights (selling the options for a profit). The owners of the olive presses , who
obviously didn't know how the harvest is going to turn out, secured profits through the sale
of the "options" to Thales no matter how the harvest turned out. This contingency claim
procedure defined how options work since that day and started the long history of options
trading. In fact, the olive press owners could be deemed to be the first ever human to have
used a Covered Call options trading strategy! Yes, they owned the underlying asset (olive
presses in this case) and sold rights to using them, keeping the "premium" on the sale no
matter if the presses were eventually used or not!
5. Calendar spread
A calendar spread typically involves buying and selling the same type of option (calls
or puts) for the same underlying security at the same strike price, but at different (albeit
small differences in) expiration dates.
A calendar spread is an options or futures spread established by simultaneously
entering a long and short position on the same underlying asset at the same strike price but
with different delivery months. It is sometimes referred to as an inter-delivery, intra-market,
time, or horizontal spread.
6. Swaptions
A swaption is an option granting its owner the right but not the obligation to enter
into an underlying swap. Although options can be traded on a variety of swaps, the term
"swaption" typically refers to options on interest rate swaps.
Futures
Maximum number that can No limit to the number of futures contracts Set by corporate charter
be issued that can be issued. There are, however, position limits and position accountability in stock
index futures
Cash Flows In and out flows to traders’ accounts are May receive dividends
based on daily marking to market – a
debiting or crediting of each futures account
based on that day’s changes in the price of
the contract(s) held in each account
Ability to Sell Short Yes, as easily as buying long; no uptick in Permitted under special circumstances. A short sale can only be made
price necessary on an uptick – when the stock price has gone up a tick
Time Typically short term Typically, but not always, long term
Fixed maturity/expiration date, usually less Stocks are perpetual instruments so long as the underlying company
than one year remains solvent
Risk Depending on price changes, more than the If the stock is not bought on margin the most that can be lost is the
initial investment can be lost entire investment
9. Hedging and Arbitrage
Hedging and arbitrage both play important roles in finance, economics and
investments. Basically, hedging involves the use of more than one concurrent bet in
opposite directions in an attempt to limit the risk of serious investment loss. Meanwhile,
arbitrage is the practice of trading a price difference between more than one market for the
same good in an attempt to profit from the imbalance.
Each transaction involves two competing types of trades: betting short versus betting long
(hedging), and buying versus selling (arbitrage). Both are used by traders who operate in
volatile, dynamic market environments. Other than these two similarities, however, they are
very different techniques that are used for very different purposes.
With the proliferation of high-speed data and access to constant price information, arbitrage
is much more difficult in financial markets than it used to be. Still, arbitrage opportunities
can be found in several types of markets such as forex, bonds, futures and sometimes in
equities.
Hedging can take place almost anywhere, but it has become a particularly important aspect
of financial markets, business management and gambling. Much like any other risk/reward
trade, hedging results in lower returns for the party involved, but it can offer significant
protection against downside risk.
Barings Bank
Founded in 1762, Barings was among the largest and most stable banks in the world.
However, thanks to unauthorized speculation in futures contracts and other speculative
dealings, it ceased operations on February 26, 1995. The direct cause was its inability to
meet its cash requirements following those unauthorized trades. Even efforts by the Bank of
England to arrange a rescue package could not avert the inevitable collapse.
Leeson's reputation since then was one of a rogue trader, operating without
supervision or oversight. At the time of the loss, he was assigned to an arbitrage trade,
buying and selling Nikkei 225 futures contract in both the Osaka Securities Exchange in Japan
and the Singapore International Monetary Exchange, in Singapore. However, instead of
initiating simultaneous trades to exploit small differences in pricing between the two
markets, he held his contracts, hoping to make a larger profit by betting on directional
moves of the underlying index.
Making matters worse, Leeson hid is losses with accounting tricks. Had the bank discovered
this earlier, it would have taken large but not devastating losses and remained solvent.
Unfortunately, the firm was declared insolvent less than a week after Leeson's trading losses
were finally discovered. After this episode, Leeson was arrested and sentenced to six and
one-half years in a Singapore prison. However, he was released in 1999 after a diagnosis of
colon cancer.
KEY TAKEAWAYS
Barings Bank was a UK-based merchant banking firm that failed after a trader named Nick
Leeson engaged in a series of unauthorized and risky trades went sour in 1995.
Barings, having lost over one billion dollars (more than twice its available capital) went
bankrupt. Following the trading debacle, Leeson wrote his aptly titled Rogue Trader while
serving time in a Singapore prison.
The bank's assets were subsequently acquired by the Dutch ING Groep, forming ING Barings.
This subsidiary was later sold to ABN Amro in 2001.
Acquisition
The Dutch bank ING Group, purchased Barings Bank in 1995 for the nominal sum of £1.00,
assuming all of Barings' liabilities and forming the subsidiary ING Barings. A few years later,
in 2001, ING sold the U.S.-based operations to another Dutch bank, ABN Amro, for $275
million. ING's European banking division absorbed the rest of ING Barings.
The Barings name lived for a while in only in two divisions, both of which were subsidiaries
of other companies. Baring Asset Management (BAM) is now part of MassMutual. BAM's
Financial Services Group became part of Northern Trust, until taken private in 2016.
12. LIBOR
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which
major global banks lend to one another in the international interbank market for short-term
loans. LIBOR, which stands for London Interbank Offered Rate, serves as a globally accepted
key benchmark interest rate that indicates borrowing costs between banks. The rate is
calculated and published each day by the Intercontinental Exchange (ICE)
LIBOR is the average interest rate at which major global banks borrow from one
another. It is based on five currencies including the US dollar, the euro, the British pound,
the Japanese yen, and the Swiss franc, and serves seven different maturities—
overnight/spot next, one week, and one, two, three, six, and 12 months.
Each day, ICE asks major global banks how much they would charge other banks for
short-term loans. The association takes out the highest and lowest figures, then calculates
the average from the remaining numbers. This is known as the trimmed average. This rate is
posted each morning as the daily rate, so it's not a static figure. Once the rates for each
maturity and currency are calculated and finalized, they are announced/published once a
day at around 11:55 am London time by IBA.
LIBOR is also the basis for consumer loans in countries around the world, so it
impacts consumers just as much as it does financial institutions. The interest rates on
various credit products such as credit cards, car loans, and adjustable rate mortgages
fluctuate based on the interbank rate. This change in rate helps determine the ease of
borrowing between banks and consumers.
But there is a downside to using the LIBOR rate. Even though lower borrowing costs
may be attractive to consumers, it does also affect the returns on certain securities. Some
mutual funds may be attached to LIBOR, so their yields may drop as LIBOR fluctuates.
KEY TAKEAWAYS
LIBOR is the benchmark interest rate at which major global lend to one another.
LIBOR is administered by the Intercontinental Exchange which asks major global
banks how much they would charge other banks for short-term loans.
The rate is calculated using the Waterfall Methodology, a standardized, transaction-
based, data-driven, layered method.
13. MIBOR
The Mumbai Interbank Offer Rate (MIBOR) is one iteration of India's interbank rate, which is
the rate of interest charged by a bank on a short-term loan to another bank. As India's
financial markets have continued to develop, India felt it needed a reference rate for its debt
market, which led to the development and introduction of the MIBOR.
Banks borrow and lend money to one another on the interbank market in order to maintain
appropriate, legal liquidity levels, and to meet reserve requirements placed on them by
regulators. Interbank rates are made available only to the largest and most creditworthy
financial institutions.
KEY TAKEAWAY
MIBOR is calculated based on input from a panel of 30 banks and primary dealers, and it
represents India's interbank borrowing rate.
Understanding the Mumbai Interbank Offered Rate
MIBOR is calculated every day by the National Stock Exchange of India (NSEIL) as a weighted
average of lending rates of a group of major banks throughout India, on funds lent to first-
class borrowers. This is the interest rate at which banks can borrow funds from other banks
in the Indian interbank market.
The Mumbai Interbank Offer Rate (MIBOR) is modeled closely on LIBOR. The rate is used
currently for forward contracts and floating-rate debentures. Over time and with more use,
MIBOR may become more significant.
As of 18 May 2018, the scam has ballooned ₹14,356.84 crore (US$2.1 billion) and Nirav Modi
is said to be hiding in London, allegedly travelling on a fake passport.
Causes
Like many hedge funds, LTCM's investment strategies were based upon hedging against a
predictable range of volatility in foreign currencies and bonds. When Russia declared it was
devaluing its currency, it defaulted on its bonds. That event was beyond the normal range
that LTCM had estimated. The U.S. stock market dropped 20 percent, while European
markets fell 35 percent. Investors sought refuge in Treasury bonds, causing long-term
interest rates to fall by more than a full point.
As a result, LTCM's highly leveraged investments started to crumble. By the end of August
1998, it lost 50 percent of the value of its capital investments. Since so many banks and
pension funds had invested in LTCM, its problems threatened to push most of them to near
bankruptcy. In September, Bear Stearns dealt the deathblow. The investment bank managed
all of LTCM's bond and derivatives settlements. It called in a $500 million payment. Bear
Stearns was afraid it would lose all its considerable investments. LTCM had been out of
compliance with its banking agreements for three months.
18. CBOT
The Chicago Board of Trade (CBOT), established on April 3, 1848, is one of the
world's oldest futures and options exchanges. On July 12, 2007, the CBOT merged with the
Chicago Mercantile Exchange (CME) to form CME Group. CBOT and three other exchanges
(CME, NYMEX, and COMEX) now operate as designated contract markets (DCM) of the CME
Group.
The concerns of U.S. merchants to ensure that there were buyers and sellers for
commodities have resulted in forward contracts to sell and buy commodities. Still, credit risk
remained a serious problem. The CBOT took shape to provide a centralized location, where
buyers and sellers can meet to negotiate and formalize forward contracts.
In 1864, the CBOT listed the first ever standardized "exchange traded" forward contracts,
which were called futures contracts. In 1919, the Chicago Butter and Egg Board,[2] a spin-off
of the CBOT, was reorganized to enable member traders to allow future trading, and its
name was changed to Chicago Mercantile Exchange (CME). The Board's restrictions on
trading after hours on any prices other than those at the Board's close gave rise to the 1917
case Chicago Board of Trade v. United States, in which the U.S. Supreme Court held that the
Sherman Antitrust Act of 1890's language outlawing "every contract ... in restraint of trade"
was not to be taken literally, but rather should be interpreted under a "rule of reason."
On October 19, 2005, the initial public offering (IPO) of 3,191,489 CBOT shares was priced at
$54.00 (USD) per share. On its first day of trading the stock closed up +49% at $80.50 (USD)
on the NYSE.
In 2007, the CBOT and the Chicago Mercantile Exchange merged to form the CME Group.
In trading and investing, certain securities, such as futures and mutual funds, are
also marked to market to show the current market value of these investments.