Introduction to Derivatives (1)

Definition of derivatives

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset

Introduction to Derivatives (2)

Common types: Futures Forward Forward Swap Underlying asset Agricultural products, poultry, mining resources, currency, financial instruments (interest rate, index), carbon, etc

Introduction to Derivatives (3)

Type of Trader Hedger : reduce risk from potential future movement Speculator : bet on the future direction for gain Arbitrageur : take offsetting positions in two or more instruments to lock in profit

Introduction to Derivatives (4)

Important Terms Spot price : the price for immediate delivery Future price : price for delivery some time in the future Long future position: someone who agreed to buy Short future position: someone who agreed to sell

Future Markets (1)

Definition : An agreement to buy or sell an asset at a certain in the future for a certain price Referred to by its delivery month, i.e. July corn futures contracts = contract of buying / selling corn for July delivery Most of futures contracts is not delivered but close out position prior to delivery period

Future Markets (2)

Closing position : enter opposite trade to the original one

that opened the position ie. May 6 : long 5 July 12 corn futures contract July 20 : short (selling) 5 July 12 corn future

Future Markets (3)

Specification of Future Contract Specific asset, contract size, place and time of delivery Will be determined by the Exchange before the contract traded Contract size must be big enough to cover admin cost but small enough to attract small hedger Delivery time: usually the whole month, with certain max delivery date

Future Markets (4)

Convergence of future price to spot price as delivery time approached, future price converge to spot price i.e. in delivery date if future price > spot price, arbitrager will :

Sell (short) a future contract, buy the asset, make delivery Will do that continuously until future price decline same to spot price

Future Markets (5)

The operation of Margin Margin needed to cease out credit risk Margin account : account to hold the margin deposit Initial margin : amount must be deposited 1st time Daily settlement / marking to market: practice to revaluing an instrument to reflect the current value Margin call , maintenance margin

Future Markets (6)

Example: June 5, buy 2 Dec gold future contract Price : $ 900 / ounce 1 contract size : 100 ounce. Total = 200 ounce Initial margin : $2000/contract Maintenance margin : 75% from initial margin / contract

Future Market (7)

Day Future Price 900 Jun 5 897 (600) (600) Daily gain / loss Cumulative gain/loss Margin acc balance 4000 3400 Margin call

Jun 6
Jun 9 Jun 10 Jun 11 Jun 12 Jun 13

896.10
898.20 897.10 896.70 895.40 893.30

(180)
420 (220) (80) (260) (420)

(780)
(360) (580) (660) (920) (1340)

3220
3640 3420 3340 3080 2660 1340

Jun 16
Jun 17

893.60
891.80

60
(360)

(1280)
(1640)

4060
3700

Future Market (8)

Clearing House Intermediary in future transactions Guarantees each parties to fulfill its obligations Deals with brokers Brokers must maintain margin account with clearing house = clearing margin Daily settlement to fulfill original margin everyday

Future Market (9)

Quotation Price Settlement Price Open interest : total number of contracts outstanding

Future Market (10)

Delivery Most contracts close out early Delivery might be taken place by hedger, but maybe expensive Decided by seller (short position) Seller notify broker which notify clearing house which notify buyer (long position) First day of notice day : first day notice can be submitted to exchange

Future Market (11)

Last notice day: last day notice can be submitted to

exchange Last trading day: usually a few days before last notice day To avoid risk of having to take delivery, long position trader must close position before first notice day

Future Market (12)

Cash settlement For financial futures (interest rate, stock index) are settled in cash because inconvenient / impossible to deliver

Forward Contract
Forward contract: Agreement to buy or sell an asset at a certain time in the future for a certain price Similar to future contracts Traded in the over-the-counter market : telephone-andcomputer linked network of dealers Typically entered by two financial institutions or financial institutions and one of its client

Forward Market (2)

Exposed to credit risk Very popular for the foreign exchange The contract size, delivery date and price according to

mutual agreement The profit / loss of forward and futures contract should be similar, otherwise arbitrage will occur Size of forward market can be 10x compared to futures market

Forward Market (3)

Forward Private contract between 2 parties
Not standardize Usually one specific delivery date Settled on end of contract Delivery / final cash settlement usually takes place Some credit risk

Futures Traded on Exchange

Standardize contract Range of delivery date Settled daily Contract usually closed out prior to maturity Virtually no credit risk