2. DERIVATIVES
• A financial contract of pre-determined duration,
whose value is derived from the value of an
underlying asset
• The asset may be:-
Securities
commodities
bullion
precious metals
currency
livestock
index such as interest rates, exchange rates , etc
3. What do derivatives do?
Minimize the loss
• arising from adverse price movements
of the underlying asset
Maximize the profits
• arising out of favorable price
fluctuation.
8. Forward Contracts
• A one to one bipartite contract, which is to be
performed in future at the terms decided
today.
• Product ,Price ,Quantity & Time have been
determined in advance by both the parties.
• Delivery and payments will take place as per
the terms of this contract on the designated
date and place.
9. Options
• An option is a contract giving the buyer the
right, but not the obligation, to buy or sell an
underlying asset at a specific price on or
before a certain date.
• An option is a security, just like a stock or
bond, and is a binding contract with strictly
defined terms and properties.
10.
11. Future Contracts
Standardized contract between two parties
Exchange of a specified asset
Standardized quantity and quality
Price agreed today
Delivery occurring at a specified future date
12. Key Elements of Futures
Underlying
Asset
Settlement or
Delivery Date
Futures price
13. Content of a Future Contract
Whether the trader wants to buy or sell
The name of the commodity
The delivery month and year of the contract
The number of contracts
The exchange on which they trade
Day order or “good-til-canceled” order
Market or limit order; if a limit order, then specify a
limit price
14. Positions in a futures contract
• this is when a person buys a futures
contract, and agrees to receive delivery
at a future date.
• this is when a person sells a futures
contract, and agrees to make delivery.
15. Futures v/s Forwards
Forward Future
Contract with Bank Exchange
Contract size (N) Flexible Standard
Maturity Date Usually 90-360 days Specified
from origination calendar dates
Margin Negotiable Fixed
Cash flows prior 0 Daily mark to
to expiration market
16. Forward Versus Futures
COMPARISON FORWARD FUTURES
Trade on organized exchanges No Yes
Use standardized contract terms No Yes
Use associate clearinghouses to
No Yes
guarantee contract fulfillment
Require margin payments and daily
No Yes
settlements
Close easily No Yes
Regulated by identifiable agencies No Yes
Any quantity Yes No
Any product Yes No
Chapter 1 16
17. Forwards vs. Futures
Advantages/Disadvantages
Smaller
contract
Disadvantages:-
size
Currencies available
Little limited
Easy
default Advantages liquidation
risk.
Limited dates of delivery
Well-
organized
and stable
market. Rigid contract sizes.
18. DIFFERENCE BETWEEN FUTURES
& OPTIONS
FUTURES OPTIONS
Futures contract is an agreement to In options the buyer enjoys the right
buy or sell specified quantity of the and not the obligation, to buy or sell
underlying assets at a price agreed the underlying asset.
upon by the buyer and seller, on or
before a specified time. Both the
buyer and seller are obliged to
buy/sell the underlying asset.
Unlimited upside & downside for both Limited downside (to the extent of
buyer and seller. premium paid) for buyer and unlimited
upside. For seller (writer) of the
option, profits are limited whereas
losses can be unlimited.
Futures contracts prices are affected Prices of options are however, affected
mainly by the prices of the underlying by a)prices of the underlying asset,
asset b)time remaining for expiry of the
contract and c)volatility of the
underlying asset.
19. How does one make money in a
futures contract?
Long • when the underlying
assets price rises above
Position the futures price.
Short • when the underlying
asset’s price falls below
Position the futures price.
20. Payoffs for futures contracts
Payoff F0 = Contract price at time 0
Payoff
F1 = Future price at time 1
F1 Sell futures
Buy futures
0 F 0 F
F0 F0
-F1
Gain if interest rates Gain if interest rates
fall and prices rise of rise and prices fall of
debt securities. debt securities.
22. Major Futures Exchange
Major Futures Exchanges in the World for 2003
EXCHANGE 2003 Volume Top 20 %
(Futures Only) Volume
Eurex (Germany) 668,650,028 24.55
Chicago Mercantile Exchange (USA) 530,989,007 19.49
Chicago Board of Trade (USA) 373,,669,290 13.72
Euronext-Liffe (Netherlands) 273,121,004 10.03
Mexican Derivatives Exchange (Mexico) 173,820,944 6.38
Bolsa de Mercadorias e Futuros (Brazil) 113,895,061 4.18
New York Mercantile Exchange (USA) 111,789,658 4.10
Tokyo Commodity Exchange (Japan) 87,252,219 3.20
London Metals Exchange (UK). 68,570,154 2.52
Korea Stock Exchange (South Korea) 62,204,783 2.28
Sydney Futures Exchange (Australia) 41,831,862 1.54
National Stock Exchange of India (India) 36,141,561 1.33
SIMEX (Singapore) 35,356,776 1.30
International Petroleum Exchange (UK) 33,258,385 1.22
OM Stockholm (Sweden) 22,667,198 .83
Tokyo Grain Exchange (Japan) 21,084,727 .77
New York Board of Trade (USA) 18,822,048 .69
Bourse de Montreal (Canada) 17,682,999 .65
MEFF Renta Variable (Spain) 17,109,363 .63
Tokyo Stock Exchange (Japan) 15,965,175 .59
Total Top 20 2003 Futures Volume 2,723,882,242 100%
Source: Futures Industry Association.
23. Clearinghouses
1. Guarantee that the traders will honor their obligations
(solves issues of trust).
2. Each trader has obligations only to the clearinghouse,
not to other traders.
3. Each exchange uses a futures clearinghouse.
4. Clearinghouses may be part of a futures exchange
(division), or a separate entity.
5. Due to 2000 CFMA, clearing arrangements vary across
industries.
6. Clearinghouses are “perfectly hedged” by maintaining
no futures market position of their own.
Chapter 1 23
24. Clearing houses
Guarantee that the traders will honor their
obligations
Each trader has obligations only to the
clearinghouse, not to other traders.
Each exchange uses a futures clearinghouse.
Clearinghouses may be part of a futures exchange,
or a separate entity.
clearing arrangements vary across industries.
Clearinghouses are “perfectly hedged” by
maintaining no futures market position of their own.
25. Major Futures Clearing Organizations
Table 1.7
Major Futures Clearing Organizations
Clearinghouse Affiliated Exchanges
The Clearing Corporation (CCorp) US Futures Exchange and the
Merchants Exchange of St. Louis
Chicago Mercantile Exchange Chicago Mercantile exchange
Clearinghouse With clearing link to CBOT
Kansas City Board of Trade Clearing Kansas City Board of Trade
Corporation
Energy Clear Corporation Exempt Commercial Markets
MGE Clearinghouse Minneapolis Grain Exchange
NYMEX Clearinghouse New York Mercantile Exchange
New York Clearing Corporation New York Board of Trade
The Options Clearing Corporation OneChicago, NQLX, & option
exchanges
The London Clearinghouse
Exempt Commercial Markets and OTC
markets
Sources: The CFTC web site, www.cftc.gov.
Chapter 1 25
27. Complications in using
financial futures
Accounting and regulatory guidelines.
Macro hedge of the bank’s entire portfolio -- cannot defer gains and
losses on futures, so earnings are less stable with this hedge strategy.
Micro hedge linked to a specific asset -- can defer gains and losses on
futures until contracts mature.
difference between the cash and futures prices are not normally
perfectly correlated
