Derivatives

ContentsArticlesDerivative (finance) Futures contract Forward contract Option (finance) Call option Put option Strike price Swap (finance) Interest rate derivative Foreign exchange derivative Credit derivative Equity derivative Warrant (finance) Foreign exchange option Gold as an investment Credit default swap Equity swap Property derivatives Freight derivative Inflation derivative 1 9 19 25 35 38 40 42 46 49 49 54 56 63 65 75 99 101 104 105

ReferencesArticle Sources and Contributors Image Sources, Licenses and Contributors 107 109

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Derivative (finance)

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Derivative (finance)In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linkedcalled the underlying asset[1] such as a share or a currency. There are many kinds of derivatives, with the most common being swaps, futures, and options. Derivatives are a form of alternative investment. A derivative is not a stand-alone asset, since it has no value of its own. However, more common types of derivatives have been traded on markets before their expiration date as if they were assets. Among the oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[2] Derivatives are usually broadly categorized by: the relationship between the underlying asset and the derivative (e.g., forward, option, swap); the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter); their pay-off profile. Another arbitrary distinction is between:[3] vanilla derivatives (simple and more common); and exotic derivatives (more complicated and specialized).

UsesDerivatives are used by investors to: provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative; speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level); hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out; obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives); create option ability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level).

HedgingDerivatives can be considered as providing a form of insurance in hedging, which is itself a technique that attempts to reduce risk. Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk. From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional

Derivative (finance) income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk. Hedging also occurs when an individual or institution buys an asset (such as 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 can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset. Derivatives can serve legitimate business purposes. For example, a corporation borrows a large sum of money at a specific interest rate.[4] The rate of interest on the loan resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money.[5] If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.

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Derivatives traders at the Chicago Board of Trade.

Speculation and arbitrageDerivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, 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 look 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. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[6]

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Types of derivativesOTC and exchange-tradedIn broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market: Over-the-counter (OTC) derivatives 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, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is US$684 trillion (as of June 2008).[7] Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform. Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange.[8] 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. The world's largest[9] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

Common derivative contract typesThere are three major classes of derivatives: 1. 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, whereas a forward contract is a non-standardized contract written by the parties themselves. 2. 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. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction.

Derivative (finance) 3. 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. More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.

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ExamplesThe overall derivatives market has five major classes of underlying asset: interest rate derivatives (the largest) foreign exchange derivatives credit derivatives equity derivatives commodity derivatives

Some common examples of these derivatives are:UNDERLYING Exchange-traded futures Equity DJIA Index future Single-stock future CONTRACT TYPES Exchange-traded options Option on DJIA Index future Single-share option Option on Eurodollar future Option on Euribor future OTC swap OTC forward OTC option

Equity swap

Back-to-back Repurchase agreement

Stock option Warrant Turbo warrant

Interest rate

Eurodollar future Euribor future

Interest rate swap Forward rate agreement Interest rate cap and floor Swaption Basis swap Bond option Credit default Repurchase agreement swap Total return swap Currency swap Currency forward Credit default option

Credit

Bond future

Option on Bond future

Foreign exchange Currency future

Option on currency future

Currency option

Commodity

WTI crude oil futures

Weather derivatives

Commodity swap Iron ore forward contract

Gold option

Other examples of underlying exchangeables are: Property (mortgage) derivatives Economic derivatives that pay off according to economic reports[10] as measured and reported by national statistical agencies Freight derivatives Inflation derivatives Weather derivatives Insurance derivatives Emissions derivatives[11]

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ValuationMarket and arbitrage-free pricesTwo common measures of value are: Market price, i.e., the price at which traders are willing to buy or sell the contract; Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts; see rational pricing.

Determining the market price

For exchange-traded derivatives, market price is usually transparent (often published in real time by the exchange, based on all the current bids and offers placed on that particular contract at any one time). Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.

[12] Total world derivatives from 1998-2007 compared to total world wealth in the year [13] 2000

Determining the arbitrage-free priceThe arbitrage-free price for a derivatives contract is complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. The stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the BlackScholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model. OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the theoretical valuation. And most of the model's results are input-dependant (meaning the final price depends heavily on how we derive the pricing inputs).[14] Therefore it is common that OTC derivatives are priced by Independent Agents that both counterparties involved in the deal designate upfront (when signing the contract).

CriticismDerivatives are often subject to the following criticisms:

Possible large lossesThe use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as: The need to recapitalize insurer American International Group (AIG) with US$85 billion of debt provided by the US federal government.[15] An AIG subsidiary had lost more than US$18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written.[16] It was reported that the recapitalization was

Derivative (finance) necessary because further losses were foreseeable over the next few quarters. The loss of US$7.2 Billion by Socit Gnrale in January 2008 through mis-use of futures contracts. The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted. The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998. The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.[17] The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[18]

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Counter-party riskSome derivatives (especially swaps) expose investors to counter-party risk. For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate. Different types of derivatives have different levels of counter-party risk. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; banks that help businesses swap variable for fixed rates on loans may do credit checks on both parties. However, in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Large notional valueDerivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. (See Berkshire Hathaway Annual Report for 2002) [19]

Leverage of an economy's debtDerivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression. (See Berkshire Hathaway Annual Report for 2002)

BenefitsThe use of derivatives also has its benefits: Derivatives facilitate the buying and selling of risk, and many people consider this to have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility.

Derivative (finance) Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

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Government regulationIn the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary Gensler, the chairman of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into derivatives, too. The departments antitrust unit is actively investigating 'the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,' according to a department spokeswoman."[20]

Definitions Bilateral netting: A legally enforceable arrangement between a bank and a counter-party that creates a single legal obligation covering all included individual contracts. This means that a banks obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement. Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default swaps, credit linked notes and total return swaps. Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof. Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures contracts and options) that are transacted on an organized futures exchange. Gross negative fair value: The sum of the fair values of contracts where the bank owes money to its counter-parties, without taking into account netting. This represents the maximum losses the banks counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counter-parties. Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money by its counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral. High-risk mortgage securities: Securities where the price or expected average life is highly sensitive to interest rate changes, as determined by the FFIEC policy statement on high-risk mortgage securities. Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional. Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted off organized futures exchanges. Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more indices and / or have embedded forwards or options. Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with non-cumulative dividends, retained earnings, and minority interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt, intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a banks allowance for loan and lease losses.

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References[1] McDonald, R.L. (2006) Derivatives markets. Boston: Addison-Wesley [2] Kaori Suzuki and David Turner (December 10, 2005). "Sensitive politics over Japan's staple crop delays rice futures plan" (http:/ / www. ft. com/ cms/ s/ 0/ d9f45d80-6922-11da-bd30-0000779e2340. html). The Financial Times. . Retrieved October 23, 2010. [3] Taylor, Francesca. (2007). Mastering Derivatives Markets. Prentice Hall [4] Chisolm, Derivatives Demystified (Wiley 2004) [5] Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal. [6] News.BBC.co.uk (http:/ / news. bbc. co. uk/ 2/ hi/ business/ 375259. stm), "How Leeson broke the bank - BBC Economy" [7] BIS survey: The Bank for International Settlements (BIS) semi-annual OTC derivatives statistics (http:/ / www. bis. org/ statistics/ derstats. htm) report, for end of June 2008, shows US$683.7 billion total notional amounts outstanding of OTC derivatives with a gross market value of US$20 trillion. See also Prior Period Regular OTC Derivatives Market Statistics (http:/ / www. bis. org/ publ/ otc_hy0805. htm). [8] Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ : Pearson/Prentice Hall, c2009 [9] Futures and Options Week: According to figures published in F&O Week 10 October 2005. See also FOW Website (http:/ / www. fow. com). [10] "Biz.Yahoo.com" (http:/ / biz. yahoo. com/ c/ e. html). Biz.Yahoo.com. 2010-08-23. . Retrieved 2010-08-29. [11] FOW.com (http:/ / www. fow. com/ Article/ 1385702/ Issue/ 26557/ Emissions-derivatives-1. html), Emissions derivatives, 1 December 2005 [12] "Bis.org" (http:/ / www. bis. org/ statistics/ derstats. htm). Bis.org. 2010-05-07. . Retrieved 2010-08-29. [13] "Launch of the WIDER study on The World Distribution of Household Wealth: 5 December 2006" (http:/ / www. wider. unu. edu/ events/ past-events/ 2006-events/ en_GB/ 05-12-2006/ ). . Retrieved 9 June 2009. [14] Boumlouka, Makrem (2009),"Alternatives in OTC Pricing", Hedge Funds Review, 10-30-2009. http:/ / www. hedgefundsreview. com/ hedge-funds-review/ news/ 1560286/ otc-pricing-deal-struck-fitch-solutions-pricing-partners [15] Derivatives Counter-party Risk: Lessons from AIG and the Credit Crisis (http:/ / www. compoundinghappens. com/ opinion/ DerivativesCounterPartyRisk. htm) [16] Kelleher, James B. (2008-09-18). ""Buffett's Time Bomb Goes Off on Wall Street" by James B. Kelleher of Reuters" (http:/ / www. reuters. com/ article/ newsOne/ idUSN1837154020080918). Reuters.com. . Retrieved 2010-08-29. [17] Edwards, Franklin (1995), "Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft" (http:/ / www0. gsb. columbia. edu/ faculty/ fedwards/ papers/ DerivativesCanBeHazardous. pdf), Derivatives Quarterly (Spring 1995): 817, [18] Whaley, Robert (2006). Derivatives: markets, valuation, and risk management (http:/ / books. google. com/ books?id=Hb7xXy-wqiYC& printsec=frontcover& source=gbs_ge_summary_r& cad=0#v=onepage& q& f=false). John Wiley and Sons. p.506. ISBN0471786322. . [19] http:/ / www. berkshirehathaway. com/ 2002ar/ 2002ar. pdf [20] Story, Louise, "A Secretive Banking Elite Rules Trading in Derivatives" (http:/ / www. nytimes. com/ 2010/ 12/ 12/ business/ 12advantage. html?hp), The New York Times, December 11, 2010 (December 12, 2010 p. A1 NY ed.). Retrieved 2010-12-12.

Further reading Mehraj Mattoo (1997), Structured Derivatives: New Tools for Investment Management A Handbook of Structuring, Pricing & Investor Applications (Financial Times) Amazon listing (http://www.amazon.com/ Structured-Derivatives-Investment-Structuring-Applications/dp/0273611208)

External links BBC News - Derivatives simple guide (http://news.bbc.co.uk/1/hi/business/2190776.stm) European Union proposals on derivatives regulation - 2008 onwards (http://ec.europa.eu/internal_market/ financial-markets/derivatives/index_en.htm) Derivatives in Africa (http://www.mfw4a.org/capital-markets/derivatives-derivatives-exchanges-commodities. html)

Futures contract

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Futures contractIn finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset (e.g. oranges, oil, gold) of standardized quantity and quality at a specified future date at a price agreed today (the futures price). The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They are still securities, however, though they are a type of derivative contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all that is, for financial futures, the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange.[1] A closely related contract is a forward contract; they differ in certain respects. Futures contracts are very similar to forward contracts, except they are exchange-traded and defined on standardized assets.[2] Unlike forwards, futures typically have interim partial settlements or "true-ups" in margin requirements. For typical forwards, the net gain or loss accrued over the life of the contract is realized on the delivery date. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations. Futures contracts, or simply futures, (but not future or future contract) are exchange-traded derivatives. The exchange's clearing house acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement.[3]

OriginAristotle described the story of Thales, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or poor and because the olive press owners were willing to hedge against the possibility of a poor yield. When the harvest time came, and many presses were wanted concurrently and suddenly, he let them out at any rate he pleased, and made a large quantity of money.[4] The first futures exchange market was the Djima Rice Exchange in Japan in the 1730s, to meet the needs of samurai whobeing paid in rice, and after a series of bad harvestsneeded a stable conversion to coin.[5] The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward contracts in 1864, which were called futures contracts. This contract was based on grain trading and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around

Futures contract the world.[6] By 1875 cotton futures were being traded in Mumbai in India and within a few years this had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion.[7]

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StandardizationFutures contracts ensure their liquidity by being highly standardized, usually by specifying: The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The currency in which the futures contract is quoted. The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing point -- the location where delivery must be made. The delivery month. The last trading date. Other details such as the commodity tick, the minimum permissible price fluctuation.

MarginTo minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%-15% of the contract's value. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission

Futures contract Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin. Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as variation margin, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day. Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the clients account. Some U.S. exchanges also use the term maintenance margin, which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term initial margin and variation margin. The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U.S. Markets). A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level. Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he does not want to be subject to margin calls. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit. Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchanges perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.

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Settlement - physical versus cash-settled futuresSettlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract: Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method

Futures contract of settlement upon expiration Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires.[8] Cash settled futures are those that, as a practical matter, could not be settled by delivery of the referenced item - i.e. how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method. Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures contract stops trading, as well as the final settlement price for that contract. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading months. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.

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PricingWhen the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is determined via arbitrage arguments. This is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. agricultural crops after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist - for example on crops before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date) - the futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract.

Arbitrage argumentsArbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply, or may be freely created. Here, the forward price represents the expected future value of the underlying discounted at the risk free rateas any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away. Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r.

or, with continuous compounding

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.

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Pricing via expectationWhen the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be applied, as the arbitrage mechanism is not applicable. Here the price of the futures is determined by today's supply and demand for the underlying asset in the futures. In a deep and liquid market, supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship. . By contrast, in a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known as cornering the market), the market clearing price for the futures may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down.

Relationship between arbitrage arguments and expectationThe expectation based relationship will also hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability. In other words: a futures price is martingale with respect to the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity.

Contango and backwardationThe situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as contango. The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as backwardation.

Futures contracts and exchangesContracts There are many different kinds of futures contracts, reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities, securities (such as single-stock futures), currencies or intangibles such as interest rates and indexes. For information on futures markets in specific underlying commodity markets, follow the links. For a list of tradable commodities futures contracts, see List of traded commodities. See also the futures exchange article. Foreign exchange market Money market Bond market Equity market Soft Commodities market

Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Although contract trading began with traditional commodities such as grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates.

Futures contract Exchanges Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbrse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 90 futures and futures options exchanges worldwide trading to include: [9] CME Group (formerly CBOT and CME) -- Currencies, Various Interest Rate derivatives (including US Bonds); Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork, Cattle, Butter, Milk); Index (Dow Jones Industrial Average); Metals (Gold, Silver), Index (NASDAQ, S&P, etc.) IntercontinentalExchange (ICE Futures Europe) - formerly the International Petroleum Exchange trades energy including crude oil, heating oil, natural gas and unleaded gas NYSE Euronext - which absorbed Euronext into which London International Financial Futures and Options Exchange or LIFFE (pronounced 'LIFE') was merged. (LIFFE had taken over London Commodities Exchange ("LCE") in 1996)- softs: grains and meats. Inactive market in Baltic Exchange shipping. Index futures include EURIBOR, FTSE 100, CAC 40, AEX index. South African Futures Exchange - SAFEX Sydney Futures Exchange Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures) Tokyo Commodity Exchange TOCOM Tokyo Financial Exchange [10] - TFX - (Euroyen Futures, OverNight CallRate Futures, SpotNext RepoRate Futures) Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures) London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel, tin and steel IntercontinentalExchange (ICE Futures U.S.) - formerly New York Board of Trade - softs: cocoa, coffee, cotton, orange juice, sugar New York Mercantile Exchange CME Group- energy and metals: crude oil, gasoline, heating oil, natural gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium Dubai Mercantile Exchange Korea Exchange - KRX Singapore Exchange - SGX - into which merged Singapore International Monetary Exchange (SIMEX) ROFEX - Rosario (Argentina) Futures Exchange

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CodesMost Futures contracts codes are four characters. The first two characters identify the contract type, the third character identifies the month and the last character is the last digit of the year. Third (month) futures contract codes are January = F February = G March = H April = J May = K June = M July = N

August = Q September = U

Futures contract October = V November = X December = Z Example: CLX0 is a Crude Oil (CL), November (X) 2010 (0) contract.

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Who trades futures?Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper", while they have no practical use for or intent to actually take or make delivery of the underlying asset. In other words, the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract. Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap. An example that has both hedge and speculative notions involves a mutual fund or separately managed account whose investment objective is to track the performance of a stock index such as the S&P 500 stock index. The Portfolio manager often "equitizes" cash inflows in an easy and cost effective manner by investing in (opening long) S&P 500 stock index futures. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. This also preserves balanced diversification, maintains a higher degree of the percent of assets invested in the market and helps reduce tracking error in the performance of the fund/account. When it is economically feasible (an efficient amount of shares of every individual position within the fund or account can be purchased), the portfolio manager can close the contract and make purchases of each individual stock. The social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences, from a hedger to a speculator, for example.

Options on futuresIn many cases, options are traded on futures, sometimes called simply "futures options". A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. See the Black-Scholes model, which is the most popular method for pricing these option contracts. Futures are often used since they are delta one instruments.

Futures contract regulationsAll futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the United States government. The Commission has the right to hand out fines and other punishments for an individual or company who breaks any rules. Although by law the commission regulates all transactions, each exchange can have its own rule, and under contract can fine companies for different things or extend the fine that the CFTC hands out.

Futures contract The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment that has more than 20 participants. These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. This type of report is referred to as the 'Commitments of Traders Report', COT-Report or simply COTR.

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Definition of futures contractFollowing Bjrk[11] we give a definition of a futures contract. We describe a futures contract with delivery of item J at the time T: There exists in the market a quoted price F(t,T), which is known as the futures price at time t for delivery of J at time T. At time T, the holder pays F(T,T) and is entitled to receive J. During any time interval , the holder receives the amount . .

The spot price of obtaining the futures contract is equal to zero, for all time t such that

NonconvergenceSome exchanges tolerate 'nonconvergence', the failure of futures contracts and the value of the physical commodities they represent to reach the same value on 'contract settlement' day at the designated delivery points. An example of this is the CBOT (Chicago Board of Trade) Soft Red Winter wheat (SRW) futures. SRW futures have settled more than 20 apart on settlement day and as much as $1.00 difference between settlement days. Only a few participants holding CBOT SRW futures contracts are qualified by the CBOT to make or receive delivery of commodities to settle futures contracts. Therefore, it's impossible for almost any individual producer to 'hedge' efficiently when relying on the final settlement of a futures contract for SRW. The trend is for the CBOT to continue to restrict those entities that can actually participate in settling commodities contracts to those that can ship or receive large quantities of railroad cars and multiple barges at a few selected sites. The Commodity Futures Trading Commission, which has oversight of the futures market in the United States, has made no comment as to why this trend is allowed to continue since economic theory and CBOT publications maintain that convergence of contracts with the price of the underlying commodity they represent is the basis of integrity for a futures market. It follows that the function of 'price discovery', the ability of the markets to discern the appropriate value of a commodity reflecting current conditions, is degraded in relation to the discrepancy in price and the inability of producers to enforce contracts with the commodities they represent.[12]

Futures versus forwardsWhile futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price, they are different in two main respects: Futures are exchange-traded, while forwards are traded over-the-counter. Thus futures are standardized and face an exchange, while forwards are customized and face a non-exchange counterparty. Futures are margined, while forwards are not. Thus futures have significantly less credit risk, and have different funding.

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Exchange versus OTCFutures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties. Thus: Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being over-the-counter. In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearing house.

MarginingFutures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). Forwards do not have a standard. They may transact only on the settlement date. More typical would be for the parties to agree to true up, for example, every quarter. The fact that forwards are not margined daily means that, due to movements in the price of the underlying asset, a large differential can build up between the forward's delivery price and the settlement price, and in any event, an unrealized gain (loss) can build up. Again, this differs from futures which get 'trued-up' typically daily by a comparison of the market value of the future to the collateral securing the contract to keep it in line with the brokerage margin requirements. This true-ing up occurs by the "loss" party providing additional collateral; so if the buyer of the contract incurs a drop in value, the shortfall or variation margin would typically be shored up by the investor wiring or depositing additional cash in the brokerage account. In a forward though, the spread in exchange rates is not trued up regularly but, rather, it builds up as unrealized gain (loss) depending on which side of the trade being discussed. This means that entire unrealized gain (loss) becomes realized at the time of delivery (or as what typically occurs, the time the contract is closed prior to expiration) assuming the parties must transact at the underlying currency's spot price to facilitate receipt/delivery. The result is that forwards have higher credit risk than futures, and that funding is charged differently. In most cases involving institutional investors, the daily variation margin settlement guidelines for futures call for actual money movement only above some insignificant amount to avoid wiring back and forth small sums of cash. The threshold amount for daily futures variation margin for institutional investors is often $1,000. The situation for forwards, however, where no daily true-up takes place in turn creates credit risk for forwards, but not so much for futures. Simply put, the risk of a forward contract is that the supplier will be unable to deliver the referenced asset, or that the buyer will be unable to pay for it on the delivery date or the date at which the opening party closes the contract. The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. This means that there will usually be very little additional money due on the final day to settle the futures contract: only the final day's gain or loss, not the gain or loss over the life of the contract. In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, further limiting credit risk in futures. Example: Consider a futures contract with a $100 price: Let's say that on day 50, a futures contract with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures contract costs $90. This means that the "mark-to-market" calculation would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin"). This money goes, via margin accounts, to the holder of the other side of the future. That is, the loss party wires cash to the other party.

Futures contract A forward-holder, however, may pay nothing until settlement on the final day, potentially building up a large balance; this may be reflected in the mark by an allowance for credit risk. So, except for tiny effects of convexity bias (due to earning or paying interest on margin), futures and forwards with equal delivery prices result in the same total loss or gain, but holders of futures experience that loss/gain in daily increments which track the forward's daily price changes, while the forward's spot price converges to the settlement price. Thus, while under mark to market accounting, for both assets the gain or loss accrues over the holding period; for a futures this gain or loss is realized daily, while for a forward contract the gain or loss remains unrealized until expiry. Note that, due to the path dependence of funding, a futures contract is not, strictly speaking, a European derivative: the total gain or loss of the trade depends not only on the value of the underlying asset at expiry, but also on the path of prices on the way. This difference is generally quite small though. With an exchange-traded future, the clearing house interposes itself on every trade. Thus there is no risk of counterparty default. The only risk is that the clearing house defaults (e.g. become bankrupt), which is considered very unlikely.

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Notes[1] Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action (http:/ / www. pearsonschool. com/ index. cfm?locator=PSZ3R9& PMDbSiteId=2781& PMDbSolutionId=6724& PMDbCategoryId=& PMDbProgramId=12881& level=4). Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp.288. ISBN0-13-063085-3. [2] Forward Contract on Wikinvest [3] Hull, John C. (2005). Options, Futures and Other Derivatives (excerpt by Fan Zhang) (http:/ / fan. zhang. gl/ ecref/ futures) (6th ed.). Prentice-Hall. ISBN 0-13-149908-4. [4] Aristotle, Politics, trans. Benjamin Jowett, vol. 2, The Great Books of the Western World, book 1, chap. 11, p. 453. [5] Schaede, Ulrike (September 1989). "Forwards and futures in tokugawa-period Japan:A new perspective on the Djima rice market". Journal of Banking & Finance 13 (4-5): 487513. doi:10.1016/0378-4266(89)90028-9 [6] "timeline-of-achievements" (http:/ / www. cmegroup. com/ company/ history/ timeline-of-achievements. html). CME Group. . Retrieved August 5, 2010. [7] Inter-Ministerial task force (chaired by Wajahat Habibullah) (May 2003). "Convergence of Securities and Commodity Markets report" (http:/ / www. fmc. gov. in/ htmldocs/ reports/ rep03. htm). Forward Markets Commission (India). . Retrieved August 5, 2010. [8] Cash settlement on Wikinvest [9] Futures & Options Factbook (http:/ / www. theIFM. org/ gfb). Institute for Financial Markets. [10] http:/ / www. tfx. co. jp/ en/ [11] Bjrk: Arbitrage theory in continuous time, Cambridge university press, 2004 [12] Henriques, D Mysterious discrepancies in grain prices baffle experts (http:/ / www. iht. com/ articles/ 2008/ 03/ 27/ business/ commod. php), International Herald Tribune, March 23, 2008. Accessed April 12, 2008

References The Institute for Financial Markets (http://www.theifm.org) (2003). Futures & Options (http://www.theifm. org/index.cfm?inc=education/focourse.inc). Washington, DC: The IFM. p.237. Redhead, Keith (1997). Financial Derivatives: An Introduction to Futures, Forwards, Options and Swaps. London: Prentice-Hall. ISBN013241399X. Lioui, Abraham; Poncet, Patrice (2005). Dynamic Asset Allocation with Forwards and Futures. New York: Springer. ISBN0387241078. Valdez, Steven (2000). An Introduction To Global Financial Markets (3rd ed.). Basingstoke, Hampshire: Macmillan Press. ISBN0333764471. Arditti, Fred D. (1996). Derivatives: A Comprehensive Resource for Options, Futures, Interest Rate Swaps, and Mortgage Securities. Boston: Harvard Business School Press. ISBN0875845606. The Institute for Financial Markets' Futures & Options Factbook (http://www.theifm.org/gfb)

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U.S. Futures exchanges and regulators Chicago Board of Trade, now part of CME Group Chicago Mercantile Exchange, now part of CME Group Commodity Futures Trading Commission National Futures Association Kansas City Board of Trade New York Board of Trade now ICE New York Mercantile Exchange, now part of CME Group Minneapolis Grain Exchange

External links BBC Oil Futures Investigation (http://news.bbc.co.uk/1/hi/magazine/7559032.stm) CME Group futures contracts product codes (http://www.cmegroup.com/product-codes-listing/) 'Bold text

Forward contractIn finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today.[1] This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.[2] Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures - such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded OTC, forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.

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PayoffsThe value of a forward position at maturity depends on the relationship between the delivery price ( underlying price ( ) at that time. For a long position this payoff is: For a short position, it is: ) and the

How a forward contract worksSuppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract. In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current ratethese two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created,

Forward contract which is typical in derivative contracts.

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Example of how forward prices should be agreed uponContinuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him - the opportunity cost will be covered.

Spot - forward paritySpot-forward parity provides the link between the spot market and the forward market. It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry, this effect can be broken down into different components, specifically whether the asset: pays income, and if so whether this is on a discrete or continuous basis incurs storage costs is regarded as an investment asset, i.e. an asset held primarily for investment purposes (e.g. gold, financial securities); or a consumption asset, i.e. an asset held primarily for consumption (e.g. oil, iron ore etc.)

Investment assetsFor an asset that provides no income, the relationship between the current forward ( ) and spot ( ) prices is

where

is the continuously compounded risk free rate of return, and

is the time to maturity. The intuition behind

this result is that given you want to own the asset at time T, there should be no difference in a perfect capital market between buying the asset today and holding it and buying the forward contract and taking delivery. Thus, both approaches must cost the same in present value terms. For an arbitrage proof of why this is the case, see Rational pricing below. For an asset that pays known income, the relationship becomes: Discrete: Continuous: where is the present value of the discrete income at time , and is the continuous or ) must dividend yield over the life of the contract. The intuition is that when an asset pays income, there is a benefit to holding the asset rather than the forward because you get to receive this income. Hence the income ( be subtracted to reflect this benefit. An example of an asset which pays discrete income might be a stock, and example of an asset which pays a continuous yield might be a foreign currency or a stock index. For investment assets which are commodities, such as gold and silver, storage costs must also be considered. Storage costs can be treated as 'negative income', and like income can be discrete or continuous. Hence with storage costs, the relationship becomes: Discrete: Continuous: where is the present value of the discrete storage cost at time , and is the storage cost where it is proportional to the price of the commodity, and is hence a 'negative yield'. The intuition here is that

Forward contract because storage costs make the final price higher, we have to add them to the spot price.

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Consumption assetsConsumption assets are typically raw material commodities which are used as a source of energy or in a production process, for example crude oil or iron ore. Users of these consumption commodities may feel that there is a benefit from physically holding the asset in inventory as opposed to holding a forward on the asset. These benefits include the ability to profit from temporary shortages and the ability to keep a production process running,[1] and are referred to as the convenience yield. Thus, for consumption assets, the spot-forward relationship is: Discrete storage costs: Continuous storage costs: where is the convenience yield over the life of the contract. Since the convenience yield provides a benefit to the holder of the asset but not the holder of the forward, it can be modelled as a type of 'dividend yield'. However, it is important to note that the convenience yield is a non cash item, but rather reflects the market's expectations concerning future availability of the commodity. If users have low inventories of the commodity, this implies a greater chance of shortage, which means a higher convenience yield. The opposite is true when high inventories exist.[1]

Cost of carryThe relationship between the spot and forward price of an asset reflects the net cost of holding (or carrying) that asset relative to holding the forward. Thus, all of the costs and benefits above can be summarised as the cost of carry, . Hence, Discrete: Continuous:

, where

.

Relationship between the forward price and the expected future spot priceThe market's opinion about what the spot price of an asset will be in the future is the expected future spot price.[1] Hence, a key question is whether or not the current forward price actually predicts the respective spot price in the future. There are a number of different hypotheses which try to explain the relationship between the current forward price, and the expected future spot price, .

The economists John Maynard Keynes and John Hicks argued that in general, the natural hedgers of a commodity are those who wish to sell the commodity at a future point in time.[3] [4] Thus, hedgers will collectively hold a net short position in the forward market. The other side of these contracts are held by speculators, who must therefore hold a net long position. Hedgers are interested in reducing risk, and thus will accept

Forward contract losing money on their forward contracts. Speculators on the other hand, are interested in making a profit, and will hence only enter the contracts if they expect to make money. Thus, if speculators are holding a net long position, it must be the case that the expected future spot price is greater than the forward price. In other words, the expected payoff to the speculator at maturity is: , where Thus, if the speculators expect to profit, is the delivery price at maturity

23

, as This market situation, where

when they enter the contract , is referred to as normal backwardation. Since forward/futures prices , is referred to as contango.

converge with the spot price at maturity (see Basis), normal backwardation implies that futures prices for a certain maturity are increasing over time. The opposite situation, where Likewise, contango implies that futures prices for a certain maturity are falling over time.[5]

Rational pricingIf is the spot price of an asset at time must satisfy , and . is the continuously compounded rate, then the forward price at a future time

To prove this, suppose not. Then we have two possible cases. Case 1: Suppose that . Then an investor can execute the following trades at time :

1. go to the bank and get a loan with amount at the continuously compounded rate r; 2. with this money from the bank, buy one unit of stock for ; 3. enter into one short forward contract costing 0. A short forward contract means that the investor owes the counterparty the stock at time . The initial cost of the trades at the initial time sum to zero. At time the investor can reverse the trades that were executed at time . Specifically, and mirroring the trades 1., 2. and 3. the investor 1. ' repays the loan to the bank. The inflow to the investor is 2. ' settles the short forward contract by selling the stock for because the buyer receives from the investor. , which by hypothesis, is positive. This is an The sum of the inflows in 1.' and 2.' equals ; . The cash inflow to the investor is now

arbitrage profit. Consequently, and assuming that the non-arbitrage condition holds, we have a contradiction. This is called a cash and carry arbitrage because you "carry" the stock until maturity. Case 2: Suppose that . Then an investor can do the reverse of what he has done above in case 1.

But if you look at the convenience yield page, you will see that if there are finite stocks/inventory, the reverse cash and carry arbitrage is not always possible. It would depend on the elasticity of demand for forward contracts and such like.

Forward contract

24

Extensions to the forward pricing formulaSuppose that is the time value of cash flows X at the contract expiration time . The forward price is then given by the formula: The cash flows can be in the form of dividends from the asset, or costs of maintaining the asset. If these price relationships do not hold, there is an arbitrage opportunity for a riskless profit similar to that discussed above. One implication of this is that the presence of a forward market will force spot prices to reflect current expectations of future prices. As a result, the forward price for nonperishable commodities, securities or currency is no more a predictor of future price than the spot price is - the relationship between forward and spot prices is driven by interest rates. For perishable commodities, arbitrage does not have this The above forward pricing formula can also be written as:

Where

is the time t value of all cash flows over the life of the contract.

For more details about pricing, see forward price.

Theories of why a forward contract existsAllaz and Vila (1993) suggest that there is also a strategic reason (in an imperfect competitive environment) for the existence of forward trading, that is, forward trading can be used even in a world without uncertainty. This is due to firms having Stackelberg incentives to anticipate their production through forward contracts.

Footnotes[1] [2] [3] [4] [5] John C Hull, Options, Futures and Other Derivatives (6th edition), Prentice Hall: New Jersey, USA, 2006, 3 Forward Contract on Wikinvest J.M. Keynes, A Treatise on Money, London: Macmillan, 1930 J.R. Hicks, Value and Capital, Oxford: Clarendon Press, 1939 Contango Vs. Normal Backwardation (http:/ / www. investopedia. com/ articles/ 07/ contango_backwardation. asp), Investopedia

References John C. Hull, (2000), Options, Futures and other Derivatives, Prentice-Hall. Keith Redhead, (31 October 1996), Financial Derivatives: An Introduction to Futures, Forwards, Options and Swaps, Prentice-Hall Abraham Lioui & Patrice Poncet, (March 30, 2005), Dynamic Asset Allocation with Forwards and Futures, Springer Check Yahoo answers (http://answers.yahoo.com/question/index;_ylt=Amc. RfpkBppP0RnqnLlc839FzKIX;_ylv=3?qid=20060818025219AALar31) Forward Contract on Wikinvest

Further reading Allaz, B. and Vila, J.-L., Cournot competition, futures markets and efficiency, Journal of Economic Theory 59,297-308.

Option (finance)

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Option (finance)In finance, an option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in some specific transaction on the asset, while the seller incurs the obligation to fulfill the transaction if so requested by the buyer. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset. An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The reference price at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless. In return for granting the option, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised. An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other over-the-counter options are customized to the desires of the buyer on an ad hoc basis, usually by an investment bank.[1] [2]

Option valuationThe theoretical value of an option is evaluated according to any of several mathematical models. These models, which are developed by quantitative analysts, attempt to predict how the value of an option changes in response to changing conditions. For example how the price changes with respect to changes in time to expiration or how an increase in volatility would have an impact on the value. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other.

Contract specificationsEvery financial option is a contract between the two counterparties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:[3] whether the option holder has the right to buy (a call option) or the right to sell (a put option) the quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock) the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise the expiration date, or expiry, which is the last date the option can be exercised the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount the terms by which the option is quoted in the market to convert the quoted price into the actual premium-the total amount paid by the holder to the writer of the option.

Option (finance)

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TypesThe primary types of financial options are: Exchange-traded options (also called "listed options") are a class of exchange-traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include:[4] [5] stock options, commodity options, bond options and other interest rate options stock market index options or, simply, index options and options on futures contracts callable bull/bear contract

Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: 1. interest rate options 2. currency cross rate options, and 3. options on swaps or swaptions.

Other option typesAnother important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Option stylesNaming conventions are used to help identify properties common to many different types of options. These include: European option - an option that may only be exercised on expiration. American option - an option that may be exercised on any trading day on or before expiry. Bermudan option - an option that may be exercised only on specified dates on or before expiration. Barrier option - any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised Exotic option - any of a broad category of options that may include complex financial structures.[6] Vanilla option - any option that is not exotic.

Option (finance)

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Valuation modelsThe value of an option can be estimated using a variety of quantitative techniques based on the concept of risk neutral pricing and using stochastic calculus. The most basic model is the Black-Scholes model. More sophisticated models are used to model the volatility smile. These models are implemented using a variety of numerical techniques.[7] In general, standard option valuation models depend on the following factors: The current market price of the underlying security, the strike price of the option, particularly in relation to the current market price of the underlier (in the money vs. out of the money), the cost of holding a position in the underlying security, including interest and dividends, the time to expiration together with any restrictions on when exercise may occur, and an estimate of the future volatility of the underlying security's price over the life of the option. More advanced models can require additional factors, such as an estimate of how volatility changes over time and for various underlying price levels, or the dynamics of stochastic interest rates. The following are some of the principal valuation techniques used in practice to evaluate option contracts.

Black-ScholesFollowing early work by Louis Bachelier and later work by Edward O. Thorp, Fischer Black and Myron Scholes made a major breakthrough by deriving a differential equation that must be satisfied by the price of any derivative dependent on a non-dividend-paying stock. By employing the technique of constructing a risk neutral portfolio that replicates the returns of holding an option, Black and Scholes produced a closed-form solution for a European option's theoretical price.[8] At the same time, the model generates hedge parameters necessary for effective risk management of option holdings. While the ideas behind the Black-Scholes model were ground-breaking and eventually led to Scholes and Merton receiving the Swedish Central Bank's associated Prize for Achievement in Economics (a.k.a., the Nobel Prize in Economics),[9] the application of the model in actual options trading is clumsy because of the assumptions of continuous (or no) dividend payment, constant volatility, and a constant interest rate. Nevertheless, the Black-Scholes model is still one of the most important methods and foundations for the existing financial market in which the result is within the reasonable range.[10]

Stochastic volatility modelsSince the market crash of 1987, it has been observed that market implied volatility for options of lower strike prices are typically higher than for higher strike prices, suggesting that volatility is stochastic, varying both for time and for the price level of the underlying security. Stochastic volatility models have been developed including one developed by S.L. Heston.[11] One principal advantage of the Heston model is that it can be solved in closed-form, while other stochastic volatility models require complex numerical methods.[11]

Option (finance)

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Model implementationOnce a valuation model has been chosen, there are a number of different techniques used to take the mathematical models to implement the models.

Analytic techniq