Topic 1 Intro to Derivatives & FRM.mechanics of Future Mkts

Introduction to Derivatives and Financial Risk Management (Hull, Chapter 1)

Mechanics of Futures Markets Part 1 (Hull, Chapter2)*Topic 1

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Introduction to Derivatives & Financial Risk Management (Hull, Chapter 1)

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IntroductionRisk is a characteristic feature of all commodity and capital markets. Over time, variations in the prices of agricultural and non-agricultural commodities occur as a result of interaction of demand and supply forces. Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010*


The last two decades have witnessed a many-fold increase in the volume of international trade and business due to the ever growing wave of globalization and liberalization sweeping across the world.As a result, financial markets have experienced rapid variations in interest and exchange rates, stock market prices thus exposing the corporate world to a state of growing financial risk.

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010*


What is Financial Risk Management ?Businesses, governments and individuals transact in financial markets such as: Foreign exchange marketsInterest Rate markets (interest rates & interest bearing securities)Commodity markets (e.g. gold, oil, wheat)Stock Markets (Equities)

Therefore, they face exposure to unfavourable price movements (risks) in these markets.Financial Risk Management concerns the management of these risks, mainly through the use of derivative instruments.


What is Financial Risk Management ?Management must identify and present financial risk exposures clearly to the Board so that it can put in place appropriate policies & procedures.Decisions then need to be taken on issues such as: whether to hedge* exposures, fully, partly, or not at allhow to hedge (which instrument) andthe duration of any hedge * Hedge: to reduce or eliminate the effect of an adverse price movement by taking an opposite position (often using derivatives) to that of the hedgers physical position. Derivatives, such as futures, options and swaps are common instruments for managing these financial risks.


Examples of Price VolatilityInterest Rate Volatility Debt is a major source of finance for companiesInterest rates on variable rate borrowings can fluctuate dramatically in short periods of timeHedging against changes in interest rates can stabilize borrowing costsExchange Rate VolatilityBusiness that have transactions denominated in foreign currencies are exposed to exchange rate riskThe more volatile the exchange rates, the more difficult it is to predict the firms cash flows in its domestic currencyIf a firm can manage its interest rate and exchange rate risk, it can reduce the volatility of its profits


Australian Short Term Interest Rates 1984 - 2008


A$ vs. US$ Jan 2005 Jan 2010


The Nature of DerivativesThe term "derivative" arises from the fact that the agreement "derives" its value from the price of an underlying asset such as a stock, bond, currency, or commodity.*


What are Derivative Instruments?DefinitionA derivative is a financial instrument whose return is derived from the return on another underlying instrument.

Derivatives are either:traded on exchanges (e.g. a futures exchange); or are customised by derivatives dealers (e.g. banks) to meet a customers requirements these are called Over the Counter (OTC) derivatives


Examples of DerivativesFutures ContractsForward ContractsOptionsSwaps *


Applications of Financial DerivativesManagement of RiskRisk management is not about the elimination of risk rather it is about the management of risk. Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in the ordinary conduct of their businesses. *


Price discoveryAnother important application of derivatives is the price discovery which means revealing information about future cash market prices through the futures market. Derivatives markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking.Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010*


Price stabilization functionDerivative market helps to keep a stabilising influence on spot prices by reducing the short-term fluctuations. In other words, derivative reduces both peak and depths and leads to price stabilisation effect in the cash market for underlying asset.Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010*


Classification of Derivatives*


Definition: a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today; subject to a daily settlement of gains and losses and guaranteed against the risk that either party might defaultExclusively traded on a futures exchange eg. the Sydney Futures Exchange (SFE), Chicago Board of Trade (CBOT), Tokyo International Financial Futures exchange (TIFFE) and London International Financial Futures Exchange ( LIFFE)

Derivative Markets & Instruments Futures Contracts


Examples: Exchange Traded FuturesExamples of underlying assets which are traded on these exchanges:

Agricultural Commodity futures - soy beans, wheat, pork bellies, live cattle

Metal futures e.g. gold, silver, platinum, copper

Energy commodities e.g. crude oil, natural gas

Currency Futures: e.g. USD v. Yen, Euro, Swiss Franc, AUD

Financial Futures:Interest rates, shares, share price indices(stock index)


Futures PriceThe futures prices for a particular contract is the price at which you agree to buy or sell

It is determined by supply and demand in the same way as a spot price*


Electronic TradingTraditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange

Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers*


Over-the Counter MarketsThe over-the counter market is an important alternative to exchanges

It is a telephone and computer-linked network of dealers who do not physically meet

Trades are usually between financial institutions, corporate treasurers, and fund managers*


TerminologyThe party that has agreed to buy has a long position

The party that has agreed to sell has a short position

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Size of OTC and Exchange Markets

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market*OTCExchange


Sheet:

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

East

West

North

Definition: a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today

Exclusively Over-the-Counter (OTC) - a telephone and computer-linked network of dealers who do not physically meet.

Most commonly traded Forward Contracts are in foreign currency and interest rate markets.

Derivative Markets & Instruments - Forward Contracts


Foreign Exchange Quotes for USD/GBP exchange rate on July 17, 2009*

BidOfferSpot1.63821.63861-month forward1.63801.63853-month forward1.63781.63846-month forward1.63761.6383


Derivative Markets & Instruments - Options

Definition: a contract between two parties that gives one party, the buyer, the right to buy or sell something from or to the other party, the seller, at a later date at a price agreed upon today

Basic Option terminologyOption premium (price)- EXTRA PREMIUMCall and Put OptionsExercise (strike) price [the agreed price]Expiration date or maturity date


OptionsA call option is an option to buy a certain asset by a certain date for a certain price (the strike price)A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

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Types of OptionsAmerican OptionsThat can be exercised any time on or before the expiration dateMultiple delivery dates are possibleEuropean OptionsThe Option contact that can only be exercised on the expiration date itself. Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010*


Google Option Prices (July 17, 2009; Stock Price=430.25) *


Options vs. Futures/ForwardsA futures/forward contract gives the holder the obligation to buy or sell at a certain price

An option gives the holder the right to buy or sell at a certain price*


Reasons to trade DerivativesThe three main reasons:To hedge risksTo speculate (to trade derivatives for profit by taking a view on the future direction of the market)To lock into an arbitrage profit by PROFIT FIX simultaneously entering into transactions in two or more markets

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The Three Broad Categories of TraderHedgers : Use futures, forwards (via Over The Counter) and options to reduce the risk that they face from potential future movements in a market variable.

Speculators: Use futures, forwards (via Over The Counter) and options to bet on the future direction of a market variable.

Arbitrageurs: Take offsetting positions in two or more instruments to lock in a profit.


Example 1: Hedging using Forward Contracts A company based in United States knows that in 3 months time it will have to pay GBP10million for imports from Britain. It decides to hedge the risk.

The US based company could hedge by: Buying GBP 10m (by selling US$) 3 month forward (OTC market)

With the Foreign Exchange Quotes for USD/GBP exchange rate below, the company will be able to hedge the price:

Hedge the risk by: Buying GBP 10m (selling US$) 3 month forward (OTC market) The US company could hedge its foreign exchange risk by buying GBP pounds from the financial institution in the three month forward market at 1.6384. This would have the effect of fixing the price to be paid to the British exporter at US$16,384,000. If exchange rate gone lower than 1.6384 the company will do better if it chooses not to hedge. If exchange rate gone up, more than 1.6384, the company will wish it had hedged.

Bid (Buy)Offer (Sell)Spot1.63821.63863-month forward1.63781.6384


Example 2: Hedging using Forward Contracts A company based in United State knows that in 3 months time it will receive GBP30million for export to Britain. It decides to hedge the risk.

The US based company could hedge by: Selling GBP 30m (Buy US$) 3 month forward (OTC market)

With the Foreign Exchange Quotes for USD/GBP exchange rate below, the company will be able to hedge the price:

Hedge the risk by: Selling GBP 30m (buying US$) 3 month forward (OTC market) The US company could hedge its foreign exchange risk by selling GBP pounds from the financial institution in the three month forward market at 1.6378. This would have the effect of fixing the price to be received from the British company at US$49,134,000 If exchange rate gone lower than 1.6378 the company will wish it had hedged.If exchange rate gone up, more than 1.6378, the company will do better if it chooses not to hedge.

Bid Offer Spot1.63821.63863-month forward1.63781.6384


Example 3: Hedging using OptionsIn May, an investor owns 1,000 Microsoft shares currently worth $28 per share. A two month ( July) put option with a strike price of $27.50 cost $1 per option. The investor decides to hedged by buying 10 contracts options with 100 options each contract for total cost of $1,000

The investor would have the right to sell a total of 1,000 shares @ $27.50Cost to pay for the for 100 contract options = $1,000Guarantees that the shares can be sold for at least $27.50 per share during the life of the optionIf the market price of the share falls below $27.50, options will be exercised, $27,500 is realized for the holding minus the cost.If the market price of the share stays above $27.50, the options are not exercised and expire worthless.


Forward Contract vs. Options for HedgingForward Contracts: Designed to neutralize risk by fixing the price that the hedger will pay or receive for the underlying asset.

Options Contracts : Designed to provide assurance. To protect the investors against adverse price movements in future and allowing them to benefit from favourable price movement.


Example 4: Speculation using FuturesA speculator from U.S., who in February thinks that the British pound will strengthen relative to the U.S. dollar over the next two months and is prepared to back that hunch to tune of 250,000.Current exchange rate : 1 = $1.6470Future Contract exchange rate( April) : 1 = $1.6410

Investors strategy - Alternative 1: Purchase 250,000 in the spot market, 1 =$1.6470If the Actual April exchange rate increased to : 1 =$1.700The profit that the speculator can made = (1.7000-1.6470) x 250,000=$13,250If the Actual April exchange rate dropped to: 1 =$1.600The losses would be (1.6470-1.6000) x 250,000= ($11,750)

Investors strategy Alternative 2: Buy futures contract. 1 =$1.6410 ( locked as minimum exchange)If the Actual April exchange rate increased to : 1 =$1.700The profit that the speculator can made = (1.7000-1.6410) x 250,000=$14,750If the Actual April exchange rate dropped to: 1 =$1.600The losses would be (1.6410-1.6000) x 250,000= ($10,250)


Example 4: Speculation Using Futures (continue)

Investors strategy - Alternative 1:Up front investment of (250,000 X 1.6470) = $411,750 is needed.

Investors strategy - Alternative 2:Only requires a small amount of cash to be deposited by the speculator in a margin account


Example 5: Speculation using OptionsSuppose that it is October and a speculator consider that a stock is likely to increase in value over the next two months. The stock price is currently $20 and a two month call option with $22.50 strike price currently selling for $1 per option. The speculator is willing to invest $2,000.**When a speculator uses futures the potential loss as well as gain is very large.**When options are used, no matter how bad things get, the loss is limited to the amount paid for options.

Investors strategy - Alternative 1: Purchase 100 shares at $20If the Actual December share price increased to : $27The profit that the speculator can made = ($27-$20) x 100 shares=$700If the Actual December share price dropped to: $15The losses would be ($20-$15) x 100= ($500)

Investors strategy - Alternative 2: Purchase 2,000 calls options (10 call options contracts)If the Actual December share price increased to : $27The profit that the speculator can made = ($27-$22.50) x 2,000=$9,000 minus cost of $2,000 = $7,000If the Actual December share price dropped to: $15The losses would be $2,000 of the option contracts costs


Example 6: Arbitrage OpportunitiesConsider a stock that is traded in both New York and London. Suppose that the stock price is $162 in New York and 100 in London at a time when the exchange rate is $1.6500 per pound. Arbitrageur prepared to buy 100 shares.

Potential investment costNew York : (100 shares x $162 ) =$16,200London : (100 shares x $1.65 x 100) =$16,500

Investors strategy Buys 100 shares in New YorkSells the shares in LondonConvert the sale proceeds form pounds to dollars

Therefore the profit is ($16,500-$16,200) = $300


Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010*


Mechanics of Futures Markets Part 1(Hull, Chapter 2)

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Introduction Consider a firm that doesn't have an immediate need for an asset, but knows that at some future date the asset will have to be purchased. For example, a firm may need a supply of copper three months from now for use in production. In such a case the firm faces three alternatives:buy the asset now and store it until it is needed;wait to buy the asset at a future date at the future "spot" price;enter into a forward or a futures contract to lock-in the price today for delivery on a specified future date.


Introduction (cont)The risks and costs of these three alternatives differ markedly:Buying the asset now would incur storage costs (physical storage for commodity type assets) plus the opportunity cost of funds being tied up; If we wait to buy in the future we are uncertain about the future price there may be an adverse price movement before we buy.Buying a futures or a forward contract locks in a price today; it incurs no storage costs; and it shifts the price risk to the seller of the contract.


Futures ContractsA futures contract is an obligation to make (seller) or take (buyer) delivery of a specified quantity and quality of an underlying asset at a specified future date and at a price agreed when the contract originates.Note: Some futures are cash settled (e.g. share price index futures) rather than requiring delivery of the physical assetMost futures contracts are closed out prior to their maturity date by making another futures trade opposite to the position held - that is, physical delivery does not often take place!


Futures Trading on Organized ExchangesFutures contracts are available on a wide range of underlying assets They are referred to by their delivery month Futures contract terms and conditions are specified by the particular futures exchangecontract grade (if relevant)contract sizequotation unitminimum price fluctuationDelivery Terms (if relevant some are cash settled)delivery date and time


Futures Trading on Organized ExchangesContract grade For some commodities a range of grades can be delivered.[e.g. No. 2 Yellow corn]For financial assets generally well defined and unambiguous. [No need to specify the grade for British Pounds]

Contract sizeThe contract size specifies the amount of the assets that has to be delivered.Too large : investors with relatively small exposure/position will be unable to use the exchangeToo small: Trading may be expensive as there is cost associated with each contract traded.

Quotation unitThe exchange defines how prices will be quoted [e.g. crude oil prices on NYME are quoted in dollars & cents]


Futures Trading on Organized ExchangesPrice limitsFor most contracts, daily price movement limits are specified by the exchange.- Normally the trading ceases for the day once the contract has reached the upper or lower limits-In some cases, the exchange has the authority to change the limits.Propose : to prevent large price movement due to excess speculative exercise Position limits- maximum number of contracts that a speculator may holdPropose : to prevent speculators from exercising undue influence on the marketDelivery date and time- A future contract is referred to by its delivery month.- The exchange must specify the precise period during the month when delivery can be made.- Most futures contracts, the delivery period the whole month


Convergence of Futures Price to Spot PriceWhen the delivery period of the contract is approaching, the future price converges to the spot price

This is the result of the future price tend to be very close to the spot price during the delivery period.

Situation 1: The future price is above the spot price. Traders have clear arbitrage opportunity to:Sell a future contractBuy the assetMake delivery as traders exploit this arbitrage opportunity, the future price will drop (market supply increases)

Situation 2: The future price is below the spot price. Traders will:Hold the future contract and wait for the delivery it is more attractive to buy a future contact and the future price tend to rise (market demand increases)


Convergence of Futures to Spot TimeTime(a)(b)FuturesPriceFuturesPriceSpot PriceSpot Price


Example: Contract Specifications - SPIContract Specification for SFE SPI ASX 200 (Source: http://www.asx.com.au )

Contract Size:A$25 x index points(e.g. $75,000 if index is at 3000)Contract Months:March, June, Sep, DecMinimum Price Fluctuation:One index point (A$25)Last Trading Day :3rd Thursday of the settlement monthDelivery Method:Cash settlement (refer ASX for calculation of settlement price)Initial Margin:Varies with level of indexand broker requirements(approx. $10,000+ at present)


Example: SPI Futures (30/1/09) Month Bid Ask High Low Last Change VolumeMar 3449.0 3451.0 3465 3431 3449 - 67.0 8119June 3443.0 3447.0 Sept 3383.0 3400.0

Source: http://www.asx.com.au Notes: 1. Change is current price compared to settlement price on previous day2. Volume refers to number of contracts traded on the day


Mechanics of Futures Trading The operation of MarginsInitial margin: a specified amount of cash and/or marketable securities which must be deposited with the futures broker for each traded contract.

Helps to ensure that traders dont default on their obligation.

Maintenance margin is set by the futures exchange, usually below the initial margin

The balance in a traders margin account is adjusted to reflect daily settlement prices (that is, accounts are marked-to-market on a daily basis)

Mechanics of Futures Trading The operation of MarginsMaintenance Margin If a trader's cumulative losses on a futures contract caused the margin account to fall below the maintenance margin then additional cash will have to be paid in order to restore the account to the initial margin level.the additional cash to be paid to maintain initial margin is also known as a variation margin. If the investor does not provide the variation margin, the broker closes out the position.

Example of a Futures TradeAn investor takes a long position (buy) in 2 December gold futures contracts on June 5contract size is 100 oz.futures price is US$900margin requirement is US$2,000/contract (US$4,000 in total)maintenance margin is US$1,500/contract (US$3,000 in total)*

A Possible Outcome

DailyCumulativeMarginFuturesGainGainAccountMarginPrice(Loss)(Loss)BalanceCallDay(US$)(US$)(US$)(US$)(US$)900.004,0005-Jun897.00(600) (600) 3,4000..................13-Jun893.30(420) (1,340) 2,6601,340 .................19-Jun887.00(1,140) (2,600) 2,7401,260 ..................26-Jun892.30260 (1,540) 5,0600+=4,000+=4,000*Margin maintenance is $3,000

Other Key Points About FuturesThey are settled dailyClosing out a futures position involves entering into an offsetting tradeMost contracts are closed out before maturity*

23810417Assume the NAB price rises to $36 at expiry date of call optionBuy 1,000 shares at $30. Profit = (36 30) x 1,000 = $6,000Buy 100,000 call options (100 contracts) at $0.30. Profit = [ (36 33 0.30) x 100,000 ] = $270,000

3. Assume NAB price falls to $24Loss on stock = (24 30) x 1,000 = $6,000Loss on unexercised options = $30,000

Options are a form of leverage they magnify the financial outcomes of a given investment17Assume the NAB price rises to $36 at expiry date of call optionBuy 1,000 shares at $30. Profit = (36 30) x 1,000 = $6,000Buy 100,000 call options (100 contracts) at $0.30. Profit = [ (36 33 0.30) x 100,000 ] = $270,000


Options are a form of leverage they magnify the financial outcomes of a given investment17Assume the NAB price rises to $36 at expiry date of call optionBuy 1,000 shares at $30. Profit = (36 30) x 1,000 = $6,000Buy 100,000 call options (100 contracts) at $0.30. Profit = [ (36 33 0.30) x 100,000 ] = $270,000


Options are a form of leverage they magnify the financial outcomes of a given investment

Topic 1 Intro to Derivatives & FRM.mechanics of Future Mkts

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