7/29/2019 Ch01_02

1/20

Introduction

Futures & Forward Markets

Chapter 1 & 2

Definition of Derivatives

An instrument whose valuedepends on the values of other

more basic underlying variables Underlying variables ( ) :

Commodity

Financials

Others : weather, trade of permission,etc.

7/29/2019 Ch01_02

2/20

Examples of Derivatives

Forwards( )

Futures( ) Swaps( )

Options( )

Synthetic Contracts( ) :options on futures, swaption, portfolioinsurance, . . .

Usage of Derivatives

Hedging( )

Speculation( )

Arbitrage( ) Others :

To change the nature of a liability

To change the nature of an investmentwithout incurring the costs of selling oneportfolio and buying another

7/29/2019 Ch01_02

3/20

(1) Futures

An agreement to buy or sell a certain

quantityof an asset at a certain timeinthe future for a certain price

Similar to down payment ( )

Spot[Cash] contract: an agreement tobuy or sell the asset immediately (orwithin a very short period of time)

Futures Price

Price at which you agree to buy or sell

Determined by supply and demand in

the same way as a spot price Specified as : Quantity

Price (futures/delivery price)

Time (maturity/delivery data)

Example : KOSPI200_futures.bmp

7/29/2019 Ch01_02

4/20

Specification of Futures Contract

Underlying asset

Contract size

Delivery arrangement

Delivery months

Price quotes

Daily price movement limits

Position limits

Example : SPEC_KTB.bmp

Examples of Futures

Agreement to:

buy 100 oz. of gold @ $400/oz. in Dec.

(COMEX) sell 62,500 @ 1.5000 $/ in Mar. (CME)

sell 1,000 bbl. of oil @ $20/bbl. in Apr.(NYMEX)

7/29/2019 Ch01_02

5/20

Types of Position

Long position( ) : a party that

has agreed to buy

Short position( ) : a party thathas agreed to sell

Types of Traders

Hedgers

Speculators

Arbitrageurs

Some of the large trading losses in derivatives

occurred because individuals who had a mandate

to hedge risks switched to being speculators. (See

Chapter 21)

7/29/2019 Ch01_02

6/20

Example of Hedging

A US company will pay 10 million forimports from Britain in 3 months

It decides to hedge using a longposition in a forward contract

Why does this company do this?

Example of Speculation

An investor with $4,000 to invest feelsthat Amazon.coms stock price will

increase over the next 2 months The current stock price is $40 and theprice of a 2-month call option with astrike of 45 is $2

What is the investors profit?

7/29/2019 Ch01_02

7/20

Example of Arbitrage

A stock price is quoted as 100 in

London and $172 in New York The current exchange rate is 1.7500

What is the arbitrage opportunity?

Exchanges Trading Futures

KOFEX (Korea Futures Exchange)

TIFFE, TOCOM (Tokyo)

CBOT (Chicago Board of Trade) CME (Chicago Mercantile Exchange)

LIFFE (London)

Eurex (Europe)

and many more . . .

7/29/2019 Ch01_02

8/20

Electronic Trading

Traditionally traded using the open

outcry system( )

Currently replaced by electronictrading( ) where a computer matches buyers and sellers

Offsetting or Delivery

Offsetting( ) : closing out aposition before maturity Most contracts are closed out before

maturity

Delivery( ) : if not closed outbefore maturity Physical delivery( )

Cash settlement( )

7/29/2019 Ch01_02

9/20

Delivery Process

Seller can initiate delivery process : Day1 (position day) : shorts broker notifies

Board of Trading Clearing Corp

Day2 (notice day) : Board matches seller witholdest long position

Day3 (delivery day) : buyers broker gives check,gets ownership receipts

Most futures are cash-settledorclosed outwith an offsetting trade

Clearing House Function

Default risk : a counter party incapableof fulfilling his/her obligation

Clearing House

Ms. Long Mr. Short

buys

sells buys

sells

7/29/2019 Ch01_02

10/20

Margins

Margin account : cash or marketablesecurities deposited by an investor withbroker

Balance adjusted to reflect dailysettlement

Minimizing the possibility of a loss

through a default on a contract

Marking-to-Market

Initial margin( ) : a securitydeposit to open a futures position

Maintenance margin( ) : if balance below it, it must be topped up

Settlement price( ) : the pricejust before the final bell each day

used for the daily settlement process

7/29/2019 Ch01_02

11/20

Margin Call (1)

Initial margin = $200/cont.

Maintenance margin = $160/cont.

Margin Call (2)

Situation : Long position in 2 Dec. gold futures on

Jun. 5

contract size : 100 oz.

futures price : $400

margin requirement : $2,000/cont. ($4,000in total)

maintenance margin : $1,500/cont.($3,000 in total)

7/29/2019 Ch01_02

12/20

Possible Outcome

Daily Cumulative Margin

Futures Gain Gain Account Margin

Price (Loss) (Loss) Balance CallDay (US$) (US$) (US$) (US$) (US$)

400.00 4,000

5-Jun 397.00 (600) (600) 3,400 0. . . . . .. . . . . .. . . . . .

13-Jun 393.30 (420) (1,340) 2,660 1,340. . . . . .. . . . .. . . . . .

19-Jun 387.00 (1,140) (2,600) 2,740 1,260. . . . . .. . . . . .. . . . . .

26-Jun 392.30 260 (1,540) 5,060 0

+

= 4,000

3,000

+

= 4,000