TOC
1. Overview of derivatives
Definition: a financial asset whose value is based on (derived from) the value of underlying asset(s)
- Underlying assets
- Also called underlying
- commodities, shares, bonds, stock indices, interest rates and currencies, some exotic derivatives: CO2 emission, weather, results of general election
- Types of derivatives: forwards, futures, options, swaps
2. Forwards
Definition: a forwards contract is an agreement between two parties to undertake an exchange of certain assets at an agreed date in the future at a pre-agreed price.
- For seller and buyer: both right and obligation
- Delivery date predetermined
- Delivery price predetermined
- Also predetermined: quality and quantity
Forwards price: the price for future delivery.
- An expected price. The delivery price is in fact the forwards price when a forwards contract is signed
- The forwards price changes all the time because market expectation constantly changes
Long position and short position
The buyer of a forwards contract takes a long position
- A long position gives the right and obligation to buy at the agreed price at a specified future date
The seller of a forwards contract takes a short position
- A selling position gives the right and obligation to sell at the agreed price at a specified future date
Characteristics of a forward contract:
- Tailor made: quantity, quality, delivery date and price are determined in the forwards market.
- Traded on the over the counter (OTC) markets
- Counter party may default: it depends on the divergence of the predetermined price from the spot price at delivery, it the spot price at delivery is very much below the fixed price, the buyer has the incentive to walk away while if it’s too much above the agreed price, the seller has incentive to walk away.
- Available for long-term maturity (3 years) while futures usually for less than or equal to 12 months.
- Difficult to reverse or cancel: the counter party does not agree and if is cancelled, there usually is a penalty.
3. Futures
3.1 Basic
(Definition) A futures contract is a standardized agreement between two parties to undertake an exchange of a fixed quantity of commodities or financial assets at an agreed price on a specified date in the future.
- Futures is a standardized version of “forwards contract”: quantity, quality, date of delivery, etc
For futures:
- For seller and buyer: both right and obligation
- Delivery date predetermined
- Delivery price predetermined
- Also predetermined: quality and quantity
Futures price
- Essentially the expectation of the spot price that will prevail at the time fo delivery
- The prefixed delivery price is the futures price at when the futures contract is bought or sold
- Futures price changes constantly as market expectations change constantly
- As a futures contract approaches expiry, futures price converges to spot price
- The accuracy of market expectation increases as a contract approaches expiry
Long position and short position
- Buyers have long positions:
- right and obligation to buy
- sellers have short positions:
- right and obligation to sell
One can hold both long and short positions; positions net out for the same futures.
Close a position
Before delivery, most of the positions are closed because few want to actually make the delivery or pay for it.
One can close a long (short) position of N futures contract by selling (buying) N futures contract.
Once closed, no rights or obligation any more.
Characteristics
Clearing House:
- The buyer and seller of a contract do not transact with each other directly, transcat through the clearing house.
- The clearing house becomes the formal counter party to every transaction.
- Reduces the risk of default
- Clearing house take measures to ensure the futures contracts are complied with
- Marking to market
3.2 Equity Index Futures
Underlying: stock market index, e.g. Nikkei 225, FTSE 100
Cash settelment: if position is not closed before the date of delivery, traders do not want 225 different shares delivered; only need to hand over the profit or loss from trade.
3.3 Short-term interest rate futures
Underlying: interest rate on a short-term deposit to be started at the date of expiry. The term to maturity of the deposit is usually 3 months
The buyer of a short-term interest rate futures contract buys the right to make a 3-month deposit at the agreed interest rate
Example:
At the current time, you could buy a futures contract that give you the right to deposit 1 million pounds for 3-months at the agreed interest rate, starting in June 2023 and ends in September 2023.
The unit of trading for a 3-month sterling time deposit futures is 500,000 pounds.
Since the futures are settled by cash, only profits and losses are handed over:
- The buyer would not actually require the seller to accept the 500,000 on deposit for three months at the pre-agreed interest rate
- The delivery date is only used to define the time of expiry for the contract
3.4 Derivative Users based on their purposes
Hedgers: hedge against unwanted changes in value of the underlying
- E.g. the flour producer and the treasurer
- A hedger in real life can have multiple risks to hedge
- British company explores platinum in Kenya
- Platinum price volatile
- Bank loans, interest risk
Speculators: take positions to obtain a profit based on price change
- Accept high risks in hope for high returns
- Not necessarily has a negative meaning
- Important for futures market:
- Risk takers
- Provide liquidity
- Seek and process information; impound information into prices; enhance market efficiency.
Arbitragers: exploit price differences on the same instrument or similar assets.
- In efficient markets, arbitrage opportunities are transitory: be very fast in order to take advantage of it; Arbitragers enhance market efficiency.
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