derivatives unit 2

8/11/2019 derivatives unit 2

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Unit - 1

Futures

1By K.Arjun Goud


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Futures

A futures contractis an agreement between a

buyer and a seller which requires the seller of

the futures contract to deliver a specific

underlying assetat a certain date and price inthe future

2By K.Arjun Goud
http://www.mysmp.com/options/underlying-security.htmlhttp://www.mysmp.com/options/underlying-security.html


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Meaning

Futures contracts are binding agreements

between the buyer and the seller. Both parties

must fulfill the contractual agreements set

forth in the future contract. The futurescontract will either call for a cash settlement

or physical commodity settlement

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Futures Contract Specifications

To prevent confusion, all of the terms of a futures contract are pre-defined.There are six key components of a futures contract:

Name of Commodity- This is the underlying security and can be an indexsuch as gold, silver, corn, and other agricultural goods.

Delivery Date- Defines the date on which the there will be cash or

physical commodity settlement Size- Contract size varies in each underlying futures contract. For

example, one gold contract will buy you 100 fine troy ounces of gold.

Quality - The futures contract will specify the grade of the underlyingcommodity that you are buying or selling. Using gold as an example, thefollowing definition is given for the quality of the deliverable: 100 troyounces (5%) of refined gold, assaying not less than .995 fineness, casteither in one bar or in three one-kilogram bars."

Delivery Instructions- Many indices and commodities will opt for cashsettlement; however, for those futures contracts that require physicaldelivery, pickup locations will be specified in the contract

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Participants in Futures Market

Hedgers

Protection from price fluctuation

Risk averse / mitigation

2) Speculators

Profit from price fluctuation

Risk takers

3) Arbitragers

Risk-less Profit seekers

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Structure of Futures Market

Clearinghouse Customer

Futures CommissionMerchant (FCM)EXCHANGE MEMBERS

Clearing

Members Nonclear

Members


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FCM SELLERFCMBUYER

Floor Broker Floor Broker

TRADING PIT

Floor Broker Floor Broker

FCM FCMClearinghouse


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Liquidating a Futures position

Physical Delivery

Offsetting

Exchange of Futures for Physicals Flexibility

Cash Delivery


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Margin Requirement

Initial Margin

Maintenance Margin

variation margin

Open account with $5000 on Feb 20 Feb 25: Buy 2 May contracts, Margin needed 2x3000=$6000

Feb 26: Add $1000 to margin to meet $6000 requirement

Feb 26: Marking to market gain 1400; Account value 7400

Feb 27: Marking to market loss 2500; Account value 4900;

Above maintenance margin of 4200

Feb 28: Marking to market loss 1000; Account value 3200;

margin call of 2800


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Futures Trading

Open Outcry

Board Trading insufficient liquidity for open outcry

Electronic Trading

Opening and Closing Call

Settlement Price Price Limits

Position limits


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Notation

T: time until delivery date (in years)

S: price of the asset underlying the forwardcontract today

K: delivery price in the forward contract

f: value of a long position in the forward contracttoday

F: forward price today

r: risk-free rate of interest per annum today, withcontinuous compounding, for an investment

maturing at the delivery date (i.e., in T years)


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Structure of Futures Market

Futures Commission Merchant

Exchange Members

Floor Broker (Commission broker)

Floor Trader (Local)

Day traders

Scalpers

Position traders

Clearinghouse


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ORDER TYPES

Market order: Order placed at current market rate. Limit order: A buy limit order can only be executed at the limit price or

lower, and a sell limit order can only be executed at the limit price or

higher.

Stop Order: A stop order is an order to buy or sell a stock once the price of

the stock reaches a specified price, known as the stop price. Investorstypically use a stop order when buying stock to limit a loss or protect a

profit on short sales. The order is entered at a stop price that is always

above the current market price. A sell stop order helps investors to avoid

further losses or to protect a profit that exists if a stock price continues to

drop. A stop order to sell is always placed below the current market price. Stop Limit order: An order to buy or sell a stock that combines the

features of a stop order and a limit order. Once the stop price is reached,

the order becomes a limit order to buy or to sell at a specified price .

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Contd.

Market-if-touched order: An order which is executed as amarket order when a pre-specified price is reached.

Discretionary order: A market order whose execution may be

delayed at the brokers discretion in order to get a better

price. Time-of-day order: An order which is executed at a particular

period of day.

Open order: An order which is in effect until executed or until

the end of the trading in the particular contract Fill-or-kill order: An order that must be executed immediately

or not at all.

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Difference between Forward Contract and Futures ContractForward Contract Futures Contract

Structure:Customized to customers need.

Usually no initial payment required.

Standardized. Initial margin payment

required.

Method of pre-

termination

Opposite contract with same or

different counterparty. Counterparty

risk remains while terminating withdifferent counterparty.

Opposite contract on the exchange.

Risk: High counterparty risk Low counterparty risk

Market regulation: Not regulated Government regulated market

What is it?:

A forward contract is an agreement

between two parties to buy or sell an

asset (which can be of any kind) at a

pre-agreed future point in time.

A futures contract is a standardized

contract, traded on a futures

exchange, to buy or sell a certain

underlying instrument at a certain

date in the future, at a specified price.

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Institutional guarantee: The contracting parties Clearing House

Contract size:Depending on the transactionand the requirements of the

contracting parties.

Standardized

Expiry date: Depending on the transaction Standardized

Transaction method:Negotiated directly by the

buyer and seller

Quoted and traded on the

Exchange

Guarantees:

No guarantee of settlement

until the date of maturity

only the forward price, based

on the spot price of the

underlying asset is paid

Both parties must deposit aninitial guarantee (margin).

The value of the operation is

marked to market rates with

daily settlement of profits

and losses.

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By K.Arjun Goud 17

Hedging A hedger is an individual who enters the futures market in

order to reduce a preexisting risk.

A preexisting position might include:

1. A commodity that you own: you have a silver mining company and

have silver stored. You own the commodity.

2. An anticipatory hedge: a commodity that you will acquire in the future.If you are a new silver mining company and just have initiated mining

operations. You expect to acquire/have silver in the future.

3. An anticipatory hedge: a commodity that you will need in the future.

You are a manufacturer of film, and silver is an essential input for film

production. You will need to acquire silver to produce the film for nextyear sales.

Each of these positions can be hedged.


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By K.Arjun Goud 18

A Long Hedge

Along hedge involves purchasing a futures contract.Example

A film manufacturing company that needs silver in the future would purchase afutures contract for silver. By doing so, the company will know with certainty howmuch it will have to pay for the silver in the future. Thus the firm has reduced itsrisk.

Suppose that the film manufacturer needs 50,000 troy ounces of silver in twomonths. The silver prices are as follows:

Table 4.12

Si lver Futures Prices on May 10

The COMEX division of NYMEX trades a silver contract for 5,000 troy ounces.

ContractPrice

(cents per troy ounce)

Spot 1052.5

JUL 1068.0

SEP 1084.0


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By K.Arjun Goud 19

A Long Hedge

The film manufacturer estimates that to pay higher than 1068.0 cents per ouncecould jeopardize profitability. Thus, the company enters the futures market to

hedge against the possibility of higher silver prices. The transactions are as follows:

Table 4.13

A Long Hedge in Silver

Date Cash Market Futures Market

May 10 Anticipates the need for 50,000troy ounces in two months andexpects to pay 1068 cents perounce, or a total of $534,000.

Buys ten 5,000 troy ounceJUL futures contracts at 1068cents per ounce.

July 10 The spot price of silver is now1071 cents per ounce. Themanufacturer buys 50,000ounces, paying $535,500.

Since the futures contract isat maturity, the futures andspot prices are equal, and theten contracts are sold at 1071cents per ounce.

Opportunity loss: -$1,500 Futures profit: $1,500

Net Wealth Change = 0


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By K.Arjun Goud 20

A Short Hedge A short hedge involves selling a futures contract to reduce risk.

You ,a silver mine owner, are concerned about future silver prices and its impacton your companys profitability. You may want to sell a futures contract to reduce

risk.

By doing so, you will know exactly how much your company will receive. Thus, you

have reduced risk.

Suppose that you expect to have 50,000 troy ounces of sliver in two months. Thesilvers prices are as follows:

Table 4.12

Silver Futures Prices on May 10

The COMEX division of NYMEX trades a silver contract for 5,000 troy ounces.

ContractPrice

(cents per troy ounce)

Spot 1052.5

JUL 1068.0

SEP 1084.0


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By K.Arjun Goud 21

A Short Hedge You estimate that a price of 1068.0 cents per ounce satisfies your

companys profitability goals. Thus, the company enters the futures

market to hedge against the possibility of lower silver prices. The

transactions are as follows:

Tab le 4.14

A Short Hedge in Si lver

Date Cash Market Futures MarketMay 10 Anticipates the sale of 50,000

troy ounces in two months andexpects to receive 1068 centsper ounce, or a total of$534,000.

Sells ten 5,000 troy ounceJuly futures contracts at 1068cents per ounce.

July 10 The spot price of silver is now1071 cents per ounce. Theminer sells 50,000 ounces,

receiving $535,500.

Buys 10 contracts at 1071.

Profit $1,500 Futures loss: -$1,500

Net Wealth Change = 0


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Advantages of Hedging

Hedging stretches the marketing period

Hedging protects inventory values.

Hedging permits forward pricing of products

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Do Hedgers Need Speculators?

Hedgers, as a group, need speculators to take

positions and bear risk only for the mismatch

in contracts demanded by long and short

hedgers.

If long and short hedgers had exactly

offsetting needs, hedgers would not need

speculators.


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By K.Arjun Goud 24

Cross-Hedging

In many cases, there will not be a futures contract availablethat exactly matches our needs. In this case, we need to

engage in a cross-hedge.

A cross-hedge is needed when the characteristics of the spot

and futures positions do not match perfectly. Some of the mismatches are:

Maturity: the hedging horizon may not match the futures expiration

date.

Quantity: the quantity to be hedged may not match the futurescontract quantity.

Quality: the physical characteristics of the commodity to be hedged

may differ from the characteristics required for futures contract.


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By K.Arjun Goud 25

Cross-Hedging

Maturity: Futures contracts may not mature at exactly the time that you

need delivery of the good. The film manufacturer needs silver almost

continuously. However, COMEX silver futures trade only for delivery in

February, April, May, Jul, September and December. Thus, the futures

expiration dates and the hedging horizon dont match perfectly.

Quantity: COMEX silver contracts are for 5,000 troy ounces. However, a

film manufacturer may only need 7,500 ounces. This company has a

problem selecting the number of contracts it needs for its production line.

Quality: For film manufacturing, silver needs to be in pellet form and it

does not need to be as pure as silver bullion. COMEX silver contracts

specifies that deliverable silver must be 1,000 ounce ingots that are 99.9

percent pure, not exactly the silver quality that the film manufacturer

needs.


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By K.Arjun Goud 26

Micro-Hedging versus Macro Hedging

Micro-Hedging: Micro-hedging occurs when a futures position

is matched against a specific asset or liability item on the

balance sheet.

Example: a bank hedging rates on one-year certificates of

deposits from the liability side of its balance sheet.

Macro-Hedging: Macro-hedging occurs when a hedge is

structured to offset the net risk associated with the hedgers

overall asset/liability mix.Example: a bank that uses interest rates to equate the interest

rate exposure of its assets with the interest rate exposure of

its liabilities.


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By K.Arjun Goud 27

Stack Hedges versus Strip Hedges

Strip Hedge: Strip hedging occurs when a

trader enters the futures market and takes a

series of futures positions of successively

longer expirations.

Stack Hedge: Stack hedging occurs when a

trader enters the futures market and takes a

number of positions that can be stacked in thefront month and then rolled forward.


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By K.Arjun Goud 28

Risk-Minimization Hedging

Sometimes we wish to minimize our risk, but do nothave a specific time horizon.

In other situations, we may need to cross-hedge.

In either case, purchasing one future for eachposition in the cash market may not perfectly get rid

of risk.

That is, the futures contract that we are using to

hedge may not move exactly with our cash position.

In this case, we may want to compute the risk-

minimizing hedge ratio.


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Costs and Benefits of Hedging

There are six market imperfections that make

hedging important and that can impose real costs to

companies, including:

1. Taxes2. Costs of financial distress

3. Transaction costs of hedging

4. Principal-agent problems

5. Costliness of diversification

6. Differences between internal and external financing costs

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Rolling The Hedge Forward

We can use a series of futures contracts toincrease the life of a hedge

Each time we switch from 1 futures contract to

another we incur a type of basis risk Strip Hedge

Stack and Roll Hedge

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derivatives unit 2