Forwards, futures swaps

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Forwards, futures swaps and options WORKBOOK By
Ramon Rabinovitch
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IntroductionChapter 1
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The Nature of Derivatives

• A derivative is a financial instrument whose
  value depends on the values of other more basic
  underlying variables
• In particular, it depends on the market price of
  the so called
• underlying asset.

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• Underlying assets
• Stocks
• Bonds
• Foreign currencies
• Gold, Silver
• Crude oil, Natural gas, Gasoline, heating oil
• Wheat, corn, rice, grain feed, soy beans, pork
• bellies
• Stock indexes

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DERIVATIVES ARE CONTRAC TS FORWARDS FUTURES OPTIO
NS SWAPS
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WHY TRADE DERIVATIVES? THE FUNDAMENTAL REASON
FOR TRADING DERIVATIVES IS TO HEDGE THE PRICE
RISK (VOLATILITY) Exhibited by the spot price of
the underlying commodity
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PRICE RISK IS THE VOLATILITY ASSOCIATED WITH THE
COMMODITYS PRICE IN THE CASH MARKET REMEMBER
THAT THE CASH MARKET IS WHERE FIRMS DO THEIR
BUSINESS. I.E., BUY AND SELL THE COMMODITY. ZERO
PRICE VOLATILITY NO DERIVATIVES!!!!
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PRICE RISK At time t, the assets price at time
T is not known.
Probability distributio
ST
St
t
T
time
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Ways Derivatives are Used

• To hedge risks
• To speculate (take a view on the future direction
  of the market)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment without
  incurring the costs of selling one portfolio and
  buying another

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• Types of risk
• Price risk
• Credit risk
• Operational risk
• Completion risk
• Human risk
• Regulatory risk
• Tax risk

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• IN THIS CLASS WE WILL ONLY ANALYZE THE
• RISK
• ASSOCIATED WITH THE
• SPOT MARKET PRICE
• OF
• THE UNDERLYING ASSET

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DERIVATIVES ARE CONTRACTS Two
parties Agreement Underlying security Contract
termination date
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DERIVATIVES ARE CONTRACTSThe distinction is
made by the different stipulations of the
contract Forwards and Futures are Fixed
obligations A FORWARD IS A CONTRACT IN
WHICH ONE PARTY COMMITS TO BUY AND THE OTHER
PARTY COMMITS TO SELL A SPECIFIED AMOUNT OF AN
AGREED UPON COMMODITY FOR A PREDETERMINED PRICE
ON A SPECIFIC DATE IN THE FUTURE.
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• BUY OPEN A LONG POSITION
• SELL OPEN A SHORT POSITION

Delivery and payment
Buy or sell a forward
t
T
Time
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Forward Price

• The forward price for a contract is the delivery
  price that would be applicable to the contract if
  were negotiated today (i.e., it is the delivery
  price that would make the contract worth exactly
  zero)
• The forward price may be different for contracts
  of different maturities

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EXAMPLE GBP 18.5.99 SPOT
USD1,6850/GBP 30 days forward USD1,7245/GBP
60 days forward USD1,7455/GBP 90 days
forward USD1,7978/GBP 180 days
forward USD1,8455/GBP The existence of forward
exchange rates implies that there is a demand and
supply for the GBP for future dates. In the
actual market, however, different rates are
quoted for buy (ask) and for sell (bid) orders.
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Foreign Exchange Quotes for USD/GBP on Aug 16,
2001 ( page 3)
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Profit from aLong Forward Position
K
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Profit from a Short Forward Position
K
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A FUTURES A STANDARDIZED FORWARD TRADED ON
AN ORGANIZED EXCHANGE. STANDARDIZATION THE
COMMODITY TYPE AND QUALITY THE QUANTITY PRICE
QUOTES DELIVERY DATES DELIVERY PROCEDURES
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Futures Contracts

• Agreement to buy or sell an asset for a certain
  price at a certain time
• Similar to forward contract
• Whereas a forward contract is traded OTC, a
  futures contract is traded on an exchange

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• AN OPTION
• IS A CONTRACT IN WHICH ONE PARTY HAS THE RIGHT,
  BUT NOT THE OBLIGATION, TO BUY OR SELL A
  SPECIFIED AMOUNT OF AN AGREED UPON COMMODITY FOR
  A PREDETERMINED PRICE BEFORE OR ON A SPECIFIC
  DATE IN THE FUTURE. THE OTHER PARTY HAS THE
  OBLIGATION TO DO WHAT THE FIRST PARTY WISHES TO
  DO. THE FIRST PARTY, HOWEVER, MAY CHOOSE NOT TO
  EXERCISE ITS RIGHT AND LET THE OPTION EXPIRE
  WORTHLESS.
• A CALL A RIGHT TO BUY THE UNDERLYING ASSET
• A PUT A RIGHT TO SELL THE UNDERLYING ASSET

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Long Call on Microsoft (Figure 1.2, Page 7)

• Profit from buying a European call option on
  Microsoft option price 5, strike price 60

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Short Call on Microsoft (Figure 1.4, page 9)

• Profit from writing a European call option on
  Microsoft option price 5, strike price 60

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Long Put on IBM (Figure 1.3, page 8)

• Profit from buying a European put option on
  IBM option price 7, strike price 90

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Short Put on IBM (Figure 1.5, page 9)

• Profit from writing a European put option on
  IBM option price 7, strike price 90

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• A SWAP
• IS A CONTRACT IN WHICH THE TWO PARTIES COMMIT TO
  EXCHANGE A SERIES OF CASH FLOWS. THE CASH FLOWS
  ARE BASED ON AN AGREED UPON PRINCIPAL AMOUNT.
  NORMALLY, ONLY THE NET FLOW EXCHANGES HANDS.
• Principal amount EUR100,000,000
• semiannual payments.

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Party B
Party A
6-months LIBOR
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Types of Derivatives Traders

• Speculators
• Hedgers
• Arbitrageurs

Some of the large trading losses in derivatives
occurred because individuals who had a mandate to
hedge risks switched to being speculators
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THE ECONOMIC PURPOSES OF DERIVATIVE
MARKETS HEDGING PRICE DISCOVERY SAVING
HEDGING IS THE ACTIVITY OF MANAGING PRICE RISK
EXPOSURE PRICE DISCOVERY IS THE REVEALING OF
INFORMSTION ABOUT THE FUTURE CASH MARKET PRICE
FOR A PRODUCT. SAVING IS THE COST SAVING
ASSOCIATED WITH SWAPING CASH FLOWS