Introduction Chapter 1

1
Module 1Futures, forwards, and swaps
2
The Nature of Derivatives

• A derivative is an instrument whose value
  depends on the values of other more basic
  underlying variables

3
Examples of Derivatives

• Swaps
• Options
• Forward Contracts
• Futures Contracts

4
Derivatives Markets

• Exchange Traded
• standard products
• trading floor or computer trading
• virtually no credit risk
• Over-the-Counter
• non-standard products
• telephone market
• some credit risk

5
Ways Derivatives are Used

• To hedge risks
• To reflect 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

6
Forward Contracts

• A forward contract is an agreement to buy or
  sell an asset at a certain time in the future for
  a certain price (the delivery price)
• It can be contrasted with a spot contract which
  is an agreement to buy or sell immediately

7
How a Forward Contract Works

• The contract is an over-the-counter (OTC)
  agreement between 2 companies
• The delivery price is usually chosen so that the
  initial value of the contract is zero
• No money changes hands when contract is first
  negotiated and it is settled at maturity

8
The 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

9
Terminology

• The party that has agreed to buy has what is
  termed a long position
• The party that has agreed to sell has what is
  termed a short position

10
Profit from aLong Forward Position
K
11
Profit from a Short Forward Position
K
12
Forward Contracts vs Futures Contracts
FORWARDS
FUTURES
Private contract between 2 parties
Exchange traded
Non-standard contract
Standard contract
Usually 1 specified delivery date
Range of delivery dates
Settled at maturity
Settled daily
Delivery or final cash
Contract usually closed out
settlement usually occurs
prior to maturity
13
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

14
Exchanges Trading Futures

• Chicago Board of Trade
• Chicago Mercantile Exchange
• BMF (Sao Paulo, Brazil)
• LIFFE (London)
• TIFFE (Tokyo)
• and many more

15
Futures Contracts

• Available on a wide range of underlyings
• Exchange traded
• Specifications need to be defined
• What can be delivered,
• Where it can be delivered,
• When it can be delivered
• Settled daily

16
Margins

• A margin is cash or marketable securities
  deposited by an investor with his or her broker
• The balance in the margin account is adjusted to
  reflect daily settlement
• Margins minimize the possibility of a loss
  through a default on a contract

17
Example of a Futures Trade

• An investor takes a long position in 2 December
  gold futures contracts on June 3
• contract size is 100 oz.
• futures price is US400
• margin requirement is US2,000/contract (US4,000
  in total)
• maintenance margin is US1,500/contract (US3,000
  in total)

18
A Possible Outcome

Daily
Cumulative
Margin
Futures
Gain
Gain
Account
Margin
Price
(Loss)
(Loss)
Balance
Call
Day
(US)
(US)
(US)
(US)
(US)
400.00
4,000
3-Jun
397.00
(600)

(600)

3,400
0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
11-Jun
393.30
(420)

(1,340)

2,660
1,340

4,000


.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
3,000

17-Jun
387.00
(1,140)

(2,600)

2,740
1,260

4,000


.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
24-Jun
392.30
260

(1,540)

5,060
0
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Other Key Points About Futures

• They are settled daily
• Closing out a futures position involves
  entering into an offsetting trade
• Most contracts are closed out before maturity

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Delivery

• If a contract is not closed out before maturity,
  it usually settled by delivering the assets
  underlying the contract. When there are
  alternatives about what is delivered, where it is
  delivered, and when it is delivered, the party
  with the short position chooses.
• A few contracts (for example, those on stock
  indices and Eurodollars) are settled in cash

21
Some Terminology

• Open interest the total number of contracts
  outstanding
• equal to number of long positions or number of
  short positions
• Settlement price the price just before the
  final bell each day
• used for the daily settlement process
• Volume of trading the number of trades in 1 day

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Convergence of Futures to Spot

Futures Price
Spot Price
Futures Price
Spot Price
Time
Time
(a)
(b)
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Choice of Contract

• Choose a delivery month that is as close as
  possible to, but later than, the end of the life
  of the hedge
• When there is no futures contract on the asset
  being hedged, choose the contract whose futures
  price is most highly correlated with the asset
  price. There are then 2 components to basis

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Basis Risk

• Basis is the difference between spot futures
• Basis risk arises because of the uncertainty
  about the basis when the hedge is closed out

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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
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Hedging Examples

• A US company will pay 1 million for imports
  from Britain in 6 months and decides to hedge
  using a long position in a forward contract

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1. Gold An Arbitrage Opportunity?

• Suppose that
• The spot price of gold is US300
• The 1-year forward price of gold is US340
• The 1-year US interest rate is 5 per annum
• Is there an arbitrage opportunity?
  

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The Forward Price of Gold

• If the spot price of gold is S the forward
  price for a contract deliverable in T years is
  F, then
• F S (1r )T
• where r is the 1-year (domestic currency)
  risk-free rate of interest.
• In our examples, S300, T1, and r0.05 so that
• F 300(10.05) 315

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Short Selling

• Short selling involves selling securities you do
  not own
• Your broker borrows the securities from another
  client and sells them in the market in the usual
  way

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Short Selling(continued)

• At some stage you must buy the securities back so
  they can be replaced in the account of the client
• You must pay dividends other benefits the
  owner of the securities receives

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Long Short Hedges

• A long futures hedge is appropriate when you know
  you will purchase an asset in the future want
  to lock in the price
• A short futures hedge is appropriate when you
  know you will sell an asset in the future want
  to lock in the price

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2. Gold Another Arbitrage Opportunity?

• Suppose that
• The spot price of gold is US300
• The 1-year forward price of gold is US300
• The 1-year US interest rate is 5 per annum
• Is there an arbitrage opportunity?

33
Swaps
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Nature of Swaps

• A swap is an agreement to exchange cash flows at
  specified future times according to certain
  specified rules

35
An Example of a Plain Vanilla Interest Rate
Swap

• An agreement by Company B to receive 6-month
  LIBOR pay a fixed rate of 5 per annum every 6
  months for 3 years on a notional principal of
  100 million
• Next slide illustrates cash flows

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Cash Flows to Company B
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Typical Uses of anInterest Rate Swap

• Converting a liability from
• fixed rate to floating rate
• floating rate to fixed rate

• Converting an investment from
• fixed rate to floating rate
• floating rate to fixed rate

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A and B Transform a Liability
5
5.2
A
B
LIBOR0.8
LIBOR
39
Financial Institution is Involved

4.985
5.015
5.2
A
F.I.
B
LIBOR0.8
LIBOR
LIBOR
40
Exchange of Principal

• In an interest rate swap the principal is not
  exchanged
• In a currency swap the principal is exchanged at
  the beginning the end of the swap

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Typical Uses of a Currency Swap

• Conversion from a liability in one currency to a
  liability in another currency

• Conversion from an investment in one currency to
  an investment in another currency

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Swaps Forwards

• A swap can be regarded as a convenient way of
  packaging forward contracts
• The plain vanilla interest rate swap in our
  example consisted of 6 FRAs
• The fixed for fixed currency swap in our
  example consisted of a cash transaction 5
  forward contracts

43
Swaps Forwards(continued)

• The value of the swap is the sum of the values
  of the forward contracts underlying the swap
• Swaps are normally at the money initially
• This means that it costs NOTHING to enter into
  a swap
• It does NOT mean that each forward contract
  underlying a swap is at the money initially

44
Credit Risk

• A swap is worth zero to a company initially
• At a future time its value is liable to be either
  positive or negative
• The company has credit risk exposure only when
  its value is positive

45
Examples of Other Types of Swaps

• Amortizing step-up swaps
• Extendible puttable swaps
• Index amortizing swaps
• Equity swaps
• Commodity swaps
• Differential swaps