DERIVATIVES

AGENDA
Derivative Markets and Instruments
 Definition
 Purpose and Criticism
 Role of Arbitrage
Forward Markets and Contracts
Future Markets and Contracts
Option Markets and Contracts
Swap Markets and Contracts
Risk Management Application of Option Strategies

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AGENDA FOR DERIVATIVE MARKETS AND
INSTRUMENTS

Definition
Characterictics of various products
Purpose and criticism of Derivatives
Role of Arbitrage

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DEFINITION
Derivative is a financial instrument whose value is derived from the value on another
instrument called underlying asset.
Exchange traded
• Traditionally open-outcry system
Main types • Switching to electronic trading
 Forwards and futures • Contracts are standardized
 Swaps • Example:
 Options - Europe: Liffe: http://www.liffe.com
 Exotics - US: Chicago Board of Trade
http://www.cbot.com

Trading Over the counter (OTC)

 Exchange traded • A computer- and telephone-linked
 OTC network of dealers
• Contracts can be non-standard

Underling
 Stocks, indices, bonds, commodities, currency, rates

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THE BIG PICTURE

Derivatives are always a zero-sum game, one person’s loss is another’s gain
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PURPOSE AND CRITICISM OF DERIVATIVES

Purpose
 Risk Management
 Price Information
 Reduce transaction costs

Criticism
 Too risky (leverage)

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ROLE OF ARBITRAGE

Arbitrage refers to Riskless profit. Such profits are generally earned when securities are
mispriced. Entering into arbitrage transactions ensures that securities return to their
fair values.

Arbitrage plays an important role in valuing securities.

Types:
 Law of one price states that securities with Identical cash flows must have the same price.
 Portfolio of securities (with uncertain individual returns) has a certain payoff ==> then the portfolio
should give risk free rate of return.

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QUESTION

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ANSWER

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QUESTION

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ANSWER

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QUESTIONS

1. Which of the following is not an advantage of Exchanges traded instruments over OTC
contracts?
A. They do not carry default risk
B. They are tailor made instruments
C. They are liquid

2. Law of one price states that:

A. All securities with identical maturity should trade at the same price.
B. All securities with identical cash flows should trade at the same price.
C. All securities with identical credit risk should trade at the same price.

3. Arbitrage profit can be earned when:

A. One has insider information
B. Securities are mispriced
C. Securities have different maturity dates

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ANSWERS

1. Answer: B, They are tailor made instruments

2. Answer: B, All securities with identical cash flows should trade at the same
price.

3. Answer: B, Securities are mispriced

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AGENDA

Derivative Markets and Instruments

Forward Markets and Contracts
 Characteristics of Forward Markets
 Settlement on Forward Contracts
 Forwards on Equity and Bonds
 Forward Rate Agreements (FRAs)
Future Markets and Contracts
Option Markets and Contracts
Swap Markets and Contracts
Risk Management Application of Option Strategies

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AGENDA FOR FORWARD MARKETS AND
CONTRACTS

What is forward contract

Characteristics
Settlement of a Forward contract
Dealer versus end user
Forwards on Equity and bonds
Eurodollar Time Deposit market
Forward Rate Agreement(FRA)
Payoff of an FRA
Currency Forward contracts

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WHATS IS FORWARD CONTRACT
• A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling
price for an asset, with the transaction set to occur in the future.
•  In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a
given asset at a predetermined price and date in the future.
• The buyer is often called long and seller is often called short.
• No cash or assets are exchanged until expiry, or the delivery date of the contract. On the
delivery date, forward contracts can be settled by physical delivery of the asset or cash
settlement.

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CHARACTERISTICS OF FORWARD MARKETS

Contract whereby parties are committed:

 To buy (sell)
 An underlying asset
 At some future date (maturity)
 At a delivery price (forward price) set in advance

When contract is initiated: No cash flow

Forward price such that PV of the contract zero.

The party which agrees to buy the specified asset is said to take a long position, and the party
which agrees to sell the specified asset is said to take a short position.

“Customization”, difficulty of “closing out” positions, low liquidity : Forward contract is always
constructed with the idea that the participants will hold their position until the contract expires.
The risk of contract default, credit risk.

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USES OF FORWARD CONTRACT
• Forward contracts offer users the ability to lock in a purchase or sale price without
incurring any direct cost.
• This feature makes it attractive to many corporate treasurers, who can use forward
contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or
ensure supply of a scarce resources. Speculators also use forward contracts to make bets
on price movements of the underlying asset.
• Many corporations and banks will use forward contracts to hedge price risk by
eliminating uncertainty about prices.
• For instance, coffee growers may enter into a forward contract with Nescafe to lock in
their sale price of coffee, reducing uncertainty about how much they will be able to
make.
• Nescafe benefits from contract because it is able to lock in their cost of purchasing
coffee.
• Knowing what price it will have to pay for its supply of coffee ahead of time helps
Nescafe avoid price fluctuations and assists in planning.

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FORWARD CONTRACT: EXAMPLE

Underlying asset: Gold

Spot price: $980 / ounce
Maturity: 6-month
Size of contract: 100 ounces
Forward price: $990 / troy ounce

Profit/Loss at maturity

Spot price 950 970 990 1010 1030

Buyer (long) -4,000 -2,000 0 +2,000 +4,000

Seller (short) +4,000 +2,000 0 -2,000 -4,000

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FORWARD CONTRACT: EXAMPLE

Long Position
Long Position

Gain/Lo Gain/Loss
ss

ST ST
$99
0 $990

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SETTLEMENT OF A FORWARD CONTRACT
A position in a forward contract can be settled depending on the type of contract:
Deliverable forward contract - Such contracts are settled by delivering the underlying asset on expiry
of the contract.
Cash settlement - Under this method the party which is on the loss side of the contract pays the
amount of the loss to the other party terminate the contract.
The person who has a obligation to purchase the asset as per the contract(long position) pays the
person who has a obligation to sell the asset(short position) if the prevailing price is lower than the
contracted price.
Terminating the position before expiration – This can be done by entering into another contract
which is opposite to the current contract. The time period of the new contract should be equal to
the time left till expiration of the current contract.

DEALER VERSUS END USER

The end users are typically corporations who want to hedge their risks.
Dealers are like the market makers for forward contracts and include banks and other Non banking
financial companies. Dealers may enter into contracts with other dealers to hedge their own
outstanding positions.
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FORWARDS ON EQUITY AND BONDS
• For Equity Forward Contracts the underlying asset is a stock. Such contracts can be settled by physical
delivery or by delivery of the stock.

• One can also have a forward contract whose underlying is the stock index. Such contracts are settled in
cash.

• Forward on zero coupon bonds or coupon paying bonds are the same as Equity Forward contracts. But
as bonds have a fixed life, the forward contract on bonds must expire before the underlying bonds
mature.

• T-bills are usually quoted at a discount to face value. This discount is annualised to arrive at the
settlement price.

Example:
$10 million face value T-bills with 100 days to maturity, priced at 2% discount.
Compute the dollar amount to be paid by long to settle the T-bill

 2% * (100/360) = 0.556%
 $ settlement price = (1 – 0.556%)*10 million = $9,944,444
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FORWARD RATE AGREEMENT(FRA)

• A forward rate agreement (FRA) is an agreement that a certain rate will apply to a certain principal
during a certain future time period.

• Forward contract to borrow (long) or lend (short) at a pre-specified rate.

• A typical FRA is where interest at a predetermined rate, R K is exchanged for interest at the market
rate.

• A 3-by-7 FRA means a120 day LIBOR starting 90 days from now.

• Payment to the long at settlement:

•
= Notional Principal X (Rate at settlement – FRA Rate) (days/360)
-------------------------------------------------------------
1 + (Rate at settlement) (days / 360)

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FRA EXAMPLE

FRA that
 Settles in 30 days
 $1 million notional
 Based on 90-day LIBOR
 Forward rate of 5%
 Actual 90-day LIBOR at settlement is 6%

Explanation of the question; The 3 month spot rate agreed after 1 month is 5%, but after one month
the 3 month forward rates become 6%. So extra payment to be made by the party who has promised
to give the loan at 5% is

(6% - 5%) * (90/360)* $1m = $2,500

This extra payment which will happen after 3months will be $2,500. Hence its present value
will be

PV: 2,500 / (1 + (90/360)*6%) = $2,463

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CALCULATION OF PAYMENT AT EXPIRATION OF FRA

Let's set up the transaction:

Dealer quotes a rate of 4% on this instrument and end user agrees. He is hoping that rates
will increase. 
Expiration is in 90 days.
The notional amount is $ 5 million.
The underlying interest rate is the 180 LIBOR time deposit.
In 90 days the 180-day LIBOR is at 5%. That 5% interest will be paid 180 days later.

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CALCULATION OF PAYMENT AT EXPIRATION OF FRA

Let's set up the transaction:

Dealer quotes a rate of 4% on this instrument and end user agrees. He is hoping that rates
will increase. 
Expiration is in 90 days.
The notional amount is $ 5 million.
The underlying interest rate is the 180 LIBOR time deposit.
In 90 days the 180-day LIBOR is at 5%. That 5% interest will be paid 180 days later.
So:                  5,000,000 ((0.05 - 0.04) (180/360)) = $ 47,600
                                               1 + 0.05 (180/360) 

Because rates increased, the long party or the end user will receive $47,600 from the short
party or the dealer.

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CURRENCY FORWARD CONTRACTS

• A currency forward contract is a contract to exchange one currency for

another at some future date at a per-specified rate.

• These contracts can be settled in cash or by actual exchange of the currencies.

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CURRENCY FORWARD CONTRACTS EXAMPLE
• Suppose there is a corporation which is USA based, hence their balance sheet is dollar
denominated.
• Corporation A has a foreign sub in Italy that will be sending it 10 million euros in six
months.
• Corp. A will need to swap the euro for the euros it will be receiving from the sub. 
• In other words, Corp. A has to be short euros and long dollars. It is long dollars because
it will need to purchase them in the near future. Corp.
• A can wait six months and see what happens in the currency markets or enter into a
currency forward contract.
• To accomplish this, Corp. A can short the forward contract, or euro, and go long the dollar.
• Corp. A goes to Citigroup and receives a quote of .935 in six months.
• This allows Corp. A to buy dollars and sell euros. Now Corp. A will be able to turn its 10
million euros into 10 million * .935 = 935,000 dollars in six months. 
• Corp. A goes to Citigroup and receives a quote of .935 in six months. This allows Corp. A to
buy dollars and sell euros. Now Corp. A will be able to turn its 10 million euros into 10
million * .935 = 935,000 dollars in six months.
•  If the rate has increased to .95, Corp. A would still receive the .935 it originally contracts to
receive from Citigroup, but in this case, Corp. A will not have received the benefit of a more
favorable exchange rate. 

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QUESTION

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ANSWER

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QUESTION

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ANSWER

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QUESTION

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ANSWER

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QUESTIONS

1. A forward contract on an index is:

A. Settled by delivery
B. Cash settled
C. Is always rolled over

2. Forwards on bonds must always:

A. Expire before the bond matures.
B. Expire after the bond matures.
C. Expire on the date of maturity of the bond.

3. Euro Dollar deposit is:

A. Euro denominated deposits outside US
B. Dollar denominated deposits outside US
C. Euro denominated deposits in US

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QUESTIONS (CONT...)

4. A 2-by-5 FRA means :

A. A 60 day LIBOR starting 90 days from now
B. A 90 day LIBOR starting 60 days from now
C. A 60 day LIBOR starting 150 days from now

5. FRA that
 Settles in 30 days, $5 million notional
 Based on 120-day LIBOR, Forward rate of 5.5%
 Actual 120-day LIBOR at settlement is 7%
The PV is
A. 25,000
B. 27,349
C. 24,429

6. Which of the following about Currency Forward contracts is not true:

A. They are always cash settled
B. They can be cash settled or settled by delivery of the underlying currencies
C. The exchange rate between the currencies is specified at the beginning of the contract.

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ANSWERS

1. Answer: B, Cash settled

2. Answer: A, Expire before the bond matures

3. Answer: A, Euro denominated deposits outside US

4. Answer: B, A 90 day LIBOR starting 60 days from now

5. Answer: C, 24,429
(7% - 5.5%) * (120/360)* $5m = $25,000
PV: 25,000 / (1 + (120/360)*7%) = $24,429

6. Answer: A, They are always cash settled

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AGENDA

Derivative Markets and Instruments

Forward Markets and Contracts
Future Markets and Contracts
 Mechanics of Futures Market
 Margins
 Termination of Futures Contract
 Types of Futures Contract
Option Markets and Contracts
Swap Markets and Contracts
Risk Management Application of Option Strategies

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AGENDA FOR FUTURE MARKETS AND CONTRACTS

• Characteristics of Futures

• Margins

• Marking to Market

• Termination of Futures contract

• Types of Futures

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CHARACTERISTICS OF FUTURES
Fundamentally, Futures are similar to Forward contracts. They differ on the following aspects:

FORWARDS
• Not traded on exchanges
• Are private agreements between
two parties and are not as rigid in
their stated terms and conditions
• Credit risk is high
• High customization
• Settlement at the end of contract
and on a specific date
• Mostly used by hedgers that want
to remove the volatility of the
underlying, hence delivery/cash
settlement usually takes place
FUTURES
• Traded on exchanges
• Standard contracts
• Clearing house and daily mark to
market reduces credit risk
• Settlement can occur over a range
of dates
• Usually closed out before maturity
and hardly any deliveries happen

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CLEARING HOUSE
• Each exchange has a clearing house.
• The clearing house guarantees that the traders in the future market will honor their
obligations.
• The clearing house does this by splitting each trade once it is made and acting as the
opposite side of each position.
• By doing this, the clearing house allows either side of the trade to reverse positions at the
future date without having to contact the other side of the initial trade.
• This allows traders to enter the market knowing that they will be able to reverse their
position.
• Traders are also freed from having to worry about the counterparty defaulting since the
counterparty is now the clearing house.
• In the history of US future’s trading, the clearing house has never defaulted on a trade.

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MECHANICS OF FUTURE MARKETS
investor broker
• Specifications of a contract
– Asset: If asset is a
commodity, exchange
specifies the asset in
complete detail: grade,
quality, size, shape,
colour, etc
– Contract size: The amount
of the asset to be
delivered
– Delivery arrangement:
place of delivery
– Delivery month
trader Exchange
• Margins
– Margin account.: investor
deposits a certain amount
of money with the broker in
the margin account
– Initial margin: the initial
amount deposited in the
margin account
– Maintenance margin: is
somewhat below the initial
margin. The minimum
amount after which a
margin call is sent to the
investor. After margin call
investor has to top his
margin account to the initial
margin
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MARGINS
• A person is required to deposit Margin money with his broker to undertake trades in the futures market.
• Initial Margin is the amount that is to be deposited even before the first trade takes place.
• Maintenance Margin is the minimum amount of margin that has to be maintained in the margin account.
• If the margin account falls below the maintenance margin due to change in the market price of the
security, then the investor will have to bring in additional margin to bring it back to the level of Initial
margin. This additional margin is known as Variation Margin.
• If the account margin exceeds the initial margin requirement, funds can be withdrawn or used as initial
margin for additional positions.

MARKING TO MARKET
• Marking to market involves adjusting the margin account to reflect the change in the price of the
underlying security.

• The exchange imposes price limits within which the future contracts can be traded. If a contract has a
daily price limit of five cents, and it is current price is $2.50, then the contract has made a limit move.
– If the contract price hits above $2.55 the contract has said to be limit up.
– If the contract price hits below $2.45 the contract has said to be limit down.

As no trade will take place the price is said to have locked limit.

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TERMINATION OF FUTURES CONTRACT

Future contracts can be terminated in any one of the following ways:

• Delivery
• Cash settlement
• Offsetting trade
• Exchange of physicals
– Ex-pit (outside exchange) transaction

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TYPES OF FUTURES

TREASURY BILL FUTURES

Based on $1 million face value T-bills maturing in 90 days.
 Price quote = 100 – Annualized discount rate in %
 Cash settled

TREASURY BOND FUTURES

Traded for Treasury bonds with maturities >15 years.
Deliverable contract.
Face value of $100,000.
Are quoted as a percent and fractions of 1% (measured in 1/32 nds) of face value.
The Short position holder has an option to deliver any of the several bonds to
satisfy the contract terms. This least expensive product is also known as the
cheapest-to-deliver-bond.

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TYPES OF FUTURES (CONT...)

EURODOLLAR FUTURES
 $1 million face value
 Based on 90-day LIBOR
 Price quote = 100 – annualized LIBOR in %
 Cash settled
 Minimum change = 1 tick = 0.01% => $1 million*0.01%/4= $25

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QUESTION

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ANSWER

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QUESTION

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ANSWER

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Types of Futures (Cont...)

STOCK INDEX FUTURE

S&P 500 is the most popular Index Future
Trades in Chicago
Settles in cash as it is not possible to physically deliver the index
Multiplier of 250
Value of contract = 250 * index level

CURENCY FUTURE
Much smaller market than currency forwards
Price is stated in USD/unit
 E.g. Size of peso contract is MXP 225,000, euro contract is EUR 145,000

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QUESTION

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ANSWER

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QUESTIONS

1. If the margin account falls below the maintenance margin the investors has to bring in
additional amount to increase the margin level to:
A. Maintenance Margin
B. Variation Margin
C. Initial Margin

2. Adjusting the margin account to reflect the change in the price of the underlying
security is known as:
A. Daily margin
B. Marked to Market
C. Settlement Margin

3. Which of the following is not a way of settling a future contract:

A. Mutual agreement of the parties to the contract
B. Exchange of underlying physicals
C. Entering into offsetting trade
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QUESTIONS (CONT...)

4. Treasury bond futures are traded with maturities:

A. Less than 15 years
B. More than 15 years
C. More than 10 years

5. Minimum Price change for a Eurodollar future contract is:

A. $50 per $ 1 million contract
B. $25 per $ 5 million contract
C. $25 per $ 1 million contract

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ANSWERS

1. Answer: C, Initial Margin

2. Answer: B, Marked to Market

3. Answer: A, Mutual agreement of the parties to the contract

4. Answer: B, More than 15 years

5. Answer: C, $25 per $ 1 million contract

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