Futures Markets and Contracts

- They are standardised ‘forward contracts’

- Traded on the organised exchange.
A futures contract is an agreement between two parties in which one party, the buyer, agrees
to buy from the other party, the seller an underlying asset or other derivative at a future date
at a price agreed on today.

 Unlike a forward contract however, a futures contract is not a private and customised
transaction but rather a public transaction that takes place on a organised futures
exchange.
 In addition, a futures contract is standardised, i.e. the exchange rather than the
individual parties set the sterms and conditions with the exception of price. As a
result futures contracts have a secondary market meaning that previously created
contracts can be traded.
 Also parties to futures contracts are guaranteed against credit losses resulting from the
counter party’s inability to pay.
 A clearing house provides this guarantee via a procedure in which it converts gains
and losses that accrue on a daily basis into actual cash gains and loses.
 Everyday the futures contract trade in the market and its price changes in response to
new information.
 Buyers benefit from price increases and sellers from price decreases.
 On the expiration day, the contract terminates and no further trading takes place.
 Either the buyer takes delivery of the underlying to the seller or two parties make an
equivalent cash settlement.

History of the Futures Market

In 1848 a group of business man formed an organisation later called Chicago Board of Trade
and created an arrangement called ‘To Arrive Contract”. These contracts permitted farmers
to sell their grain before delivering it, that is in other words, farmers could harvest the grain
and enter into a contract to deliver it at a much later date at a price already agreed on. This
transaction allowed the farmers to hold the grain in storage at some other location besides
Chicago. It soon became ap[parent that trading in these “to arrive Contracts” was more
important than trading in grain itself. With the addition of a clearing house in the 1920s,
1
which provided a guarantee against default modern futures firms established their plan in the
financial world.

Examples of futures exchange include:

1. Chicago board of Traders
2. Chicago Mercantile Exchange
3. LIFFE
4. South African Futures Exchange e.t.c.

Features of a Futures Contract

1) Standardised Transaction
A futures transaction is reported to the futures exchange the clearing house and at least one
regulatory agent. The price is rewarded and is available from price reporting services or even
on the internet. The information reported to the public does not report or disclose the identity
of the parties to the transaction but only that a transaction took place at a particular price. In
a futures contract the price is the only term established by the two parties, the exchange
established by the other terms. More over the terms that are established by the exchange are
standardised.

2) Expiration dates
For a futures contract the exchange establishing a set of expiration dates. The fist
specification of the expiration is the month e.g. March. June. September, December. The
second is the expiration day. Many but not all contracts expire during the 3 rd week of the
expiration month.

3) Contract Size
For example, one futures contract on crude oil covers 1000 barrels.

4) Homogeneity and Liquidity

The font that the instruments are standardised make it acceptable to a broader group of
participants, with the advantage being that the instruments can more easily trade in the
secondary market.

The Clearing House Daily Settlement and performance Guarantee

2
The futures exchange guarantees to each party the performance of the other party through a
mechanism known as clearing house. This guarantee means that if one party makes money
on the transaction, he does not have to worry about whether he will be able to collect the
money from the other party because the clearing house guarantees that it will be paid. An
important feature o the futures contract is that the gains or losses on each party’s position are
credited are charged on a daily basis, that is market to market.

Regulation of the Futures Market

In most futures contracts are regulated at the government level. In the
 USA the commodity futures Trading Commission regulates commodity futures
markets.
 In the UK – the Financial Services Authority (FSA) regulate the futures market.
 In South Africa – the Financial Services board regulates the futures market.

Example: A producer agrees to deliver one million barrels of oil to an oil export at $100 per
barrel at some future date. The trader takes a long position of 10 contracts on day O,
depositing $10 which is ($5 times contracts).

We start with the assumption that the futures price is $100 when the transaction opens. The
initial margin requirement is $5 and the maintenance margin is $3.

Although the trader can withdraw any funds in excess of the initial margin requirements we
shall assume that he does no do so.

Day Beginning Funds Settlement Futures Gain/Loss Ending

Balance Deposited Price Price Balance
Change
0 0 50 100 - - -
1 50 - 99.20 -0.80 -8 42
2 42 - 96.00 -3.20 -32 10
3 10 40 101.00 +5 50 100
4 100 - 103.50 +2.50 25 125
5 125 - 103.00 -0.50 -5 120
6 120 0 104.00 +1 10 130

Example:

3
Consider a futures contract in which the current prize is $82. The initial margin requirement
is $5 and the maintenance margin is $2. You go long 20 contracts and meet all margin calls
but do not withdraw ant excess margin. Assume that on the first day the contract is
established at the settlement prize so that there is no mark to market gain that day.

Day Beginning Funds Settlement Futures Gain/Loss Ending

Balance Deposited Prize Price Balance
Change
0 0 100 82 - -100
1 100 84 +2 +40 140
2 140 78 -6 -120 20
3 20 80 73 -5 -100 0
4 0 100 79 6 120 120+100=220
5 220 82 +3 60 280
6 280 84 +2 40 320

Types of Futures Contracts

1) Commodity Futures
2) Financial Futures

Financial Futures
(i) Interest rates futures contracts
(ii) Currency rates future contracts
(iii) Stock index futures contracts

(i) Short term interest rate futures contracts

The primary short term interest rate futures are those on US Treasury bills and
Euro Dollars on the Chicago Mercantile Exchange.

(a) Treasury Bill Futures- The treasury bill

- Contract launched in 1976 was the first interest rate futures contract.
- It is based on a 90 day US Treasury bill, one of the most important US government
debt instrument. The treasury bill is a discount instrument meaning that its prize =
face value

4
 - The discount = face value x quoted rate x the days to maturity divided by 360. Thus
if a 180 dya treasury bill is selling at a discount of 4%, its prize per $1 par is

1−0 ,04 ( 180

360 )
=$ 0. 98.

- An investor who holds the bill to maturity would receive $1 ant maturity netting a
given of $0,02. The futures contract is beized on a 90 day $1 million US treasury
(TB). Thus on any day, the contract trades with the understanding that a 90 day. TB
will be delivered at expiration.
- While the contract is trading, its price is quoted as “100 – the rate quoted as a percent”
priced into the contract by the futures market. This value is known as the IMM index.
The IMM index is a reported and publicity available price, however it is not the actual

90
(
futures price which is 1 00 1−rate x
30 )
For example: Suppose on a given date, the rate priced on the contract is 6,25%. The quoted
price will be 100-6,25 = 93,75.
The actual futures price will be:
90
(
1000 0 00 x 0 , 0625 x
360 )
=984375.

90
1000 0 00 x ( 1−0 , 0625 x
360 )
=984375

b) Eurodollar Futures
the 3 months Eurodollar futures contract traded on the CME is one of the most liquid
financial futures contracts in the world. It is widely used by financial institutions to hedge
short term interest rate possures or to take a leveraged position in anticipation of a rise or fall
in interest rates.
The CME contract is based on the LIBOR rate on a notional $1 million Euro dollar deposit
starting at a specific date in the future. While the contract is trading, its prize is quoted as 100
the rate priced into the contract by futures traders.
For example’
If the rate priced into the contract is 5,25% the quoted price will be 100-5,25%=94,75%.

5
With each contract based on $1 million notional principal of Euro dollars, the actual futures

90
[
price is $ 1000 000 1−0 , 0525 ( 360 )]=986875 , 00
(c) Stock Index Futures Contract
One of the most successful types of futures contracts of all times is the class of futures on
stock indices. The most successful has been the Chicago Mercantile Exchange’s contract on
the standard and poor 500 (S&P500).
FTSE 100, NIKKEI, DAX

Called the S & P 500 stock index futures, this contract premiered in 1982 and has benefit
from widespread acceptance of the S & P 500 index as a stock market benchmark. The
contract is quoted in terms of the price on the same order of magnitude as the S & P 500
itself.

Example

If the S &P 500 index is at 1183, a two months futures contract might be quoted at a price of
say 1187. The contract implicitly contains a multiplier which is appropriately multiplied by
the quoted price to produce the actual futures price. The multiplier for the S&P500 is $250
thus for a future price of 1187 the actual price is 1187x$250= $296 750.

The S &P500 futures expirations are March, June, September and December.

(d) Currency futures contracts

Currency futures were the first futures contracts not based on physical commodities and their
initial success paved the way for the later introduction of interest rate and stock index futures
compared with forward contracts on currencies, currency futures contracts are much smaller
in size.

Pricing and valuation of futures contracts

(i) Futures contracts on a security with no income. When they are no distributions
from the underlying asset, the cost of carry is equal to riskless interest rate. The
futures price is given by: F= SerT. More generally the relation represents the
forward or futures price as a function of the spot prices. It applies to the valuation
of forwards or futures contracts an a security their provides no income, e.g

6
 Example

Consider the futures contract on a non-dividend paying stock. Suppose the maturity date
is in 3 months the current asset price is $100 and the 3 months risk free rate is 7% per
annum. In this case: S=100

R =0,07

3
T= = 0,25 years
12

The future price = SerT = 100 e0,07x0,25

= 101,7654

ii) Futures contracts on a security with known Income.

For dividend paying assets the cost of carrying the stocks is given by the difference
between the risk less rate and the dividend yield d. This gives the following relation:

F = Se(r-d)T

This relationship gives the futures price F as a the function of the spot price S for a
forward or futures contract on a security that provides a known dividend yield.

e.g

Consider the valuation of a 3 months futures contract on a security that provides a continuous
dividend yield of 5% per annum. Suppose the current asset price is $100 and the risk free rate
is 7% per annum.

S =100
T = 0,25 years
r =0,07
d =0,05
F = Se(r-d)T= 100 e(0,07-0,05)x0,25
= 100, 5012521

(iii) Futures Contracts on Foreign Currencies

The cost of carrying a foreign currency is given by the difference between the domestic
riskless rate and the foreign riskless rate, r* this gives the following relation between the
futures price and the spot price of the currency:
F=Se(r-r*)T
This relationship also gives the futures price F (or foreign exchange rate F) as a function of
the spot price S for a forward contract in a currency.
This is often known in international finance as the interest rate parity theorem;
For example;

7
Consider the valuation of a 3 months forward or futures contract on a foreign currency: If the
spot price is 180, the domestic riskfree rate is 6% p.a. and the foreign risk free rate is 7% p.a..
Then
S=180
T=0,25
r=0,07
r*=0,06

F=180e(0,07-0,06)x0,25
= 180,45

3(iv)
Question

The spot exchange rate for the Swiss Frank is $0,60. The US interest rate is 6% and the Swiss
interest rate is 5%. A futures contract expires in 78 days. Find the appropriate future price.

F = 0,60e(0,06-0,05)x0,2166666
= 0,60130
78

[
¿
(
1+0 , 06 x

1+0 , 05 x

1 , 013
360
78
360
)
]
1, 01083333

= 0,6013

CHF 1 :$0,60
Counter currency
Base currency

Exam questions
APPLICATION

RISK MANAGEMENT OF FUTURES STRATEGIES

The Managing of risk of an Equity Portfolio

We consider the specific problem of an equity portfolio manager from the risk of an adverse
movement of the overall stock market. Have the risk manager wishes to establish a short
ledger position to reduce risk and must determine the number of futures contracts required to
properly ledge a portfolio. In this hedging example;

You are responsible for managing a broadly diversified stock portfolio with a current
portfolio valued at $185 million. Analysis if the market conditions leads you to believe the
market is unusually vulnerable to a price decline during the next few months. A fundamental
problem however is that no futures contract exactly matches as a result you decide to protect
your stock portfolio from a fall in value caused by failing stock market, using stock index
futures this is an example of a cross- hedge, where a futures contract on a related but not

8
identical commodity or financial instrument is used to hedge a particular spot stock
positioning thus to hedge the portfolio you wish to establish a short hedge using stock index
futures. (Beta of Market Portfolio is 1.)

To do this one needs to know how many index futures contracts one needed to form an
effective hedge
- Three basic impacts are needed to calculate the number 6 index futures to hedge the
stock portfolio.
1. The current value of the stock portfolio.
2. The Beta of your stock portfolio
3. The contract value of the index Futures contract used for hedging.

Beta measures the portfolio risk relative to the stock market.

- We assume a Beta of 1,25 to the stock portfolio of $185million.
- You believe that the market & your portfolio will fall in value over the next 3 months
and you decide to eliminate the market risk from your portfolio that is you would like
to convert your risk portfolio with a Beta of O. A riskless is like Treasury Bill
(conventional Bills) 0.
- Because you hold a stock portfolio, you know that you need to establish a short hedge
using Future contracts.
- You decide to cede Futures contracts on the S&P Index and find that the S&P Futures
price for contracts that mature in 3 months is $1480
- Because the contract size for the S& P Futures is $250 times the index level, the
current value of single S&P500 Index futures is 250x1480 = $370 000.
- The number of stock index futures contracts needed to convert Beta of the portfolio
from 1,25 to 0 is determined by the following formula:

VP
Number of contracts = (BD-BP) x
VF

Where: BD =Desired Beta of Stock Portfolio (o)

BP = Current Betya of the stock portfolio (1,25)

Vp = Value of stock Portfolio = $185 million

V F = Value of the stock index futures contract. (370 000)

185 000 000

=(0-1,25) x
37 0000

= - 625 You must not sell 625 futures contracts. Negative you must sell.
Positive you must buy.

Thus the manager can establish an effective short hedge by going short 625 S &P, Index
fuctorus contract.

9
 - This short hedge will protect the stock portfolio of a general fall in the stock market
during thje remaining 3 months life of the Futures contract.

QUESTION

How many stock Index Futures contracts are required to hedge a $250million stock portfolio
assuming a portfolio Beta of 0,75 and S &P Index Futures level of 1500.

Current value of a single S &P500 Index Futures is:

(250x1500) = 375 000

25 0 00 0 000
No. of contracts = (0 – 0,75) x
37 5 000

= - 500. This short 500 futurs contracts (sell)

4(ii)

QUESTION

BBH is a US nenghomorati. US Pension Fund generates market forecast internally and

receives forecasts from independent consultants. As a result of the forecasts, BBH expect the
market for large Cap stocks to be stronger than it believes everyone in the market is expecting
over the next 2 months.

Action: BBH decides to adjust the Beta on $ 38 500 000 of large stocks from its current
current l to 1,10 for the period of the new 2 months. It has selected a Futures contract deemed
to have sufficient liquidity. The Futuns contract deemed to have sufficient liquidity. The The
Fuctons price is currently $ 275 000 and thye contract has a Beta of 0, 95. The approximate
number of Futurs contracts to adjust the Beta would be

N = ( B D−B P ) ( VP
VF )

= (1,10 – 0,9) ( 3805000 000

275 000 )

10
 = 28 They have to buy 28 futurs contracts. (Positive answer = Buy)

N ( BDBF−BP ) ( VP
VF )

To completely eliminate market to Zero

= ( 1 ,10−0 , 9 38 500 000

0 ,95 ) ( 27 5 000 )

=29 Futures contracts Scenario (December 3)

The market as a whole increases by 4,4 %

The stock portfolio increases to 40 103 000

The stock index Futures contract rises to $ 286 687,50 an increase of 4,25%

Outcome and analysis

- The profit on the futures contract is:

- - 29 Futures contracts (286 687,50 – 275 000)

=$338 937,50

The rate of return for the portfolio is

40 1 03 000
(38 5 00 000 )−1=4 ,1 6 %

- Add profit from Futures contract to the current stock portfolio’s value

40 103 000 +338 937,50 = $ 40 441 937, 50

- ( 4038441937,50
500 000 )
-1 = 5,04%

0 , 0504
- Effective Beta = =1,15
0 , 044

OPTIONS MARKETS AND CONTRACTS

PUT SELL
CALL BUY
Option

11
Option

An option is a financial derivative that provides a party the right to buy or sell an underlying
at a fixed price by a certain time in the future.
The party holding the right is the option buyer, the partly granting the right is the option seller
or the writer.

There are 2 types of options, a call and a put

A call is an option granting the right to buy the underlying is an option granting the right to
buy the underlying.
- A put option gives the right to sell the underlying.
- The right to buy or sell is held by the option buyer also called the long or option
holder and granted by the option seller also called the short or option writer.
- To obtain this right the option buyer pays the seller a sum of money commonly known
as option price or option premium.
- This money is paid when the contract is initiated.
- The fixed price at which the option holder can buy or sell the underlying is called the
exercise price or Strike price.
- The use of this right to buy or sell the underlying is referred to a exercising the option
- An option has an expiration date giving rise to the motion of an option’s time to
expiration
- When the expiration date arrives, an option that is not exercised simply expires.
- There are 2 primary exercise styles associated with options.
- One type of option has European style exercise which means exercise can only be
exercised on its expiration day.
- The other style of exercise is the American style exercise, Such an option can bre
exercised at any day through expiration day and is generally called an American
option.
- Option contracts specify a designated of units of the underlying for exchange listed
standardized options, The exchange establishes each term with the exception of the
price.
- For over the center options, the 2 parties decide each of the term through negotiation.

BASICS OF A CALL(CALL OPTION)

OWNING A CALL OPTION

XYZ is currently trading at a price of $100 (per share) suppose you are given free of charge
the right to buyXYZ (shares) at the current price of $100 for the next 2 months. If XYZ stays
where it is or if it declines in price, you have no use of your right to buy that is you can
simply ignore it but if XYZ rises to $105, you can exercise your right by buying XYZ for
$100 as the new owner of XYZ you can then sell it at $105 or hold it as an asset worth $105.
In either case you can make a profit of $5. What you do by exercising your right is to call
XYZ from its previous owner. Your original option to buy is known as a call option.
- It is important to visualise profit and loss in graphical terms, that is :

Profit

+-10 (Owning a call)

12
+-5

0
100 105 110 Prize

OFFERING A CALL (Writing) (Selling)

- Lets consider the position of option writer

- By giving the investor the right to buy, the option writer has assumed an obligation to
sell consequently this option writer’s loss/ profit position is exactly the aggressive of
the investor. The risk for this investor is that XYZ will rise in price and that will be
“called away from him”. The option writer will relinquish all profit above $100

Price
100 105 110

-5

-10

Loss

Buying A Call
The investor who offers a call also demands a free or a premium, the buyer and seller must
agree on the price for the call contract. Suppose the price in this case the price agreed upon is
44 a contract, profit/loss position for the buyer when the contract expires is shown below

+6

+1

13
 0

-4

By paying $4 for the call option, the buyer differs his profit until XYZ reaches $104. At $104
the call is paid for by the right to buy $100 for XYZ. The advantages of this position is that
profit above $104 is potentially unlimited. Another advantage is that by buying call option
instead of XYZ the call buyer is not supposed to the downside in XYZ.

All option contracts like their underlying contracts have contracts have contract multipliers,
both contracts have usually the same multiplier. If the multiplier for the above contract is
$100, then the actual cost of the contract will be $4 x $100 = $400
- So the value of XYZ at $100 will be $100 000

4(iii) Example
Suppose GE is trading at !8,03 the April 18 calls are priced at $0,58. If one purchased one of
these calls, the break even level will be the strike price + the price of the call ($18, 58)
assuming the strike price or exercise price is $18. If G>E is above this level at expiration then
one would profit one on one with the stock.

14
The contract multiplier for G.E and stock options at the Chicago Exchange is $100. Therefore
the cost of the April 18 Call and the Investors maximum risk is $58, In other words the
investor for purchase 100 shares at GE at a price of $18 per share. These shares have a total
value of $18000 (18x100)

4(iii) Example of a call Option

Suppose GE is trading at $18.00 and the April 18 calls are trading at

If an option writer sold one of the calls at expiration:

The break even Above 18,58 the option writer would loose one to one with the stock.
Between 18.00 and 18,58, the option would have a profit equal to the stock price plus the call
income.

THE BASICS OF PUT OPTIONS

A put option hedges a decline in the value of an underlying asset by giving the put owner the
right to sell the underlying at a specified price for a specified time period. The put owner has

15
the right to put the underlying to ) the opposing party (sell) the other party the put seller
consequently incurs the potential obligation to purchase the underlying.

4(iv) Buying Puts

Suppose you own XYZ and it is currently trading at a price of $100. You are so concerned
that XYZ may decline in value and you want to receive a selling price of $100. In other
words you want to ensure your XYZ for a value of $100. YOU do this by purchasing an XYZ
100 put at a cost of $4. If XYZ declines in price you have the right to sell it at $100.

Example of selling Put Options

At expiration the sell of of XYZ put for $4 would be grouped as shown below

Types of Financial Options

(a) Stock Options

16
Options on individual stocks also known as equity options are among the most popular.
Exchange listed options are available on mostly widely traded stocks and option only stock
can be potentially created on the OTC market .

(b) Index Options

(c) Index options, because a stock index is just on artificial........ it is reasonable to expect,
that one would create an option on a stock index e.g Consider Option on a S & P 500
index which treads on the Chicago Board options exchange and has a designated
index multiplier of 250. On 13 June of a given year the S & P500 closes at 1241,60. A
call option with an exercise price of $1250 expiring on 20mJuly was selling for $28.
The option is European style and settles in cash.

5(i) The underlying, the S & P 500 is treated as though it were a share of stock worth
$1241,60 which can be bought using the call option using $1250 on 20 July. At expiration if
the the option in the money the buyer exercises it and the writer pays the buyer $250 contract
multiplied x the difference between the index value at expiration and $1250 (exercise price)

Bond Option
Option on bonds usually called bond options are primarily traded on the OTC market.
- Cooperate bonds are not very actively traded, most are purchased and held to
expiration.
- Government Bonds are however actively traded thus bond options are found almost
exclusively in the OTC market and are and are almost always Options on Government
Bonds.

INTEREST RATE OPTIONS

An interest rate option is an option in which the underlying is the interest rate. Instead of an
exercise price it has an exercise rate or strike rate. At expiration the option pay off is based on
the difference between the underlying rate in the market and the exercise rate.

Currency Options
A currency option allows the holder to buy (if a call) or sell on underlying asset at a fixed
exercise rate expressed as an exchange rate. Many companies knowing that they would need
to convert a currency x at a future date into currency y will buy a call option on currency
specified in terms of currency x eg: Say a US company will be in need of E50 000 000 for an
expansion program in 3 months, thus it will be buying Euros and exposed to the risk of the
Euro rising against the US dollar.

E 1/ US 1,10 $1, 30
50x1,11 = 55 000 000 ) Risk $10 million
50 x 1,30 = $65 000 000

Example
Even though it has that concern it would also like to benefit if the Euro weaken against the $,
thus it might buy a call option on the euro.
Let us say it specifies and exercise a rate of $0,90 so it pays cash up front for the right to buy
the € 50 000 000 at a rate of 0,90/ Euro.

17
If the option expires with the € above $0,90 it can buy the € at 0,90 and avoid any additional
cost above $0,90. If the option expires with the € at the market rate.

Flows in Risk Identification and measurement

Risks are not identified currently. This may indicate that the risk function is not given
enough information to evaluate the risk of products and business or that the risks analysts are
too junior or inexperienced to discern different types of rights.

When firms looses that are greater that expented, or which are a complete surprise as in the
independent risk function is unable to distinguish between different sources of risk or risk
measurement analystics are toocoleral in their underlying assumptions. It may also mean that
risk limit structures are infective in controlling exposures. The independent risk function
should understand the nature of underlying risk bearing products to currently qualify the
potential impact of the risk.

Flows in reporting and mentoring

Where risk reporting cannot be done on a timely basis, or is routingly inaccurate as was the
call which sometimes, The firm lacked automatic reporting process.

Positions and trades must be reconciled to the official books and records. The fact that this
was not the cause in samtoking situation, include indicated defectiveness in the firm’s
technological platform as well as the use of multiple sources of Data to control single
business. It also reflects on an ineffective and financial control processes.

Risk limits and decisions should also be properly documented and provide a verifiable
conflict travel. The absence of this in our case suggests lack of discipline and procedure in
basic risk policy and governance.

Flows in Management

Risk officers must be seen to be active and ........in the risk management process. They should
not be intimidated by business manages. Experience risk function also should possess the
requisite knowledge and depths to work with question or challenge business managers.
Senior management should also hire more experienced and qualified risk professionals.

Characteristics of Dernatives Vs Other Financial Instruments

(1) Life Span

(2) Settlement - Cash/delivery
(3) Investment – Initial Margin
(4) Positions – Open and close position
(5) Credit Risk – Credit exposure is bilateral/ not unilateral
(6) Cash flow direction – 2 way cash flows

18
 (7) Risk Exposure – Trade risk exposure without owning assets
(8) Position anagement – Managing a dernative deficit from managing the underlying.

Major benefits of listed contracts

(1) Obligation guaranteed by clearing house as central centre party (CCP to a listed
contract
(2) Standardised contracts – efficient market, multilateral trading and liquidity
(3) Exchange Trading leads to lower transaction wots.

Market Players – Professional wholesale market

a) Buy Firms – Mend users Institutional investors – hedge, portfolio managers,

insurance cos, asset managers, speculators, orbitrages.
b) Sell-side Firms- Broker / dealers = Act types of brokerage firms, including market
makers – By & sell rates for profit
c) Trading Venues – Dervations exchanges, Electronic trans platforms
d) Regulatory Authorities – Governments

The Uses of Dervatives

(a) Hedging against risk

(b) Speculation
(c) Alternative instrument opportunity
(d) Risk trading
(e) Price discovery
(f) Promotion as advanced strategies to manage risk

Dangers of Dervatives

(1) Complexity
(2) High levels of exposure
(3) Complex risk measures
(4) Systematic risk
(5) Regulatory complexity

Forward Markets and Contracts

(1) A commitment by 2 parties to engage in a transaction at a later date with the price set
in advance.

Delivery and Settlement of a forward Contract

(1) Delivery: The long will pay the agreed upon price to the short
(2) Cash Settlement: Permits the long and the short to pay the net cash value of the
position on the delivery date.

Default and Forward contracts

19
Types of Forward Contracts

Equity Forwards – A Contract calling for the purchase of an Individual stock, Stock portfolio
or Stock index at a later date.
Forward Rates: FRA

- There is a large global market for time deposits in various currencies issued by large
credit with Banks.
- Market primarily based in London (Not in USA)
- Euro Dollar = Primary time deposit instrument
- It is a dollar deposited outside the US.
- Banks borrow dollars from other banks byb issuing Euro Dollar time deposits
- Short term unsecured loans
- The rate on such dollar was (inLondon) is called the London Interbank Rate.
- The Lending rate = LIBOR is commonly used in dernaatives contracts
- LIBOR = the rate at which London banks land dollars to other London banks.

FRA – Forward Rate Agreement

- A bilateral contract between 2 parties fixing the rate of interest – that will apply on a
nnotional principal for an agreed term in the future
- Buyer is compensated by sender if benchmark interest rate tends out to be above the
agreed figure at the end of the contract.
- Seller a rates are lower
- Corporate borrowers – Natural buyers
- Money market investors – natural sellers

1) BX (Libour fix – Contract Rate) x

No . da ys−Co nlt
2)
36 0
3)

20