DERIVATIVES.

Lecture 1.

Forwards and Futures.

1
 Chapter 1

Introduction
 Financial Instruments

Real Asset vs Financial Asset

Major types of Financial Assets

(also called Financial Instruments, Financial Contracts)
Cash
Debt instruments (Money Market instruments, Bond
instruments)
Equity instruments
Derivatives
 Financial Instruments

Derivatives are contracts which value is based on (derived

from) the value of other financial instrument, other asset
(it can be real asset as well) or even conditions and
processes.
Major types of Derivatives we will be interested in

Forwards
Futures
Options
Swaps
Derivatives.
That security value (its payoff) depends upon the
price (or value) of something else (oil, corn, etc.). The
asset (oil, corn, etc.) is called underlying. The contract of
interest derives its value from the value of underlying
asset. That is why such contract are called derivatives.

So, forwards and futures are derivatives or

derivative contracts.

5
Derivatives Are Important. Why?

Important by themselves:
Derivatives play a key role in transferring risks in the
economy
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments, electricity
prices, insurance payouts, the weather, etc.

Important as means of computation:

Many financial transactions have embedded derivatives
The real options approach to assessing capital
investment decisions has become widely accepted
How and Where Derivatives Are Traded

On exchanges such as:

The Chicago Board Options Exchange (CBOE);
Chicago Board of Trade (CBOT) and the
Chicago Mercantile Exchange (CME) merged to form
the CMEGroup (futures are traded).

In the over-the-counter (OTC) market where traders

working for banks, fund managers and corporate
treasurers contact each other directly (very large
market)
Size of OTC and Exchange-Traded Markets

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of
underlying assets for exchange market
The OTC Market Prior to 2008

Largely unregulated

Banks acted as market makers quoting bids and offers

Master agreements usually defined how transactions between

two parties would be handled

But some transactions were cleared through central

counterparties (CCPs). A CCP stands between the two sides
to a transaction in the same way that an exchange does
The OTC Market Since 2008
OTC market has become regulated. Objectives:

Reduce systemic risk

Increase transparency
In the U.S and some other countries, standardized OTC
products must be traded on swap execution facilities (SEFs)
which are electronic platforms similar to exchanges

CCPs must be used to clear standardized transactions

between financial institutions in most countries

All trades must be reported to a central repository

The Lehman Bankruptcy (Possible project)

Lehman’s filed for bankruptcy on September 15, 2008.

This was the biggest bankruptcy in US history

Lehman was an active participant in the OTC derivatives

markets and got into financial difficulties because it took high
risks and found it was unable to roll over its short term funding

It had hundreds of thousands of transactions outstanding

with about 8 000 counterparties

Unwinding these transactions has been challenging for

both the Lehman liquidators and their counterparties
Forwards. Example.
Farmers vs. Processors

Farmer is concerned that the price of the crop may

go down next harvest.
Processor is concerned that the crop price may go
up.

Both face the price risk.

Can they reduce it?

12
Forwards. Example.
Farmers vs. Processors

Their options:

1. Do nothing. Whatever price happen to be -- accept it.

2. Make an agreement with the opposite party and lock in

an acceptable price. E.g. enter into a financial contract.
Negotiate the contract to your specifications (what, when,
where, how much, price, etc.)

13
Forwards. Example.
Let's assume that your contract looks something like the
following.

On specific day, say October 1st, one party (e.g.

you) agrees to bring xxx units of crop (specify very
accurately what you are delivering) at the following
location (specify the location). The other party agrees to
accept the delivered asset and agrees to pay yyy.yy units
of currency per unit of asset, say per unit of your crop.

14
Forwards.
What do we see? The contract specified several
things. First and second, the type of asset to be traded on
a specific day in the future (date). Third, the delivery
location (in case of physical goods; if you are trading
stocks or bonds there is no specific location needed
actually). Fourth, the amount of assets to be delivered.
And, very important, the price one pays and the other
accepts in the future (note, the price is determined today).

There is NO change of funds/assets (including

cash) as of today.
15
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.
Delivery
If a futures contract is not closed out before
maturity, it is 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.

Some contracts (for example, those on stock

indices and Eurodollars) are settled in cash
Forwards. Example.
Assume you have signed a contract with following
terms. You agree to deliver 1000 barrels of (special type
of) crude oil at some specified location on Jan.15th of the
next year. The price which the buyer would pay is $110
per barrel.

Now let's see what the outcomes of such an

arrangement on Jan.15th of the next year. For simplicity
we will assume that every party honors its obligations.
The market price of the same/similar asset on open
market, is out of our control. Yes, we will receive the
promised $110 per barrel, but still we want to know what
our profits (losses) are relative to not having the contract.
18
Forwards. Example.
We consider "what-if" scenarios (very popular in
finance).
What if the spot price on Jan.15th is $85 per barrel?
Well, in that case you could get only $85 per barrel, so for
1000 barrels you would get $85 000. However, you have
the contract which calls for $110 price per barrel. If you
use it you can receive $110 000 instead of $85 000. That is
$25 000 difference ($25 per barrel, unit of you asset).
Continue considering different what-if prices, say
$140 per barrel. Well, in that case instead of selling for
$140 000 you have to sell for $110 000. The relative loss
is $30 000.
19
Spot Seller perspective. Financial outcome relative to no-
price contract case
50 60
60 50
65 45
70 40
75 35
80 30
85 25
90 20
95 15
100 10
105 5
110 0
115 -5
120 -10
125 -15
130 -20
135 -25
140 -30
145 -35 20
150 -40
Forwards.
Profit / Loss due to the contract.
80

60

We can represent 40

the same information 20

Profit / Loss
graphically. 0
50 60 70 80 90 100 110 120 130 140 150 160

-20

It can be interpreted -40

as Contract Value -60

Spot price

to the seller. Seller perspective. Financial outcome relative to no-contract case

21
Forwards. Example.
Consider the same "what-if" approach for the
buyer of underlying asset.

Create a table and plot the results.

22
Spot Buyer perspective. Financial outcome relative to no-
price contract case
50 -60
60 -50
70 -40
75 -35
80 -30
85 -25
90 -20
95 -15
100 -10
105 -5
110 0
115 5
120 10
125 15
130 20
135 25
140 30
145 35 23

150 40
Forwards.
Profit / Loss due to the contract.

We can represent 60

that graphically as well. 40

20

It can be interpreted 0

Profit / Loss
50 60 70 80 90 100 110 120 130 140 150 160

as Contract Value -20

to the buyer. -40

-60

-80
Spot price

Buyer perspective. Financial outcome relative to no-contract case

24
Spot price Value to Seller Value to Buyer Value to both the Seller and the
Buyer.
0 110 -110 0
10 100 -100 0
30 80 -80 0
50 60 -60 0
60 50 -50 0
70 40 -40 0
80 30 -30 0
90 20 -20 0
100 10 -10 0
110 0 0 0
120 -10 10 0
130 -20 20 0
140 -30 30 0
150 -40 40 0
160 -50 50 0
170 -60 60 0
180 -70 70 0
190 -80 80 0 25

200 -90 90 0
 Future Agreement Contract.Values to a Seller and a
Forwards. Buyer.
150

Graphical125
100
representation.
75

50

Contract Value
Spot price
25

0
0 25 50 75 100 125 150 175 200 225 250
-25

-50

-75

-100

-125
Value to Seller
-150 Value to Buyer
Value to both the Seller and the Buyer.
26
Forwards.
The contract was designed to hedge the risk.
However, as always, that (or essentially similar, see
below) type of contracts can be used for speculation
and/or for arbitrage. Approximately 95-99% of such or
similar contract traded on exchanges are used for
speculative and/or arbitrage purposes (are you surprised?).

The contract is zero-sum game. That means that

contract does not create new wealth (real, physical wealth)
in the economy, it just redistributes money between
interesting parties.

27
Forwards.
As usual, such contracts have special name. If the
contracts we are speaking about are custom-made and are
not traded on exchange, we will call them the Forwards.

There is another type of contract, which is

extremely similar to a forward, but has some distinctive
features. First, they are very standardized and can be
traded on an exchange. Second, you sign a contract with a
clearinghouse (you might not even know your counter-
party). Third, the risks are reduced using special features.
Such contracts are called Futures contracts.

28
 Forwards and Futures
Forward - an agreement/contract calling for a future delivery
of an asset at a currently agreed-upon price
Futures - similar to forward contract but features contract has
formalized and standardized characteristics
Key difference of futures
Secondary trading - higher liquidity
Standardized contracts - higher liquidity
Marked-to-market - less risk
Clearinghouse guarantees outcome - less risk
May be settled in cash
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 end of contract Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk
Terminology / Jargon

The party that has agreed to buy the asset is called

a long position

The party that has agreed to sell the asset is called

a short position
Derivatives. Forwards, Futures. Jargon.
Long position - the participant agrees to purchase
the underlying asset. So, “to be long in such and such
futures” means the investor entered into contract to buy
such and such asset. Also may be referred as “Buying a
forward/futures contract”. Actually, nothing is bought at
the time of signing the contract. No money changes
hands.

Short position - the participant agrees to sell the

asset and accept the cash payment from another party.
Also may be referred as “Selling a forward/futures
contract”. 32
Derivatives. Forwards vs. Futures.
If you enters into forward contract it looks like that:

CASH/MONEY
LONG position SHORT position
ASSET

Generally, such positions (e.g. a forward) are

subject to some risks. Yes, you have removed the PRICE
RISK, but you received some other risk, the counter-party
risk, e.g. there is a risk that the other party will not honor
its obligations. You can try to take the failed party to a
court, but it is very expensive to do so. So, still there is a
risk. 33
Derivatives. Forwards vs. Futures.
In case of futures contracts that risk is almost zero, as
you are dealing with very reputable entity.

CASH CASH
LONG position CLEARINGHOUSE SHORT position
ASSET ASSET

Trading futures involves an Exchange which serves as a

clearinghouse, e.g. it guarantees to honor all transactions. So,
you enter into contract with the clearinghouse and will never
know the party on the other side of the contract.

34
Problems.
Problem 1.
You entered into contract to deliver 5000 bushels of
corn on August 15th with forward price $15 per bushel.
Create a payoff table. Draw a graph.

Problem 2.
You are buying. So, you have 100 futures with
forward (or sometimes people say "strike") price $70 and
200 futures with a strike price $80 (assume each future
contract is per unit of whatever you are buying). What is
your payoff if the spot price at the day of delivery is $60?
$75? $80? $95? $120? Draw a graph.
35
Derivatives.

That security value (its payoff) depends upon the

price (or value) of something else (oil, corn, etc.). The
asset (oil, corn, etc.) is called underlying. The contract of
interest derives its value from the value of underlying
asset. That is why such contract are called derivatives.

So, forwards and futures are derivatives or

derivative contracts.

36
Derivatives. Forwards, Futures. Jargon.

Futures/Forward/Strike price - currently agreed

price to be paid/received at maturity.

Settlement/Exercise/Delivery Date - the date at

which the contract is settled, either in cash or actual
delivery (e.g. one party must deliver the asset and the
other party must accept it and pay for it).

37
Derivatives. Forwards, Futures. Jargon.

Futures contracts are traded on different assets.

They are called underlying assets.

We can assign them to five major categories:

Equity Indexes futures

Interest Rate futures
Foreign currencies
Agricultural commodities
Metals and minerals
38
Futures. Examples of underlying assets.

Equity Indexes futures:

Dow Jones industrial, NYSE index, CAC index (France),
FTSE index (GB), S&P Midcap, etc.
Interest Rate futures:
Eurodollar CD, Treasury bills, notes, bonds, LIBOR,
Federal funds rate, etc.
Foreign Currencies futures:
Euro, US dollar, British pound, Swiss franc, Japanese yen, etc.
Agricultural Commodities futures:
Corn, soybeans, wheat, milk, cattle, pork, hogs, etc.
Metals and Minerals futures:
Gold, silver, aluminum, crude oil, platinum, electricity, etc.
39
Derivatives. Futures. Jargon.

Open interest is the number of contracts outstanding.

Closing out position -- entering into an opposite contract

(reversing the position) or making/accepting
the actual delivery (about 1-5% of all futures contracts).
E.g. if you are long, you may simply enter the short side of
the contract to close out your position.

40
Derivatives. Futures. Jargon.

Settlement Price - the price just before the final bell

each day. It is used for the daily settlement process.

Convergence of Price - the strike/futures price converges

to spot price as maturity (exercise time) approaches.

41
Derivatives. Futures. Jargon.

Marking to Market - is re-computing the strike price each

day to normalize the value of the futures contract to zero.
If at the end of the day the value of a futures contract for one
party is positive, that value is credited to the investor's account,
making the value of the contract equal to zero for that party. For
the other party the futures contract is a liability (negative value),
so the value of liability subtracted from that investor's account
(e.g. paying the liability right now, therefore zeroing it, and making
the value of the futures contract zero). Essentially, the futures
contract is settled and re-written with a new strike price. In that
sense the futures is a set of forward contracts. 42
Derivatives. Futures. Jargon.

Initial Margin - cash or liquid securities (like T-bills)

deposited into investor's account to guarantee payment of
losses

Maintenance Margin - the minimum amount of cash or

liquid securities in an investor's account. If that amount is
depleted the broker will call the investor for extra funds.
That process is called Margin Call.

Margin Call - the process of asking the investor to deposit

extra funds when the margin is depleted to dangerously
low levels (e.g. hit the maintenance margin).
43
Derivatives. Futures. Jargon.

Futures are traded at XXX - strike price of the

futures contract.
If you hear that "oil futures are traded at $105" that
does not mean that somebody pays today $105 for the
futures. The futures contracts are free at time of signing
(disregarding some costs, margins, etc.). What that means
is that investors are signing futures contracts with
promise to deliver or accept oil in the future and pay or
accept $105 per barrel as an exchange value of one barrel
of oil.

44
Derivatives. Futures. Market Participants.
The first reason people enter into forward and future
contracts is hedging. Such traders are called Hedgers.

Does somebody want to enter such contract for a

different reason?
Yes, they are called speculators and arbitragers.

Speculators are betting on the price movement in

one (or another) direction. Very risky business.

Arbitragers find such combination of securities as

to make riskless profit.
45
Derivatives. Futures. Trading Strategies.
Hedging (reducing risk)
long hedge - protecting against increase in price
short hedge - protecting against decrease in price

Speculation (risky, but potentially rewarding)

short - the speculator believes price will go down
long - the speculator believes price will go up
Settled in cash.

Arbitrage (making money with no risk and no capital)

borrowing cash or assets, buying or selling financial
securities in such a way as to make riskless money with no
initial investment. 46
Derivatives. Futures. Hedging.
Is hedging always makes the hedger better off
(compared to the case of no hedging)?

Assume, you have a long hadge (protecting against

increase in price). What will happen, if the price will go
down?

47
Derivatives. Futures. Pricing.
Spot-futures parity theorem.

Two ways to acquire an asset to have it at some date

in the future.
Purchase it now and store/keep it till the desired
date;
Take a long position in futures for delivery at the
desired date.

These two strategies must have the same market

costs. Otherwise there is arbitrage possible (free lunch for
somebody) which will adjust the prices as to make costs
equal. 48
Derivatives. Spot-Futures Parity Theorem.
With a perfect hedge the futures payoff is certain --
there is no risk.

A perfect hedge should return the riskless rate of return.

This relationship can be used to develop futures pricing

relationship.

49
Derivatives. Spot-Futures Parity Theorem.
Assume no Benefits/Income or Costs (such as Storage
costs, etc)
F0 = S0 * (1+R)t = FV(S0)
If Benefits/Income, but no Costs
F0 = (S0 - B) * (1+R)t = FV(S0 - B)
If no Benefits/Income, but there are Costs
F0 = (S0 + C) * (1+R)t = FV(S0 + C)
Where B (or C) are the Present Value of all future
Benefits (or Costs)

50
Derivatives. Spot-Futures Parity Theorem.
In general (both Benefits/Income and Costs)
F0 = (S0 - B + C) * (1+R)t = FV(S0 - B + C)
If the futures price (strike price) is different from the
above -- an Arbitrage is possible.

51
Derivatives. Spot-Futures Parity Theorem.
If spot-futures parity is not observed, then arbitrage is
possible.
If the futures price is too high, short the futures and
acquire the asset by borrowing the money at the risk
free rate.
If the futures price is too low, go long futures, short the
asset and invest the proceeds at the risk free rate.

52
Derivatives. Spot-Futures Parity Theorem.
Example of an Arbitrage.

The spot price of XXY stock is $50.00, it expected to pay

dividend of $1.00 in a year. The futures price on the
XXY stock with maturity in a year (just after the
dividend is paid) is $51.50. The interest rate to
borrow/lend money is 1%. Can you make money out of
nothing?

Hint: check Spot-Futures Parity Equation.

53
 Derivatives. Interest Rate Futures.
In our class we might be interested in
Interest Rate Futures.

Interest Rate Futures contract is a contract to buy/exchange

(in the future) financial instruments which determine the
interest rates. E.g. contract to buy 3-month Eurodollar
CD (traded on Chicago Mercantile Exchange and London International
Financial Futures Exchange) -- can be called short term interest
rate futures contract, or Treasury Bond/Note (traded on
Chicago Board of Trade) -- can be called long term interest
rate futures contract.
54
 Derivatives. Interest Rate Futures.
Can you make an Arbitrage profit in the following
environment?

Consider very hypothetical financial instruments you can

buy/sell short at given prices. You can buy/sell one-year
zero-coupon bond at 99:24 and/or two-year zero-coupon
bond at 97:16. Simultaneously you can buy/sell futures
contract (interest rate futures) for delivery of one-year
zero-coupon bond at 99:04 in one year from now.

55
 Derivatives. Currency Futures/Forwards.
We might be also interested in Currency futures/forwards.

The Currency Futures/Forward contracts are contracts to

exchange (e.g. buy or sell) specified amount of one
currency (actually, currency denominated deposits) using
specified amount of another currency (deposits) as a
payment at some specified future date.

56
Currency Futures/Forwards. Interest Rate Parity.
⁄ ⁄
1+
⁄
= ⁄
=
1+

where
S0d/f -- today’s (spot) exchange rate (domestic per foreign),
Ftd/f -- forward rate for time t periods (domestic per foreign),
R -- a nominal interest rate per period in particular (d or f) country,
t -- a number of periods till the Forward contract's exchange date.

Forward exchange rates are entirely determined by the spot

exchange rate and the interest rates in corresponding countries.
This is a parity condition that always holds. Otherwise somebody
will be making a lot of money on others and any violations will
disappear quickly.
57
Currency Forwards/Futures. Interest Rate Parity.
Example. Covered Interest Arbitrage.
Very hypothetical numbers.
Assume the spot exchange rate is S0$/£ = $2.000/£ and
forward rate one year from now is F1$/£ = $2.125/£. the
interest rate in US is 5%, while in UK is 3% (you can borrow
or lend without restriction in both countries). Check the non-
arbitrage condition.

$⁄£ $
1+
$⁄£
= 1.0625 > £ = 1.019417
1+

Arbitrage is possible. Tell us how to do it!

58
Currency Forwards/Futures. Interest Rate Parity.

Future $ are cheaper (relative to £) than the current ones!

Borrow, for example, $100M from a US bank at 5% interest
rate (e.g. you have to repay $105M one year from now). Buy
£50M using $100M. Invest in a UK bank at 3%.
Simultaneously sign a forward contract to buy dollars at
rate $2.125/£ (in 1 year).
In one year you will have £50M*1.03 = £51.5M. Use
forward to buy dollars $2.125/£ * £51.5M = $109.4375M.
Pay US bank $105M and keep the arbitrage profit of
$4 437 500.
You have invested zero of your own money (all money are
borrowed!) and received guaranteed profit.
59
Forwards, Futures. Important summary.
A forward (futures) contract is an obligation to
make (accept) a delivery of the underlying asset at the
predetermined price (called forward, futures or strike
price). The strike price is determined and put into the
contract today, but with actual payment and delivery (e.g.
settlement) made on a future date.
Long position is a commitment to purchase the
asset (commodity, etc.) on the specified date (called
delivery or exercise date). Short position is an obligation
to sell the asset (commodity, etc.) on the specified date.
At the time of contract signing, no money changes
hands, everything will be settled on the delivery date.
60