FM06 Derivatives MKT 0316

FIN3103B/3703B
Financial Markets
06 – Derivatives Market
1 Sem2 AY2020/21
The Derivatives Market
I. Introduction
II. Forwards and futures
• Forwards
• Futures
• Hedging with forwards/futures
• Margining procedure
• Delivery options
• Theoretical future prices (self reading)
III. Options
• Option basics
• Put-call parity (self reading)
• Combining options (self reading)
IV. Singapore derivatives market
2
Derivatives
• Definition: A financial security whose value depends on or is
derived from an underlying financial security or asset.
• Examples: forwards, futures, options, swaps, etc
• Functions:
• To help in the price discovery process: Forwards and futures
give a market indication of the value of the underlying assets
in the future.
• Hedging
• Risk management: Using derivatives to hedge risk
exposure
• Speculation
• Trading strategies to reap short-term profits
• Minimal initial cash outlay compared to cash positions
3 Introduction
Markets for derivatives
• Forwards: OTC
• Futures: Organized exchanges
• Options:
• Standard calls/puts on stocks, futures, currencies, etc are
traded on organized exchanges;
• OTC options: vanilla and exotic
• Others (e.g., embedded options)
• Swaps: OTC
• Other derivatives: OTC
4 Introduction
Global futures and options trading reaches record
level in 2020
• The total number of futures and options traded on exchanges worldwide
reached a record level of 46.77 billion contracts in 2020, up 35.6% from
2019.
• Global:
• Total futures trading rose 32.7% to 25.55 billion.
• Total options trading rose 39.3% to 21.22 billion.
• Open interest, which measures the number of outstanding contracts at a point
in time, also reached a record high, reaching 987.3 million contracts at year-
end, up 9.7% from December 2019.
• Regional:
• Asia-Pacific region: the largest increase in trading in 2020. Total volume in
that region reached 20.15 billion contracts, up 5.64 billion or 38.9% from the
previous year.
• North America: the second largest region in terms of trading volume, recorded
12.85 billion contracts traded in 2020, up 2.58 billion or 25.2% from the
previous year.
Source: Futures Industry Association
5 Introduction
Annual Volume of Futures and Options on Exchanges
2011-2020
Annual Trading Volume of Futures and Options on Exchanges
50,000
Millions of Contracts
46,767
45,000
40,000
34,492
35,000
30,323
30,000
24,946 24,830 25,235 25,218

25,000
21,567 21,868
21,128
20,000
15,000
10,000
5,000
‐
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Source: Futures Industry Association
6 Introduction
I. Introduction
• Forwards
• Futures
III. Options
• Option basics
9
• Both forwards and futures are agreements to deliver (or take
delivery of) a specific asset at a future date.
Forwards
• Private arrangement between two parties (at time t) to exchange a
real or financial asset in the future (at time t+1)
• Contracting terms at t:
• Price
• Date
• Quantity
• Quality
• Location for delivery
• Any other conditions
10 Forwards and Futures
Forwards
• At time t+1: _____ party
• Take delivery
• Make payment
• Important characteristics:
• Bilateral contract: Negotiated directly by seller and buyer.
• Customizable: Terms of the contract can be tailored.
• Default risk: There is possible default risk for both parties.
• No unilateral reversal (i.e. non-negotiable): Neither party can
unilaterally transfer its obligations in the contract to a third
party.
• The forward market is an informal network consisting mostly of

large corporations and financial institutions.
Futures
• Arrangement between two parties (at time t), through an organized
market mechanism (eg. an exchange), to transact real or financial
assets in the future (at time t+1)
• Contracting terms at t:
• Price
• Date
• Quantity: standard contract size
• Quality
• At time t+1:
• Normally do not take delivery. Why?
• Take cash profits or pay cash losses
Futures
• Negotiable
• Margin trading
• Initial margin
• Maintenance margin
• Marked to market daily
• Occurs on organized exchanges:
• Derivative exchanges: such as CME Group (CME, CBOT, NYMEX,
COMEX, KCBOT) and EUREX (part of the Eurex Group)
• Part of a multi-asset class exchanges: such as SGX and Korea
Exchange.
• Clearinghouse: the unit that oversees trading on the exchange
and guarantees all trades made by exchange traders.
• Either party can reverse its position at any time by closing out its
contract. In other words, futures contracts are negotiable
instruments.
Distinctions between Forwards and Futures
Forwards Futures
Private arrangement and not ?

traded on organized exchanges
No guarantee: parties bear their Clearinghouse
? guarantees the
own risk trades
Non-negotiable Negotiable
Cash basis Margin trading and mark-to-

market
Not normally use for speculation Can be use for speculation
All terms are tailor-made ?

Contracts are standardized
Take delivery Normally do not

? take delivery
Hedging with Futures
• Zero-sum game between the long and the short
• The spot price and the price of the futures will converge as the
expiration date draws near
• Types of futures:
• Agricultural commodities
• Metal and minerals (including energy)
• Interest rate (eg. Eurodollar, T-bills, T-bonds)
• Forex
• Stock index
Basis Risk
• Basis risk:
• Basis: 𝐵 𝑆 𝑓,
• where 𝐵 , 𝑆 , and 𝑓 , are the basis, spot price, and the
price of the futures (with maturity at T) at time t
• Basis risk occurs when the basis changes between the time a
hedge is placed and the time it is lifted.
• Basis risk will cause the hedge to be less than perfect, i.e., the
effective price when the hedge is lifted is different from the initial
spot price.
Hedging with futures: Example
Example:
A cotton farmer expects to produce 100,000 lbs of cotton in
October. The price of cotton in June is $0.6468 per lbs. The
current price of cotton futures (contract size is 50,000 lbs)
maturing in December is $0.6418.
Today (June)
To hedge: __________ 2 contract of cotton futures
“Cashflow” (paper) = $(____________________)
= $ __________
Hedging with futures: Example (cont’d)
Example:
In October:
Suppose spot price of cotton = $0.6316
December futures price of cotton = $0.6266
To reverse: _________ 2 contracts of cotton futures

“Cashflow” (paper) = ____________________
= __________
In October:
Profit from future contract (real) = $(__________________)
= $______
Sell cotton at spot = $(_________ x 100,000)
= $ _________
Total Cashflow = $(__________________)
= $ _________
Effective price of the cotton = _________
Effective price in Oct _________ Spot price in June
• Basis in June = $ _________
• Basis in June = $ _________
• Note: We ignore the margin accounts here!
Example:
In October:
Suppose spot price of cotton = $0.6316
December futures price of cotton = $0.6296
To reverse: _________ 2 contracts of cotton futures

“Cashflow” (paper) = ____________________
= __________
In October:
Profit from future contract (real) = $(__________________)
= $______
Sell cotton at spot = $(_________ x 100,000)
= $ _________
Total Cashflow = $(__________________)
= $ _________
Effective price of the cotton = _________
Effective price in Oct _________ Spot price in June
• Basis in June = $ _________
• Basis in June = $ _________
• Note: We ignore the margin accounts here!
The margining procedure (mark-to-market)
• Initial margin:
• Amount initially deposited by investor into margin account.
• Maintenance margin:
• Floor level of margin account.
• If balance falls below this, customer receives margin call.
• If the margin call is not met, account is closed out immediately.
• Mark-to-market (MTM):
• Daily adjustment of margin account balances to reflect
gains/losses from futures price movements over the day.
Mark-to-market: Example
• Investor takes long position in 10 wheat futures contracts at a
futures price of $3.60 per bushel.
• Size of one futures contract: 5,000 bushels.
• Thus, futures price: $18,000 per contract.
• Suppose that
• Initial margin = $878 per contract.
• Maintenence margin = $650 per contract.
• Margin account balance at t=0: $_________________
Mark-to-market: Example (cont’d)
• Investor takes long position in 10 wheat futures contracts at a futures
price of $3.60 per bushel. Size of one futures contract: 5,000 bushels.
• Settlement price on day 1: $3.58 per bushel = $17,900 per contract.

• “Loss” per contract: $( )=$ per contract.
• Total “loss” = : deducted from the margin account.
• Margin account balance: .
• Effectively:
• Original contract at $3.60/bushel has been replaced with new
contract at $3.58/bushel.
• Difference is deducted from the margin account.
• Of course, margin account of corresponding short position would
increase/decrease by .
Mark-to-market: Example (cont’d)
• Investor takes long position in 10 wheat futures contracts at a
futures price of $3.60 per bushel. Size of one futures contract:
5,000 bushels.
• Settlement price on day 2: $3.54 per bushel = $17,700 per

contract.
• “Loss” per contract: $( )=$ per contract.
• Total loss = $ ; deducted from the margin account.
• New margin account balance: $ . Margin call ??
• Suppose that the exchange requires a top-up to initial margin.

• If account is topped up, situation continues.
• If not, investor’s position is closed out.
Margin trading (MTM): summary
• To reiterate: mark-to-market essentially involves:
1. Rewriting the customer’s futures contract at the current
settlement price, and
2. Settling immediately the gains or losses to the customer
from the rewriting.
• Basic idea: If an investor is not able to meet “small” losses (from

price movements over a day), it is unlikely she will be able to meet
larger losses that might result.
• Historically, margining has worked very well in inhibiting defaults.

Exchanges also retain right to change margin at any time.
Futures delivery options
• Contract terms must be standardized, since buyer and seller do
not interact directly.
• Standardization is perhaps the most important task performed by
the exchange.
• Essential in promoting liquidity and improving quality of hedge.
• Standardization involves the following components:
1. Maturity dates
2. Quantity (size of contract)
3. Quality (standard deliverable grade)
4. Delivery options (other deliverable grades + price
adjustment mechanism)
Delivery options: Example (1)
Corn Futures
• Exchange: Chicago Board of Trade (CBOT), USA
• Contract months: March, May, July, September, December
• Size: 5,000 bushels
• Quality: No. 2 Yellow Corn
• Delivery options:
• No. 1 Yellow and No. 3 Yellow may also be delivered.
• If No. 1 Yellow is delivered, the short position receives 1.5
cents per bushel more than the contract price.
• If No. 3 Yellow is delivered, the short position receives
between 2 and 4 cents per bushel less than the contract price,
depending on broken corn and foreign material and damage
grade factors.
52 Source: CME Group Forwards and Futures
Consequences of delivery options
• Why provide delivery options in futures contracts?
• It makes corners and squeezes more difficult.
• Enhance market liquidity.
• However, there is an important cost: the quality of the hedge may

be degraded.
• The delivered grade is not the standard grade, but the cheapest-
to-deliver grade.
U.S. 5-Year T-Note Futures
• Exchange: Chicago Board of Trade (CBOT), USA
• Contract months: March quarterly cycle: March, June, September,
and December
• Size: 100,000 USD (face value)
• Quality: Not relevant
• Delivery options: 4 1/6 to 5 1/4 years (deliverable maturities).
55 Source: CME Group Forwards and Futures
USD/SGD Futures (Mini)
• Exchange: Singapore Exchange (SGX)
• Contract months: monthly
• Size: 25,000 USD (versus 100,000 USD for the “full-sized”
contract)
• Quality: Not relevant
• Delivery options: None
56 Source: SGX Forwards and Futures
Theoretical Future Prices (self reading)
Spot-future (or spot-forward) parity:
• Borrow to invest in an asset over time T
• Short futures of the asset over time T
Cashflow at time 0 Cashflow at time T
Borrow S0 S0 S 0 (1 rf )
Buy asset S0 ST
Short futures 0 f0 ST
Total 0 f0 S 0 (1 rf )
• Parity condition: f0 S 0 (1 r f ) 0
• Hence, f0 S 0 (1 r f )
Assumptions of spot-futures parity (self reading)
• Futures = forwards (no cash flow at time = 0 and 𝑓 = contract
price)
• Borrow at 𝑟
• T = 1 year
• Alternatively: 𝑓 𝑆 · 1 𝑟 or 𝑓 𝑆 ·𝑒
• Asset has no yield

• Alternatively: 𝑓 𝑆 · 1 𝑟 𝐷
• or 𝑓 𝑆 · 1 𝑟 𝑦 where 𝑦 is the dividend yield (𝐷 𝑦𝑆 )
• No holding or carrying or storage cost

• Alternatively, 𝑓 𝑆 · 1 𝑟 ℎ where ℎ is the holding cost
Stock index arbitrage (self reading)
• Similar to the creation-redemption in ETF
• Index futures prices should be close to the aggregate of the index

stock price
• Futures overpriced: short futures and buy index stocks
• Futures underpriced: long futures and short index stocks
• Restrictions to arbitrage:
• Transaction costs in buying all the index stocks
• Execution timing of all index stocks
Stock index arbitrage (self reading)
• Program trading
• Index arbitrage: possible impact

• Triple-witching hour: high trading volume on last trading hour
of the third Friday (Freaky Friday) of March, June, September,
and December when options on the S&P stocks, the S&P
index futures, and S&P index option expire.
• May increase volatility
I. Introduction
• Forwards
• Futures
III. Options
• Option basics
61
What are Options
• A contract that gives the holder the right, but not the obligation, to
buy or sell an asset at a pre-specified price at or within a pre-
specified period of time
• Call vs Put:
• Call option: an option that gives a purchaser the right, but not
the obligation, to buy the underlying asset from the writer of
the option at a pre-specified exercise price on a pre-specified
date
• Put option: an option that gives a purchaser the right, but not
the obligation, to sell the underlying asset to the writer of the
option at a pre-specified price on a pre-specified date
• European vs American:
• European option: can only be exercised on the expiration date
• American option: can be exercised at any time before the
expiration date
62 Options
What are Options
• Note that the right belongs to the buyer of the options NOT the
writer => writer needs to maintain a margin
• The writer earns the option premium
• Payoff structures
• Long call
• Short call
• Long put
• Short put
63 Options
Option basics (self reading)
Notation:
X: exercise or strike price
t: time
T: expiry date of the option
T t : time to expiry at time t
rf : risk-free interest rate
y: yield on the underlying asset over (t,T) in T's dollar
St : price of the underlying asset at time t
Ct : value of call at time t
Pt : value of put at time t
64 Options
Option value (self reading)
Intrinsic value = St X ( for call )

X St ( for put )
Extrinsic value = time value of option
Option price (premium) = Intrinsic value + Extrinsic

value/time value
65 Options
At time t = T
Call
Exercise if 𝑆 𝑋
Do not exercise if 𝑆 𝑋
Intrinsic value of the call: 𝐶 𝑚𝑎𝑥 𝑆 𝑋 , 0
Put
Exercise if 𝑆 𝑋
Do not exercise if 𝑆 𝑋
Intrinsic value of the put: 𝑃 𝑚𝑎𝑥 𝑋 𝑆 , 0
66 Options
• Time value of option
• Variables affecting option value:
Variable Call Price Put Price
Stock price Increase Decrease
Exercise price Decrease Increase
Time to expiration Increase Increase
Stock volatility Increase Increase
Interest rate Increase Decrease
Dividends Decrease Increase
67 Options
Put-call parity (self reading)
• Simplified version: The payoff structure of a put option is
equivalent to the combine payoff structure of a call and a short
stock position.
• Assumptions:
• European options
• No transaction costs
• No default risk
• Same strike price and expiry date for the options
69 Options
Put-call parity (self reading)
Time = t Time = T
ST X ST X
Long Call CT ST X 0
Short Stock St ST ST
Lend PV(X) Xe rT X X
(1) Total St Ct Xe rT 0 X ST
(2) Long put Pt 0 X ST
Since the payoffs of (1) and (2) are the same, they
should have the same cost:
rT
Hence, Pt Ct Xe St
70 Options
Combining Options (self reading)
• Protective put: long stock + long put
• To protect the value of a stock against the risk of a decline in
the market value
• Straddle: long call + long put

• Strategy for profiting from high volatility
71 Options
Black-Sholes formula (self reading)
S : stock price
X :strike price
T : time to expiration
: volatility of underlying stock
r : riskfree rate
V SN (d1 ) Xe rT
N (d 2 ) , where
N ( x) P[ Z x] ,
2
ln(S / X ) (r / 2)T
d1 , and
T
d 2 d1 T
72 Options
I. Introduction
• Forwards
• Futures
III. Options
• Option basics
73
The Singapore Exchange (SGX)
• Future and options traded (as at December 2020):
• Interest rates futures:

• Eurodollar (disappearing)
• Japanese Government Bonds (JGB)
• Mini Japanese Government Bonds (Mini JGB)
• Interest rates options:
• Mini Japanese Government Bonds (Mini JGB)
74 SG Derivatives Market
• Forex: 24 future contracts

• The popular ones are:
• INR/USD
• USD/CNH
• KRW/USD
• USD/SGD
• Forex: 2 options contracts

• INR/USD
• USD/CNH
• Equity index futures:

• MSCI indices mostly replaced by FTSE indices
• 2 Nifty indices
• 4 Nikkel indices
• 1 Strait Times index
• Equity index options: 3 contracts

• MSCI Singapore Index
• Nifty 50 Index
• Nikkel 225 Index
• Commodities: futures, swaps, and options

• Rubber: SICOM Rubber
• Energy: Oil, petrochemicals, coal, and electricity
• Metal: iron ore and steel
• Freight
Stock futures in SGX
• Single Stock Futures: 21 blue-chips stocks
• The Single Stock Futures (SSF): Contracts have been
designated as "Dormant" with effect from 19 March 2007. The
trading of the SSF Contracts are suspended with effect from
the same date.
• Single Stock Derivatives (SSD)
• Renamed as Extended Settlement Contracts and started
trading in Feb 2009
• Designated as “Dormant” with effect from 1 April 2015.
• Single Stock Futures:

• February 2018
• Launch of 50 Indian SSF
• June 2020
• Launched 10 Singapore SSF
Stock options in SGX
• First tried out in 1977 with calls: ended in 1980
• Second attempt in 8th March 1993

• Stocks: City Dev; Creative Tech; DBS; Keppel Corp; Natsteel;
SIA; UOB
• Third attempt: structured warrants
Warrants
• A warrant is a type of option.
• A call warrant gives the holder a right to buy the underlying asset
• A put warrant gives the holder a right to sell the underlying asset
• Warrants have a fixed tenure and, if not exercised, are worthless
after their expiry date
• Risk and hedging properties of warrants are similar to those of
options
Comparison between ordinary warrants and options
• Ordinary warrants are issued by the firms themselves (vs options

are issued by parties outside the firms).
• When an ordinary call warrant is exercised, a firm must issue new

shares. The number of outstanding shares increases (vs when a
call option is exercised, there is no change in the number of
shares outstanding. If the writer does not already own a share, he
has to enter the market and buy one.).
• The exercise of an ordinary call warrant brings cash into the firm
(vs the exercise of an option does not bring cash into the firm).
Structured warrants
• A structured warrant is issued by a third party financial institution,
on the shares of an unrelated company’s shares, a basket of
companies’ shares or an index.
• Underlying assets may be a particular security or a basket of

securities or an index. Unlike (structured) warrants on individual
stocks, index and basket (structured) warrants provide exposure
to a sector or market.
ICE Futures Singapore
• Singapore Mercantile Exchange (SMX) was the first pan-Asian
multi-product commodity and currency derivatives exchange was
granted license by MAS in August 2010
• SMX was acquired by Intercontinental Exchange Group (ICE) in
February 2014.
• Renamed as ICE Futures Singapore
• All SMX products delisted soon after acquisition
• Five products were relaunched in early 2015
• Currently: 16 contracts
• 12 currencies
• 3 energy (crude oil)
• 1 Bitcoin futures
Asia Pacific Exchange (APEX)
• The 3rd exchange (and clearing house) approved by MAS
• International derivative exchange
• First product launched on May 25, 2018: Palm Olein Futures
contract (USD)
• Currently:
• Palm olein futures
• Crude palm oil futures
• USD/CNH futures
• Fuel oil futures
• Low Sulphur fuel oil future

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FIN3103B/3703B

IV. Singapore derivatives market

• Examples: forwards, futures, options, swaps, etc

24,946 24,830 25,235 25,218

IV. Singapore derivatives market

• The forward market is an informal network consisting mostly of

Private arrangement and not ?

Cash basis Margin trading and mark-to-

All terms are tailor-made ?

Take delivery Normally do not

To reverse: _________ 2 contracts of cotton futures

• Note: We ignore the margin accounts here!

To reverse: _________ 2 contracts of cotton futures

• Note: We ignore the margin accounts here!

• Margin account balance at t=0: $_________________

• Settlement price on day 1: $3.58 per bushel = $17,900 per contract.

• Settlement price on day 2: $3.54 per bushel = $17,700 per

• Suppose that the exchange requires a top-up to initial margin.

• Basic idea: If an investor is not able to meet “small” losses (from

• Historically, margining has worked very well in inhibiting defaults.

• However, there is an important cost: the quality of the hedge may

• Asset has no yield

• No holding or carrying or storage cost

• Index futures prices should be close to the aggregate of the index

• Index arbitrage: possible impact

IV. Singapore derivatives market

• The writer earns the option premium

Intrinsic value = St X ( for call )

Extrinsic value = time value of option

Option price (premium) = Intrinsic value + Extrinsic

Variable Call Price Put Price

Stock price Increase Decrease

Exercise price Decrease Increase

Time to expiration Increase Increase

Stock volatility Increase Increase

Interest rate Increase Decrease

Dividends Decrease Increase

• Straddle: long call + long put

IV. Singapore derivatives market

• Interest rates futures:

• Forex: 24 future contracts

• Forex: 2 options contracts

• Equity index futures:

• Equity index options: 3 contracts

• Commodities: futures, swaps, and options

• Single Stock Futures:

• Second attempt in 8th March 1993

• Third attempt: structured warrants

• Ordinary warrants are issued by the firms themselves (vs options

• When an ordinary call warrant is exercised, a firm must issue new

• Underlying assets may be a particular security or a basket of

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