BRUNEL UNIVERSITY LONDON

Department of Economics and Finance

EC1030 LECTURE 9

Derivative Markets
Contents

1. Forward Markets
2. Futures Markets
3. Options Markets
4. Lecture 9 Summary
Derivative Markets
• Derivatives include
forward, futures and
option contracts.

• Derivative markets can

use a variety of
underlying assets

Source: https://www.cmegroup.com/#analyze-market-data
Example:
£ /$ Futures Quotes

Source: https://www.cmegroup.com/#analyze-market-data
Forward Markets
 Introduction

• Starting in the 1970’s and increasingly in the 1980’s and 1990’s, the world became a riskier place for financial
institutions:
(a) swings in interest rates widened,
(b) the stock market has been through episodes of increased volatility, and
(c) exchange rates have proven to be very volatile.
 As a result, managers of financial institutions have become more concerned with reducing the risks their
institutions face.
• Given the greater demand for risk reduction, the process of financial innovation has come to the rescue to
produce new financial instruments that help financial institution managers manage risk.
• These instruments, called financial derivatives, have payoffs that are linked to previously issued securities and
are extremely useful risk reduction tools.
 The market in derivatives has developed as a response to uncertainty about prices.
 The crucial factor operating in these markets is that they provide a means for transferring risk cheaply.
Introduction (cont.)

e.g. A producer importing raw materials (such as coffee) will be exposed

to exchange rate risk. He/she may be risk-averse.
 wants to hedge (what is hedge?) by passing the risk to a counter-party.
• On the other hand, the counter party may consider this to be exactly the feature they
find attractive, and are willing to take on the risk as a speculative investment.
• So for a premium, these markets allow hedgers to avoid risk by
( ) who seek it.
• They are known as derivative securities, because their value is derived from the
underlying asset with which they are associated.
Forward Markets

• Forward contracts are agreements by two parties to engage in a financial

transaction at a future (forward) point in time at a priced agreed upon today.
• Of the two participants in a forward contract, one agrees to buy the underlying
asset in the future, and one agrees to sell the asset at the same time, thus
taking a long position (=buy) and a short position (=sell) respectively.
• Because of this, there is generally no secondary market since they are
essentially customised contracts
 they are a very illiquid instrument, which cannot be cancelled
without mutual agreement.
Forward Markets (cont.)

• Also, since forward contracts are settled entirely at maturity, there is a risk of
default, with the purchaser failing to meet the obligation specified.
 investors entering into forward contracts are required to deposit some funds
initially to act as a guarantee.
Futures Markets
Futures Markets

• Given the default risk and liquidity problems in the forward market, another
solution to hedging risk was needed. The solution was provided by the
development of futures contracts in 1975 by the Chicago Board of Trade.
• A futures contract is similar to a forward contract in that it specifies that the
underlying asset must be delivered by one party to the other on a stated future
date and at a fixed price.
• However, the quantities involved are standardised and the contracts are only
offered for delivery at certain dates. Therefore, the terms of the contract are
not negotiable between buyer and seller.
• The advantage of standardisation of these contracts is that secondary markets
can exist, and contracts can be exchanged.
Futures Markets (cont.)

• Futures Players
a) The hedger: somebody who uses a futures contract to reduce the risk
associated with holding a pre-existing position in the spot (asset) market.
b) The speculator: uses a futures contract primarily to profit on a forecast of
subsequent spot price changes by taking the risk.
c) Another important player in the futures markets is the clearing house i.e
the exchange itself. The clearing house separates the buyer from the seller.
• You do not buy a futures contract from XYZ. You buy a futures contract from a
clearing house.
• The clearing house guarantees contract performance to all market participants.
Futures Markets (cont.)

• One difference between a futures and a forward contract is the margin

requirement.
• If you enter into a forward contract, then you sign an agreement between
two individual traders and no money is exchanged until the contract matures.
• If you participate in the futures market, then you have to pay a ‘margin’.
• A margin - which is often a cash deposit - ensures that both parties honour
their obligations to buy or sell - it insures the clearing house against default
risk.
Futures Markets (cont.)

• There are two types of margin requirements:

(a) Initial margin: This is an initial deposit which both parties have to put
down when the trade is made.
(b) Variation margin: is a daily resettlement which is dependent on how the
underlying asset price moves. Each day, futures market participants either
have to pay or receive a certain amount (variation margin) depending on how
the futures price moves relative to the spot price.
This system is known as ‘marking to market.’ i.e. I either receive my
winnings or deposit my losses each day. The reason for this is to control
default risk
 the incentive to default never becomes very large - there is only a little bit
every day.
 Forward versus Futures

Forward Futures
Private agreements between two parties Exchange-traded (using secondary market)
Non-standardized contracts Standardized contracts
(Less rigid terms and conditions)
Higher counterparty risk (higher default risk) Lower counterparty risk (lower default risk)
→ Clearing house guarantees the transaction
Settlement only occurs at the end of the Daily changes are settled day by day until the
contract term. end of the contract term (Marking-to-market)
→ Settlement can occur over a range of dates
More frequently used by hedgers More frequently used by speculators
(risk-adverse investors) (risk-lover investors)
Options Markets
Options Markets

• Another vehicle for hedging risk involves the use of options on financial
instruments.
• Options are contracts that give the buyer (owner) the option, or the right (not
the obligation!) to buy or sell the underlying financial instrument at a
specified price, called the exercise price or strike price, within a specific time
period (the term to maturity).
• The seller (sometimes called the writer) of the option is obligated (not the
right!) to buy or sell the financial instrument to the purchaser if the owner of
the option exercises the right to buy or sell.
Options Markets (cont.)

• These option contract features are important enough to be emphasised:

• The owner of an option does not have to exercise the option; he or she can let
the option expire without using it. Hence the owner of an option is NOT
obligated to take any action but rather has the right to exercise the contract if
he or she so chooses.
• The seller of an option, by contrast, has no choice in the matter; he or she is
obligated to buy or sell the financial instrument if the owner exercises the
option.
Options Markets (cont.)

• Option contracts are different from futures contracts.

• If investors enter into a futures (or forward) contract to buy and sell a
specified amount of an asset at a certain price and a certain date in the future,
they are obligated to both buy and sell that asset.
• If an investor holds an option which gives an option to buy the asset, this
option holder is NOT obligated to buy the asset but has the right to buy the
asset at a certain price and a certain date in the future that the option owner
provides.
• However, if the option holder chooses to buy the asset, the option seller (the
writer) IS obligated to sell that asset.
Options Markets (cont.)

• Because the right to buy or sell a financial instrument at a specified price has
value, the owner of an option is willing to pay an amount for it called the
option premium.
• There are two types of option contracts:
• American options can be exercised at any time up to the expiration date
of the contract, and
• European options, which can be exercised only on the expiration date.
• Option contracts can be written on a number of financial instruments e.g.
interest rates, foreign exchange, individual stocks, indexes, and futures
contracts.
 Options Markets (cont.)
• Call Option: This option owner has the right (not an obligation) to BUY the
underlying financial instrument S at exercise price K (or strike price K)
within a specified period of time when S≥K.

Payoff
(Profit or Loss)

0 K (Strike Price)
Option Premium
(Call Option Fee) S (Price of the Underlying Financial Instrument)
→ The call option
buyer pays it
 Options Markets (cont.)
• Put Option: This option owner has the right (not an obligation) to SELL
the underlying financial instrument S at exercise price K (or strike price K)
within a specified period of time when S≤K.

Payoff
(Profit or Loss)

K (Strike Price)
0
Option Premium S (Price of the Underlying Financial Instrument)
(Put Option Fee)
→ The put option
buyer pays it
 Options Markets (cont.)

• K = Exercise Price (or Strike Price): Price at which the financial instrument
underlying an option contract can be purchased (in case of call option) or sold (in
case of put option).
• P = Price of the underlying financial instrument
• Option Premium: the fee an investor pays to buy an option
• Payoff (profit or loss):
(1) Call option buyer’s payoff = Max [0, S-K] – Option Premium
(2) Put option buyer’s payoff = Max [0, K-S] – Option Premium

Max [0, S-K]: gives out the maximum value between 0 (zero) and S-K
Max [0, S-K]: gives out the maximum value between 0 (zero) and K-S
Lecture 9 Summary
1. Forward contracts
• An agreement by two parties that one agrees to buy (long
position) while the other party agrees to sell (short
position) the underlying asset simultaneously at an
agreed certain future time and price.
• Non-standardized (i.e. customized) contracts with no
secondary market
• Very illiquid instrument and only settled at the maturity
→ high counterparty default risk
→ Thus, required to deposit some funds initially for
unexpected loss protection
Lecture 9 Summary
(cont.)
2. Futures contracts
• Futures contracts are similar to forward contracts
(i.e. deliver the underlying asset at an agreed certain
future time and
price).
• However, futures contracts are standardized contracts
and secondary market exists.
• The clearing house guarantees contract performance.
• To participate in the futures market, you have to pay the
‘margin’.
Lecture 9 Summary
(cont.)
• Initial margin: initial cash deposit for futures contracts
• Variation margin: daily resettlement depending on how
the future price moves relative to the spot price (i.e.
marking-to-market).
→ It controls the default risk by providing an incentive not
to default.
Lecture 9 Summary
(cont.)
3. Options
• Option contracts give the buyer (owner) the right (not
an obligation) to buy or sell the underlying financial
instrument at the exercise price (or strike price) within a
specific time period.
• On the other hand, option contracts give the seller
(writer) the obligation (not the right) to buy the
underlying financial instrument if the owner exercises
the option at a certain price and date .
• Option owner pays the option price (a fee for buying an
option) called option premium.
Lecture 9 Summary
(cont.)
• American option: It can be exercised at anytime up to the
expiration date (maturity) of the contract
• European option: It can be exercised only on the expiration
date (maturity) of the contract.

• Call option: This option owner has the right to buy the
underlying financial instrument S at exercise price (strike
price) K before maturity when S≥K.
→ Payoff = Max [0, S-K] – Option Premium
• Put option: This option owner has the right to sell the
underlying financial instrument S at exercise price (strike
price) K before maturity when S≤K
→ Payoff = Max [0, K-S] – Option Premium