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INTRODUCTION
TO DERIVATIVES &
MECHANICS OF
FUTURES
MARKET
LEARNING OBJECTIVES
2) The Futures contracts: real hedge instrument; to buy or sell assets through a futures exchange market; contracts are
highly standardized; default risk protected by margin mechanism. Futures market exists side by side to the spot or cash
market. Almost any asset that has an active secondary market will be listed in the futures market. Most of the time
futures contracts are closed off before the maturity date and offset for exchange of cash instead of taking delivery of the
underlying asset.
3) The Options contracts: a financial insurance; to cover price variations with an agreed strike price through an option
seller for an upfront fee / price known as premium.
4) The Swaps contracts: bilateral contracts to exchange cash-flows at stipulated future dates typically the earnings /
interest rate on an investment or borrowing.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
5) We will learn the detained characteristics and mechanics of trading on each type as we get into the topic.
WHO AND WHY USE DERIVATIVES?
Used by: hedgers, speculators, and arbitragers.
Types of Traders
1) Hedgers use it to minimize or neutralize losses against underlying asset price movement risks.
Hedging means to transfer the risks of adverse price movement to another party.
2) Speculators use derivative contracts to make profit against future price movements of underlying
assets by taking the risk of losses if price movements are adverse.
3) Arbitragers use it to lock in a guaranteed profit at zero risk based on the mispricing of same asset in
two different markets.
Basically to create a safety net against unanticipated adverse movements of the underlying asset prices.
To change the nature of an investment without incurring the costs of selling one portfolio and buying
another to protect the fund value.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
A CONCEPTUAL EXAMPLE ON FORWARD CONTRACT
Gold is not a derivative. It is a commodity with a unit price determined in the gold market that has
uncertain price movements. However, gold price can be used as an underlying since it has a secondary
market daily spot price variation.
Consider the following forward contract:
On September 10, a buyer and seller enter into a forward contract to trade in 100 oz. of gold in 3 months (i.e. on
December 10) at an agreed price of $1000 /oz.
That is, the seller is undertaking to sell 100 oz. of Gold in 3 months at an agreed price of $1000 /oz. while the
buyer is undertaking to buy 100 oz. of Gold at $1000/oz. (This is a bilateral agreement between two parties in
an OTC market). Total contract value is 100 x 1000 = $100,000.
Consider two possible outcomes of Gold price on December 10:
a) What if the spot price of gold on December 10, turns out to be $1200 /oz.?
b) Alternatively, if the spot gold price on December 10 is $850 /oz. ?
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
A CONCEPTUAL EXAMPLE ON FORWARD CONTRACT
a) What if the spot price of gold on December 10, turns out to be $1200 /oz.?
The seller will buy gold at $1200/oz and sell at $1000/oz as promised
Seller make a loss of $200/oz (1000-1200 = -200)
The buyer will buy gold from the seller based on the forward contract at $1000/oz
Buy @$1000/oz and sell to the market @$1200/oz making a profit of $200/oz (1200-1000)
b) Alternatively, if the spot gold price on December 10 is $850 /oz. ?
The seller will buy gold at $850/oz and sell at $1000/oz as promised
Seller make a profit of $150/oz (1000-850 = 150)
The buyer will buy gold from the seller based on the forward contract at $1000/oz
Buy @$1000/oz when the market price is only @$850/oz making a more expensive purchase of $150/oz
(850-1000)
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
WHY TRADE ON DERIVATIVES?
In the previous example, the buyer of gold may be a jeweller who need to buy gold in December but is
concerned that gold prices may rise: hedging
Think how selling / buying gold forward can be a hedging transaction?
Alternatively, a trader may merely think the gold price in December will be considerably higher than
the current $1000/oz.: speculation
Another, less known reason is arbitrage: The seller, for example, may be certain that the forward gold
price quoted in the market may be too high compared to the current spot price they are able to trade,
(plus other considerations), thus trying to exploit this mispricing.
Yet another reason is market making: the buyer or seller could be a financial institution serving their
customer and wish to earn a spread between the buying and selling price for a given maturity.
https://www.bis.org/statistics/rpfx19.htm?m=6_32_617
The gross market value of over-the-counter (OTC) derivatives increased by $300 billion to $15.8
trillion during the second half of 2020, led by increases in foreign exchange (FX) derivatives. The
sizeable US dollar depreciation against major currencies is likely to have contributed to the rise.
https://www.isda.org/a/tBngE/Key-Trends-in-the-Size-and-Composition-of-OTC-Derivatives-Markets-in-
the-First-Half-of-2021.pdf
Just as it is named upon, futures contracts are derivatives on any underlying asset that trades in its listed futures
exchange market based on its futures contract floating price. (not fixed price)
Futures exchange market exists side by side to the corresponding assets spot market, however the futures
contract drawn upon an asset will have its floating futures price moving along with the spot price of its
underlying asset based on its maturity horizon.
Futures contracts normally has its maturity dates as 1-month futures, 3-month futures, 6-month futures and 1-
year futures written on any listed underlying asset.
Futures contract price on an asset is determined by its contract month’s demand and supply on the number of
contracts being held by counterparties called number of open interest.
Futures contracts are highly standardized in terms of Quantity, Quality, Size and Maturity (Q/Q/S/M).
The contract specifications of an underlying asset may vary between one market to another market.
Futures contracts are recognized by its underlying asset and its maturity horizons.
E.g. Crude Palm Oil Futures (FCPO) contracts mature in the Spot month and the next 11 succeeding months,
and thereafter, alternate months up to 36 months ahead.
A September FCPO contract means that this future contract expires in the month of September and its price is
specified according to that particular contract maturity.
Contract Months Spot month and the next 11 succeeding months, and thereafter,
alternate months up to 36 months ahead
Pricing Unit Malaysian Ringgit (MYR)
Exchange Traded
All futures contracts are traded through Futures Exchange Market (FEM).
The FEM plays the role of an intermediary and the clearing house.
As an intermediary the FEM discovers the futures prices of an underlying for the contract expiry months and
connects the counterparties instantaneously.
As a clearing house, the FEM guarantees the counterparties against default risks through a Margin mechanism.
Margin is a cash or marketable securities provided as collateral by both the counterparties to the FEM.
The gain / loss of a contract is tracked and settled every day via marking-to-market (daily rebalancing)
mechanism on a daily basis. Margin are like our e-wallets that stores cash for designated purposes.
These margins are to ensure funds are available to pay traders when they make a loss, hence protecting the
clearing house and the futures market as a whole.
Traders do not have to hold the futures until maturity. In fact, it is more common that they close out /exit prior to
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
maturity.
TRADING POSITIONS IN FUTURES MARKET
Long Futures Position: Is to buy futures contract on a selected underlying asset now and to sell it on or
before maturity of the contract.
If an investor is bullish about the underlying asset price in a specified contract time, this investor will take a long
position to gain profit on speculation of the raising price of the asset within the contract expiry time.
Therefore, Long Futures Position: Buy now and sell later.
Short Futures Position: Is to sell futures contract on a selected underlying asset now and buy back on or
before the maturity date of the contract. (also called Short Selling)
If an investor is bearish about the underlying asset price movement in a specified contract time, he/she will
take a short position to gain profit on speculation of the falling price of the asset within the contract expiry
time.
Therefore, Short Futures Position: Sell now and buy back later.
The Buyer and Seller of the same futures contract is known as Counterparties to each other.
The counterparties may not know each other, and they are matched or paired by the Futures market.
Maintenance Margin
Throughout the contract life
Maintenance margin is about
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
75% of the Initial margin
MARGINS IN FUTURES CONTRACTS
Margin is like a wallet created with the futures brokers to hold a sum of cash or near cash instruments to receive
profits or to pay losses.
Both counterparties must contribute the specified Initial margin (IM) to open a contract and must maintain a
specified % of Maintenance Margin (MM) throughout the life of the contract.
The IM amount is about 4 to 5% of the total contract value as the daily contract price may vary within this
percentage.
The MM must be always set at 75% of the IM value at all days throughout the contract life.
What happens when the MM threshold is breached on any trading day?
The party in deficiency must replenish the margin to its IM level within the next trading day.
Failing to replenish the margin will lead to confiscation of the contract be by the broker to offer it to any other interested party.
Therefore, futures contract margin is the mechanism set by futures market to protect the counterparties from default
risk and to uphold the integrity of the futures market.
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
SOME TERMINOLOGY IN FUTURES CONTRACTS
Open interest: the total number of contracts outstanding : equal to number of long
positions and short positions in trade
Settlement price: the price just before the final bell each day used for the daily
settlement process
Volume of trading: the number of trades in one day
Short Selling: Selling something that you don’t own. Short selling is common in Futures
market where the party in short position sells a certain number of contracts on an
underlying asset with an agreement to buy back on or before the maturity of the contract.
Long Position: To buy now and sell later to reverse the contract (close out)
Short Position: To Sell now and buy back later to reverse the contract (close out)
It is a bet on the price / value of some underlying asset in the future contract maturity date.
Unlike the bets you typically see like horse racing which settles the bet once the race finished, futures
trade is an ongoing floating prices that can be closed out anytime before the maturity.
The gain/loss from the bet in a futures trade is tracked and settled every day via marking-to- market
concept.
The ability to close out before maturity also means that you do not have to deliver or take delivery of
the underlying asset.
This also means that futures markets, originally designed to help businesses hedge risk, can become a
casino (which I am not saying a bad thing) for speculative purposes.
Most of the contracts are closed out before maturity and they are cash settled (daily transferred from
counterparty’s margin account)
If a futures contract is not closed out before maturity, it is usually settled by delivering the underlying
asset in the contract. (it can be Physical settlement or Cash settlement)
When there are alternatives about what is delivered, where it is delivered, and when it is delivered,
generally the party with the short position chooses.
The exchange specifies the exact range of dates during which delivery can take place. Trading
generally ceases before the last day on which delivery can take place.
A few contracts (for example, those on stock indices like SPI futures and Eurodollars) are settled in
cash
FIN3074 RISK MANAGEMENT APPLICATIONS OF DERIVATIVES BY RAFF
FUTURES PRICE CONVERGES TO SPOT PRICE AT MATURITY
Provided the asset being hedged and the future contract is same in terms of specifications, the futures price and the spot price of the asset should converge at
the contract maturity point.
The futures price may be higher or lower than the spot price of the underlying asset at the inception of the futures contract (which is called Basis) should be
same at the contract maturity.
Price Price
FP SP
SP FP
t0 T1 Time t0 T1 Time
The Futures Price is higher than Spot Price at t 0, The Spot Price is higher than Futures Price at t 0
Converges to FP = SP at T1 Converges to SP = FP at T 1
The condition is that both the hedged asset and the hedging futures should be on the same underlying asset, expiring on same maturity and have same quantity.
Both are agreements to buy or sell an asset for a price at a certain future date.
A forward contract is traded in the OTC (Over‐The‐Counter) market, not at an exchange-traded
market.
There is no daily settlement in a forward contract as gain or loss is settled at the maturity