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Investment Planning
Lect 23: Different Derivative Instruments
April 9, 2015
Vandana Srivastava
Futures Contract
• contract between two parties to exchange assets or services
– at a specified time in the future
– at a price agreed upon at the time of the contract
• In most conventionally traded futures contracts:
– one party agrees to deliver a commodity or security at some time in the
future (seller of the futures contract)
– other party agrees to pay an agreed upon price on delivery (buyer)
• pricing of futures contracts can be done on a number of
different assets - perishable commodities, storable commodities
and financial assets
investopedia
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Futures Contracts
•
are all viewed as derivative contracts because they derive their value from an
underlying asset
•
price changes in the asset after the futures contract agreement is made
provide gains to one party at the expense of the other
•
after the agreement is done:
– If the price of the underlying asset increases the buyer gains at the expense of the seller
– If the price of the asset drops, the seller gains at the expense of the buyer.
– While futures and forward contracts are similar in terms of their final
results, a forward contract does not require that the parties to the
contract
Futures vs Forward Contracts
a forward contract does not require that the parties to the
contract settle at expiration of the contract
• Settling up usually involves the loser (i.e., the party that
guessed wrong on the direction of the price) paying the
winner the difference between the contract price and the
actual price
• futures contract
•
– the differences is settled every period, with the winner's account
being credited with the difference, while the loser's account is
reduced (marking to the market)
• net settlement is the same under the two approaches, the
timing of the settlements is different and can lead to different
prices for the two types of contracts
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Example: Futures vs Forward Contract
Futures Contract: Characteristics
• standardized
– they specify the underlying commodity's quality, quantity and delivery
so that the prices mean the same thing to everyone in the market
– For example, each kind of crude oil (light sweet crude, for example)
must meet the same quality specifications so that light sweet crude
from one producer is no different from another and the buyer of light
sweet crude futures knows exactly what he's getting
• Price Limits
– Futures exchanges generally impose ‘price movement limits’ on most
futures contracts
– If the price of the contract drops or increases by the amount of the
price limit, trading is generally suspended for the day
http://www.investinganswers.com/financial-dictionary/options-derivatives/futures-contract-4894
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Futures Contract: Characteristics.....
• Marking to Market
positions of both buyers and sellers of the
contracts are adjusted every day for the change in
the market price that day
– profits or losses associated with price movements
are credited or debited from an investor’s account
even if he or she does not trade
–
• Futures trading is a zero-sum game; that is, if
somebody makes a million dollars, somebody else
loses a million dollars
http://www.investinganswers.com/financial-dictionary/options-derivatives/futures-contract-4894
Futures and Forward Contracts versus Options
• options:
– no obligation to fulfill the contract
– buyer pays premium upfront for this privilege
• future / forward contract
– both the buyer and the seller are obligated to
fulfill their sides of the agreement
– buyer does not have to pay upfront
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Pricing of Futures Contracts
• Most futures contracts can be priced on the basis of arbitrage
• Perishable Commodities’ price can be influenced by
– the expected spot price of the underlying commodity
– any risk premium associated taking the futures position
• Stock Index Futures
• Currency Futures
– a contract to buy a foreign currency at a price fixed today
Swaps
• Swaps are financial agreements to exchange cash flows
• can be based on interest rates, stock indices,
foreign currency exchange rates and even commodities prices
• ex: an interest rate swap in which one party pays a fixed interest
rate and the other pays a floating interest rate
• party paying the floating rate of the swap believes that interest
rates will go down. If they do, the party's interest payments will
go down as well
• party paying the fixed rate of the swap doesn't want to take the
chance that rates will increase, so they lock in their interest
payments with a fixed rate
http://www.investinganswers.com/financial-dictionary/businesses-corporations/swap-1640
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Example: Swaps
•
Company XYZ issues $10 million in 15-year corporate bonds with a
variable interest rate of LIBOR + 150 basis points. Let the current rate of
LIBOR is 3%, so Company XYZ pays bondholders 4.5%
•
After selling the bonds, an analyst at Company XYZ decides there's reason
to believe LIBOR will increase in the near term.
•
Company XYZ doesn't want to be exposed to an increase in LIBOR, so it
enters into a swap agreement with Investor ABC
•
Company XYZ agrees to pay Investor ABC 4.58% on $10 million
each year for 15 years. Investor ABC agrees to pay Company XYZ LIBOR +
1.5% on $10 million per year for 15 years
•
Note: floating rate payments that XYZ receives from ABC will always
match the payments they need to make to their bondholders
•
Investor ABC thinks that interest rates are going to go down. He is willing
to accept fixed rates from Company XYZ
http://www.investinganswers.com/financial-dictionary/businesses-corporations/swap-1640
Statistics on Derivatives
•
At least $350 trillion in derivatives and other financial products are tied to
the Libor
In the BIS “Statistical release: OTC derivatives statistics at endDecember 2013” (May, 2014) the total derivatives market, as of
the end of December, 2013,
•was reported to be a notional of $710 trillion.
• Of this, 82% ($584.364 trillion) were interest rate derivatives;
•foreign exchange contracts accounted for 10% ($70.553 trillion)
• 3% ($21.020 trillion) were credit derivatives.
•within the interest rate category, 79% ($461.281 trillion) were
interest rate swaps.
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Quiz 7
1. What are the 2 components in replicating portfolio of
a put option? (2 marks)
2. Why are options not included in market portfolio? (2
marks)
3. Draw a binomial tree for put option for 2 time periods,
with the payoff at each node. (3 marks)
4. Model for pricing European options is ........... (1 mark)
5. What will be the value/payoff in a put option whose
underlying asset is another put option? (2 marks)
Lab Assignment 6- Peer Assessment
• Submit your choice of 3 stocks with your name
on the paper.
• The write up is due next Thursday, April 16,
2015.
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Next Presentation! (Starting From 16th April)
• Topics:
– Derivative market in India
– Global Derivative Market
– LIBOR
– Major 5 Stock Exchanges in the World
– Case study in CAPM
– Case study in Derivatives
– Case study in Option Trading
references
• http://pages.stern.nyu.edu/~adamodar/pdfile
s/valn2ed/ch34.pdf
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