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Topic 1

Introduction to Derivatives and Financial


Risk Management (Hull, Chapter 1)

Mechanics of Futures Markets Part 1


(Hull, Chapter2)

Introduction to Derivatives &


Financial Risk Management
(Hull, Chapter 1)

Introduction
Risk

is a characteristic feature of all


commodity and capital markets. Over
time, variations in the
prices of
agricultural
and
non-agricultural
commodities occur as a result of
interaction of demand and supply forces.

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

The

last two decades have witnessed a


many-fold increase in the volume of
international trade and business due to the
ever growing wave of globalization and
liberalization sweeping across the world.
As
a result, financial markets have
experienced rapid variations in interest and
exchange rates, stock market prices thus
exposing the corporate world to a state of
growing financial risk.
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

What is Financial Risk Management ?

Businesses, governments and individuals transact in financial


markets such as:
Foreign exchange markets
Interest Rate markets (interest rates & interest bearing
securities)
Commodity markets (e.g. gold, oil, wheat)
Stock Markets (Equities)

Therefore, they face exposure to unfavourable price movements


(risks) in these markets.
Financial Risk Management concerns the management of these
risks, mainly through the use of derivative instruments.

What is Financial Risk Management ?

Management must identify and present financial risk exposures


clearly to the Board so that it can put in place appropriate
policies & procedures.

Decisions then need to be taken on issues such as:

whether to hedge* exposures, fully, partly, or not at all

how to hedge (which instrument) and

the duration of any hedge

* Hedge: to reduce or eliminate the effect of an adverse price


movement by taking an opposite position (often using
derivatives) to that of the hedgers physical position.

Derivatives, such as futures, options and swaps are common


instruments for managing these financial risks.

Examples of Price Volatility


Interest Rate Volatility

Debt is a major source of finance for companies


Interest rates on variable rate borrowings can fluctuate
dramatically in short periods of time
Hedging against changes in interest rates can stabilize
borrowing costs

Exchange Rate Volatility

Business that have transactions denominated in foreign


currencies are exposed to exchange rate risk
The more volatile the exchange rates, the more difficult it is
to predict the firms cash flows in its domestic currency

If a firm can manage its interest rate and exchange rate risk, it
can reduce the volatility of its profits

Australian Short Term Interest Rates 1984 - 2008

A$ vs. US$ Jan 2005 Jan 2010

The Nature of Derivatives

The term "derivative" arises from the fact


that the agreement "derives" its value
from the price of an underlying asset
such as a stock, bond, currency, or
commodity.

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What are Derivative Instruments?


Definition
A

derivative is a financial instrument whose


return is derived from the return on another
underlying instrument.

Derivatives

are either:

traded on exchanges (e.g. a futures exchange); or


are customised by derivatives dealers (e.g. banks)
to meet a customers requirements these are
called Over the Counter (OTC) derivatives

Examples of Derivatives

Futures Contracts
Forward Contracts
Options
Swaps

12

Applications of Financial
Derivatives
Management

of Risk

Risk management is not about the elimination of


risk rather it is about the management of risk.
Financial derivatives provide a powerful tool for
limiting risks that individuals and organizations
face in the ordinary conduct of their businesses.

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Price discovery
Another

important application of derivatives is the


price discovery which means revealing information
about future cash market prices through the
futures market.
Derivatives markets provide a mechanism by
which diverse and scattered opinions of future are
collected into one readily discernible number which
provides a consensus of knowledgeable thinking .
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

14

Price stabilization function


Derivative
market helps to keep a
stabilising influence on spot prices by
reducing the short-term fluctuations. In other
words, derivative reduces both peak and
depths and leads to price stabilisation effect
in the cash market for underlying asset.
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

15

Classification of Derivatives

16

Derivative Markets & Instruments

Futures Contracts

Definition: a contract between two parties for


one party to buy something from the other at a
later date at a price agreed upon today;
subject to a daily settlement of gains and
losses and guaranteed against the risk that
either party might default

Exclusively traded on a futures exchange eg. the


Sydney Futures Exchange (SFE), Chicago Board of
Trade (CBOT),
Tokyo International Financial
Futures exchange (TIFFE) and London International
Financial Futures Exchange ( LIFFE)

Examples: Exchange Traded Futures


Examples of underlying assets which are traded on these
exchanges:

Agricultural Commodity futures - soy beans, wheat, pork bellies,


live cattle

Metal futures e.g. gold, silver, platinum, copper

Energy commodities e.g. crude oil, natural gas

Currency Futures: e.g. USD v. Yen, Euro, Swiss Franc, AUD

Financial Futures:
Interest rates, shares, share price indices(stock index)

Futures Price
The

futures prices for a particular contract is


the price at which you agree to buy or sell

It

is determined by supply and demand in the


same way as a spot price

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Electronic Trading
Traditionally

futures contracts have been


traded using the open outcry system where
traders physically meet on the floor of the
exchange

Increasingly

this is being replaced by


electronic trading where a computer matches
buyers and sellers
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Over-the Counter Markets


The

over-the counter market is an important


alternative to exchanges

It

is a telephone and computer-linked network


of dealers who do not physically meet

Trades

are usually between financial


institutions, corporate treasurers, and fund
managers
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Terminology
The

party that has agreed to buy has a long


position

The

party that has agreed to sell has a


short position

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Size of OTC and Exchange Markets

OTC

Exchange

Source: Bank for International Settlements. Chart shows total principal amounts
for OTC market and value of underlying assets for exchange market
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Derivative Markets & Instruments - Forward


Contracts

Definition: a contract between two parties for one


party to buy something from the other at a later date
at a price agreed upon today

Exclusively Over-the-Counter (OTC) - a telephone


and computer-linked network of dealers who do not
physically meet.

Most commonly traded Forward Contracts are in


foreign currency and interest rate markets.

Foreign Exchange Quotes for USD/GBP


exchange rate on July 17, 2009
Spot

Bid
1.6382

Offer
1.6386

1-month forward

1.6380

1.6385

3-month forward

1.6378

1.6384

6-month forward

1.6376

1.6383
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Derivative Markets & Instruments Options


Definition: a contract between two parties that
gives one party, the buyer, the right to buy or sell
something from or to the other party, the seller, at
a later date at a price agreed upon today
Basic

Option terminology
Option premium (price)- EXTRA PREMIUM
Call and Put Options
Exercise (strike) price [the agreed price]
Expiration date or maturity date

Options
A call

option is an option to buy a certain


asset by a certain date for a certain price
(the strike price)
A put option is an option to sell a certain
asset by a certain date for a certain price
(the strike price)
27

Types of Options
American

Options

That can be exercised any time on or before


the expiration date
Multiple delivery dates are possible

European

Options

The Option contact that can only be exercised on the


expiration date itself.

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

28

Google Option Prices (July 17,


2009; Stock Price=430.25)

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Options vs. Futures/Forwards


A futures/forward

contract gives the holder the


obligation to buy or sell at a certain price

An

option gives the holder the right to buy or


sell at a certain price

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Reasons to trade Derivatives


The three main reasons:
To hedge risks
To

speculate (to trade derivatives for profit by


taking a view on the future direction of the
market)
To lock into an arbitrage profit by PROFIT
FIX simultaneously entering into transactions
in two or more markets
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The Three Broad Categories of Trader

Hedgers : Use futures, forwards (via Over The Counter)


and options to reduce the risk that they face from
potential future movements in a market variable.

Speculators: Use futures, forwards (via Over The


Counter) and options to bet on the future direction of a
market variable.

Arbitrageurs: Take offsetting positions in two or more


instruments to lock in a profit.

Example 1: Hedging using Forward Contracts


A company based in United States knows that in 3 months time it will have to pay GBP10million for imports from Britain. It decides to hedge the risk.
The US based company could hedge by: Buying GBP 10m (by selling US$) 3 month forward (OTC market)
With the Foreign Exchange Quotes for USD/GBP exchange rate below, the company will be able to hedge the price:

Bid (Buy)

Offer (Sell)

Spot

1.6382

1.6386

3-month forward

1.6378

1.6384

Hedge the risk by: Buying GBP 10m (selling US$) 3 month forward (OTC market)
The US company could hedge its foreign exchange risk by buying GBP pounds from the
financial institution in the three month forward market at 1.6384. This would have the effect of
fixing the price to be paid to the British exporter at US$16,384,000.
If exchange rate gone lower than 1.6384 the company will do better if it chooses not to hedge.
If exchange rate gone up, more than 1.6384, the company will wish it had hedged.

Example 2: Hedging using Forward Contracts


A company based in United State knows that in 3 months time it will receive GBP30million for export to Britain. It decides to hedge the risk.
The US based company could hedge by: Selling GBP 30m (Buy US$) 3 month forward (OTC market)
With the Foreign Exchange Quotes for USD/GBP exchange rate below, the company will be able to hedge the price:

Bid

Offer

Spot

1.6382

1.6386

3-month forward

1.6378

1.6384

Hedge the risk by: Selling GBP 30m (buying US$) 3 month forward (OTC market)
The US company could hedge its foreign exchange risk by selling GBP pounds from the
financial institution in the three month forward market at 1.6378. This would have the effect of
fixing the price to be received from the British company at US$49,134,000
If exchange rate gone lower than 1.6378 the company will wish it had hedged.
If exchange rate gone up, more than 1.6378, the company will do better if it chooses not to
hedge.

Example 3: Hedging using Options

In May, an investor owns 1,000 Microsoft shares currently worth


$28 per share. A two month ( July) put option with a strike price of
$27.50 cost $1 per option. The investor decides to hedged by buying
10 contracts options with 100 options each contract for total cost of
$1,000

The

investor would have the right to sell a total of 1,000 shares


@ $27.50
Cost to pay for the for 100 contract options = $1,000
Guarantees that the shares can be sold for at least $27.50 per
share during the life of the option
If the market price of the share falls below $27.50, options will
be exercised, $27,500 is realized for the holding minus the cost.
If the market price of the share stays above $27.50, the options
are not exercised and expire worthless.

Forward Contract vs. Options for Hedging


Forward Contracts:
Designed to neutralize risk by fixing the price that the
hedger will pay or receive for the underlying asset.
Options Contracts :
Designed to provide assurance. To protect the
investors against adverse price movements in future
and allowing them to benefit from favourable price
movement.

Example 4: Speculation using Futures


A speculator from U.S., who in February thinks that the British pound will
strengthen relative to the U.S. dollar over the next two months and is
prepared to back that hunch to tune of 250,000.

Current exchange rate : 1 = $1.6470


Future Contract exchange rate( April) : 1 = $1.6410

Investors strategy - Alternative 1: Purchase 250,000 in the spot market, 1 =$1.6470


If the Actual April exchange rate increased to : 1 =$1.700
The profit that the speculator can made = (1.7000-1.6470) x 250,000=$13,250
If the Actual April exchange rate dropped to: 1 =$1.600
The losses would be (1.6470-1.6000) x 250,000= ($11,750)
Investors strategy Alternative 2: Buy futures contract. 1 =$1.6410 ( locked as
minimum exchange)
If the Actual April exchange rate increased to : 1 =$1.700
The profit that the speculator can made = (1.7000-1.6410) x 250,000=$14,750
If the Actual April exchange rate dropped to: 1 =$1.600
The losses would be (1.6410-1.6000) x 250,000= ($10,250)

Example 4: Speculation Using Futures


(continue)
Investors strategy - Alternative 1:

Up front investment of (250,000 X 1.6470) = $411,750 is needed.

Investors strategy - Alternative 2:

Only requires a small amount of cash to be deposited by the speculator in a


margin account

Example 5: Speculation using Options


Suppose that it is October and a speculator consider that a stock is likely to
increase in value over the next two months. The stock price is currently $20
and a two month call option with $22.50 strike price currently selling for $1
per option. The speculator is willing to invest $2,000.
Investors strategy - Alternative 1: Purchase 100 shares at $20
If the Actual December share price increased to : $27
The profit that the speculator can made = ($27-$20) x 100 shares=$700
If the Actual December share price dropped to: $15
The losses would be ($20-$15) x 100= ($500)
Investors strategy - Alternative 2: Purchase 2,000 calls options (10 call options contracts)
If the Actual December share price increased to : $27
The profit that the speculator can made = ($27-$22.50) x 2,000=$9,000 minus cost of $2,000
= $7,000
If the Actual December share price dropped to: $15
The losses would be $2,000 of the option contracts costs
**When a speculator uses futures the potential loss as well as gain is very large.
**When options are used, no matter how bad things get, the loss is limited to the amount paid for options.

Example 6: Arbitrage Opportunities


Consider a stock that is traded in both New York and London. Suppose that the
stock price is $162 in New York and 100 in London at a time when the exchange
rate is $1.6500 per pound. Arbitrageur prepared to buy 100 shares.

Potential investment cost


New York : (100 shares x $162 ) =$16,200
London : (100 shares x $1.65 x 100) =$16,500
Investors strategy
Buys 100 shares in New York
Sells the shares in London
Convert the sale proceeds form pounds to dollars
Therefore the profit is ($16,500-$16,200) = $300

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

41

Mechanics of Futures Markets


Part 1
(Hull, Chapter 2)

42

Introduction

Consider a firm that doesn't have an immediate need


for an asset, but knows that at some future date the
asset will have to be purchased.
For example, a firm may need a supply of copper
three months from now for use in production.
In such a case the firm faces three alternatives:
a) buy the asset now and store it until it is needed;
b) wait to buy the asset at a future date at the future
"spot" price;
c) enter into a forward or a futures contract to lock-in
the price today for delivery on a specified future date.

Introduction (cont)
The risks and costs of these three alternatives
differ markedly:

a)

b)

c)

Buying the asset now would incur storage costs


(physical storage for commodity type assets) plus
the opportunity cost of funds being tied up;
If we wait to buy in the future we are uncertain
about the future price there may be an adverse
price movement before we buy.
Buying a futures or a forward contract locks in a
price today; it incurs no storage costs; and it shifts
the price risk to the seller of the contract.

Futures Contracts

A futures contract is an obligation to make (seller) or


take (buyer) delivery of a specified quantity and
quality of an underlying asset at a specified future
date and at a price agreed when the contract
originates.

Note:
a.

b.

Some futures are cash settled (e.g. share price index


futures) rather than requiring delivery of the physical
asset
Most futures contracts are closed out prior to their
maturity date by making another futures trade
opposite to the position held - that is, physical delivery
does not often take place!

Futures Trading on Organized Exchanges


Futures contracts are available on a wide range of
underlying assets
They are referred to by their delivery month
Futures contract terms and conditions are specified by
the particular futures exchange
contract grade (if relevant)
contract size
quotation unit
minimum price fluctuation
Delivery Terms (if relevant some are cash settled)
delivery date and time

Futures Trading on Organized Exchanges

Contract grade
For some commodities a range of grades can be delivered.
[e.g. No. 2 Yellow corn]
For financial assets generally well defined and unambiguous. [No need to
specify the grade for British Pounds]

Contract size
The contract size specifies the amount of the assets that has to be
delivered.
Too large : investors with relatively small exposure/position will be unable to
use the exchange
Too small: Trading may be expensive as there is cost associated with each
contract traded.

Quotation unit
The exchange defines how prices will be quoted [e.g. crude oil prices on
NYME are quoted in dollars & cents]

Futures Trading on Organized Exchanges

Price limits

For most contracts, daily price movement limits are specified by the exchange.
- Normally the trading ceases for the day once the contract has reached the upper
or lower limits
-In some cases, the exchange has the authority to change the limits.
Propose : to prevent large price movement due to excess speculative exercise

Position limits

- maximum number of contracts that a speculator may hold


Propose : to prevent speculators from exercising undue influence on the market

Delivery date and time


- A future contract is referred to by its delivery month.
- The exchange must specify the precise period during the month when delivery
can be made.
- Most futures contracts, the delivery period the whole month

Convergence of Futures Price to Spot Price

When the delivery period of the contract is approaching, the future price
converges to the spot price

Situation 1: The future price is above the spot price. Traders have clear arbitrage
opportunity to:
Sell a future contract
Buy the asset
Make delivery
as traders exploit this arbitrage opportunity, the future price will drop (market supply
increases)
Situation 2: The future price is below the spot price. Traders will:
Hold the future contract and wait for the delivery
it is more attractive to buy a future contact and the future price tend to rise (market demand
increases)

This is the result of the future price tend to be very close to the spot price during the
delivery period.

Convergence of Futures to Spot


Futures
Price

Spot Price
Futures
Price

Spot Price
Time

(a)

Time

(b)

Example: Contract Specifications - SPI


Contract Specification for SFE SPI ASX 200 (Source: http://www.asx.com.au )
Contract Size

Contract Months
Minimum Price Fluctuation
Last Trading Day

:
:
:

Delivery Method

Initial Margin

A$25 x index points


(e.g. $75,000 if index is at 3000)
March, June, Sep, Dec
One index point (A$25)
3rd Thursday of the
settlement month
Cash settlement (refer
ASX for calculation of
settlement price)
Varies with level of index
and broker requirements
(approx. $10,000+ at present)

Example: SPI Futures (30/1/09)


Month
Mar
June
Sept

Bid
Ask
3449.0 3451.0
3443.0 3447.0
3383.0 3400.0

High Low Last Change Volume


3465 3431 3449
- 67.0 8119

Source: http://www.asx.com.au
Notes:
1. Change is current price compared to settlement price on
previous day
2. Volume refers to number of contracts traded on the day

Mechanics of Futures Trading


The operation of Margins
Initial margin: a specified amount of cash and/or marketable
securities which must be deposited with the futures broker for
each traded contract.
Helps to ensure that traders dont default on their obligation.
Maintenance margin is set by the futures exchange, usually
below the initial margin
The balance in a traders margin account is adjusted to reflect
daily settlement prices (that is, accounts are marked-tomarket on a daily basis)

Mechanics of Futures Trading


The operation of Margins
Maintenance Margin
If a trader's cumulative losses on a futures contract
caused the margin account to fall below the
maintenance margin then additional cash will have
to be paid in order to restore the account to the
initial margin level.
the additional cash to be paid to maintain initial
margin is also known as a variation margin. If the
investor does not provide the variation margin, the
broker closes out the position.

Example of a Futures Trade


An investor takes a long position (buy) in 2
December gold futures contracts on June 5
contract size is 100 oz.
futures price is US$900
margin requirement is US$2,000/contract
(US$4,000 in total)
maintenance margin is US$1,500/contract
(US$3,000 in total)
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A Possible Outcome

Day

Futures
Price
(US$)

Daily
Gain
(Loss)
(US$)

Cumulative
Gain
(Loss)
(US$)

900.00

Margin
Account Margin
Balance
Call
(US$)
(US$)
4,000
3,400
.
.
.

Margin
maintenance
is $3,000

5-Jun 897.00
.
.
.
.
.
.

(600)
.
.
.

(600)
.
.
.

0
.
.
.

13-Jun 893.30
.
.
.
.
.
.

(420)
.
.
.

(1,340)
.
.
.

2,660 + 1,340 = 4,000


.
.
.
.
.

19-Jun 887.00
.
.
.
.
.
.

(1,140)
.
.
.

(2,600)
.
.
.

2,740 + 1,260 = 4,000


.
.
.
.
.
.

26-Jun 892.30

260

(1,540)

5,060

59

Other Key Points About Futures


They are settled daily
Closing out a futures position involves
entering into an offsetting trade
Most contracts are closed out before maturity

60

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