Lecture 9: Introduction to Financial Derivatives

Explain the relationship between ex-ante and ex-post in a forward contract

but ex-ante (at the time of writing the contract) both firms already know: Ex-post, a forward contract has one winner and one loser

Buying a forward contract opens what type of position?

buying a forward contract opens a long position (the contract becomes more valuable if the spot price of the asset in the future increases)

What is the purpose of daily settlement?

(Marked-to-market): it is the mechanism that virtually eliminates default risk and makes futures so attractive

Explain why credit risk is no longer an issue with the margin system.

If a counterparty defaults, this is no big problem: its position will be closed immediately but the entire value which the contract had at the moment of the default has already been paid by the now-defaulting counterparty via the margin account system, So you could simply look for another contract partner for your futures position (in fact, the exchange will do that even automatically for you), and you suffered no loss at all

Which funds can be withdrawn from a margin account?

If the balance of your margin account exceeds the "initial margin requirement", you may withdraw those excess funds at anytime

How are futures contracts on stock market indices settled?

convention: future contracts on stock market indexes are cash-settled: + the contract has a multiplier, and at end-of-contract the seller must deliver this amount for every point of the stock index in cash: +the seller delivers Q = multiplier × stock index in cash. Everything else is the same as with futures on resources

Selling a forward contracts opens what type of position?

selling a forward contract opens a short position (which is the more valuable the lower the spot price of the asset will be in the future)

What is a futures contract?

a futures contract is a contract promising delivery of an underlying asset at a defined moment in the future

Explain forward contract equivalency.

a short / long position in a futures contract has the same profits and losses (and also the same payoffs) as a short / long position in an equivalent forward contract + the difference is that your profits/losses are received/paid in the form of a continuous in-/outflow to/from your margin account, not in the form of a rebated/overpriced final delivery (as in the forward contract). + in fact, if delivery finally takes place, it will be charged to you at the spot market price, but the amount that has accumulated in your margin account will be such that it exactly compensates you for the difference to the price at which you opened your futures position.

What could happen if futures price does not equal spot market price?

+ if futures price for delivery today was above the spot price, you could buy on the spot market and sell this futures contract and make a certain profit (arbitrage) + if futures price for delivery today was below the spot price, you could buy futures contracts and take delivery and sell on the spot market for a certain profit (arbitrage) + such arbitrage opportunities would be quickly taken advantage of by traders, thus eliminating them

What are some of the problems with forward contracts?

+ since they are customized OTC products, they have high transaction cost and low liquidity --- liquidity in this context means the ease of finding a counterparty (rather than the ease at which the contract can be converted into cash) + they suffer from a substantial risk that the counterparty may default + they are not transferable to other parties in case you need to avoid delivery for some reason

How are futures standardized with regards to quality?

+ the quality of the asset to be delivered: the goods to be delivered in a futures contract are standardized by the futures exchange in much detail (such that it can be verified by court)

What is a forward contract?

A typical forward contract is a contract between two firms specifying at least +Quantity: the amount to be delivered, +Quality: the properties of the good to be delivered +Delivery price: the price to be paid upon delivery +Time: the date when delivery is required to take place +Place: where the assets are to be delivered. Since a forward contract is not standardized in any way, it can contain customized clauses that reflect specific needs of both parties

Why and how do futures prices move?

The movement of future prices is largely driven by changes in expectations about the future demand and supply of the asset + for example, a flood in the Midwest that destroys many crops will let the prices of corn futures contracts increase (because in the future there will be less supply of corn) As the futures contract approaches delivery, the futures price will always converge towards the spot market price

How do the vast majority of futures contracts end?

The vast majority of futures contracts does not lead to delivery this is because most traders choose to close their position before thedelivery period

How are futures standardized with regards to delivery?

delivery months and circumstances of delivery are standardized, too + for example, futures trading on the Chicago Board of Trade have delivery months of March, May, July, September and December + at the beginning of the delivery period the party which sold the future contract issues a notice of intention to deliver and coordinates delivery with the buyer + however, the vast majority of all futures contracts never get delivered because positions are closed out before delivery

Where are futures traded?

futures are traded on special exchanges (largest exchange: Chicago Mercantile Exchange) + most futures exchanges have an integrated clearinghouse for settlement

How can hedging go wrong?

hedging can reduce downside risk, but you also give up chances (i.e. upside risk) + if you hedge input prices (for example, an airline hedging its fuel prices), this can be beneficial for you if spot prices of your inputs indeed continue to increase + but if spot prices of your inputs fall all of a sudden, competitors who did not hedge their exposures will have a substantial cost advantage over you

What is hedging?

hedging is the process of sterilizing your risks by entering additional financial contracts which have risk that is opposite to your original risk. Hedging can reduce your risk, and does so both on the downside and on the upside (i.e. you give up some profit opportunities by hedging)

When do you receive a margin call?

if the margin account ever runs below a certain minimum ("maintenance requirement"), your bank will give you a margin call asking you to top it up with more money (or they will automatically close your position)

What is a short position?

if you benefit if the asset's price falls, you have what we call a short position in this asset

What is a long position?

if you benefit in case the asset's price increases, you have what we call a long position in this asset

How big is the damage if a counterparty to a forward contract defaults?

it depends on difference in delivery prices of the forward contract that was defaulted upon, and the delivery prices that you can obtain in a similar forward contract written today.

How does a forward contract offer a reduction in risk?

it eliminates the uncertainty about the price of the asset at the maturity date This reduction of uncertainty can help firms in many aspects of their business, e.g. accessing capital markets

How is each problem of a futures contract solved? (3)

lack of liquidity → design a standardized contract that trades on an exchange (rather than OTC) counterparty risk → introduce a mechanism to automatically protect against counterparty default non-transferability → introduce multilateral netting of positions in a clearinghouse

How do futures eliminate the risk of counterparty default?

marked-to-market and daily settlement eliminates the risk of counterparty default

How does daily settlement work?

the exchange requires both parties in a futures contract to keep margin accounts + at the end of every day, the exchange looks at how futures prices have moved + the clearinghouse of the exchange debits automatically the margin accounts of the party whose contract has become more valuable and credits the margin account of its counterparty by exactly this amount + the amount debited/credited corresponds exactly to the change in futures prices + in case the margin account has insufficient funds and the party does not top up funds after receiving a margin call, the position will be automatically closed

What happens when a party buys a forward contract?

the party buying a future contract agrees to take delivery of the underlying asset in the future at a delivery price F fixed today

What happens when a party sells a forward contract?

the party selling a forward contract promises to deliver the underlying asset in the future at a delivery price F that is fixed today

What is a margin account?

think of a margin account as a bank account to which the clearinghouse of the futures exchange can make automatic debits/credits, depending on how your futures contract evolves

How do you close a position?

to close a position, you simply need to enter the opposite type of trade than the original one, i.e. : + if you had a short position, you open an additional long position of the same contract + if you had a long position, you open an additional short position of the same contract Then, the exchange will recognize that you both receive and deliver the same asset on the same date (so your net position is zero) and will close out your position

How do you open a long position in a futures market?

to open a long position, you buy a futures contract (you promise to receive a delivery of the asset in the future) + at the moment of buying a futures contract, you do not have to pay anything + however, you will need to deposit some funds on a margin account to guarantee your position

How do you open a short position in a futures market?

to open a short position, you sell a futures contract (you promise to deliver the asset in the future) + at the moment of selling a futures contract, you do not receive any funds either + however, you will also need to place some funds on a margin account, and all financial consequences of your contract will be settled via this account

How are futures standardized with regards to size?

usually, futures on resources (oil, livestock, grain) have contract sizes that correspond to values around $10 000 − $20 0000. Usually, futures on financial assets (stock indexes, treasuries, shares) have contract sizes beyond ∼ $100 000