Futures & Options Chapter 1 PDF

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FUTURES & OPTIONS CHAPTER 1: INTRODUCTION Hedging:  is about trying to have no risk/or to reduce risk  Doesn’t mean that hedging would always result in favorable outcomes! Partial hedging:  trying to have some element of risk Why do we need a futures contract?  Protects both parties from risk  Farmer plants corn -> price high when there are days of scarcity, price low when there is an oversupply -> farmer exposed to a lot of risk  Company who always need to use corn -> oversupply, price favorable; scarcity, price of corn not favorable -> exposed to price risk  Protect each other’s interest by entering into a futures contract, agreeing on a future price. Reduces risk for both sides of the uncertain future price of corn, as your loss won’t be that much as compared to when you are unprotected.  But 1 party’s loss is the mirrored gain of the other party  People also trade the futures contract because it is another alternative way to earn money  There could be futures contracts on commodities such as corn, oats, soybean, T bonds, T notes  Can also have futures trading on foreign currencies Asset classes: 1. Commodities: speculative products such as gold and silver, energy* 2. Interest rates: fixed income (type of investment security that pays investors fixed interest payments until its maturity date, investors are paid the principal amount at maturity i.e. government bonds and corporate bonds) a. In this class we are using the risk-free rate 2. Stocks* 3. Credit (separate thing from interest rates) Accounting: Assets = Liabilities + Equity VS Finance: Value = Sum of PV (discounted at I)(CF) X Probability (credit includes probability/ risk free rate no probability)

Derivatives:  For hedging diversification, they are tools for hedging

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Initially created as risk management tools Can also be used for speculation and arbitraging Who needs to do hedging: o Pension funds: 60% bonds, 40% stocks: use derivative to reduce transaction costs o Financial institutions: they use it for a variety of things, can manage their own assets for hedging purposes and this is also their business: they make markets in derivatives, banks are usually the first to show prices  One of the most profitable business for banks: derivatives huge money for the banks  Banks play as intermediaries, matching buyers and sellers and earning commission fees from this or they are the buyers and sellers as well  Banks use derivatives to hedge to reduce risks in the bank’s operation (might be vulnerable to loses due to change in interest rates)  They can also sell options premiums and earn from it  Banks getting derivative products to different people, one goes to pension funds, the other treasury of companies (S & P companies), another place is commodities: natural hedgers for oil  Companies that uses oil and companies that produces oil has to hedge oil They can protect themselves when the oil prices tanks or increases (refer to corn e.g. above) It’s a contract, agreement between parties, and this agreement has a certain value. Referenced to something else that has value o Counterparties:  It is bilateral: agreement between 2 parties, each party is a counter party to the other, it is like a bet on the value of another financial or real asset o Maturity date:  Stock is perpetual, only ends when the company ends  Commodity is perpetual, it can degenerate but it is perpetual  Derivative contracts have maturity dates: usually quite short  Futures markets typically first 12 months, most commonly traded  They are definitely finite o Involves leverage: it is the equivalent of a leverage transaction  Buy something 100% leverage: the money you borrowed to buy the stock, in the end will end up with same economics with a forward  Buy with leverage: you are using other people's money to purchase, you have nothing at risk o Collateral:  Derivatives is a 0 sum game: your gain is my loss, there will be a winner and a loser inevitably, mirror image: amount gained is amount lost by the other user  Lehman brothers were losers to a lot of these derivatives, winners of derivatives suddenly couldn’t get their winnings, because Lehmans are bankrupt and they are no longer there (2008 crisis) -> therefore now more stricter collateral, imposing daily collateral  Collateral is anything of value such as cash or risk-free bonds (US: treasury bonds)  If you’ve won and they’ve defaulted, you can seize collateral and liquidate it so that you get your winnings  Important to have high quality collateral

Where are derivatives traded?  Organized markets o derivatives exchange NOT stock exchanges - Standardized contracts o Standardized In terms of maturity dates and the amount of the underlying 3rd friday is the maturity o Helps a lot with liquidity - Settlement rules:  Settlement period: time between the trade date (day when the order is executed) and the settlement date (when a trade is considered final)  During the settlement period, the buyer must pay for the shares, the seller must deliver the shares - Linked with a clearing house: o Central counterparty to everyone traded the derivative o Acts as an intermediary between buyer and seller, to make buyer and seller honor their contract obligations  Responsibilities include collecting margins, regulating delivery of bought and sold instruments  Act as 3rd parties to all futures and options contracts o Created by the financial banks usually, backed by a lot of financial banks that are most implicated in these activities as they are the biggest players in these markets o One of them falls, they won't all fall together because central bank will step up  Over the counter markets o No need for standardization  Can customize a derivative for a particular need, but would be limited about who can take over that contract when he wants to get out of it, because it is difficult to find someone who would want to take over and have the same particular need as him when the contract is so unique o Contract between 2 parties o No central exchange Difference between Futures and Forwards - Futures are highly standardized while the terms for forwards can be privately negotiated and discussed (customized) - Futures traded on exchange, forwards in OTC - Counterparty risk:  Risk that one side will not follow through with the agreement

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Futures contract -> have clearing house and it acts as a counterparty to both parties in the agreement to reduce counterparty risk Futures also have marked to market daily with margins required to be posted and maintained by the participants at all times, there 0 counterparty risk Forwards do NOT have these mechanisms in place, forwards are only settled at the time of delivery, profits and loss on a forward contract is only realized at the time of settlement -> credit exposure keeps increasing -> if there is a default, loss is very great for participants of a forward contract Because futures are very standardized, they can be traded in the secondary market, no secondary market for forwards

Categories of derivatives  Forward Contracts o FRA: Forward Rate Agreement:  OTC contracts between parties that determine the interest rate to be paid on an agreed upon date in the future  Agreement to exchange an interest rate commitment on a notional amount o Agricultural products: pork, wheat o Industrial products: iron, copper, cotton, silver in some cases o Energy: oil and natural gas, electricity  Options: o Stocks:  Can have options on any types of ETFs especially on the liquid ones  ETFs have pretty decent liquidity  ETFs: Exchange Traded Funds - It is a collection of securities such as stocks, that tracks an underlying index - Contains many types of investments such as stocks, commodities, bonds etc. - It is a marketable security where it has an associated price that allows it to be easily bought and sold - They trade on an exchange just like a stock - ETF share prices will fluctuate daily due to it being bought and sold o Market index  S &P 500, traded mostly by institutions because they are large dollar amounts  Hypothetical portfolio of investment holdings which represents a segment of the financial market  Calculation of the index value comes from the prices of underlying holdings  Investors follow market indexes to gauge the market movements

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S&P 500, Dow Jones, NASDAQ -> most popular stock indices to track performance of the US market Exchange rates Used by hedgers who are worried about the exchange rate moving against them, they would be protected Options involves the exchange of money where there is a premium involved, pay upfront first for the options

Forward Contracts  Agreement o Obligation to provide a collateral for e.g. o In forward, no money exchanged!!  Forward price: price determined today (right now) about the price they are getting at the maturity date. Using spot price for future transactions, would be unfair to one party, so don’t use spot price. But on the maturity date, it is a spot contract  Spot price: current price of a commodity  Profit of long = loss of short (that’s why 0 sum game)

Options  You have a right, it is NOT an obligation  Exercise the option only if it's worth more, because if it is worth less, we would rather buy from the spot market (call option)  But you have to pay for the option, but there are free options  It can be an option on stock, commodity, bond, credit (referring to the "asset" and what kinds of "assets" that we can buy/sell)  E.g. In this case could be any option, like pertaining to a building: option to renew the rental of the building (in 10 years, able to renew the rental for a certain price)  Forward and future is an OBLIGATION vs Option is a RIGHT (exercise it when the economics are favorable to you)  Put option: option to sell o Worried that the price is going to go down, no option, you are exposed to the risk that the asset becomes completely devalued, but put option can help protect you a bit

Options E.g. 1: Cost you $29 for call option per share to buy $550 per share K is strike price of the option

Options E.g. 2: You have a put option where your pain threshold is $525: Cannot lose any more money than until $525 assuming you bought google shares at $532.34 On Sept 18:  If spot price on this date is going to decrease below $525 -> exercise options and sell. Net profit has to deduct $2240  If spot price on this date increased above $525, options not exercised, net profit = -$2240

Uses of derivatives: For Hedging Purposes Hedging E.g. with a forward contract 1.5 (optimistic scenario) 1.6 (pessimistic scenario)

To Note: Futures and Forwards are obligations They cost nothing except margin requirements And they have unlimited gains and losses

Options are a RIGHT You have to pay an option premium upfront and you have controlled/limited losses

Scope of Hedging Option: paid for the option therefore no full elimination of risk as compared to a forward contract Price increases: smaller profits because you still had to pay for the cost of the option as compared to forward Put option is like an insurance: car insurance

Speculation with a Futures contract e.g. Futures contract: in practice margin required when you set the contract, needed in the event that you are on the wrong side of the price movement 20000USD is just collateral, if price go up above 1.541, going to get the 20000 back and your profits With a futures contract, you earn more profits than without futures contract and lesser loss than without a future's contract

No futures contract have many transactions, so require many transaction costs for opening and closing everything With futures contract, only 2 transactions -> lesser transaction costs to just open and then close

Arbitrage Sell the forward and collect the $500 and buy the spot Bought the spot price of 1 share at $50 (assuming you borrowed this amt from someone and have to pay them 5% interest) therefore total upfront cost is $50 + $2.5 = $52.5 However in this e.g., if you hold this forward contract till maturity, you will get $500 for one share Arbitrage is taking advantage of the price difference between 2 or more markets. Sure way of making money. When you have arbitrage, whatever you do, it would be in your favour. Risk free profit opportunities -> because you confirm knew that things would be in your favour Arbitrage means it is the realization of the guaranteed risk free profit...