Futures and swaps


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Futures and swaps

  2. 2. DERIVATIVES• A financial contract of pre-determined duration, whose value is derived from the value of an underlying asset• The asset may be:- Securities  commodities  bullion  precious metals  currency  livestock  index such as interest rates, exchange rates , etc
  3. 3. What do derivatives do?Minimize the loss• arising from adverse price movements of the underlying assetMaximize the profits• arising out of favorable price fluctuation.
  4. 4. Derivatives and Market
  5. 5. Types of Derivatives CommodityFinancial Index DERIVATIVES
  7. 7. DERIVATIVE INSTRUMENTSForward ContractsFuture Contracts• Commodity• FinancialOptions• Put• CallSwaps• Interest rate• currency
  8. 8. Forward Contracts• A one to one bipartite contract, which is to be performed in future at the terms decided today.• Product ,Price ,Quantity & Time have been determined in advance by both the parties.• Delivery and payments will take place as per the terms of this contract on the designated date and place.
  9. 9. Options• An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.• An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.
  10. 10. Future ContractsStandardized contract between two partiesExchange of a specified assetStandardized quantity and qualityPrice agreed todayDelivery occurring at a specified future date
  11. 11. Key Elements of Futures Underlying Asset Settlement or Delivery DateFutures price
  12. 12. Content of a Future ContractWhether the trader wants to buy or sellThe name of the commodityThe delivery month and year of the contractThe number of contractsThe exchange on which they tradeDay order or “good-til-canceled” orderMarket or limit order; if a limit order, then specify alimit price
  13. 13. Positions in a futures contract• this is when a person buys a futures contract, and agrees to receive delivery at a future date.• this is when a person sells a futures contract, and agrees to make delivery.
  14. 14. Futures v/s Forwards Forward FutureContract with Bank ExchangeContract size (N) Flexible StandardMaturity Date Usually 90-360 days Specified from origination calendar datesMargin Negotiable FixedCash flows prior 0 Daily mark toto expiration market
  15. 15. Forward Versus FuturesCOMPARISON FORWARD FUTURESTrade on organized exchanges No YesUse standardized contract terms No YesUse associate clearinghouses to No Yesguarantee contract fulfillmentRequire margin payments and daily No YessettlementsClose easily No YesRegulated by identifiable agencies No YesAny quantity Yes NoAny product Yes No Chapter 1 16
  16. 16. Forwards vs. Futures Advantages/Disadvantages Smaller contract Disadvantages:- size Currencies available Little limited Easydefault Advantages liquidation risk. Limited dates of delivery Well- organized and stable market. Rigid contract sizes.
  17. 17. DIFFERENCE BETWEEN FUTURES & OPTIONS FUTURES OPTIONSFutures contract is an agreement to In options the buyer enjoys the rightbuy or sell specified quantity of the and not the obligation, to buy or sellunderlying assets at a price agreed the underlying asset.upon by the buyer and seller, on orbefore a specified time. Both thebuyer and seller are obliged tobuy/sell the underlying asset.Unlimited upside & downside for both Limited downside (to the extent ofbuyer and seller. premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited.Futures contracts prices are affected Prices of options are however, affectedmainly by the prices of the underlying by a)prices of the underlying asset,asset b)time remaining for expiry of the contract and c)volatility of the underlying asset.
  18. 18. How does one make money in a futures contract? Long • when the underlying assets price rises abovePosition the futures price. Short • when the underlying asset’s price falls belowPosition the futures price.
  19. 19. Payoffs for futures contracts Payoff F0 = Contract price at time 0 Payoff F1 = Future price at time 1 F1 Sell futures Buy futures 0 F 0 F F0 F0-F1 Gain if interest rates Gain if interest rates fall and prices rise of rise and prices fall of debt securities. debt securities.
  20. 20. Futures Contracts Payoff Profilesprofit Long futures profit Short futures F(0,T) F(1,T) F(0,T) F(1,T)The long profits if the next day’s futures The short profits if the next day’sprice, F(1,T), exceeds the original futures price, F(1,T), is below thefutures price, F(0,T). original futures price, F(0,T). ©David Dubofsky and 6-21 Thomas W. Miller, Jr.
  21. 21. Major Futures Exchange Major Futures Exchanges in the World for 2003EXCHANGE 2003 Volume Top 20 % (Futures Only) VolumeEurex (Germany) 668,650,028 24.55Chicago Mercantile Exchange (USA) 530,989,007 19.49Chicago Board of Trade (USA) 373,,669,290 13.72Euronext-Liffe (Netherlands) 273,121,004 10.03Mexican Derivatives Exchange (Mexico) 173,820,944 6.38Bolsa de Mercadorias e Futuros (Brazil) 113,895,061 4.18New York Mercantile Exchange (USA) 111,789,658 4.10Tokyo Commodity Exchange (Japan) 87,252,219 3.20London Metals Exchange (UK). 68,570,154 2.52Korea Stock Exchange (South Korea) 62,204,783 2.28Sydney Futures Exchange (Australia) 41,831,862 1.54National Stock Exchange of India (India) 36,141,561 1.33SIMEX (Singapore) 35,356,776 1.30International Petroleum Exchange (UK) 33,258,385 1.22OM Stockholm (Sweden) 22,667,198 .83Tokyo Grain Exchange (Japan) 21,084,727 .77New York Board of Trade (USA) 18,822,048 .69Bourse de Montreal (Canada) 17,682,999 .65MEFF Renta Variable (Spain) 17,109,363 .63Tokyo Stock Exchange (Japan) 15,965,175 .59Total Top 20 2003 Futures Volume 2,723,882,242 100%Source: Futures Industry Association.
  22. 22. Clearinghouses1. Guarantee that the traders will honor their obligations (solves issues of trust).2. Each trader has obligations only to the clearinghouse, not to other traders.3. Each exchange uses a futures clearinghouse.4. Clearinghouses may be part of a futures exchange (division), or a separate entity.5. Due to 2000 CFMA, clearing arrangements vary across industries.6. Clearinghouses are “perfectly hedged” by maintaining no futures market position of their own. Chapter 1 23
  23. 23. Clearing housesGuarantee that the traders will honor theirobligationsEach trader has obligations only to theclearinghouse, not to other traders.Each exchange uses a futures clearinghouse.Clearinghouses may be part of a futures exchange,or a separate entity.clearing arrangements vary across industries.Clearinghouses are “perfectly hedged” bymaintaining no futures market position of their own.
  24. 24. Major Futures Clearing Organizations Table 1.7 Major Futures Clearing OrganizationsClearinghouse Affiliated ExchangesThe Clearing Corporation (CCorp) US Futures Exchange and the Merchants Exchange of St. LouisChicago Mercantile Exchange Chicago Mercantile exchangeClearinghouse With clearing link to CBOTKansas City Board of Trade Clearing Kansas City Board of TradeCorporationEnergy Clear Corporation Exempt Commercial MarketsMGE Clearinghouse Minneapolis Grain ExchangeNYMEX Clearinghouse New York Mercantile ExchangeNew York Clearing Corporation New York Board of TradeThe Options Clearing Corporation OneChicago, NQLX, & option exchangesThe London Clearinghouse Exempt Commercial Markets and OTC marketsSources: The CFTC web site, www.cftc.gov. Chapter 1 25
  25. 25. Uses of FuturesHedging: long security, sell futureSpeculation: bullish security, buy FuturesSpeculation : bearish Security, Sell FuturesArbitrage: overpriced Futures: buy spot,sell futuresArbitrage: underpriced Futures: buy spot,sell futures
  26. 26. Complications in using financial futuresAccounting and regulatory guidelines.Macro hedge of the bank’s entire portfolio -- cannot defer gains andlosses on futures, so earnings are less stable with this hedge strategy.Micro hedge linked to a specific asset -- can defer gains and losses onfutures until contracts mature.difference between the cash and futures prices are not normallyperfectly correlated