Contents• Derivatives Introduction• Participants• Forward Contracts• Options• The Future Contracts• Key elements, content & types of Futures• Different positions in Future contracts• Future v/s Forwards
• Difference between Future & Options• Money making through Futures• Pricing and Pay-off of Future Contracts• Clearinghouses• Uses & Functions of Future Contracts• Complications in Future Contracts• SWAPS• Size of swap market• Types of Swap• Risks in Swap Contracts• Conclusion
Objective of Presentation• To have a brief introduction about the Future and Swap contracts.• To have a brief knowledge about the types, markets, constraints and risks in Future & Swap Contracts.
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
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.
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.
Futures Contracts: Foreign Currency and Interest-Earning AssetForeign Currency Interest-Earning AssetsAustralian dollar Treasury billsBrazilian Real NotesRussian Ruble BondsNew Zealand dollar Eurodollar depositsSwedish Krona Interest rate swapsSouth African Rand Fed fundsNorwegian Krone Municipal bondsBritish poundCanadian dollarJapanese yenSwiss francMexican pesoEuro
Futures Contracts: Index Based• Traders must fulfill their obligation by reversing trade or cash settlement at the end of trading. EXAMPLE OF INDEX BASED CONTRACTS US Exchanges Foreign ExchangesBroad-Based stock indexes Foreign Stock IndexesS&P 500 British FTSE 100Dow Jones Industrial Average French CAC 40Russell 2000 Dow Jones Euro Stoxx 50NASDAQ 100 German DAXStyle-Based Indexes Brazillian Bovespa stockS&P Barra Growth Japanese Nikkei 225S&P Barra Value Korean KOSPI 200
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,mainly by the prices of the underlying affected by a)prices of the underlyingasset asset, b)time remaining for expiry of the contract and c)volatility of the underlying asset.
How does one make money in a futures contract?
Pricing of Futures• for a simple, non-dividend paying asset, the value of the future, will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r.• F(t) = S(t)(1 +r)(R+r)
• With continuous compounding• F(t) = S(t) er(T-t)
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.
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Major Futures Clearing Organizations M jo F tu e C a in O g n a n a r u r s le r g r a iz tio sClearinghouse 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.
Introduction• A swap is an agreement between counter-parties to exchange cash flows at specified future times according to pre-specified conditions.• A swap is equivalent to a coupon-bearing asset plus a coupon-bearing liability. The coupons might be fixed or floating.• A swap is equivalent to a portfolio, or strip, of forward contracts--each with a different maturity date, and each with the same forward price.
Size of the Swap Market• In 2007 the notational principal of: Interest rate swaps was $271.9 trillion USD. Currency swaps was $12 trillion USD• The most popular currencies are: – U.S. dollar – Japanese yen – Euro – Swiss franc – British pound sterling
The Swap Bank• A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.• The swap bank can serve as either a broker or a dealer. – As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. – As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.14-45
Interest Rate Swap• There are two types of interest rate swaps:
Interest Rate Swap– Counterparty A is called the fixed rate payer or swap buyer– Counterparty B is called the floating rate payer or swap seller Fixed rate paymentsCounterparty A Counterparty B Floating rate payments
Interest rate SWAP 13.1% Bank Libor Bank makes debt Firm A payments Firm B Libor + 1% 12%Starting conditions: Starting conditions:Firm A borrows floating rate Firm B borrows fixed rate 12% bondsbank loan at Libor + 1% (AAA bonds with no premium for risk)(premium for risk)
Swap Market Efficiency• Swaps offer market completeness and that has accounted for their existence and growth.• Swaps assist in tailoring financing to the type desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.14-54