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  1. 1. Derivatives - The Futures Trade ProcessMost U.S. futures exchanges offer two ways to enact a trade - the traditional floor-trading process (also called "open outcry") and electronic trading. The basic steps areessentially the same in either format: Customers submit orders that are executed - filled- by other traders who take equal but opposite positions, selling at prices at which othercustomers buy or buying at prices at which other customers sell. The differences aredescribed below.Open outcry trading is the more traditional form of trading in the U.S. Brokers takeorders (either bids to buy or offers to sell) by telephone or computer from traders (theircustomers). Those orders are then communicated orally to brokers in a trading pit. Thepits are octagonal, multi-tiered areas on the floor of the exchange where traders conductbusiness. The traders wear different colored jackets and badges that indicate who theywork for and what type of traders they are (FCM or local). Its called "open outcry"because traders shout and use various hand signals to relay information and the price atwhich they are willing to trade. Trades are executed (matches are made) when thetraders agree on a price and the number of contracts either through verbalcommunication or simply some sort of motion such as a nod. The traders then turn theirtrade tickets over to their clerks who enter the transaction into the system. Customersare then notified of their trades and pertinent information about each trade is sent to theclearing house and brokerages.In electronic trading, customers (who have been pre-approved by a brokerage forelectronic trading) send buy or sell orders directly from their computers to an electronicmarketplace offered by the relevant exchange. There are no brokers involved in theprocess. Traders see the various bids and offers on their computers. The trade isexecuted by the traders lifting bids or hitting offers on their computer screens. Thetrading pit is, in essence, the trading screen and the electronic market participantsreplace the brokers standing in the pit. Electronic trading offers much greater insight intopricing because the top five current bids and offers are posted on the trading screen forall market participants to see. Computers handle all trading activity - the softwareidentifies matches of bids and offers and generally fills orders according to a first-in,first-out (FIFO) process. Dissemination of information is also faster on electronic trades.Trades made on CME® Globex®, for example, happen in milliseconds and areinstantaneously broadcast to the public. In open outcry trading, however, it can takefrom a few seconds to minutes to execute a trade.Price LimitThis is the amount a futures contracts price can move in one day. Price limits areusually set in absolute dollar amounts - the limit could be $5, for example. This wouldmean that the price of the contract could not increase or decrease by more than $5 in asingle day.Limit MoveA limit move occurs when a transaction takes place that would exceed the price limit.This freezes the price at the price limit.
  2. 2. Limit UpThe maximum amount by which the price of a futures contract may advance in onetrading day. Some markets close trading of these contracts when the limit up is reached,others allow trading to resume if the price moves away from the days limit. If there is amajor event affecting the markets sentiment toward a particular commodity, it may takeseveral trading days before the contract price fully reflects this change. On each tradingday, the trading limit will be reached before the markets equilibrium contract price ismet.Limit DownThis is when the price decreases and is stuck at the lower price limit. The maximumamount by which the price of a commodity futures contract may decline in one tradingday. Some markets close trading of contracts when the limit down is reached, othersallow trading to resume if the price moves away from the days limit. If there is a majorevent affecting the markets sentiment toward a particular commodity, it may takeseveral trading days before the contract price fully reflects this change. On each tradingday, the trading limit will be reached before the markets equilibrium contract price ismet.Locked LimitOccurs when the trading price of a futures contract arrives at the exchangespredetermined limit price. At the lock limit, trades above or below the lock price are notexecuted. For example, if a futures contract has a lock limit of $5, as soon as thecontract trades at $5 the contract would no longer be permitted to trade above this priceif the market is on an uptrend, and the contract would no longer be permitted to tradebelow this price if the market is on a downtrend. The main reason for these limits is toprevent investors from substantial losses that can occur as a result of the volatility foundin futures markets.The Marking to Market ProcessAt the initiation of the trade, a price is set and money is deposited in the account.At the end of the day, a settlement price is determined by the clearing house. Theaccount is then adjusted accordingly, either in a positive or negative manner,with funds either being drawn from or added to the account based on thedifference in the initial price and the settlement price.The next day, the settlement price is used as the base price.As the market prices change through the next day, a new settlement price will bedetermined at the end of the day. Again, the account will be adjusted by thedifference in the new settlement price and the previous nights price in theappropriate manner.If the account falls below the maintenance margin, the investor will be required to addadditional funds into the account to keep the position open or allow it to be closed out. If
  3. 3. the position is closed out the investor is still responsible for paying for his losses. Thisprocess continues until the position is closed out.OPTIONSDerivatives - Options: Calls and PutsAn option is common form of a derivative. Its a contract, or a provision of a contract,that gives one party (the option holder) the right, but not the obligation to perform aspecified transaction with another party (the option issuer or option writer) according tospecified terms. Options can be embedded into many kinds of contracts. For example, acorporation might issue a bond with an option that will allow the company to buy thebonds back in ten years at a set price. Standalone options trade on exchanges or OTC.They are linked to a variety of underlying assets. Most exchange-traded options havestocks as their underlying asset but OTC-traded options have a huge variety ofunderlying assets (bonds, currencies, commodities, swaps, or baskets of assets).There are two main types of options: calls and puts:Call options provide the holder the right (but not the obligation) to purchase anunderlying asset at a specified price (the strike price), for a certain period oftime. If the stock fails to meet the strike price before the expiration date, theoption expires and becomes worthless. Investors buy calls when they think theshare price of the underlying security will rise or sell a call if they think it will fall.Selling an option is also referred to as writing an option.Put options give the holder the right to sell an underlying asset at a specifiedprice (the strike price). The seller (or writer) of the put option is obligated to buythe stock at the strike price. Put options can be exercised at any time before theoption expires. Investors buy puts if they think the share price of the underlyingstock will fall, or sell one if they think it will rise. Put buyers - those who hold a"long" - put are either speculative buyers looking for leverage or "insurance"buyers who want to protect their long positions in a stock for the period of timecovered by the option. Put sellers hold a "short" expecting the market to moveupward (or at least stay stable) A worst-case scenario for a put seller is adownward market turn. The maximum profit is limited to the put premiumreceived and is achieved when the price of the underlyer is at or above theoptions strike price at expiration. The maximum loss is unlimited for anuncovered put writer.To obtain these rights, the buyer must pay an option premium (price). This is theamount of cash the buyer pays the seller to obtain the right that the option is grantingthem. The premium is paid when the contract is initiated.In Level 1, the candidate is expected to know exactly what role short and long positionstake, how price movements affect those positions and how to calculate the value of theoptions for both short and long positions given different market scenarios. For example:
  4. 4. Q. Which of the following statements about the value of a call option at expiration isFALSE?A. The short position in the same call option can result in a loss if the stock priceexceeds the exercise price.B. The value of the long position equals zero or the stock price minus the exercise price,whichever is higher.C. The value of the long position equals zero or the exercise price minus the stock price,whichever is higher.D. The short position in the same call option has a zero value for all stock prices equal toor less than the exercise price.A. The correct answer is "C". The value of a long position is calculated as exercise priceminus stock price. The maximum loss in a long put is limited to the price of the premium(the cost of buying the put option). Answer "A" is incorrect because it describes a gain.Answer "D" is incorrect because the value can be less than zero (i.e. an uncovered putwriter can experience huge losses).Derivatives - Options: Basic CharacteristicsBoth put and call options have three basic characteristics: exercise price, expiration dateand time to expiration.The buyer has the right to buy or sell the asset.To acquire the right of an option, the buyer of the option must pay a price to theseller. This is called the option price or the premium.The exercise price is also called the fixed price, strike price or just the strike andis determined at the beginning of the transaction. It is the fixed price at which theholder of the call or put can buy or sell the underlying asset.Exercising is using this right the option grants you to buy or sell the underlyingasset. The seller may have a potential commitment to buy or sell the asset if thebuyer exercises his right on the option.The expiration date is the final date that the option holder has to exercise herright to buy or sell the underlying asset.Time to expiration is the amount of time from the purchase of the option until theexpiration date. At expiration, the call holder will pay the exercise price andreceive the underlying securities (or an equivalent cash settlement) if the optionexpires in the money. (We will discuss the degrees of moneyness later in thissession.) The call seller will deliver the securities at the exercise price and receivethe cash value of those securities or receive equivalent cash settlement in lieu ofdelivering the securities.Defaults on options work the same way as they do with forward contracts.Defaults on over-the counter option transactions are based on counterparties,while exchange-traded options use a clearing house.
  5. 5. Example: Call OptionIBM is trading at 100 today. (June 1, 2005)The call option is as follows:Strike price = 120, Date = August 1, 2005,Premium on thecall = $3In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 forthe right to purchase IBM at $125 on or before August 1, 2005. If the buyer decides toexercise the option on or before August 1, 2005, the seller will have to deliver IBMshares at a price of $125 to the buyer.Example: Put OptionIBM is trading at 100 today (June 1, 2005)Put option is as follows:Strike price = 90, Date = August 1, 2005, Premium on the put =$3.00In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for theright to sell IBM at $90 on or before August 1, 2005. If the buyer of the put decides toexercise the option on or before August 1, 2005, the seller will have to purchase IBMshares at a price of $90.Example: Interpreting DiagramsFor the exam, you may be asked interpret diagrams such as the following, which showsthe value of a put option at expiration.A typical question about this diagram might be:
  6. 6. Q: Ignoring transaction costs, which of the following statements about the value of theput option at expiration is TRUE?A. The value of the short position in the put is $4 if the stock price is $76.B. The value of the long position in the put is $4 if the stock price is $76.C. The long put has value when the stock price is below the $80 exercise price.D. The value of the short position in the put is zero for stock prices equaling orexceeding $76.The correct answer is "C". A put option has positive monetary value when the underlyinginstrument has a current price ($76) below the exercise price ($80).SWAPDerivatives - SwapsA swap is one of the most simple and successful forms of OTC-traded derivatives. It is acash-settled contract between two parties to exchange (or "swap") cash flow streams. Aslong as the present value of the streams is equal, swaps can entail almost any type offuture cash flow. They are most often used to change the character of an asset orliability without actually having to liquidate that asset or liability. For example, aninvestor holding common stock can exchange the returns from that investment for lowerrisk fixed income cash flows - without having to liquidate his equity position.The difference between a forward contract and a swap is that aswap involves a series of payments in the future, whereas aforward has a single future payment.Two of the most basic swaps are:Interest Rate Swap - This is a contract to exchange cash flow streams that might beassociated with some fixed income obligations. The most popular interest rate swapsare fixed-for-floating swaps, under which cash flows of a fixed rate loan are exchangedfor those of a floating rate loan.Currency Swap - This is similar to an interest rate swap except that the cash flows arein different currencies. Currency swaps can be used to exploit inefficiencies ininternational debt markets. For example, assume that a corporation needs to borrow$1O million euros and the best rate it can negotiate is a fixed 6.7%. In the U.S., lendersare offering 6.45% on a comparable loan. The corporation could take the U.S. loan and
  7. 7. then find a third party willing to swap it into an equivalent euro loan. By doing so, thefirm would obtain its euros at more favorable terms.Cash flow streams are often structured so that payments are synchronized, or occur onthe same dates. This allows cash flows to be netted against each other (so long as thecash flows are in the same currency). Typically, the principal (or notional) amounts ofthe loans are netted to zero and the periodic interest payments are scheduled to occuron that same dates so they can also be netted against one another.As is obvious from the above example, swaps are private, negotiated and mostlyunregulated transactions (although FASB 133 has begun to impose some regulations).Purpose and benefits of derivativesDerivatives - Purposes and Benefits of DerivativesTodays sophisticated international markets have helped foster the rapid growth inderivative instruments. In the hands of knowledgeable investors, derivatives can deriveprofit from:Changes in interest rates and equity markets around the worldCurrency exchange rate shiftsChanges in global supply and demand for commodities such asagricultural products, precious and industrial metals, and energy products such asoil and natural gasAdding some of the wide variety of derivative instruments available to a traditionalportfolio of investments can provide global diversification in financial instruments andcurrencies, help hedge against inflation and deflation, and generate returns that are notcorrelated with more traditional investments. The two most widely recognized benefitsattributed to derivative instruments are price discovery and risk management.1. Price DiscoveryFutures market prices depend on a continuous flow of information from around the worldand require a high degree of transparency. A broad range of factors (climatic conditions,political situations, debt default, refugee displacement, land reclamation andenvironmental health, for example) impact supply and demand of assets (commodities inparticular) - and thus the current and future prices of the underlying asset on which thederivative contract is based.This kind of information and the way people absorb itconstantly changes the price of a commodity. This process is known as price discovery.o With some futures markets, the underlying assets can be geographicallydispersed, having many spot (or current) prices in existence. The price of
  8. 8. the contract with the shortest time to expiration often serves as a proxyfor the underlying asset.o Second, the price of all future contracts serve as prices that can beaccepted by those who trade the contracts in lieu of facing the risk ofuncertain future prices.o Options also aid in price discovery, not in absolute price terms, but in theway the market participants view the volatility of the markets. This isbecause options are a different form of hedging in that they protectinvestors against losses while allowing them to participate in the assetsgains.As we will see later, if investors think that the markets will be volatile, the prices ofoptions contracts will increase. This concept will be explained later.2. Risk ManagementThis could be the most important purpose of the derivatives market. Risk management isthe process of identifying the desired level of risk, identifying the actual level of risk andaltering the latter to equal the former. This process can fall into the categories ofhedging and speculation.Hedging has traditionally been defined as a strategy for reducing the risk in holding amarket position while speculation referred to taking a position in the way the marketswill move. Today, hedging and speculation strategies, along with derivatives, are usefultools or techniques that enable companies to more effectively manage risk.3. They Improve Market Efficiency for the Underlying AssetFor example, investors who want exposure to the S&P 500 can buy an S&P 500 stockindex fund or replicate the fund by buying S&P 500 futures and investing in risk-freebonds. Either of these methods will give them exposure to the index without the expenseof purchasing all the underlying assets in the S&P 500.If the cost of implementing these two strategies is the same, investors will be neutral asto which they choose. If there is a discrepancy between the prices, investors will sell thericher asset and buy the cheaper one until prices reach equilibrium. In this context,derivatives create market efficiency.4. Derivatives Also Help Reduce Market Transaction CostsBecause derivatives are a form of insurance or risk management, the cost of trading inthem has to be low or investors will not find it economically sound to purchase such"insurance" for their positionsDerivatives - Criticisms of Derivatives
  9. 9. Options offer the potential for huge gains and huge losses. While the potential for gain isalluring, their complexity makes them appropriate for only sophisticated investors with ahigh tolerance for risk.1. When a derivative fails to help investors achieve their objectives, the derivativeitself is blamed for the ensuing losses when, in fact, its often the investor whodid not fully understand how it should be used, its inherent risk, etc.2. Some view derivatives as a form of legalized gambling enabling users to makebets on the market. However, derivatives offer benefits that extend beyond thoseof gambling by making markets more efficient, helping to manage risk andhelping investors to discover asset prices.While professional traders and money managers can use derivatives effectively, the oddsthat a casual investor will be able to generate profits by trading in derivatives aremitigated by the fundamental characteristics of the instrument:Lifespan - Derivatives are "time-wasting" assets. As each day passes and the expirationdate approaches, you lose more and more "time" premium and the options valuedecreases.Direction and Market Timing - In order to make money with many derivatives,investors must accurately predict the direction in which the market or index will move(up or down) and the minimum magnitude of the move during a set period of time. Amistake here almost guarantees a substantial investment loss.Costs - The bid/ask spreads of more common derivatives such as options can bedaunting. An option with a bid of 5.25 and an ask of 5.875 means an investor could buya round lot (100 units) for $587.50 but could only sell them for $525, resulting in animmediate loss of $61.50 before factoring in commissions.Derivatives - ArbitrageArbitrage opportunities exist when the prices of similar assets are set at different levels.This opportunity allows an investor to achieve a profit with zero risk and limited funds bysimply selling the asset in the overpriced market and simultaneously buying it in thecheaper market.This buying and selling of the asset will push the cheaper assets price up and the higherasset price down. This process will continue until the asset price is equal in bothmarkets.Achieving this equilibrium through buying and selling is referred to as the law of oneprice. This law may look like it has been violated at times, but this usually is usually notthe case once you factor in financing or delivery costs associated with the differentmarkets.
  10. 10. For example, on exchange A IBN is trading at $25 and on exchange B IBN istrading at $30 dollars. If you buy IBN on exchange A and simultaneously sell it onexchange B, you can net a profit of $5 with out any risk or any outlay of cash.As people continue to buy on exchange A, the price of IBN will increase and all ofthe selling of IBN on exchange B will force the price down until equilibrium hasbeen reached. This is how arbitrage works to make the marketplace efficient.Additional information about arbitrage and its theories:Theoretically, the large number of market participants combined with real-timeprice-setting mechanisms eliminates the opportunity to generate risk-freeprofits.This leads to an important question: If there are no arbitrage opportunities (i.e.opportunities to earn a risk-free profit), why does the industry survive? Onereason is that individual investors may have different views on how, why and towhat degree market prices are off kilter. Also, investors are reluctant to believethat there are no arbitrage opportunities and so they spend a good deal of timewatching price movements, ferreting out inconsistencies and trading on thosethey perceive to exist. The process itself ensures that any potential arbitrageopportunities will be quickly discovered and eliminated. If investors believed therewere no arbitrage opportunities and were no longer vigilant about identifying andexploiting price differentials, the lack of continuous oversight might, in itself, leadto arbitrage opportunities In other words, disbelief concerning the absence ofarbitrage opportunities is required to maintain its legitimacy as a principle.Relatively efficient markets have either no arbitrage opportunities or the marketparticipants quickly remove them. The opportunity can occur, but only throughchance and it would be considered an abnormal returnDerivatives - Common Characteristics of Futures and ForwardsForward CommitmentsA forward commitment is a contract between two (or more) parties who agree to engagein a transaction at a later date and at a specific price, which is given at the start of thecontract. It is acustomized, privately negotiated agreement to exchange an asset or cashflows at a specified future date at a price agreed on at the trade date. In its simplestform, it is a trade that is agreed to at one point in time but will take place at some latertime. For example, two parties might agree today to exchange 500,000 barrels of crudeoil for $42.08 a barrel three months from today. Entering a forward contract typicallydoes not require the payment of a fee.There are two major types of forward commitments:Forward contracts, or forwards, are OTC-traded derivatives with customizedterms and features.
  11. 11. Futures contract, or futures, are exchange-traded derivatives with standardizedterms.Futures and forwards share some common characteristics:Both futures and forwards are firm and binding agreements to act at a later date.In most cases this means exchanging an asset at a specific price sometime in thefuture.Both types of derivatives obligate the parties to make a contract to complete thetransaction or offset the transaction by engaging in anther transaction that settleseach partys obligation to the other. Physical settlement occurs when the actualunderlying asset is delivered in exchange for the agreed-upon price. In caseswhere the contracts are entered into for purely financial reasons (i.e. the engagedparties have no interest in taking possession of the underlying asset), thederivative may be cash settled with a single payment equal to the market valueof the derivative at its maturity or expiration.Both types of derivatives are considered leveraged instruments because for littleor no cash outlay, an investor can profit from price movements in the underlyingasset without having to immediately pay for, hold or warehouse that asset.They offer a convenient means of hedging or speculating. For example, a ranchercan conveniently hedge his grain costs by purchasing corn several monthsforward. The hedge eliminates price exposure, and it doesnt require an initialoutlay of funds to purchase the grain. The rancher is hedged without having totake delivery of or store the grain until it is needed. The rancher doesnt evenhave to enter into the forward with the ultimate supplier of the grain and there islittle or no initial cash outlay.Both physical settlement and cash settlement options can be keyed to a widevariety of underlying assets including commodities, short-term debt, Eurodollardeposits, gold, foreign exchange, the S&P 500 stock index, etc.