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Bangalore, Karnataka
Part-01
Introduction to Futures and Forwards
Derivative Securities
Derivatives
Introduction (Cont)
A stock A bond A foreign currency (USD) A commodity like wheat A precious metal like gold A portfolio of assets such as a stock index (NIFTY, DJIA)
Options contracts
Swaps
Illustration
90 days later:
Mitoken is obliged to pay Rupees 5.05 MM The bank is obliged to deliver $100,000
The counterparty
agreeing to sell the underlying asset is called
the SHORT
Said to assume a Short position.
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Futures/Forwards impose
an obligation on both parties
the seller
Option buyers are referred to Option sellers are referred to
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as Holders
as Writers
Options vs F&F
Right vs Obligation
Right A right need be exercised only if Obligation
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When a person is given a right with respect to an asset, it can take on two forms
Call option Put option Gives the holder the right to Gives the holder the right to buy the underlying asset sell the underlying asset
If a holder exercises the writer has to deliver If a holder exercises the writer has to take delivery
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The expiration date is the only The expiration date is the point in time at which the last point in time at which option can be exercised the option can be exercised
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On the NSE and BSE stock options are now European Index options have always been European They are easier to value
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Illustration
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Example of a Put
He has to pay $110 to the writer In the US each contract is for 100 shares
If ST < $85
It makes sense to exercise and deliver the shares for $85 each Else it is better to let it expire The writer once again has a contingent obligation.
Swaps
One payment may be based on a fixed interest rate The other may be based on a variable rate such as LIBOR
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Swaps
LIBOR
The most widely used LIBOR is the value computed by the British Bankers Association (BBA) Benchmark Value
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Swaps
BBA LIBOR
Most widely used benchmark for short term interest rates Rate is compiled by BBA and Reuters and released at around 11:45 a.m. London time BBA maintains a panel of min 8 banks per currency
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Swaps
BBA
7.
8. 9. 10.
Australian Dollar Canadian Dollar Swiss Franc Danish Krone Swedish Krone Euro Sterling Pounds Japanese Yen New Zealand Dollar US Dollar
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BBA (Cont)
In 2013 the BBA will discontinue the process of disseminating the LIBOR for certain currencies and maturities The UK Government has
Recommended regulation of activities related to LIBOR A new set of institutions to administer and oversee LIBOR Set up the Hogg Committee for this purpose
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BBA (Cont)
To collect Calculate And Distribute LIBOR rates BBA LIBOR Limited will be authorized and regulated by the Financial Conduct Authority (UK)
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Swaps
All interest rate swaps need not be fixed rate floating rate
Floating rate floating rate swaps where each rate is based on a different benchmark
E.g. one leg could be based on Libor and the other on the US T-bill rate BASIS Swaps
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Swaps
Pure interest rate swap The cash flows are denominated in the same currency We cannot have a fixed We can have all possibilities
Currency swaps Swaps where the cash flows are in two different currencies
Fixed to Fixed
Fixed to Floating Floating to Floating
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Swaps
Principal
Pure interest rate swap Currency swaps There is no need to exchange The principal amount is the principal actually exchanged Both interest streams are in the same currency However a principal is required
Purely to facilitate the computation of interest Hence it is called a Notional principal
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Similarities
Both require the long to acquire the asset and the short to deliver
Difference
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Forward vs Futures
Customization vs Standardization
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Forward vs Futures
Customization vs Standardization
Customized contract Standardized contract
features
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Forward vs Futures
Forward vs Futures
The futures contract is suitable for both parties If they were to meet on the floor of the exchange at the same time a trade could be executed for 50 contracts
Assume that the agreed upon price is Rs. 16 per kg. The price is not specified by the exchange and has to be set by bilateral negotiations
Forward vs Futures
Illustration
Jacob wants to buy 4,750 kg Vishant is looking to deliver
of BT rice in Kochi during the the same quantity of BT last week of the month rice in Kochi during that period. The terms that are being sought are not within the framework - A futures contract is unsuitable
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Forward vs Futures
Futures contracts are Forward contracts are exchange traded products private contracts. like stocks and bonds
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Forward vs Futures
Multiple Grades/Locations
If the contract permits delivery of more than one grade and/or at multiple locations
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Forward vs Futures
Multiple
Thus longs who do not wish to take delivery will exit before delivery commences.
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Clearinghouse
It guarantees the long & the short against the possibility of default by the other
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Clearinghouse
How it functions
it becomes the effective buyer for every seller it becomes the effective seller for every buyer
A party needs to worry only about the financial strength & integrity of the clearinghouse.
Neither party actually trades with the clearinghouse.
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Clearinghouse
It will be in the interest of 1 party to transact A price move in favor of one party would translate into a loss for the other
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Clearinghouse
Illustration
Poonam has gone long in a futures contract to buy an asset 5 days hence at Rs 400.
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Clearinghouse
Illustration
Assume that the spot price 5 days hence is Rs 425. If Kunal does not have the asset asset
He is obliged to deliver at
Rs. 400 Has to forego an
He is required to acquire it
for Rs. 425 and deliver at Rs. 400
Clearinghouse
Illustration
He would be happy to deliver it He would be more than happy for Rs 400 to buy it for Rs 375 and then deliver it The problem is that Poonam would like to default if possible
contd
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Clearinghouse
Illustration
If Poonam does not want the asset She would have to take delivery and then sell it for Rs 375
If Poonam wants the asset She would rather buy it in the spot market for Rs 375
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Clearinghouse
Why?
The presence of a clearinghouse ensures that defaults do not occur. It ensures protection for both parties by requiring them to post a performance bond / collateral Margin The collateral is adjusted daily to reflect any profit/loss compared to the previous day.
Margins
Margin
Margins - Collateral
The collateral represents the potential loss for a party. Once it is collected the incentive to default is
taken away.
The collateral would be adequate to take care of the interests of the other party
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Margin
Clearing Margin
Since the clearinghouse gives a guarantee to both sides, it also collects Clearing margin In practice:
Margin Clearinghouse
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Offsetting
If a party has originally gone long it should subsequently go short and vice versa.
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Offsetting
Forward contract It is a customized contract Futures contract The 2 parties effectively enter into a contract with the clearinghouse Canceling is a lot easier. Both contracts have been designed according to exchange specified features
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Offsetting
A contract between any two parties will be identical to a contract between two other parties
The moment Jacob & Vishant trade, they effectively enter into a contract with the clearinghouse
Offsetting
He simply goes back to the floor & offers to take a short position
By entering into an initial long position followed by a short position, Jacob is effectively out of the market and has no further obligations 52
This time the opposite position may be taken by, say Rahul
Offsetting
Illustration
Jacob has bought a contract Jacob sold an identical contract Jacobs net position is 0
Profit/Loss for a party who trades & subsequently offsets = (the futures price prevailing at inception) (the price at the time of cancellation)
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Once a position is opened it will invariably lead to a loss for one party if it were to comply
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Marking to market
The loss will not arise all of a sudden at the time of expiration
One party will experience a gain The other will experience a loss
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at a specified time
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The party with a profit will have his margin account credited
Marking to market
Illustration
Consider Poonam who has gone long in a futures contract with Kunal
Assume that the prices EOD are as depicted in the following table.
Each contract is for 100 units of the underlying The initial collateral (Initial Margin) is Rs.5,000
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Marking to market
Illustration
Day t 0 1 2 3 Futures Price 400 405 395 380
4
5
405
425
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Marking to market
Marking to market
When the contract is MTM Poonam would have a loss of Rs. 1,000 Once again a new long position would be established, this time at a price of Rs. 395
Marking to market
Illustration
As can be seen
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Marking to market
Illustration
EOD 1st day, MTM when the price is Rs. 405 would imply a loss of Rs. 500 By the same logic the next day his margin account will be credited with Rs. 1000
Marking to market
Profit/loss for the long is identical to the loss/profit for the short
Lead to profits for the long Lead to losses for the long
One participants gains are due to anothers equivalent losses The net change in total wealth for all traders considered together is zero
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Marking to market
Illustration
By the time the contract expires the loss incurred by 1 party (here the short) would have been totally recovered
In this case Poonams account would have been credited with Rs. 2,500
Marking to market
Illustration
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Typically a trader will trade more than once on a given day The profit/loss from MTM is given by the difference between:
The previous days settlement price and the current settlement price
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Illustration (Cont)
For contracts executed during the day and offset on the same day
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Example-1
Yesterdays settlement price was $122 Each contract is for 50 units He went long in 125 more contracts at 125 75 of these were subsequently offset at 127.50 Todays settlement price is $130
Today:
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Example-1 (Cont)
Profit/loss for contracts entered into during the day and offset on the same day:
Profit/loss for contracts entered into during the day and not offset:
Example-2
Yesterdays settlement price was $114 Each contract is for 50 units of the underlying 125 contracts were subsequently offset at $122.50 Todays settlement price is $126
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Example-2 (Cont)
Profit/loss for contracts executed during the day and offset on the same day:
Profit/loss for contracts carried over from the previous day and offset today:
It will debit the margin account of the broker whose client has incurred a loss
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Forward Contracts
Consequently parties to a forward contract tend to be large and well known, such as
In a futures contract
Both longs and shorts have to deposit a performance bond known as the Initial Margin
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Maintenance Margin
Maintenance
The broker has to ensure that the client always has adequate funds Otherwise the entire purpose of margining can be defeated
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Maintenance Margin
Maintenance
If the balance in the margin account declines below the maintenance level
The client will be asked to deposit additional funds to take the balance back to the initial level
A call for additional margin is referred to as a Margin Call. The additional funds deposited are referred to as Variation Margin
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Maintenance Margin
Illustration
Contract for 100 units Price of Rs 400 per kg, Deposited an initial margin of Rs 5,000. Assume the maintenance margin = 4,000
The contract lasts for 5 days and daily prices are as depicted earlier
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Maintenance Margin
Illustration
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Initial Margins
Need not be in the form of cash Brokers will accept cash-like assets like marketable securities
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Maintenance Margin
Initial Margins
But the value assigned to the collateral will be less than its current market value.
To protect the broker against a sharp price decline E.g. a security worth $100 may be valued at $90
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Value at Risk
If the collateral collected is high, the potential for default will be reduced. : Potential for default
Amount of collateral
Margins specified by the exchange would depend on the estimate of the potential loss. Value at Risk (VaR) : Statistical technique for estimating loss
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Value at Risk
Concept of VaR
We cannot be sure about the loss from one day to the next. At best - with a given level of probability, the loss cannot exceed a specified amount VaR : Summary statistical measure of the possible loss of a portfolio of assets over a pre-specified time horizon.
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Value at Risk
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Value at Risk
Interpreting VaR
Probability level
E.g. the 99% VaR for a portfolio will differ from the
95% VaR
Holding period
Value at Risk
Value at Risk
Gross Margins vs. Net Margins Some clearinghouses collect margins on a Gross basis while others do so on a Net basis.
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Illustration
Alfred is long in 100 contracts Betty is short in 80 contracts Charlie is long in 80 contracts Debby is short in 100 contracts
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Illustration (Cont)
Alpha will collect 4 x 180 = 720 from his two clients Beta will collect 720 from his two clients
We say that the brokers are collecting margins on a Gross Basis Variation margin is paid/withdrawn the following morning
Illustration
Gross margining Each broker will have to deposit the entire Rs 720
Price Limits
Limits are measured with respect to the previous days settlement price
Apply in both directions There is a limit of 30 c on the daily price change So tomorrows price limits will be $6.30 and $5.70
Limit moves
If it moves to the lower limit Limit Down If it moves to the upper limit Limit Up
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The Initial Margin is $4 There is no maintenance margin Limit moves should be such that balance in the margin account cannot become negative
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Illustration (Cont)
160 is with the clearinghouse 640 is with each broker Longs will have a profit of $4 Alpha will require 400 to pay Alfred Beta will require 320 to pay Charlie
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Illustration (Cont)
If the clients want to hold on to their positions Betty will have to pay 320 to Alpha and Debby will have to pay 400 to Beta
The margin balances of the shorts have gone to Zero They must raise the balance to the initial level
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Illustration (Cont)
It will pay 80 to the clearinghouse which will pay Alpha Alpha would receive 320 from Betty It will have a total of 400 adequate to pay Alfred
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Illustration (Cont)
As long as the magnitude of the price change does not exceed the IM
The deposit held by the clearinghouse and brokers will be adequate to protect buyers and sellers
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Illustration (Cont)
It requires 160
Illustration (Cont)
Alpha goes bankrupt He is assured of only the 160 that is available with the clearinghouse
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Net margining
Clearinghouse can guarantee payment for 40 contracts only since each broker deposited only 80 with it Clients need to be more concerned with the financial strength and integrity of the broker. They cannot bank on the clearinghouse to always bail them out 100