DERIVATIVE

Derivatives
A derivative is a financial
instrument that offers a return
based on the return of some other
underlying asset.
RETURN is derived from another
instrument

Derivatives
Trades in a market in which buyers and
sellers meet and decide on a price
The seller then delivers the asset to
the buyer
Buyer is often called long
Seller is often called short
And the seller receives the payment
Spot Price- the price for immediate
purchase of the underlying asset

Derivative Contract
Initiates on a certain date and
terminates on a later date
Agreement between two parties in
which each does something for the
other
One party paying the other some money
and receiving coverage against potential
losses
Parties simply agree that each will do
something for the other at a later dateNO MONEY NEED CHANGE HANDS UP

TYPES OF MARKET
Exchange Traded
Have standard terms
Traded on an organized derivatives
trading facility
Such as futures exchange and an
options exchange

Over-the-counter
Any transactions created by two parties
anywhere else

TWO GENERAL CATEGORIES

Forward Commitments
Parties enter into an agreement
Engage in a transaction at a later date
Price established at the start
Classifications of forward commitment
Exchanged-traded contracts- FUTURES
Over-the-counter Contracts- FORWARD
CONTRACTS and SWAPS

Contingent Claims (Options)

Forward Contract
Agreement between two parties
Buyer agrees to buy from the seller
an underlying asset at future
date at a price established at the
start
Parties specify terms and conditionscustomized
Each party subject to default risk
Everyday transaction e.g., ordering
pizza

Forward Contract
Joseph and Clint could enter into a forward contract in
which Joseph agree to buy Clint's boat for $150,000 and
he agrees to sell it to Joseph in 12 months for that
price.
-Long?
-Short?
-Who is obliged to sell?

 A Pension Fund Manager anticipating a

future inflow, could engage in a forward
contract to purchase a portfolio equivalent
to the S&P500 at a future date timed to
coincide with the future cash inflow date
at a price agreed on at the start.
Other examples commitments to buy and
sell a foreign currency or a commodity at
a future date, locking in the exchange rate
or commodity price at the start.

 No money changes hands at the start

Possible arrangements when forward
contract expires
Delivery
Cash settlement

Delivery
Deliverable forward contract
stipulates that the long will pay the
agreed-upon price to the short
Short will deliver the underlying the
asset to the long

Cash Settlement (Non deliverable

Forwards)
Permits the long and short to pay the net cash
value of the position on the delivery date
Forward contract to deliver a zero-coupon bond at a
price of $98 per $100 par. At the contracts
expiration, suppose the underlying zero-coupon
bond is selling at a price of $98.25, for which the
payment to the short $98.00 is required.
Short pays the long $0.25
If it is selling @$97.50, the long would pay the short
$0.50

Only the party owing the greater amount can

default

Termination of a Forward
Contract
Prior to Expiration
A party can re-enter the market and create a
new forward contract expiring at the same
time as the original forward contract, taking
the other position instead.
Clint is long to buy at $40 and short to deliver at
$42
Everything could go as planned; Clint nets $2; transaction
is over
The counterparty on the long may default; Clint is still
obligated to deliver the asset on the short
There is also a possibility the counterparty on the short
could fail to pay him $42 (CREDIT RISK)

Avoid Credit Risk

Instead of re-entering (to go short) in the
forward contract, Clint could contact the same
counterparty with whom he engaged in the
(long ) forward contract. They could agree to
cancel both contracts.
Clint owes $2 at expiration
Counterparty paying him the present value of
$2
This termination or offset of the original forward
position is clearly desirable for both counterparties
because it eliminates the credit risk.

Types of Forward Contracts

Equity Forwards- contract calling for the purchase of an
individual stock, a stock portfolio, or a stock index at a
later date
1. Forward Contracts on Individual Stocks
Client notifies the portfolio manager of his need for $2Million
in cash in six months
It can be raised by selling 16,000 shares at the current price
of $125/share.
The manager contracts a forward contract dealer and obtains
a quote of $128.13
Stock price > $128.13= client will still have to deliver
@$128.13/share
Stock Price < $128.13= client will still get @ $128.13/share

Type of Forward Contracts

2. Forward Contract on Stock Portfolios
Investors should hold diversified portfolios
A pension fund manager needs to sell about $20M of
stock to make payments to retirees in three months
1st option: enter a forward contract on each stock that he
wants to sell (costly, each contract would incur
administrative costs)
2nd option: enter a forward contract on the overall
portfolio

provide a list of the stocks and number of shares of each he

wishes to sell
The dealer gives him a quote of $20,200,000
In three months, the manager will sell the stock to the dealer
and receive $2,200,000

Types of Forward Contracts

3. Forward Contracts on Stock Indices
Assume that the portfolio manager
decides to protect $15,000,000 of stock.
The dealer quotes a price of $6,000 on a
forward contract covering $15,000,000.
We assume that the contract will be
cash settled. When the contract expires,
lets say that the index is at $5,925 a
decrease of 1.25% from the forward
price. Thus, the transaction should make
0.0125*$15,000,000= $187,500. The
dealer would have to pay $187,500 in

Types of Forward Contracts

4. The effect of dividends
Any equity portfolio nearly always has at least a few
stocks that pay dividends
Some equity forward on stock indices are based on
total return indices
Example: S&P 500 Total Return Index daily
dividends paid by the stocks are reinvested in
additional units of index, as though it were a portfolio
The rate of return on the index and the payoff of any
forward contract based on it , reflects the payment
and reinvestment of dividends into the underlying
index

Types of Forward Contracts

Bond and Interest Rate Forward Contracts- forward
contract on bonds and forward contract on interest rate
1. Forward Contract on Individual Bonds and Bond
Portfolios
default is defined, what it means for bond to default and how
default would affect the parties
T-Bills: one party agrees to buy the T-bill at a later date, prior
to maturity at price agreed today
T-Bills: sold at discount from par value and quoted in terms of
discount rate
Example: 180-day T-Bill @ a discount of 4%, price per $1par
will be $1-0.04(180/360)= $0.98
the bill will sell for $0.98 and it will pay $1 if purchased and
held to maturity

Types of Forward Contracts

2. Forward Contract on Interest Rates:
Forward Rate Agreements
Primarily centered in London and also
exist elsewhere, though not in the US
LIBOR- London Interbank Offer Rate
Are contracts in which the underlying is
neither a bond nor a Eurodollar deposit
but simply an interest payment made in
dollars

Types of Forward Contracts

Cont. FRAs

Forward contract rate- represents

the two parties agree will be paid
Days in underlying rate- refers to
the number of days to maturity of
the instrument on which the
underlying rate is based

Types of Forward Contracts

Currency Forward Contracts
Microsoft JP Morgan Chase- asks for a quote on
a currency forward for 12Million
JP Morgan quotes a rate of $0.925 enable
Microsoft to sell and buy $ at a rate of $0.925
in 3 mos.
Thus: 12,000,000 x $0.925= $11,1000,000
After 3 mos.
Spot rate for euros is $0.920
Microsoft locked in a rate of $0.925

Other Types of Forward

Contracts
Commodity Forwards- underlying
asset is oil, a precious metal, or
some other commodity are widely
used.

Futures Contract
Variation of a forward contract; with some
additional features
Not a private and customized
transaction
Public and standardized transaction
that takes place on a futures exchange
Future exchanges guarantees to each party
that if the other fails to pay, the exchange
will pay
Each party has a contract with the exchange

 Implement performance
guarantee through clearinghouse
Clearinghouse
For some, a separate corporate entity
Division or subsidiary of the exchange
Protects itself by requiring the parties to
settle their gains and losses on a daily
basis- daily settlement or marking to
market

 Futures contract trades in the market

and its price changes in response to
new information
Buyers benefit from price
increases
Sellers benefit from price
decreases
On the expiration day, the contract
terminates and no further trading
takes place

Ability to engage in offsetting

transactions
Forward Contracts
A party might commit to purchase
1Million euros at a future date at an
exchange rate of $0.85/. Suppose that
later the euro has a forward price of
$0.90/. The party might then choose
to engage in a new forward contract
to sell the euro at the new price
$0.90/. The party then has the
commitment to buy the euro at
$0.85/ and sell it at $0.90/.

Ability to engage in offsetting

transactions
Futures Contract
U.S. Treasury bond futures contract covering
$100,000 face value of Treasury bonds, with
an expiration date in March, June, September,
or December, is a standard contract.
If a party wanted a contract covering $120,000
of Treasury bonds, he would not find any such
instrument in the futures markets and would
have to create a nonstandard instrument in
the forward market

Clearinghouse, Margins, and Price

Limits
Before taking a long or short position
in the futures market, one must first
deposit sufficient funds in a
margin account
Margin Account in Stock Market VS
Margin Account in Futures Market

Margin Account in the Futures

Market
Amount of money that must be put into an
account by a party opening a futures position
Trader puts up a certain amount to meet the
initial margin requirement
Money is not borrowed
More like a down payment for the commitment
to purchase the underlying at a later date
Form of a good faith money, collateral, or a
performance bond
Both the buyer and the seller must deposit a
margin

Marking to Market
Conversion of gains and losses on
paper into actual gains and losses
Maintenance margin
requirement
Lower than the initial margin
requirement
amount of money in the margin account
at the end of the day > maintenance
margin requirement trader must
deposit sufficient fund to bring the
balance back up to the initial margin

Marking to Market
Trader can simply close out the position
Responsible for any further losses incurred if the price
changes before a closing transaction can be made

Clearinghouse- designate official price for

determining the daily gains and losses this price
is called settlement price
Settlement price- average of the final few trades
of the day
Clearinghouses are able to control the risk of
default by setting margin requirements and
collecting margin money every day

Example of a Margin Account

Marked to Market

Futures Price- $100

Initial Margin Requirement- $5
Maintenance Margin Requirement- $3
Table A- trader takes a long position
of 10 contracts on Day 0, depositing
$50
Table B- trader takes a short position
of 10 contracts on Day 0, depositing
$50

Table A Holder of Long Position of

10 Contracts
Day (1)

Beginni Funds
ng
Deposit
Balanc ed (3)
e (2)

Settlem
ent

Price
(4)

Futures Gain/Lo Ending

Price
ss (6)
Balanc
Change
e (7)
(5)

50

100

50

50

99.20

-0.80

-8

42

42

96.00

-3.20

-32

10

10

40

101.00

5.00

50

100

100

103.50

2.50

25

125

125

103.00

-0.50

-5

120

120

104.00

1.00

10

130

Table B Holder of Short Position of 10 Contracts

Day (1)

Beginni Funds
ng
Deposit
Balanc ed (3)
e (2)

Settlem
ent

Price
(4)

Futures Gain/Lo Ending

Price
ss (6)
Balanc
Change
e (7)
(5)

50

100

50

50

99.20

-0.80

58

58

96.00

-3.20

32

90

90

101.00

5.00

-50

40

40

103.50

2.50

-25

15

15

35

103.00

-0.50

55

55

104.00

1.00

-10

45

Closeout VS. Physical Delivery Vs.

Cash Settlement

Types of Futures Contracts

Commodity Futures- traditional
agricultural, metal, and petroleum
products
Financial Futures- stocks, bonds, and
currencies

Short-Term Interest Rate Futures

Contracts
Treasury Bill Futures
price = face value discount
(representing interest)
Based on a 90-day $1,000,000 US
Treasury bill
International Monetary Market (IMM):
100 rate value 100- (Rate/100)
(90/360)

Short-Term Interest Rate Futures

Contracts
Suppose on a given day the rate priced into the
contract is 6.25%.
Quoted Price: 100 6.25 = 93.75
Actual Futures Price:
$1,000,000 [1 0.0625 (90/360)] = $984,375

Account marked to market: 6.25%, IMM Index 93.50

and the actual futures price
$1,000,000[1 0.065(90/360)] = $983,750

Actual Futures Price decreased by

$984,375 - $983,750= $625

Short-Term Interest Rate Futures

Contracts
Eurodollars- contracts pay-off based
on a LIBOR on a given day