Why do derivative securities exist?
due to fluctuating gold prices, a mining company cannot be sure
what price they will get when their gold is extracted and
processed ready for sale.
due to fluctuating exchange rates, an Australian importer who is
invoiced in USD will fear a decline in the value of the AUD.
due to volatility in share markets, fund managers fear another
market crash like 1987 or 2008 which will reduce the value of
their portfolios.
due to fluctuating interest rates, a company which knows it will
need to borrow money in six months time will fear a rise in
interest rates.
An orange farmer fears an unusually cold winter which will
adversely impact the crop yield.
Derivative securities enable us to manage these sorts of risks.
2
What is a derivative?
A derivative security is an instrument whose value depends on
the value of another variable:
– The underlying variable might be a traded asset (e.g., stocks,
market indices, exchange rates, interest rates, etc).
– It might be a commodity (gold, oil, gas, wheat, cocoa, pork bellies,
orange juice).
– Or, it might be something more exotic (e.g., electricity, rainfall,
temperature, carbon emissions).
Common types of derivative securities include, forward
contracts, futures contracts, options and swaps.
3
Are derivatives good or evil?
Derivative securities/markets are often viewed in a negative
light:
– Derivatives markets have not always been tightly regulated.
– Derivatives have occasionally been at the center of high-profile
scandals resulting in huge losses.
– The features of derivative securities are often complicated and
many people do not properly understand them.
4
Lehman Brothers bankruptcy
Lehman Brothers filed for bankruptcy on 15 Sept-2008. This
was the biggest bankruptcy in US history.
Lehman was an active participant in the OTC derivatives
market:
– It took high risks and got into financial difficulty when it was unable
to roll over its short-term funding.
– It had hundreds of thousands of transactions outstanding with
about 8,000 counterparties.
– Unwinding these transactions has been challenging for both
Lehman liquidators and their counterparties.
https://www.youtube.com/watch?v=AsBV4xi4pa8
Hull’s Business Snapshot 1.1
5
Are derivatives good or evil?
Nonetheless, derivative markets are here to stay:
– Since options were first traded in Chicago in 1973, the use and
trading of derivatives has exploded.
– The value of derivative trading dwarfs the value of trading in the
underlying securities.
6
Example of derivatives use by ANZ
7
Extract from ANZ financial statements
for year ending 30 September 2019
8
9
Example of derivatives use by Qantas
10
Extract from QAN financial statements
for year ending 30 June 2019
Aims of BFF3751
There are three goals for this unit:
To become familiar with derivative instruments that are available
in the marketplace and how they work,
To know how to use derivatives to manage risk (and speculate)
in a variety of circumstances, and
To gain some understanding of and intuition for how derivative
securities are valued/priced.
11
Forward contracts
A forward contract is an agreement to either buy or sell an asset
at a specified price on a specified future date.
– Aside: contrast this to a spot contract, which is an agreement to buy
or sell an asset today at the current market (or “spot”) price S0.
Let F denote the delivery price for the forward contract and T
denote the time remaining until delivery.
12
Always two parties to a forward contract
Long forward position: the party who takes a long forward
position is contracted to buy the underlying asset.
Short forward position: the party who takes a short forward
position is contracted to sell the underlying asset.
Party A
Long Forward
Position
Party B
Short Forward
Position
Party A agrees to buy asset at time T for $F from Party B
Party B agrees to sell asset at time T for $F to Party A
13
Speculating with forward contracts
To illustrate how a forward contract works, consider an example
where a forward is used for speculation:
– Over the last 12 months, I have observed the spot price of gold
increase from around USD 1280 per ounce in Mar-2019 to USD
1600 in Feb-2020.
– However, over looking back the last five years, gold seems to have
a pattern where it hits a peak, then falls back sharply. As such, I
believe that gold price will fall to about USD 1300 by Jun 2020.
– I am so convinced that a sharp fall in the price of gold will transpire
that I am going to speculate on it!
– I contact my bank and learn that the forward price (F) for delivery of
gold in Jun-2020 is USD 1650.
In a few weeks time, we will learn how banks
set the price (F) for a forward contract.
14
Spot price of gold (last 12 months)
Source: www.goldprice.org
15
Spot price of gold (last 5 years)
Source: www.goldprice.org
16
Speculating with forward contracts
The forward contract allows me to lock in either a purchase or
sale of gold with delivery in Jun-2020 at the forward price of
USD 1650:
– I am predicting that gold price will fall significantly.
– If my prediction is correct and gold falls to USD 1300 by June, I
would love to have a contract that allows me to sell gold for
USD1650!
– Hence, I enter a short forward contract for Jun-2020 delivery of gold
at F = USD1650.
– I negotiate a contract size of 1,000 ounces.
Let’s see what happens …
17
Speculating with forward contracts
In Jun-2020, my short forward contract means that I am obliged
to deliver (i.e., sell) 1,000 ounces of gold at a contract price of
USD 1650.
Let’s assume that my prediction was pretty much correct and the
spot price of gold has fallen to USD 1320 by June.
– I go into the (spot) market and buy 1,000 ounces of gold at the spot
price of USD 1320. That costs me USD 1,320,000.
– My short forward contract allows me to sell 1,000 ounces of gold at
F = $1650/oz. And the counterparty (the long side of the forward
contract) is obliged to buy 1,000 ounces from me at the contract
price of USD 1650. I ring them and say “I have a truck load of gold
on its way to you. Please transfer USD 1,650,000 to me”.
– I make a USD 330,000 profit from my correct prediction that gold
price will fall (1.65m – 1.32m).
18
Speculating with forward contracts
Of course, the danger with this speculative strategy is that my
prediction of falling gold price is wrong.
What if, when the delivery date arrives in Jun-20, the spot price
of gold has risen to USD 1800.
– Under my short forward contract, I am obliged to sell 1,000 ounces
of gold at the contract price of USD 1650.
– I reluctantly go into the (spot) market and buy 1,000 ounces of gold
at the spot price of USD 1800. That costs me USD 1,800,000.
– I answer my phone rings when it rings and, sure enough, it’s my
counterparty. “I’ve just transferred USD 1,650,000 to your account
and am sending a truck to collect 1,000 ounces”.
– I have lost USD 150,000 from my incorrect prediction (1.65m –
1.80m).
19
Payoff diagram: Short forward position
This example demonstrates that with a short forward position:
– You make a profit when the price of the underlying asset falls, and
– You make a loss when the price of the underlying asset rises.
This can be depicted using the payoff diagram for a short
forward position.
20
Payoff diagram: Short forward position
Payoff
Price of
underlying asset
0
F=1650
Payoff to short
forward position
21
1320
+330,000
1800
-150,000
Payoff diagram: Long forward position
You will soon see some examples involving long forward
contracts.
What you will learn is that, with a long forward position:
– You make a profit when the price of the underlying asset rises, and
– You make a loss when the price of the underlying asset falls.
This can be depicted using the payoff diagram for a long forward
position.
22
Payoff diagram: Long forward position
Payoff
0
F
Payoff to long
forward position
Price of
underlying asset
23
Profit when
price rises
Loss when
price falls
Where do forward contracts trade?
Forward contracts are traded in the over-the-counter (OTC)
market:
– OTC market is an informal market where traders communicate by
phone and/or computer.
– It is a network of traders working at financial institutions,
corporations or fund managers.
Financial institutions often act as “market makers”:
– When a customer wants to enter a long forward contract, the
institution is prepared to take the short side. And vice versa.
– Quote bid prices (price at which they are prepared to go long).
– Quote offer prices (price at which they are prepared to go short).
24
Defining characteristics of forward contracts
Because they are arranged informally between two parties,
forward contracts can be highly customised (wrt size, timing,
delivery, underlying asset).
Each party bears some credit risk:
– Delivery under the contract is not guaranteed.
– Hence, there is some risk that the counterparty defaults.
25
Party A
Long Forward
Position
Party B
Short Forward
Position
Party A agrees to buy asset at time T for $F from Party B
Party B agrees to sell asset at time T for $F to Party A
How big is the OTC market?
Derivative trading of formal exchanges is dwarfed by OTC
trading.
Source: Bank for International Settlements
26
Futures Contracts
A futures contract is an agreement to either buy or sell an asset
at a specified price on a specified future date.
Let F denote the delivery price for the futures contract and T
denote the time remaining until delivery.
Note that this is the same definition as given for a forward
contract!
– In terms of their outcomes and the ways in which they are used,
there is little difference between forwards and futures.
– They both have long (short) parties who agree to buy (sell) the
underlying asset at a fixed price at a given time.
– They can both be used in similar ways to hedge risk or speculate.
27
Defining characteristics of futures contracts
The characteristics of futures contracts that differ most from
forward contracts are as follows:
– Futures contracts trade on organised exchanges.
– There is no risk of default.
– Futures contracts are highly standardised.
– Futures contracts are “marked to the market” on a daily basis.
– Futures contracts are often cash settled, with no physical delivery
of the underlying asset.
28
Organised exchange trading
Whereas forwards trade over-the-counter, futures contracts
trade on organised exchanges:
– Australian Securities Exchange (ASX)
– Chicago Mercantile Exchange (CME Group)
– Hong Kong Futures Exchange (HKFE)
– Shanghai Futures Exchange (SHFE)
– Euronext
– Bombay Stock Exchange (BSE)
– Tokyo Financial Exchange (TFX)
29
Organised exchange trading
Some big advantages of having the contracts trade on an
exchange:
– No effort required to find a counterparty.
– No default risk. With a forward contract, there is always a danger
the counterparty will default. With futures contracts, the exchange
“clearing house” assumes the role of counterparty. In essence, the
clearing house guarantees the specified terms will be met.
30
Organised exchange trading
OTC markets involve
bilateral agreements
between two parties
On organized exchanges,
all agreements go through
central clearing house
Source: Hull (2018, Figure 2.2) 31
Standardised contract specifications
The specific terms of a futures contracts are highly standardized
with respect to:
– Underlying asset: precisely what asset must be delivered and what
its quality must be.
– Contract size: the amount of the underlying asset that has to be
delivered under one contract.
– Delivery date: which months the contract expires in.
– Delivery arrangements: if physical delivery is possible, exactly the
underlying asset must be delivered.
32
Example of Standardisation
NYSE Orange Juice Futures
US Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid
ratio of not less than 13 to 1 nor more than 19 to 1, with factors of colour and
flavour each scoring 37 points or higher and 19 for defects, with a minimum score
94.
CME Lumber Futures
Delivery on track and shall either be unitized in double-doored boxcars or, at no
additional cost to the buyer, each unit shall be individually paper-wrapped and
loaded on flatcars. Par delivery of hem-fir in California, Idaho, Montana, Nevada,
Oregon, and Washington, and in the province of British Columbia.
33
CBOT corn futures contract specs
Contract Size 5,000 bushels (~ 127 Metric Tons)
Deliverable Grade #2 Yellow at contract Price, #1 Yellow at a 1.5 cent/bushel premium #3 Yellow
at a 1.5 cent/bushel discount
Pricing Unit Cents per bushel
Tick Size (minimum fluctuation) 1/4 of one cent per bushel ($12.50 per contract)
Contract Months/Symbols March (H), May (K), July (N), September (U) & December (Z)
Trading Hours
CME Globex (Electronic
Platform)
6:00 pm – 7:15 am and 9:30 am – 1:15 pm
central time, Sunday – Friday Central Time
Open Outcry (Trading Floor) 9:30 am – 1:15 pm Monday – Friday Central
Time
Daily Price Limit
$0.30 per bushel expandable to $0.45 and then to $0.70 when the market
closes at limit bid or limit offer. There shall be no price limits on the current
month contract on or after the second business day preceding the first day of
the delivery month.
Settlement Procedure Physical Delivery
Last Trade Date The business day prior to the 15th calendar day of the contract month.
Last Delivery Date Second business day following the last trading day of the delivery month.
Product Ticker Symbols
CME Globex (Electronic
Platform)
ZC
C=Clearing
Open Outcry (Trading Floor) C
Exchange Rule These contracts are listed with, and subject to, the rules and regulations of
CBOT.
34
Marking to the market
Futures contracts are marked to the market on a daily basis.
This will be relevant if you actually trade futures, but is not
important for the purpose of BFF3751. In brief:
– When you open a futures position (irrespective of whether you go
long or short), you must lodge an initial margin (i.e., a deposit) with
the exchange.
– At the end of each day, the exchange calculates whether you have
made or lost money today (i.e., mark you to the market). Gains
(losses) are added to (subtracted from) your account.
– If your balance gets too low, the exchange makes a margin call
(i.e., requires you to deposit more funds).
35
Settlement procedures for futures
Once you have entered a futures position (either long or short):
– You might hold that position right through to the expiry/delivery
date, or
– You might “close-out” prior to expiry.
Let’s consider how each of these plays out.
36
Closing-out prior to expiry
All futures contracts can be “closed-out” prior to expiry.
Closing out a futures position simply means entering a new
futures position equal in magnitude but opposite in direction to
your original futures position:
– If your opening futures positions was long, you close it out by
entering a short position in the same futures contract.
– If your opening futures positions was short, you close it out by
entering a long position in the same futures contract.
37
Closing-out prior to expiry
Example: our opening position was one long contract on May-
2020 Eastern Australian Wheat futures at $358 per tonne.
If the futures price is 400 when we close:
– Close by entering one short May-20 wheat contract at 400
– Profit of $840 = (400 – 358) 20 tonnes
If the futures price is 300 when we close:
– Close by entering one short May-20 wheat contract at 300
– Loss is $1160 = (300 – 358) 20 tonnes
38
Wheat futures have a standard
contract size of 20 metric tonnes
39
Physical delivery at expiry
Some (but not many) futures contracts allow physical delivery of
the underlying asset on the expiry date.
– The contract specifications clearly articulate where, when and how
the delivery must take place.
– In such cases, the futures contract is very similar to a forward
contract.
In practice, it is rare that futures contracts result in physical
delivery:
– The vast majority of futures are closed out prior to expiry.
– They have served their purpose (hedging or speculation).
– Physical delivery is more trouble than it is worth.
Hull’s Business Snapshot 2.1
40
Cash settlement at expiry
Some futures contracts cannot be physically delivered.
– For example, the asset underlying SPI200 index futures is a portfolio of 200
stocks. It is infeasible to deliver a portfolio of 200 stocks precisely weighted
to mimic the S&P/ASX 200 index.
Instead, these futures are cash settled.
– If my futures contract has not been closed out prior to expiry, the exchange
effectively enters a reversing transaction on my behalf. For example:
– Assume that my initial trade was to enter 2 long contracts on the SPI200
futures expiring in Jun-2020 (F = 7027).
– On the expiry date in June 2020, the ASX effectively takes 2 short Jun-2020
SPI200 contracts on my behalf.
– They calculate whether I have made a profit or a loss, which is then
transferred to/from my account.
41
42
Cash settlement at expiry
On 19 Feb-20, we enter 2 long Jun-20 SPI200 futures contracts
at 7027 (see “settlement price” in newspaper clipping).
At expiry, if the Jun-20 SPI200 futures price is 7500:
– Close by entering 2 short Jun-20 SPI200 contract at 7500.
– Profit of $23,650 = 2 ctts × (7500 – 7027) $A25.
At expiry, if the Jun-20 futures price is 6000:
– Close by entering 2 short Jun-20 SPI200 contract at 6000.
– Loss is $51,350 = 2 ctts × (6000 – 7027) $A25.
43
SPI200 futures have a standard
contract size of $25 per index point
Payoff diagram for long futures position
Payoff
Fclose
0
Fopen
Payoff to long
futures position
44
Payoff diagrams for futures contracts
0 0
Fclose
Fclose
Payoff Payoff
Long Position Short Position
Fopen
Fopen
45
Futures contracts in Australia (ASX)
Equities
– share price index (SPI200) futures
Interest rates
– 30-day interbank cash rate
– 90-day bank accepted bill (BAB) futures
– 3-year, 10-year and 20-year bond futures
Agricultural:
– Eastern Australia wheat futures
– Eastern Australia feed barley futures
Energy futures: some base load electricity contracts
46
47
Futures trading on CME
US exchanges offer trading on a much wider variety of
underlying assets:
– http://www.cmegroup.com/trading/products/
48
Comparison of forwards and futures
Forwards Futures
Traded where? Over the counter On exchanges
Terms of contract are Tailored to your needs Highly standardised
Delivery date is Tailored to your needs A range of standard delivery
months
Settlement occurs At expiry Marked to market daily
What happens to the
underlying asset?
Often physically delivered Contract is usually closed out
prior to expiry
Any credit risk? Yes, some None
49
Key takeaways from this lecture
Forward contracts:
– What are they? How to do they work? Defining characteristics.
– Difference between long and short forwards.
– What are you obligations under long and short forward contracts?
– Being able to calculate the profit/loss on forward positions.
Futures contracts:
– What are they? How do they work? Defining characteristics.
– Difference between long and short futures positions.
– Being able to calculate the profit/loss on futures positions.
– Closing out v physical delivery.
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