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DERIVATIVESDerivativesA derivative is a financial instrument that offers a return based on the return of some other underlying asset.RETURN is derived from another instrumentDerivativesTrades in a market in which buyers and sellers meet and decide on a priceThe seller then delivers the asset to the buyerBuyer is often called longSeller is often called shortAnd the seller receives the paymentSpot Price- the price for immediate purchase of the underlying asset

Derivative ContractInitiates on a certain date and terminates on a later dateAgreement between two parties in which each does something for the otherOne party paying the other some money and receiving coverage against potential lossesParties simply agree that each will do something for the other at a later date- NO MONEY NEED CHANGE HANDS UP FRONTSimple Insurance Analogy- one party receiving coverage against potential losses

4TYPES OF MARKETExchange TradedHave standard termsTraded on an organized derivatives trading facilitySuch as futures exchange and an options exchangeOver-the-counter Any transactions created by two parties anywhere elseTWO GENERAL CATEGORIESForward CommitmentsParties enter into an agreement Engage in a transaction at a later date Price established at the startClassifications of forward commitmentExchanged-traded contracts- FUTURESOver-the-counter Contracts- FORWARD CONTRACTS and SWAPSContingent Claims (Options)6Forward ContractAgreement between two partiesBuyer agrees to buy from the seller an underlying asset at future date at a price established at the startParties specify terms and conditions- customizedEach party subject to default riskEveryday transaction e.g., ordering pizzaDefault risk- only creditworthy parties can generally engage in forward contracts 7Forward ContractJoseph 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?Let's assume that Joseph have just taken up sailing and like it so well that he expect he might buy Clints sailboat in 12 months. Josephs sailing buddy, Clint, owns a sailboat but expects to upgrade to a newer, larger model in 12 months.

Like all forward contracts, in this example, no money exchanged hands when the contract was negotiated and the initial value of the contract was zero.

In this scenario, as the buyer, Joseph has entered a long forward contract. Conversely, Clint, the seller will have the short forward contract.At the end of one year, Joseph find that the current market valuation of Clint's sailboat is $165,000. Because Clint is obliged to sell his boat to you for only $150,000, you will have effectively made a profit of $15,000. (Joseph can buy the boat from Clint for $150,000 and immediately sell it for $165,000.) Clint, unfortunately, has lost $15,000 in potential proceeds from the transaction.

8A 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.The date arrives, the cash is received and used to settle the obligation on the forward contract.The manager commits to the position without having to worry about the risk that the market will rise during that period.Advantage: Manager is hedged against an increase in stock prices until the cash is received and invested.Disadvantage: Manager is also hedged against any decreases in stock prices.IT LOCKS IN A PRICE.

9No money changes hands at the startPossible arrangements when forward contract expiresDeliveryCash settlement

DeliveryDeliverable forward contract stipulates that the long will pay the agreed-upon price to the shortShort will deliver the underlying the asset to the longCash Settlement (Non deliverable Forwards)Permits the long and short to pay the net cash value of the position on the delivery dateForward 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 $0.25If it is selling @$97.50, the long would pay the short $0.50Only the party owing the greater amount can defaultTermination of a Forward ContractPrior to ExpirationA 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 $42Everything could go as planned; Clint nets $2; transaction is overThe counterparty on the long may default; Clint is still obligated to deliver the asset on the shortThere is also a possibility the counterparty on the short could fail to pay him $42 (CREDIT RISK)

Other position- if buyer before, take the position of seller instead and vice versa

Clint has to buy the asset in the market and could suffer a significant loss (if the counter party in the long may default)

If the counter party in the short defaults, Clint need not to deliver the asset but would be exposed to the risk of changes in the assets price (CREDIT RISK in a forward contract)

13Avoid Credit RiskInstead 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 expirationCounterparty paying him the present value of $2This termination or offset of the original forward position is clearly desirable for both counterparties because it eliminates the credit risk.Types of Forward ContractsEquity Forwards- contract calling for the purchase of an individual stock, a stock portfolio, or a stock index at a later dateForward Contracts on Individual StocksClient notifies the portfolio manager of his need for $2Million in cash in six monthsIt 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 $128.13Stock price > $128.13= client will still have to deliver @$128.13/shareStock Price < $128.13= client will still get @ $128.13/shareType of Forward Contracts2. Forward Contract on Stock PortfoliosInvestors should hold diversified portfoliosA 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 portfolioprovide a list of the stocks and number of shares of each he wishes to sellThe dealer gives him a quote of $20,200,000In three months, the manager will sell the stock to the dealer and receive $2,200,000

Types of Forward Contracts3. Forward Contracts on Stock IndicesAssume 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 cash.Forward contract based on index17Types of Forward Contracts4. The effect of dividendsAny equity portfolio nearly always has at least a few stocks that pay dividendsSome equity forward on stock indices are based on total return indicesExample: S&P 500 Total Return Index daily dividends paid by the stocks are reinvested in additional units of index, as though it were a portfolioThe 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 ContractsBond and Interest Rate Forward Contracts- forward contract on bonds and forward contract on interest rateForward Contract on Individual Bonds and Bond Portfoliosdefault is defined, what it means for bond to default and how default would affect the partiesT-Bills: one party agrees to buy the T-bill at a later date, prior to maturity at price agreed todayT-Bills: sold at discount from par value and quoted in terms of discount rateExample: 180-day T-Bill @ a discount of 4%, price per $1par will be $1-0.04(180/360)= $0.98the bill will sell for $0.98 and it will pay $1 if purchased and held to maturity

Types of Forward Contracts2. Forward Contract on Interest Rates: Forward Rate AgreementsPrimarily centered in London and also exist elsewhere, though not in the USLIBOR- London Interbank Offer RateAre contracts in which the underlying is neither a bond nor a Eurodollar deposit but simply an interest payment made in dollars Types of Forward ContractsCont. FRAs

Forward contract rate- represents the two parties agree will be paidDays in underlying rate- refers to the number of days to maturity of the instrument on which the underlying rate is based

Types of Forward ContractsCurrency Forward ContractsMicrosoft JP Morgan Chase- asks for a quote on a currency forward for 12MillionJP 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 $0.920Microsoft locked in a rate of $0.925Other Types of Forward ContractsCommodity Forwards- underlying asset is oil, a precious metal, or some other commodity are widely used.Futures ContractVariation of a forward contract; with some additional featuresNot a private and customized transactionPublic and standardized transaction that takes place on a futures exchangeFuture exchanges guarantees to each party that if the other fails to pay, the exchange will payEach party has a contract with the exchangeForward Contract- risk of default is of concern

24Implement performance guarantee through clearinghouseClearinghouseFor some, a separate corporate entityDivision or subsidiary of the exchangeProtects itself by requiring the parties to settle their gains and losses on a daily basis- daily settlement or marking to marketMarking to Market- critical distinction between forward and future contracts-Profits and Losses are charged and credited to participants accounts each day prevents losses from accumulating without being collectedForward contract- losses accumulated until the end of the contract

Credit losses on forward contracts are extremely rare, owing to the excellent risk management practices of the participantsFutures contract parties do default on occasion. In fact, it is likely that there are more default on futures than on forward. Nonetheless, the exchange has never failed for the party on the other side of the transaction.Clearinghouse- an extremely small possibility of defaulting. Futures contract are default-free. 25Futures contract trades in the market and its price changes in response to new informationBuyers benefit from price increasesSellers benefit from price decreasesOn the expiration day, the contract terminates and no further trading takes placeAbility to engage in offsetting transactionsForward ContractsA 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/.Distinction: Forward Vs. Future- ability to engage in offsetting transactions

Forward Contracts Purchase 1Million @ $0.85/Later on, euro has a forward price $0.90/Buy at $0.85/ and sell it at $0.90/27Ability to engage in offsetting transactionsFutures ContractU.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 marketClearinghouse, Margins, and Price LimitsBefore taking a long or short position in the futures market, one must first deposit sufficient funds in a margin accountMargin Account in Stock Market VS Margin Account in Futures Market Margin Account in Stock Market- margin means a loan is made

29Margin Account in the Futures MarketAmount of money that must be put into an account by a party opening a futures positionTrader puts up a certain amount to meet the initial margin requirementMoney is not borrowedMore like a down payment for the commitment to purchase the underlying at a later dateForm of a good faith money, collateral, or a performance bondBoth the buyer and the seller must deposit a marginThe money help fulfils his or her obligation30Marking to MarketConversion of gains and losses on paper into actual gains and lossesMaintenance margin requirementLower than the initial margin requirementamount 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 requirement 31Marking to MarketTrader can simply close out the positionResponsible for any further losses incurred if the price changes before a closing transaction can be madeClearinghouse- 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 dayClearinghouses are able to control the risk of default by setting margin requirements and collecting margin money every dayExample of a Margin Account Marked to MarketFutures Price- $100Initial Margin Requirement- $5Maintenance Margin Requirement- $3Table A- trader takes a long position of 10 contracts on Day 0, depositing $50Table B- trader takes a short position of 10 contracts on Day 0, depositing $50Table A Holder of Long Position of 10 ContractsDay (1)Beginning Balance (2)Funds Deposited (3)Settlement Price (4)Futures Price Change (5)Gain/Loss (6)Ending Balance (7)O05010050150099.20-0.80-842242096.00-3.20-321031040101.005.005010041000103.502.502512551250103.00-0.50-512061200104.001.0010130Variation margin- additional margin that must be deposited34Table B Holder of Short Position of 10 Contracts

Day (1)Beginning Balance (2)Funds Deposited (3)Settlement Price (4)Futures Price Change (5)Gain/Loss (6)Ending Balance (7)005010050150099.20-0.80858258096.00-3.2032903900101.005.00-50404400103.502.50-251551535103.00-0.505556550104.001.00-1045Closeout VS. Physical Delivery Vs. Cash SettlementTypes of Futures ContractsCommodity Futures- traditional agricultural, metal, and petroleum productsFinancial Futures- stocks, bonds, and currenciesShort-Term Interest Rate Futures ContractsTreasury Bill Futures price = face value discount (representing interest)Based on a 90-day $1,000,000 US Treasury billInternational Monetary Market (IMM): 100 rate value 100- (Rate/100)(90/360)

Short-Term Interest Rate Futures ContractsSuppose on a given day the rate priced into the contract is 6.25%.Quoted Price: 100 6.25 = 93.75Actual 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= $625Short-Term Interest Rate Futures ContractsEurodollars- contracts pay-off based on a LIBOR on a given day