1.

Course Overview
• Derivatives builds on the knowledge you have developed
Derivatives in Foundations of Finance.
• In this unit, we provide an in-depth examination of the
Lecture 1 - Course Overview following derivatives:
– Options;
– Futures;
– Forwards; and,
– Swaps.
• We examine these instruments on a range of underlying
commodities including stocks, interest rates and foreign
Hull et al: Chapters 1 & 2
exchange.
• We also look at more exotic instruments such as
weather and electricity derivatives.
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1. Course Overview 2. Lecture Overview

• At the completion of Derivatives students • In this lecture we will:
– Recap the basics of forward, futures and options
are expected to have a good contracts;
understanding of how derivative – Revisit the concepts of hedging, speculation and
arbitrage; and
instruments are priced, traded and used. – Discuss the mechanics of futures and forward
markets.
• It would be a good idea to review your
Foundations of Finance notes to ensure you are
familiar with all of the terminology pertaining to
futures, forwards and options contracts. We will
only discuss this prerequisite material briefly.

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3. The Nature of Derivatives 4. In What Ways are Derivatives Used

• A derivative is an instrument whose value • Derivatives can be used to:

depends on the values of other more basic – Hedge risks;
underlying variables. – Speculate;
• take a view on the future direction of the market
• Examples of derivative contracts include:
– Lock in an arbitrage profit;
forward; futures; and, options contracts.
– Change the nature of a liability; and,
– Change the nature of an investment without
incurring the costs of selling one portfolio and
buying another.

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 5. Forwards and Futures Contracts 5. Forwards and Futures Contracts
• A futures/forward contract is an • The future/forward prices for a particular
agreement to buy or sell an asset at a contract is the price at which you agree to
certain time in the future for a certain buy or sell the underlying asset.
price. • It is determined by supply and demand in
• By contrast in a spot contract there is an the same way as a spot price.
agreement to buy or sell the asset
immediately (or within a very short period
of time).

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5. Forwards and Futures Contracts 5. Forwards and Futures Contracts

• In a forward or futures contracts: • Example of a forward/futures contract:
– The party that has agreed to buy has a long – It is January and an investor enters into a long
position. They have a final payoff of St-F. futures contract on COMEX to buy 100 oz of
– The party that has agreed to sell has a short gold @ $1,200 in April
position. They have a final payoff of F- St. – If in April the spot price of gold ends up being
$1,215 per oz, what is the investor’s profit?
• As the investor is the long position, the payoff from
the contract is ST-F, which equals ($1215-
$1200)x100=$1,500.

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5. Forwards and Futures Contracts 5. Forwards and Futures Contracts

• Some important points about Futures and • Some important points about Futures and Forward contracts
Forward contracts: (continued):
– The initial value of the contract is zero. – The forward/futures price for a contract is the delivery price that
– No money changes hands when forward and futures contracts would be applicable to the contract if were negotiated today (i.e., it
are first negotiated & the contract is settled at maturity. is the delivery price that would make the contract worth exactly
– Forward contracts are similar to futures except that they trade in zero).
the over-the-counter market. Futures contracts on the other – In other words, it would make no difference whether you entered
hand are exchange traded instruments. into the forward contract to receive the asset in 6 months from
• In Australia, futures contracts are traded on the Australian Securities now, or bought the asset today and stored it for 6 months. The
Exchange (ASX).
cost of either strategy would be identical.
– In addition, if you recall from Foundations of Finance,
intermediate gains or losses are posted each day during the life – The forward price may be different for contracts of different
of the futures contract. maturities.
• This feature is known as marking to market.
• The intermediate gains or losses are given by the difference between
today’s futures price and yesterday’s futures price.
• These monies are transferred between the margin accounts of contract
parties.

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 5. Forwards and Futures Contracts 5. Forwards and Futures Contracts
– Profit from a long forward/futures position:

• Some important points about Futures and Profit

Forward contracts (continued):

– Examples of futures markets:
• ASX (http://www.asx.com.au) Price of Underlying

• Chicago Board of Trade at Maturity

• Chicago Mercantile Exchange

• LIFFE (London)
• Eurex (Europe)
• BM&F (Sao Paulo, Brazil)
• TIFFE (Tokyo)
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5. Forwards and Futures Contracts 5. Forwards and Futures Contracts

– Profit from a short forward/futures position:
Profit – Convergence of Futures to Spot:

Futures
Price of Underlying Price Spot Price
at Maturity
Spot Price Futures
Price

Time Time

(a) (b)

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5. Forwards and Futures Contracts 5. Forwards and Futures Contracts

• Some important points about Futures and Forward • Some important points about Futures and
contracts (continued):
– As the delivery month of a futures contract is approached, the futures
Forward contracts (continued):
price converges to the spot price of the underlying asset. When the – If the futures price is below the spot price during the
delivery price is reached, the futures price equals, or is very close to the
spot price. delivery period, companies wanting to acquire the
– If the futures price is above the spot price during the delivery period, asset would enter into a long position in the futures
traders will have an arbitrage opportunity, and will short the futures
contract, buy the asset and make delivery. This will force the futures
contract and wait for delivery to be made. As they do
price to fall and converge to the spot price. so, the futures price will tend to rise, until the futures
and spot prices converge.

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 5. Forwards and Futures Contracts 5. Forwards and Futures Contracts
Key Features of Forward/Futures Contracts: • Margin Accounts
FORWARDS FUTURES
– As noted previously in the lecture, futures contracts
involve a margin account.
Private contract between 2 parties Exchange traded
– A margin is cash or marketable securities deposited
Non-standard contract Standard contract by an investor with his or her broker.
Usually 1 specified delivery date Range of delivery dates – The balance in the margin account is adjusted to
reflect daily settlement.
Settled at maturity Settled daily
– Margins minimize the possibility of a loss through a
Delivery or final cash Contract usually closed out default on a contract.
settlement usually occurs prior to maturity

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5. Forwards and Futures Contracts 5. Forwards and Futures Contracts

• Closing Out of a Futures Position • Closing Out of a Futures Position (continued)
– Closing out a futures position involves entering – If a contract is not closed out before maturity, it is
into an offsetting trade. usually settled by delivering the assets underlying the
• For example, if you hold a long position in wool, to contract.
close it out you would take a short position on wool • When there are alternatives about what is delivered, where it is
delivered, and when it is delivered, the party with the short position
on the same quantity with the same maturity date. chooses.
• Most futures contracts are closed out before – Some contracts (for example, those on stock indices
maturity. and Eurodollars) are settled in cash.
– The terms of the contract will stipulate whether there
is physical or cash settlement.

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5. Forwards and Futures Contracts 5. Forwards and Futures Contracts

• Some futures terminology: • Regulation of Futures Markets
– Open interest: the total number of contracts – Designed to protect the public interest.
outstanding.
• Equal to number of long positions or number of short
– Regulators try to prevent questionable
positions. trading practices by either individuals on the
– Settlement price: the price just before the final bell floor of the exchange or outside groups.
each day.
• Used for the daily settlement process.
– Volume of trading: the number of trades in 1 day.

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 6. Option Contracts 6. Option Contracts
• A call option is an option to buy a certain • The person in the long position of either a call or
put option is the holder of the option.
asset by a certain date for a certain price – They make the choice as to whether the option is
(the strike price). exercised or not.
– For this privilege they must pay an option premium to
• A put option is an option to sell a certain the writer.
asset by a certain date for a certain price • The person in the short position of either a call
or put option is the writer of the option.
(the strike price). – They are obliged to fulfil the terms of the option
contract if the holder exercises it.
– In return they receive an option premium from the
holder.

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6. Option Contracts 6. Option Contracts

• If someone is long in a call option: • If someone is long in a put option:
– They have the right, but not the obligation to buy the – They have the right, but not the obligation to sell the
underlying asset to the person who is short in the call underlying asset to the person who is short in the put
option for a specified price. If they choose to exercise option for a specified price. If they choose to exercise
the option, the payoff is X-St.
the option, the payoff will be St-X.
• If someone is short in a put option:
• If someone is short in a call option: – They are obligated to buy the underlying asset for the
– They are obligated to sell the underlying asset for the specified price from the person in the long position if
specified price to the person in the long position if the the holder decides to exercise the option. If the
holder decides to exercise the option. If the option is holder decides to exercise the option, the payoff to
exercised by the holder, the payoff to the writer is – the writer will be –(X-St)
(St-X).

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6. Option Contracts 6. Option Contracts

• Options can be either exchange traded, or • Another way to distinguish between
traded on an OTC market. Examples of options options is whether they are American or
exchange markets are: European in nature:
– ASX (http://www.asx.com.au)
– An American options can be exercised at any
– Chicago Board Options Exchange
time during its life, up to and including the
– American Stock Exchange
expiry date; and,
– Philadelphia Stock Exchange
– LIFFE (London) – A European option can be exercised only at
– Eurex (Europe) the expiry date.

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 6. Option Contracts 7. Types of Market Traders
• Options contracts differ from forward and futures • There are three main types of market participants:
contracts in a number of ways: 1. Hedgers want to avoid exposure to adverse movements in the
price of an asset.
– A futures/forward contract gives the holder the • As such, they will have a position in both the derivative, and the
underlying asset.
obligation to buy or sell at a certain price; 2. Speculators take a position in the market betting that either the
– An option gives the holder the right but not the price of an asset will go up, or it will go down.
• If they are correct they will make large gains, but if they are wrong
obligation to buy or sell at a certain price; they have the potential to make enormous losses.
– In return for this right, the holder must pay an option • Some of the largest trading losses in derivatives have occurred
because individuals who had a mandate to hedge against risks
premium to the writer; and, switched to being speculators.
3. Arbitrageurs attempt to lock in a riskless profit by
– Options can be both OTC and exchange traded, simultaneously entering into transactions in two or more
whereas forward contracts are OTC and futures markets.
contracts are exchange traded instruments.

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7. Types of Market Traders 7. Types of Market Traders

• If the spot price of gold is S & the futures price is for a contract
• An Example of Arbitrage: deliverable in T years is F, then:
– Suppose that: F = S (1+r+q )T
• The spot price of gold is US$1090; where r is the 1-year (domestic currency) risk-free rate of
• The quoted 1-year futures price of gold is US$1195; interest, and q is the cost of storage.
• The 1-year US$ interest rate is 5% per annum; and, • In our example, S=1090, T=1, r=0.05 and q=0.02 so that:
• The cost of storage is 2% per annum.
F = 1090(1+0.05+0.02)1 = 1166.30

• Here F = 1195 but S0(1 + r+q)T = 1166.30. Hence we should take a

• Is there an arbitrage opportunity? short position in the futures contract (which is relatively overvalued)
and take a long position in physical commodity (which is relatively
undervalued), making an arbitrage profit of $28.70 per ounce.

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8. Conclusion
• In today’s lecture we have had a broad
overview of forward, futures and options
contracts.
• In next week’s lecture, we will focus on
forward and futures contracts in greater
detail, with a particular emphasis on
hedging strategies and the determination
of forward and futures prices.

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