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125220_16(T9): Derivatives

  1. Economic Purposes of the Futures Market
    • Price discovery
    • Risk transference
    • Lower transaction costs
  2. Economic Purposes of the Futures Market - "1. Price discovery"
    • Provides information to public about future spot prices.
    • Increases competitiveness of markets
  3. Economic Purposes of the Futures Market - "2. Risk transference"
    • Enables investors & borrowers to protect assets & liabilities against risks e.g. changes in interest rates, exchange rates & security prices
    • Can be likened to buying insurance policies
  4. Economic Purposes of the Futures Market - "3. Lower transaction costs"
    But markets are zero sum games. i.e. one person’s loss is another’s gain.
  5. Futures Contract
    Legally binding agreement to buy or sell a specified quantity of a specified commodity/financial instrument for a specified delivery date in the future at a price agreed upon at setting up of contract
  6. Features of futures contract(s)
    • exchange traded contracts
    • highly standardised contract in terms of amounts, prices & conditions unlike a forward contract
  7. Derivative and derivative markets - "Types of derivatives markets"
    • Futures markets (organised exchange market)
    • Forward markets (OTC markets)
    • Options contracts (many organised markets)
    • Swap markets (OTC markets)
  8. Risk Transference
    • First, risks must be identified, measured & managed.
    • Risk management strategies may be internal or external
  9. Risk Transference - "Hedging"
    • Transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another party
    • Change in market price of a commodity or security in physical market is offset by a profit or loss on futures contract in futures marke
  10. Risk Transference - Example - "A dairy farmer who has a very large scale operation will be selling whole milk powder in a couple of months. He is concerned that milk price is going to fall in meantime. How can he hedge this price risk?"
    • Use exchange traded futures contract & conduct a transaction in futures market that corresponds with what is planned to be done in physical market at later date
    • Farmer enters into a whole milk powder futures contract to sell milk powder at a specified price & amount
    • So, if prices fall, futures contract will rise in value to offset loss in the physical market from fall in milk prices
  11. Australasian Futures & Options Exchanges
    • ASX recently bought Sydney Futures Exchange (SFE)
    • NZ Futures market- established 1985 by NZ FIs but bought by Sydney Futures Exchange Ltd in 1992
    • Electronic screen trading (relatively small size & spread of participants). Note majority of futures markets are electronic
  12. Two main types of futures contracts
    • Commodity (e.g. gold, wheat, pork bellies)
    • Financial (e.g. shares, government securities, money market instruments, share indices)
  13. 1 long futures contract
    • Agreement to buy futures
    • Hedger: Will have money to invest in future
    • Speculator: believes market will go up
  14. 1 short futures contract
    • Agreement to sell futures
    • Hedger: Has shares to sell in future
    • Speculator: Believes market will fall.
  15. Operations of futures market- Initial Margin & it's purpose
    • Funds put up as security for guarantee of contract fulfilment at time futures position is established
    • Purpose: to cover the maximum one-day movement in the futures contract
  16. Initial margin features
    • Paid by both buyer & seller to clearing house
    • Set by Futures Exchange for its Members who then set margin for client (depends on volatility & standing
  17. Operations of futures market - Variation Margin
    • Any adverse price movement in the market must be covered daily by further deposit of funds (maintenance margin call).
    • Known also as settlement to market when contract is marked-to-market daily by clearing house.
  18. Variation Margin - Example - "1 NZX15 futures contract bought at 6,000 × $10= $60,000, so you put up $1,000 at the start as initial margin. So if on next day, index price drops to 5990..."
    • 5990 × 10 = $59,900,
    • $100 variation
    • You will have a margin call to put $100 in to margin account so to top-up initial deposit.
  19. Futures market operation: Clearing house
    When a futures deal is concluded on the Exchange, a record is goes to the clearing house who then assumes responsibility for admin. & fulfilment of contract
  20. Role of Clearing House
    • The clearing house guarantees the performance of clearing house member by becoming opposite party in all transactions, being buyer to every selling clearing member & seller for every buying clearing member.
    • Often owned by Exchange but operates as separate entity
  21. Clearing House - Example
    • Sells one contract to B at 97 & buys one contract from S at 97
  22. Clearing House - Example
    • As there is one new ‘long’ & one new ‘short’ position, the open position on exchange increased by one contract
  23. Clearing House - Note - "An agreement to buy (long position) always..."
    Balanced by short position (agreement to sell)
  24. Operation of futures market - Closing out of a futures contract
    • Actual delivery of contract
    • Majority of financial futures closed out before expiry date
  25. Closing out of a futures contract - "1. Actual delivery of contract"
    • Seldom used with financial contracts (as managing a risk exposure or trying to profit)
    • Final settlement of futures contracts may be standard delivery or cash settlement
  26. Closing out of a futures contract - "2. Majority of financial futures closed out before expiry date"
    Reverse trade by taking a position in market equal & opposite to that already held
  27. Reverse - Example
  28. Reverse - Example (2)
  29. Participants in the markets
    • Hedger
    • Arbitrageur
    • Speculator
    • Traders
  30. Participants in the markets - Hedger
    • Attempt to reduce price risk (from interest rate, exchange rate & share price)
    • “Conducts same transaction in futures market today that is to be carried out in physical market in future time”
  31. Participants in the markets - Arbitrageur
    • Someone taking advantage of price differentials between two markets & making riskless profits.
    • e.g. differentials between futures contract price & physical spot price of the underlying commodity
  32. Participants in the markets - Speculator
    • someone prepared to take-over hedgers risk or holding a contrary view to another speculator.
    • Enter market in expectation that market price will move in a favourable direction for them
  33. Speculator - Example - Speculators who expect price of underlying asset go up, go down
    • Asset up = go long
    • Asset down = go short
  34. Participants in the markets - Traders
    • Special class of speculator
    • Trade on very S/T changes in the price of futures contracts (i.e. intra-day changes)
    • Provide liquidity to the market
  35. Hedging - Example (Part 1) - Individual has $60,000 worth of shares representing NZX15 index. Assume physical share market is at 6,000 & future market’s price is also at 6,000. Assume basis risk is zero (basis = difference between future & spot price), means futures & physical prices differences are the same, & will stay the same May need $60,000 in 3 months, so want to hedge position. Doesn’t want to sell the shares now.
    • 1 futures contract is $60,000 as 6,000 × 10 = 60,000.
  36. Hedging - Example (Part 2) - "Shares now worth $56,000"
  37. Hedging - Example (Part 3) - "The share index = 6400 in three months"
  38. Risks of Using Futures for Hedging
    • Standard Contract Size
    • Margin Risk
    • Basis Risk
    • Cross-commodity Hedging
  39. Risks of Using Futures for Hedging - Standard Contract Size
    A perfect hedge may not be possible (i.e. due to contract size, the physical market exposure may not exactly match the futures market exposure)

    • 90-day bank bill —$1,000,000 Face Value
    • 3 year Govt. bond —$100,000 Face Value
    • Listed Company Share —1,000 shares
  40. Risks of Using Futures for Hedging - Margin Risk
    • Initial margin- buyers & sellers need to pay initial margin (2-10% of futures contract)
    • Further cash required if prices move adversely (i.e. margin calls)
    • Opportunity costs & cash-flow risks associated with margin requirements
  41. Risks of Using Futures for Hedging - Basis Risk
    A perfect hedge requires there to be zero initial & final basis risk between the physical and futures markets
  42. Derivatives - Forward Contract
    • Agreements to buy or sell an asset at a certain time in the future for a certain price but NOT traded on a futures exchange
    • Private agreements
    • One party assumes long position & agrees to buy the asset for specified price & date while other assumes short position & agrees to sell the asset on same date for same price
  43. Differences between futures & forwards - Forwards
    • Don’t have to conform to standards of an exchange
    • Prices are less transparent than exchange
    • Usually a single delivery date unlike futures, range of delivery dates
    • Not marked to market daily like future contracts
    • Market players- may be known to each other
  44. Forward Rate Agreements (FRAs)
    • OTC agreement between two parties on an interest rate level that will apply at a specified future date
    • Allows lender & borrower to lock in interest rates based on a notional principle (no exchange of principal)
  45. FRA specifics
    • Specifies FRA settlement date when compensation is paid
    • Specifies FRA contract date on which cover is based: If a party wants to protect against rise in 3-month interest rates in 6 months time when they intend to borrow, they may use a FRA 6Mv9M
    • Dealer quotes FRA as 6Mv9M 8.50-8.00 so in 6 months dealer will lend 3-month money at rate=8.50% or borrow at 8.00%
Author
jordan_hs
ID
328095
Card Set
125220_16(T9): Derivatives
Description
t9
Updated

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