Reading 67: Forward Commitment and Contingent Claim Features and Instruments

Book 3: Derivatives

Forward Contract

one party commits to buy and the other party commits to sell an asset at a specific price on a specific date

What’s the difference between a forward contract and a futures contract?

Future

• more standardized

• traded on exchange

• backed by clearinghouse

• cash settlement of gains and losses

• trade in more transparent markets

Margin

cash or other acceptable collaterals that both the buyer and seller must deposit

What’s the purpose of margin in the context of a future account?

protects the clearinghouse

What is the value of the futures account based on?

Mark to market

How is maintenance margin different from maintenance margin with an equity margin account?

maintenance margin requires the margin level be brought up to the initial margin, not the maintenance margin

What is roughly the initial margin in a futures account?

the one day maximum price movement on the total value of the assets covered by the contract

Price Limits

exchange-imposed limits on how much each day’s settlement price and change from the previous day’s settlement price

Circuit Breakers

when a futures price reaches a limit price, trading is suspended for a short period of time

Swaps

agreements to exchange a series of payments on multiple settlement dates over a specific time period

True or False: the payments on swaps net out.

true

only one party pays the gross amount to the other

Do swaps trade in OTC or dealer market?

dealer

parties are exposed to counterparty risks

Notional Amount

a pure calculation device that is used to assist in calculating interest payments

Credit Default Swaps (CDS)

a protection buyer makes fixed payments on the settlement dates and the protection seller pays only if the underlying has a credit event

Reference Security

the underlying asset in a CDS

How much does a protection seller payoff the protection buyer if a credit event occurs?

an amount that covers the loss in value of the reference security

Call Option

gives the buyer the right to buy 100 shares at a specified price for a specified period of time

Put Option

gives the buyer the right to sell 100 shares at a specified price for specified period of time

Long Call Option Payoff

Max (0, S – K)

Long Call Option Profit

Payoff – C

Short Call Option Payoff

–Max (0, S – K)

Short Call Option Profit

C – Payoff

Call Option BE

K + C

Long Put Option Payoff

Max (0, K – S)

Long Put Option Profit

Payoff – P

Short Put Option Payoff

–Max (0, K – S)

Short Put Option Profit

P – Payoff

Put Option BE

K – P

Forward Commitment

a legally binding promise to perform some action in the future

forwards, futures, swaps

Contingent Claim

a claim that depends on a particular event

options, CDS