Derivatives - New
Page 1: Introduction
HERIOT WATT UNIVERSITY
LEADING Derivatives
Page 2: What are Derivatives?
Definition: A derivative is a financial instrument that derives its value from the price of an underlying asset.
Types of Underlying Assets:
Real commodities: agricultural products, energy, precious metals.
Financial assets: currencies, common stocks, bonds.
Page 3: Summary of Derivatives
A derivative is a financial contract whose value depends on the price of another security or commodity.
Page 4: Example Scenario
John, a restaurant owner, requires wheat for his operations.
He buys wheat from Kate, but the price fluctuates due to supply and demand.
John is concerned the price of wheat may rise next month.
Page 5: Price Agreement
John approaches Kate to agree on a price for wheat to be bought next month.
They agree on a contract: John will purchase 100 bushels at $9 per bushel.
Page 6: Outcomes of the Contract
Two potential market price scenarios after a month:
Market price rises to $10:
John benefits by purchasing at $9; Kate incurs a loss.
Market price drops to $8:
John incurs a loss as he pays $9 instead of $8.
Page 7: Contract Dynamics
John and Kate enter a financial contract based on the price of wheat.
This is a forward contract with:
John having a long position (buying the underlying)
Kate having a short position (selling the underlying)
Page 8: Definition of Forward Contracts
A forward contract involves agreeing to exchange an asset at a future date for a price decided now.
The Chicago Board of Trade (CBOT) was established in 1848, facilitating early trading in forward contracts.
Page 9: Purpose of Derivatives
Derivatives manage price volatility.
Buying and selling pressures can lead to significant asset price movements in a short period.
Page 10: Historical Context
Derivatives originated to address price volatility in Chicago's food markets.
Contracts were formed based on promises to buy/sell at future dates.
Page 11: Forward Contracts in Commodities
A commodities forward contract allows exchanges of a commodity at a defined future date at a currently agreed price.
This provides predictability in costs for food processing companies.
Page 12: Introduction to Futures
Futures contracts specify a future trade at a current price.
Futures differ from forwards in multiple ways.
Page 13: Trading Futures
Futures are traded on exchanges (e.g., CME Group).
They are standardized regarding quantities, types of commodities, and delivery dates.
Example: A wheat futures contract typically represents 5,000 bushels.
Page 14: Forward vs. Futures Contracts
Forwards are traded over-the-counter (OTC), allowing customization.
OTC trades directly between parties without a centralized exchange.
Page 15: Advantages of Standardization
Standardized contracts make it easier to find counterparties, reducing search costs.
Enhanced liquidity allows for easy buying/selling of futures contracts.
Page 16: Cost Benefits
Known terms and conditions cut down contract preparation costs.
Page 17: Market Efficiency
Futures contracts traded in markets provide efficient price discovery.
Forward contracts, being private, may not have a clear value.
Page 18: Value Changes of Contracts
The value of forward or futures contracts may change before delivery due to market conditions.
Page 19: Impact of Favorable Exercise Price
The contract's value increases if the exercise price becomes favorable, leading to potential profit.
Page 20: Risk of Unfavorable Contracts
If the contract turns out unfavorable, it can lose value.
Page 21: Exchange-Traded Futures
Futures contracts typically have easily ascertainable values due to market trading.
Forward contracts have less certainty in their value.
Page 22: Counterparty Risk
There is a risk that one party may not honor a forward contract under unfavorable market conditions.
Futures contracts minimize credit risk through exchange settlement procedures.
Page 23: Contract Settlement
Forward contracts settle at maturity with no prior fund transfers.
Futures contracts settle daily throughout their life.
Page 24: Marking to Market and Margins
Futures utilize a marking-to-market feature, settling daily on contract value changes.
A margin is collateral deposited with brokers to cover potential losses.
Page 25: Margin Requirements
Initial margin: amount deposited when entering a contract.
Daily adjustments reflect trade gains/losses; failure to maintain margins triggers margin calls.
Page 26: Holding Period Differences
Forward contracts are generally held to maturity, while futures are often closed before maturity.
Page 27: Uses of Derivatives
Hedging: a strategy to offset losses by taking opposing positions in related assets.
Speculation: engaging in risky financial transactions expecting significant gains.
Page 28: Speculation Example
Buying crude oil futures anticipating price increases leads to potential profits.
Selling futures expecting price drops can also yield profits.
Page 29: Hedging in Commodities
Chicago's market allowed early forms of risk management for producers through derivatives.
Page 30: Farmer Hedging Example
Farmers hedge against low market prices through forward contracts to secure profits.
Page 31: Risk Acceptance in Hedging
Choosing to hedge means farmers miss out on potential gains from high prices.
However, they reduce risks from price declines.
Page 32: Risk Management Principles
Similar to portfolio theory, risk reduction often comes with the trade-off of reduced potential gains.
Page 33: Evolution into Financial Markets
Traditional risk management principles transitioned to financial markets with the introduction of foreign currency futures in 1971.
Page 34: Key Financial Derivatives
The introduction of a 90-day U.S. Treasury Bill futures followed soon after foreign currency futures.
Page 35: Physical Delivery in Derivatives
Unlike commodity contracts, physical delivery is rare in financial derivatives; they mainly manage price movements.
Page 36: Appeal of Derivatives
Derivatives attract investors seeking to mitigate risks from adverse price movements by hedging.
Page 37: Example of T-Bill Futures
T-bill futures provide hedging against rising interest rate risks, influencing overall interest rate structures.
Page 38: Profit Mechanism
Firms can profit by selling T-bills at previously agreed prices when interest rates rise.
Page 39: Loss Mechanism
If interest rates fall, losses occur from higher spot prices compared to exercise prices, offset by lower interest expenses.
Page 40: Variety of Financial Derivatives
Financial derivatives encompass various underlying assets, including equities, indices, and bonds.
Page 41: Types of Other Derivatives
Options: Offers the right, not obligation, to buy/sell at an exercise price.
Swaps: Exchanges cash flows, like interest rates or currencies.