Derivatives I HO 2020
Page 1: Derivatives: Introduction BEAM031
Page 2: Lecture Structure
Overview of the lecture topics:
The spot market
What are derivatives?
Forward contracts: market and characteristics
Futures contracts: market and characteristics
Option contracts: market and characteristics
Reading List:
Chapter 20: An introduction to derivative markets and securities
Chapter 21: Forward and futures contracts
Chapter 22: Option contracts
Page 3: What are Derivatives?
Definition: Instruments whose price is dependent on another asset.
Characteristics:
Price derives from the underlying good.
Contracts for deferred delivery; delivery occurs in the future.
Types of Derivatives:
Over-the-counter (OTC) contracts: Negotiated directly between two parties.
Exchange-traded contracts: Standardized contracts traded on organized exchanges (e.g., ICE, CME).
Page 4: The Spot Market
Definition: Market for immediate sale and delivery of an asset.
Characteristics:
Transactions occur today.
Price for immediate delivery referred to as the spot price.
Page 5: The Spot Market (Detailed)
Bid Price: Price at which a market-maker will buy the asset.
Ask Price: Price at which a market-maker will sell the asset.
Example: Spot price in foreign exchange context.
Page 6: The Forward Market
Overview of the forward market and its significance in derivatives.
Page 7: Forwards: Characteristics
Forward Contracts: Obligate the holder to buy or sell an asset at a predetermined price and time.
Arranged as individual transactions, often between financial institutions.
Unit Size: Typically large (e.g., £1 million for FX forwards).
Page 8: Forwards: Characteristics 2
Nature:
Contracts for deferred delivery with lengths of 30, 90, or 180 days.
Obligatory nature; must fulfill obligations.
Flexibility vs. Liquidity:
Highly flexible but illiquid due to non-standardization.
Limited price transparency compared to standardized contracts.
Page 9: Spot and Forward Prices: Example
Example: EUR/USD forward rates on a specific date.
Bid and ask prices for various contract lengths.
Page 10: The Futures Market
Overview of the futures market and its infrastructure.
Page 11: Futures Contracts Characteristics
Futures Contracts: Obligates buying/selling at a predetermined price/time.
Standardized, facilitating trade and minimizing transaction costs.
Trading Mechanism: Auction mechanism; daily marked to market.
Page 12: Futures Contracts - Types of Assets
Types of Futures Contracts:
Financial futures (e.g., equities, bonds).
Commodity futures (soft and hard commodities).
Quality specifications defined for contracts involving commodities.
Page 13: Future Contract Example: Robusta Coffee
Description of Robusta Coffee futures as a global price benchmark.
Market Specifications:
Contract size, pricing, and series details.
Page 14: Future Contract Example: Robusta Coffee 2
Settlement Terms:
Physical delivery within specified delivery points.
Standards and quality requirements for deliverable coffee.
Page 15: Future Contract Example: Robusta Coffee 3
Quality Basis: Defined classes with specific quality parameters.
Importance of ensuring quality in commodity futures.
Page 16: Futures Exchanges
Overview of consolidation in futures exchanges over the last 20 years.
Examples of major combined futures exchanges.
Page 17: Spot and Futures Prices: Example Gold
Example of Gold Prices:
Closing prices of gold contracts and spot prices as of a historical date.
Page 18: Trading Futures: The Clearing House
Clearing House Role: Act as a counterparty to trades, ensuring market integrity.
Page 19: The Role of a Clearing House
Functions:
Guarantees financial integrity, facilitates trades, records trades, reduces counterparty risk via centralized systems.
Page 20: Margining & Marking to Market
Margin Requirements:
Initial margin covers maximum expected market movement.
Variation margin maintains account balance.
Page 21: Margining
Detailed structure of initial and maintenance margins, along with how margin calls work.
Page 22: Hedging, Speculation, and Arbitrage
Definitions:
Hedgers manage risk exposure.
Speculators aim for profit from price fluctuations.
Arbitrageurs exploit price discrepancies.
Importance of speculators in increasing market liquidity for hedgers.
Page 23: Forwards, Futures, & Risk
Notable examples of losses faced by companies using derivatives.
Historical context of risks associated with forward and futures contracts.
Page 24: Forwards, Futures, & Risk (Continued)
Discussion on various risks associated with derivatives, including market, credit, liquidity, cash flow, and basis risk.
Page 25: Futures vs. Forwards
Comparison:
Contracts, obligations, standardization, liquidity, and risk.
Futures contracts generally offer more liquidity and transparency than forwards.
Page 26: Futures vs. Forwards 2
Additional contrasts concerning trading environments, margin systems, and settlement processes.
Page 27: Futures vs. Forwards 3
Risk Analysis: Differences in credit and liquidity risks between futures and forwards.
Page 28: Further Reading
Recommended texts on futures and option markets.
Page 29: Options
Introduction to options as financial derivatives.
Page 30: What is an Option?
Definition: Options give buyers the right, not the obligation, to buy/sell an asset.
Page 31: Terminology & Basic Concepts
Call Option: Right to buy an asset.
Put Option: Right to sell an asset.
Types of options: European, American, Bermudan.
Page 32: Trading Options
Characteristics of options specified similar to futures.
Types: OTC, exchange-traded, options on futures.
Page 33: Trading Options (Detailed)
Overview of option quotes, and examples with underlying assets.
Page 34: Call Options
Dynamics of call options, including conditions to exercise and profit concepts.
Different states of an option: 'In the Money', 'At the Money', 'Out of the Money'.
Page 35: Contingency Graphs for Call Options
Visuals explaining the profit or loss scenarios for buying call options.
Page 36: Contingency Graphs for Selling Call Options
Profit/loss analysis for selling call options based on market movements.
Page 37: Determining Call Option Premiums
Factors influencing call option premiums, including the spot price and time to expiration.
Page 38: Uses of Call Options 1: Hedging Example
Example: UK firm hedging against USD price fluctuations through a call option.
Page 39: Uses of Call Options 2: Hedging Example
Further hedging strategies involving multiple currencies and options.
Page 40: Uses of Call Options 3: Speculating Example 1
Speculative Strategy: Purchasing a call option in anticipation of currency appreciation.
Page 41: Uses of Call Options 4: Speculating Example 2
Selling a call option as a speculation strategy.
Page 42: Options on the £/$ Example
Detailed financial breakdown involving options and calculations of intrinsic value and profits.
Page 43: Put Options
Introduce put options, their characteristics, and parameters for loss calculation.
Page 44: Determining Put Option Premiums
Factors influencing the premium prices of put options.
Page 45: Contingency Graphs for Buying a Put Option
Analysis of profit/loss scenarios for buying put options.
Page 46: Contingency Graphs for Selling a Put Option
Overview of outcomes when selling a put option.