C define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives, and compare their basic characteristics Flashcards
define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives, and compare their basic characteristics;
Forwards
Agreement on a specified future price.
- Transactions: Private
- Customized
- No money exchanges until contract expiration
- Credit risk (counterparty default)
- Early exit (negotiate w/ counterparty)
• Example: A cereal manufacturer enters into a forward agreement to buy 1,250 metric tons of wheat from a farmer next month, who agrees to sell it to the manufacturer for $140 per ton.
“neither party pays any money to the other when the contract is initiated. Value accrues as the futures price changes”
“a forward has only one payment, made at its expiration date.”
Oblige a contractual FWD Prive execution
FWD’s trade OTC
A FWD price is fixed (in the terms)
Formal Defintion: “A forward contract is an over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a fixed price they agree on when the contract is signed.”
Characteristics:
*“forward contracts have zero value at the start as not value is exchanged for FWD contracts are neither A nor L and thus always end up with non-zero values at expiry”
*“forward contracts can be structured to create a perfect hedge, providing an assurance that the underlying asset can be bought or sold at a price known when the contract is initiated.”
Payoff: Buy: FWD Contract: “Payoff from Buying = St – F0(T)” Looks like supply, positive relationship, +slope
“Payoff from Selling = –[ST – F0(T)]” looks like demand, inverse relationship, -Slope
Assumption: Contract spotted at 0 and spot at T or future price is unknown
Keep in mind, parties are going Long (buy) and short (sell) respectively.
Ex: Short sells contract at 0 and expires at T, F0(T)
Example and Assumption: Long pays F0(T) and receives asset worth St, or rather the value of the contract at expiration.
St [asset value reception] >f0(T) [payment), spot price should exceed short sale
Payoff Long: St-F0(T)
Payoff Short: F0(t) - St
Zero sum game best understood as shorts payoff the negative of longs payoff.
St is a driver: Price of underlying at expiration
St-S0 is the underlying payoff
St-F0(t)= FWD contract payoff
F0(T) is fwd price
FWD > *Entire payoff is made at expiration which means a large loss at expiration may trigger default (consider counter-party credit quality)
Futures
Exchange-traded (standardized)
contract size (no cost to enter into)
underlying asset quality (protected via established margin accounts w/ clearinghouse that marks-to-market daily)
term of expiration (Either party can exit contract with an offsetting position with a clearinghouse)
delivery method
transactions: Public (price transparency)
• Example: A cereal manufacturer buys 10 Sept delivery wheat futures contracts at a price of $3.20 per bushel, while a farmer sells 10 wheat contracts for the same price.
Futures: Standardized FWD’s basically (become more liquid and protected against default)
Defintion: “A futures contract is a standardized derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initi- ated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.”
Most important Characteristics: “ most important distinctive characteristic of futures contracts is the daily settlement of gains and losses and the associated credit guarantee provided by the exchange through its clearinghouse. “ aka daily settlement and credit guarantee via clearinghouse.
Futures Price: Agreed Upon Price
Mark to Market: Daily Settlement, which becomes ‘marked to settlement price’ as the clearinghouse determines an average of final futures trades and pays the long if settlement price exceeds futures price or short if settlement price dips below futures price.
Futures contracts operate on initial margin as a percentage of the contract price in support of the trade as a performance bond or good faith on credit to cover possible future loss.
Futures Price: Agreed upon price. Rising prices benefit the long, falling prices benefit the short.
Futures account is margin account on initial margin or % of futures price in support of the trade (not as a credit, such as equity) or a performance bond or good faith deposit, aka “an amount of money put into an account that covers possible future losses.” Leads to a ‘maintenance’ margin or ““money that each participant must maintain in the account after the trade is initiated, and it is always significantly lower than the initial margin.”
Whoever doesn’t meet maintenance margin receives a “margin call, which is a request to deposit additional funds up to the initial margin.”
“neither party pays any money to the other when the contract is initiated. Value accrues as the futures price changes, but at the end of each day, the mark-to-market process settles the gains and losses, effectively resetting the value for each party to zero.”
Future provisions limiting price changes > price limits : Upper band (no trade takes place above this: Limit up), lower band (no trade takes place below this: Limit down) : Locked limit : market hits these bands, limits and trading stops. *Price limits help a clearinghouse manage its credit exposure.
*Open Interest: #outstanding contracts, have long and short position.
If delivery then delivery replaces mark to market process on final day; ensuring futures price converges to spot price at expiration. Short delivers product, long pays spot price which is equal to futures price at that time.
~~Review: FWD contracts: “the process by which they pay off as the spot price at expiration minus the forward price, ST – F0(T), the former determined at expiration and the latter agreed upon when the contract is initiated.”
St: (determined at expiration)
F0(T): (Agreed upon when the contract is initiated)
Futures profits timing is different than fwd’s. ->”Forward contracts realize the full amount, ST – f0(T), at expiration, whereas futures contracts realize this amount in parts on a day-to-day basis.”
“futures contracts settle gains and collect losses daily, the amounts that could be lost upon default are much smaller and naturally give the clearinghouse much greater flexibility to manage the credit risk it assumes.”
“Some futures contracts are subject to daily price limits and their payoffs are received daily”
Swaps
Formal Definition:
- Private
- Subject to default (only greater net party can default)
- OTC
- two parties agree to exchange a series of cash flows
- one party pays a variable series (mixed payments) that will be determined by an underlying asset or rate
- other party pays either a variable series (variable payments) determined by a different underlying asset or rate or a fixed series
Basically a series of forwards…
Value initiated = 0
Swaps: [series of future transactions, CF’s ; concept - two parties swap a series of cashflows] at specified times for a price specified at the contract’s initiation.
-one party makes mixed payments, while counterparty
makes variable payments.
• Example: A bank enters a swap agreement with an insurance company to make fixed interest payments in exchange for receiving variable interest payments.
Most Common: “fixed-for-floating interest rate swap; plain vanilla;vanilla swap”
Convert floating rate loans to fixed rate loans by adding an interest rate swap via a swap dealer in order to better pay bank lenders floating interest rate payments but with a fixed rate [received by swap dealer] (better anticipation of cash flows for paying back interest)
“A LIBOR-based loan with monthly payments based on the 30/360 convention would be matched with a swap with monthly payments based on LIBOR and the 30/360 convention and the same reset and payment dates”
“it has no principal so ‘balance’ = ‘notional principal’, which ordinarily matches the loan balance.”
“Swaps are better suited for risks that involve multiple payments”
Options
Agreement - A right to buy into future transaction at price specified at contract’s initiation.
-Trades: Exchange or OTC
- Right to call or buy underlying
- Right to put or sell underlying
- American (exercise≤expiration)
- European (exercise=expiration)
•Example: An investor buys an American call option on a stock with a 13$ strike price that expires in three months.
An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.
“When an option is terminated, either early or at expiration, the holder of the option chooses whether to exercise it. If he exercises it, he either buys or sells the underlying asset, but he does not have both rights”
Call: Right to buy (bull)
Put: Right to sell (bear) (insurance: bad outcomes trigger a payoff for the put)
The fixed price at which the underlying asset can be purchased: Exercise, or strike.
“The strike price of the option is chosen by the participants.”
Buyer pays writer an option premium or fair price of the option and it is the present value of the cash flows that are expected to be received by the holder of the option during the life of the option.”
Default in options is possible only from the short to long as the long is not obliged to buy the short, only obliged to pay the premium.
Example:
St - underlying value at expiration T
X - Exercise price of the option
Profit, St>X (Exercise), otherwise, simply let the option expire.
“Option payoff at expiration date, the option is described as having a payoff = Ct (value of option at expiration) = Max(0,ST – X)” where holder of option is entitled to exercise and claim this amount. ^ Payoff to the Call Buyer
“read as “take the maximum of either zero or ST – X.””
(Institute 26)
Values as “in the money” or St>X where option value is *positive, *equal to St-X
“Out of the Money” as St
Credit Derivatives
A derivatives contract between a credit protection buyer and a credit protection seller, in which the credit protection seller provides protection to the former against a specific credit loss.
-total return swap
The Nature of Contingent Claims
“All forward commitments are firm contracts. The parties are required to fulfill the obligations they agreed to. The benefit of this rigidity is that neither party pays anything to the other when the contract is initiated. If one party needs some flexibility, however, it can get it by agreeing to pay the other party some money when the contract is initiated. When the contract expires, the party who paid at the start has some flexibility in deciding whether to buy the underlying asset at the fixed price. Thus, that party did not actually agree to do anything. It had a choice. This is the nature of contingent claims.”
Put Options (bear)
“a put option allows its holder to sell the underlying asset at the exercise price”
Put Holder exercises in the money, where (StX
“payoff to the put holder is
pT = Max(0, X − ST ) (payoff to the put buyer). If the put buyer paid p0 for the put at time 0, the profit is
Π = Max(0, X − ST ) − p0 And for the seller, the payoff is
− pT = −Max(0, X − ST ) And the profit is
(profit to the put buyer). (payoff to the put seller).
B. Payoff and Profit from Selling
Π = −Max(0, X − ST ) + p0
(profit to the put seller).
Basic Derivative Instruments are…
FWD's Futures Options Swaps Credit
