Chapter 8 - Fixed Interest Securities Flashcards
What is a future?
A future is an agreement to buy or sell a standard quantity of a specified asset on a fixed future date at a price agreed today
Identify the parties to a futures contract and explain each of the terms in the above statement.
There are two parties to a futures contract, a buyer and a seller whose obligations are as follows.
- The buyer of a future enters into an obligation to buy on a specified date.
- The seller of a future is under an obligation to sell on a future date.
These obligations relate to a standard quantity of a specified asset on a fixed future date at a price agreed today.
Standard quantity - exchange-traded futures are traded in standardised parcels known as contracts. For example, a futures contract on a gilt is to be for £100,000 nominal of a 6% gilt, or an interest-rate
future might be for £0.5m nominal value.
The purpose of this standardisation is that buyers and sellers are clear about the quantity that will be
delivered. If you sold one gilt future, you would know that you were obligated to sell £100,000
nominal of gilts.
Futures are only traded in whole numbers of contracts. So, if you wished to buy £200,000 nominal of
gilts, you would buy two gilt futures.
Specified asset - all futures contracts are governed by their contract specifications. These legal
documents set out in great detail the size of each contract, when delivery is to take place, and what
exactly is to be delivered.
Fixed futures date - the delivery of futures contracts takes place on a specified date(s) known as delivery day(s). This is when buyers exchange money for goods with sellers. Futures have finite lifespans so that, once the last trading day is past, it is impossible to trade the futures for that date.
At any one time, a range of delivery months may be traded (for example, most Euronext.liffe
contracts have March, June, September and December delivery months); and, as one delivery day
passes, a new date is introduced.
In many cases, a physical delivery does not occur on the delivery day. Rather, the exchange
calculates how much has been lost, or gained, by the parties to a futures contract. It is only this
monetary gain or loss that changes hands, not the underlying asset. The Euronext.liffe gilt future is
an example of a physically-settled contract, whereas the FTSE 100 Index future is cash settled.
Price agreed today - the final phrase in the definition is arguably the most important of all. The
reason why so many people, from farmers to fund managers, like using futures is that they introduce
certainty. In the absence of a futures market, a farmer growing wheat, for example, has no idea
whether he will make a profit or a loss when he plants the seeds in the ground. By the time he
harvests his crop, the price of wheat may be so low that he will not be able to cover his costs.
However, with a futures contract, he can fix a price for his wheat many months before harvest. If, six
months before the harvest, he sells a wheat future, he enters into an obligation to sell wheat at that
price on the stipulated delivery day. In other words, he knows what price his goods will fetch.
You might think that this is all well and good, but what happens if there is a drought or a frost that
makes it impossible for the farmer to deliver his wheat?
Futures can be traded, so although the
contract obligates the buyer to buy and the seller to sell, these obligations can be offset (closed out)
by undertaking an equal and opposite trade in the market.
Outline the uses of futures contracts from a speculator’s perspective, including in your
answer a summary of the risks and rewards involved.
All sorts of people use futures. Some may use them to reduce risk. Others use futures to seek high
returns; and, for this, they must be willing to take high risks. Futures markets are, in fact, wholesale
markets in risk: they are markets in which risks are transferred from the cautious to those with more
adventurous (or reckless) spirits. The users fall into one of three categories; namely, the hedger, the
speculator, and the arbitrageur.
The speculator – buying a future
A transaction in which a future is purchased to open a position is known as a long position.
Thus, the purchase of an oil future would be described as going long of the future or simply long.
The purpose of undertaking such a transaction is to open the investor to the risks and rewards of
ownership of the underlying asset by an alternative route.
On 1 May, say, a speculator thinks that UK interest rates are set to fall and, therefore, that gilt prices
are likely to rally.
How can he use the futures market to buy in anticipation of this price rise, and what will his position
be if the price rise does occur by 21 May?
Solution
Action 1 May: Buy 1 June Gilt Future at £101.10
On 21 May, let’s say there is a reduction in interest rates, and gilt prices rally sharply.
Action 21 May: Sell 1 June Gilt Future at £102.10
Clearly, the speculator has made a profit of £1.00 between the buying and selling prices, but how
can we calculate the profit of the futures trade?
The method used to calculate profits and losses in the futures markets involves the following
formula. The tick value is the monetary impact per contract of a 1-tick movement. If the price of the
future (which is quoted per £100 nominal) moves by 0.01, the cost of £100,000 nominal (the contract
size) will change by 1,000 times this amount. 1,000 times £0.01 equals
£10. Thus, the tick value is £10.
Because only one future was purchased, the calculation becomes
Ticks × Tick value × No. of contracts
100 × 10 × 1 = £1,000 profit
The reason the speculator has made a profit is that the futures market has risen in response to a rise
in the underlying or cash-market price of gilts. Generally, futures prices can be expected to move at
the same rate and to the same extent as cash-market prices. This is a far from trivial observation:
although they normally do move in line, it should be remembered that these are separate markets,
and they are each subject to their own supply and demand pressures.
Summary of position
Risk = Limited. The maximum loss would occur if the future fell to zero. For our gilt speculator, this
would be if the June future fell from £101.10 to zero.
Reward = Unlimited. The futures price could rise to infinity, so the profit is potentially unlimited.
The speculator – selling a future
A transaction in which a future is sold to open a position is known as a short position. Thus, the sale
of the oil future would be described as going short of the future or simply short.
The purpose of undertaking such a transaction is to open the investor to the opposite risks, and
rewards of ownership of the underlying asset.
If a speculator thinks that an asset price or index will fall, he will seek to make a profit by selling the
future at the currently high price and, subsequently, buying it back at a lower price.
This is not an activity commonly undertaken in the cash markets, and therefore needs a little
explanation. There are two ways of making profits.
Buy at a low price and sell at a high price. For example, we may buy a house at £80,000 and sell it
at £100,000 making a £20,000 profit.
In futures markets, it is equally easy to sell something at a high price and buy it back at a low price. If
you thought the property market was going to fall, you could sell a house at £100,000 and buy it
back at £80,000, again realising a £20,000 profit.
In the actual property market, it is not easy to go short of a house; but, in the futures market in which
deliveries are at some future date, it is straightforward.
Action 1 June – Sell 1 September FTSE 100 Future at 4100
Committing himself to delivering on 1 September an asset (the asset being the cash value of the
FTSE 100 shares) he does not own.
Action 14 July – Buy 1 September FTSE 100 Future at 4000
By 14 July, the future price has fallen and the speculator buys back his short futures position, thus
extinguishing any delivery obligations. The profit can be calculated by again determining the number
of ticks moved and then multiplying this by the tick value and the number of contracts.
The tick value of the FTSE 100 future is £5.00 and the tick size is 0.5 index points. Thus, tick
movement equals 100 full index points or 200 half index points.
Ticks x Tick value x No of contracts
200 x £5 x 1 contract = £1,000
Risk = unlimited – because future could rise to infinity. Reward = limited, but large.
Define and explain the salient points of Interest Rate Swaps.
Definition An interest rate swap is the most important OTC (over-the-counter) product.
It is a contract which commits two counterparties to exchange – over an agreed period – two
streams of interest payments, each calculated using a different interest rate index but applied to a
common notional principal amount.
Key Points
Only interest is exchanged in the swap; there is no exchange of principal.
Swaps do not, therefore, impact on the balance sheet, only on the profit and loss account.
They are, therefore, classed as ‘off balance sheet instruments’.
Cash movements that take place at intervals during the swap’s life are normally netted. For
example, in a swap in which one side is paying a fixed rate and the other a floating rate, such
as six-month LIBOR, only the cash difference is exchanged. This reduces credit risks.
The most common type of interest rate swap in which a fixed rate of interest is exchanged for
a floating rate of interest is known as a coupon swap or vanilla swap.
The floating rate is normally measured by an index such as LIBOR.
The market in interest rate swaps is an OTC market. Trading is conducted over the
telephone and price information is disseminated through quote vendor systems such as
Reuters and Telerate.
In interest rate swaps, the floating rate in a coupon swap (the most common) is assumed to
be six-month LIBOR. Therefore negotiation concentrates on the fixed rate, sometimes called
the swap rate.
As with futures and options, there are three basic motivations – speculation, hedging and
arbitrage.
Define and explain each of the following derivative products: covered warrants and
options.
Covered warrants:
Covered warrants are instruments issued by securities houses. These are warrants over the shares
of another company. Technically, a warrant can only be issued by the company itself, given that it
gives the investor the right to buy new shares in the company. The securities house issues a longdated option into the security and this is referred to as the covered warrant. In order to cover its
position, the securities house may own shares in the relevant company, or warrants on the
company’s shares.
This is a relatively new market which emerged in the late - 1980s and has only recently been
introduced on to the London Stock Exchange.
Covered warrants have the following characteristics:
The original company is not the issuer.
The issuer will be a financial institution (e.g. investment bank) which hedges its position in
traded options or the underlying shares.
The issuer bank makes a market in the covered warrants.
Covered warrants have a future expiry date of up to five years and can normally be
exercised at any time up to this date.
Most are ‘call’ types (i.e. giving the investor the right to benefit from price increases) but ‘put’
types (i.e. benefit from price falls) are also available.
Covered warrants are cash settled so stamp duty is not payable on exercise.
Covered put warrants are a useful way to hedge exposure to an underlying share.
Options:
Definition - An option is a contract that confers the right but not the obligation to buy or sell an asset
at a given price on or before a given date.
The right to buy is known as a call option.
The right to sell is known as a put option.
The rights to buy (call) or sell (put) are held by the person buying the option who is known as the
holder.
The person selling an option is known as a writer and is obliged to make (call) or take (put) delivery
on or before the date on which an option comes to the end of its life. This date is known as its expiry
date.
Options can also be differentiated by their exercise style. Most options are known as American style,
which means that the holders can exercise at any time until the expiry date. A less common type of
exercise is the European style exercise. In these types of options, the holder can only exercise on
the expiry date.
The exchange stipulates the type of exercise style in its contract specifications. Most option
contracts traded on Euronext.liffe are American style.
Call writers agree to deliver the asset underlying the contract if called upon to do so.
When option holders take up their rights under the contract, they are said to exercise the contract.
For a call, this means that the writer must deliver the underlying asset for which he will receive the
fixed amount of cash stipulated in the option contract.
Call options:
Thus, for example, for a share call option that gives the holder the right, but not the obligation, to buy
at £6.00, this would mean that the writer would be required to deliver the share to the holder at
£6.00. The option holder will only want to buy at £6.00 when it would be advantageous for him to do
so, i.e. only when the real or market price is somewhat higher than £6.00. If the market price were
lower than £6.00, there would be no sense in paying more than the market price for the asset.
Writers of call options run considerable risks. In return for receiving the option’s premium, they are
committed to delivering the underlying asset at the fixed price.
The price of the asset could, in theory, rise infinitely. Thus, they could be forced to buy the
underlying asset at a high price and to deliver it to the option holder at a much lower value. The price
at which an option contract gives the right to buy (call) or sell (put) is known as the exercise price or
strike price.
Put options:
The dangers for writers of put options are also substantial. The writer of a put is obligated to pay the
exercise price for assets that are delivered to him. Put options are only exercised when it is
advantageous for the holders to do so. This will be when they can use the option to sell their assets
at a higher price than would be otherwise available in the market.
When investors buy or hold options, the risk is limited to the option’s premium. If the market moves
against them, they can simply decide not to exercise their options and sacrifice the premium.
Remember, option holders have the right, but not the obligation to buy (call) or sell (put). If it does
not make sense to buy or sell at the exercise price, the holder can decide to abandon the option.
