Forward and Futures (8) Flashcards
What is a derivative?
A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security). Underlying assets can include: Stocks Currencies Interest rates
There are 5 types of derartives but what will be focusing on?
Forwards and futures
Options ( European and American call and put options)
John owns a bicycle factory, to produce a new line of bicycles he needs 5 tonnes of steal a year, Harry manufacturers steel, what can he do with John? Why not just buy steel when John needs it ?
He can agree to sell John 5 tonnes of steel at a certain price at a predetermined date and or future, thus make a contract( derivative) with steal being the underlying asset .
John could think what would happen if the price of steel sky rockets, I will lose money. Harry thinks what if the price falls, I will lose money. So entering a contract manages risk of market fluctuations.
What is a Forward/future contract?
The obligation to buy/sell the underlying asset at a pre-specified price and on a pre-specified date.
What is a call option? What is an American and European call option.
The right not the obligation to buy the underlying asset for a pre-specified price and on (or before) a pre-specified date.
A European option may be exercised only at the expiration date of the option, i.e. at a single pre-defined point in time.
An American option on the other hand may be exercised at any time before the expiration date.
What is put option and what is a European/American put option?
The right not the obligation to sell the underlying asset for a pre-specified price and on (or before) a pre-specified date.
A European option may be exercised only at the expiration date of the option, i.e. at a single pre-defined point in time.
An American option on the other hand may be exercised at any time before the expiration date.
What is an Over-the-counter (OTC) market?
An Over-the-counter (OTC) market is a decentralized financial market where trading occurs directly between parties without the involvement of a centralized exchange. It provides a platform for the trading of various financial instruments, including forwards.
What is an Exchange-traded market?
A market where trades are in standardised contracts that have been defined by the exchange.
For example the Chicago Board Options Exchange (CBOE).
Futures usually traded here.
What are 3 main uses of Derivatives?
Hedging (removes risk due to market volatility
Speculation( making bets): making bets on what you think where the underlying asset going to go. You can make a lot of money, but also lose money.
Create arbitrage portfolios:( deratives are based on pricing underlying asset, so create a portfolio of deratives, which have same cash flows in future, and if they do not have same price today, can make risk free arbitrage profit.
What is the main similarities and differences between forward and future contracts ?
Forwards: They are bilaterally agreed contracts and are not exchange traded. Thus they are often described as ‘over the counter’ or OTC.
A futures contract is the same as a forward contract, except that it is typically standardized (not tailor made and traded on an exchange where gains and losses are settled daily (marked to market). Therefore less default risk with a future in comparison to a forward.( e.g. if the price of steel is too high for John, he may default.
Buy 1000 barrels of crude oil at $45.89/barrel on September 20, 2020.
Sell 15000 lbs of orange juice at 182.35 cents/lb on November 9, 2020.
What are these both examples of?
Forward contracts ( obligations to pay )
Does cash exchange hands today with forward and future contracts?
No they do not at t=0, they just agree a price and date.
What position does an individual have who is contracted to purchase the asset and what position is the individual selling the asset have?
The individual contracted to purchase the asset is said to have a long position in the forward while the individual selling the asset has a short position.
What is the payoff at maturity for a long forward when does he make a profit and when does he make a loss?
where ST is the market price of the underlying asset at the maturity date, T
If the market price exceeds the specified asset price F0,t, then the person longing the forward has made a profit.
If at maturity the market price is lower than the forward price than he makes a loss.
What is the payoff at maturity for a short forward?
If the Forward price agreed at Maturity is more than market value then i will make a profit, equal to the difference ( you are selling the asset more than what its worth)
If the Forward price agreed at Maturity is less than market value then i will make a loss equal to the difference ( you are selling the asset less than what its worth)
To supply 5000 bushels of wheat, 6 months from today (i.e. on harvest), at a
price of £4.50 per bushel (i.e. for a total consideration of 5000 X £4.5 = £22,500).
On the delivery date, if the market price of wheat turns out to be:
£3.50 and 4.75?
£3.50. The farmer makes a gain, relative to the market price, of £1.00 per
bushel, or 5000 X £1 = £5000 in total.
£4.75. The farmer makes a loss relative to the market price of £0.25 per
bushel, or 5000 X £0.25 = £1250 in total.
But regardless of what happens in the market, the farmer’s revenue is given. He
will receive £22,500. He has eliminated any uncertainty about this.
Are the total payoffs to long and short sides of a futures contract exactly the same as for a forward?
The total payoffs to long and short sides of a futures contract are exactly as for the forward,
However, money is exchanged over the lifetime of the contract rather than in one lump on the delivery date.
(FUTURE CONTRACT) What is a margin account?
A margin account for futures contracts is an account where traders deposit funds as collateral to cover potential losses on their open futures positions. It ensures financial obligations are met and minimizes counterparty risk in futures trading.
Explain this
Weekly change = change Future prices x 100
in the margin balance if it falls below 1000, tou need to top up balance to initial margin.
We will ignore the differences in the timing of cash flows between futures and
forwards and treat forwards and futures as being identical.
What are these notations equal to?
We are going to look at look at pricing forwards on invesment assets with no income( so the stock doesn’t pay any income between time 0( when you entet contract) to maturity). So we know if we can get 2 portfolios with the exact same payoff in the future they must have the same price, if not you can make arbitrage profit, so lets say we have 2 portfolios what is the cash flows at t = 0 and at maturity t = T. ( ATTACHED IS A REPLICATING PORTFOLIO)
As you can see this replicating portfolio has the same cash flows at maturity so we can. solve for price today when the asset pays no income.
As you can see this is a replicating portfolio of portfolio 1, hence, we can solve for the price of the forward contract today. Solve this. ( FORMULA NEED TO LEARN)
We know the law of arbitrage holds here , so we can equate, the 2 payoffs today and solve for F0,T.
What is a potential different replicating portfolio we could make which give the same payoff to find the forward price ? ( NOTICE THAT REPLCIATING PORFOLIO DONT INVOLVE SHORTING ANYTHING)
What happens if the forward price in the market is £108. what do you do?
THERE COULD POSSIBLY BE 2 WAYS DO WHAT YOU LIKE)
Short the forward in the market long the replicating portfolio,
We are going to look at Pricing Forwards on Investment Assets with Fixed Cash Income ( we know know what dividends are going to be, Show the payoffs of this replicating portfolio
When we buy asset the payoff in the future is that we own the stock today + FV of income ( we assume the stock pays dividends and reinvest at the risk free rate)
By no arbitrage arguments the cash flows at t=0 associated with constructing
portfolios 1 and 2 must be the same so what is the price of the forward on investment assets with fixed cash income?
BIG BIG NOTE : I is the present value of the fixed unknown future dividend.
A 6 month forward contract on a security that pays a dividend of £2 in 5 months should have what price in the market? The underlying security is currently priced at £25 and the risk free EAR is 10%
F0,0.5 = ( £25 - I(1.10)/2
So we have a market price of £24.17, now show the replicating portfolio which have the same payoff?
Pricing Forwards on Investment Assets with Investment Yield(e.g. dividend yield financial ratio that shows how much a company pays out in dividends each year relative to its stock price.) What is the forumla for working out the price of forward?
We going to Price Forwards on Investment Commodities with Fixed Storage Costs
What is the payoff’s of the 2 portfolios?
By no arbitrage arguments the cash flows at t=0 associated with constructing
portfolios 1 and 2 must be the same: What must be the formula for the price of forwards on investment commodities with fixed storage costs?
Pricing Forwards on Consumption Commodities with Net Convenience Yield
Net convenience yield is the value of having an inventory minus storage cost
of the inventory (NCY = (y – s) where y is the convenience yield and s is the
storage cost as a rate).
What do we denote here as home currency and foreign currency and what does this say? what are we going to assume?
Home currency = GBP ( numerator )
Foreign currency = USD ( deniomator)
You can excange £0.75 for $1.
ASSUMING NO TRANSCATION COSTS.
What is the formula of pricing forwards on Foreign currency?
the forward rate is equal to the spot rate x (1 + domestic interest rate) / (1 + foreign interest rate).
The exchange rate means i can exchange £0.792157 for 1 euro. Remember that its to the power of 1 because its EAR.
HARD ( we want to confirm why this is the exact forward rate in the question.),so firstly what i want you do do is rearrange the first formula so we have 2 strategies. So we just have 1 + r home currency on the left and everything else on the right.
(HARDDD)At t=0 if we invest £1 in each strategy, explain how the 2 strategies will have the same cash flows at t =1 ?
Show that these 2 strategies give the same payoff at t=0 and t=1.
