Futures & Forward Contracts Flashcards
Stock Price
value/price of stock at some point in time t
Spot Price
Price at present time (t=0)
Market Price
Price at maturity (t=T) - spot price for immediate deliver
Zero Coupon Bond
earns interest at zero risk-free rate
Law of one Price
Under no arbitrage assumption, two replicating Portfolio (with exact same future Cashflow) have to have the same initial value (same price at t=0)
Derivative
simplest financial instrument between 2 parties whose value depend on the value of one/more assets (underlying asset)
Derivative are used to manage risk (compared to other financial instruments)
You can either decrease risk (hedging) or increase risk (speculating)
Forward Contract
Agreement between 2 parties traded over the counter and not standarised
One party promises to sell a certain asset, for a specified price (forward price -settled at t=0) at certain time T (maturity) and the other party promises to buy the asset and pay the Price F
Price (F) doesn´t depend on how spot price will move in future or on model for underlying stock price
Value of the contract
0 - since both parties agree on settlement price (F) such that it is costless to enter the contract and no money transactions take place until maturity T
Replicating Portfolios
long position of FC and Zero Coupon Bonds
short position on FC and borrow money to invest in the asset at the start
at maturity pay-offs cancel out and you can derive the relevant formula for F (respectively) at t=0
Future Contract
contract allowing trader to buy/sell commodity or financial asset or cash (sugar, wool, interest, currencies)
Specified conditions (standarised and via an exchange market (e.g CME)
2 parties don´t have to know each other (exchange provides mechanism that gives the party guarantee that contract will be honored)
Similar to FC but with the introduction of a margin account to mitigate credit risk
Same as futures: can be used for speculating with actually no needing to sell/buy underlying asset but by just reversing position before last trading day
No money transaction at the start
Valuation of Future Contracts
complication –> “marking to the market” feature
money takes place at daily basis - sequence of CF associated with movement of future prices has to be evaluated to value of contract
Special case: constant interest rate than both contracts are identical and PV of total intermediary CF is 0
Forward/Future
- Non-Standarised/ Standarised
- traded over-the counter/ traded on market exchange
- one specify delivery date / various delivery dates
- settled at end of contract/ settled daily (adjustments)
- delivery or final cash settlement usually takes place/ contract is usually closed out prior to maturity
- some credit risk/ hardly any credit risk
Operation of Margin
margin account - adjusted daily to reflect capital gain/loss where each party deposits funds in their account
initial margin - original money deposit
minimum level of margin - maintenance level before one can make “margin call”
Margin Call
deliver funds immediately (to bring it back to initial margin)
If fail to do so - the other party is allowed to liquidate you position immediately to makeup for any losses it may have incurr in you behalf
Remember - you add the difference (needed to bring it back to inital margin) plus the gain/loss of this day
Cross- Hedging
Own asset
Own S and want to sell it –> short- position on N of S* (buy S, sell S for F>S* and sell S for lower price)
FRA
Forward Rate Agreement between 2 parties to lend/buy a principal L for a fixed Rate (Rk) between T1 & T2
Rk (fixed) and Rf (floating future rate - according to market (LIBOR)) are both compounded T2-T1 per year
RM - actual forward rate at maturity( i.e actual Market Price)
Note: Value of FRA doesn´t have to be 0 (only if Rk = Rf - fair market rate)
Eurodollar
agreement (FC) on 3-months- IR applied in future period (T; T + 3 months) applied in future period, and L= nominal amount of 1 mill. $ and spec. delivery months (M,J,S,D)
NOTE - interest (value) is already known at maturity, however you will receive it at (t+3m)
Gain/loss = difference in IR or PRICE (index)
Gain/Loss = money at maturity - money at 0 - margin calls
Hedging/Speculating
Reverse position - thus you actually only exchange interest rates
Difference between actual LIBOR - rate at maturity and FORWARD rate agreed at the start
But in case you need to actually borrow money at T - use ED to just pay the FR (as LIBOR cancells out with the actual Rate apply for the loan at T (= LIBOR))
Currency - Trading
Loan borrow at the start has to cancel ou
Long-position (borrow foreign and change to domestic)
Short-position (start with domestic to exchange to foreig which you going to deliver but only has to repay loan on domestic currency)
SWAPS
Agreement between 2 parties agree to swap one or several payments (CF) in the future. Generally the future value of an interest rate or of a foreign exchange rate
several future dates of exchange of C.F
Sum of several FRA (take difference between Rk and each RF at that Time ti)
Currency Swaps: use FC to find out foreign price (So) which equates to the swap price (domestic) needed
Short-Selling
“borrowing”a stock and selling it immediately and giving it back (by buying the stock again)
Thus you make a profit by selling a asset (you don´t own) for a higher price and buying it for a lower.
Short-selling FC
Short-Sell the asset for So and buy ZCB with FV = So*ert
Receive Soert and pay F (profit is Soert - F > 0 and give back asset (one you got from FC)
Cross- Hedging
Short-Selling
Short-sell asset & long-position on N of S*
buy S* for F and sell imm. with S* > F, and buy S> St
