Lecture 1

Question 1

what is a Derivative?

Answer 1

A financial derivative is an economic contract whose value depends on the value of another underlying instrument.
Possible underlyings: stocks, bonds, commodities, interest rates, etc.

Question 2

who transacts in Derivatives?

Answer 2

Hedgers: The farmer might want to hedge his production of corn, so the farmer will own the actual corn and might be selling it short in the futures market.

The breakfast cereal company needs to buy corn, so they will buy corn futures. They lock up a price on corn for some point in the future.

Speculators: In the corn and cereal company example, they were hedging because they have an economic interest in the business. A speculator might be a person who works as a weatherman at a TV station and feels he’s good at predicting the weather and thinks he knows there will be a dry summer and all corn will die, so ofc if there won’t be enough corn, corn will become valuable so prices will be high, so the speculator might buy corn.

Arbitrageurs

Question 3

How are Derivatives traded?

Answer 3

Exchange Listed Derivatives
- Exchange sets the rules that govern trading and information flows.
- Closely linked to the clearing facilities.
- Centralizes the communication of prices to market participants.
- Well suited to most people.

OTC
- Less formal but well-organized, networks of trading.
- Relationship centered around one or more dealers.
- Costs more

Question 4

Futures Contract

Answer 4

An agreement to buy or sell an asset at a specified time in the future at a specified price.

The buyer of the underlying at that future time and the specified price has a long futures position.

The seller of the underlying at that future time and the specified price has a short futures position.

Futures contract specification:
- Standardised terms are determined by the exchange
- Specified asset quality
- Contract size pre-specified
- Delivery location
- Physical or cash settlement agreed at the outset

Characteristics:
- Standardised
- Less flexible
- Advantages of scale
- Higher volumes
- Lower trading costs

Question 5

Forward Contract

Answer 5

A forward contract is negotiated over-the-counter derivative so it is not exchange listed.

Characteristics:
- More flexible
- More paperwork
- Hard to participate
- Less liquid
- Higher trading costs

Question 6

Arbitrage

Answer 6

A riskless profit from selling an identical asset for a higher price in one venue and buying it for a lower price at another venue instantaneously.

Do Arbitrageurs add value to the market?

Yes, because if you call your broker to buy something, the price the broker will give you has to be the FAIR price simply because if the price was different according to where you are trading and somewhere else, an arbitrageur will come in and get rid of the difference, so hopefully most investors and traders get fair pricing because of the existence of arbitrageurs.

Question 7

Position Limits

Answer 7

Maximum position one investor can amass across different brokers in a futures contract.

Set by the exchange to prevent market manipulation, to prevent someone from taking a huge position in an underlying and trying to drive the price around.

Question 8

Futures daily settlement and margins

Answer 8

Different contracts will have different margins so things that are more volatile will have higher margins and less volatile will have lower margins.

Each day both buyers and sellers adjust
their margin reflecting the profitability
of their position.

The trader who lost money will have to
post more money on margin.

The trader that made money can post
less or even take cash out of the margin
account (subject to an exchange minimum
called maintenance margin)

Margin Types:

Margin Call: If a sufficient margin is not maintained in accounts, the broker will close out positions.

Initial Margin: Minimum account balance before
you are allowed to initiate a derivatives transaction

Maintenance margin: The minimum account value that you must maintain in order to avoid having your position liquidated.

Question 9

Futures Clearing

Answer 9

Clearinghouses are the actual counterparties of exchange-traded derivatives.

They act like insurance providers on trades.

Futures traders neither know nor care who actual counterparties are for their trades.

The clearinghouse guarantees payouts at maturity to all parties

Charge a fee

Hold the margin

Question 10

Mark to Market

Answer 10

A daily calculation where all trading positions are valued at their current market price.
The reason why you mark to model is that you don’t really know the market price.

Question 11

Rolling futures

Answer 11

The process of closing out an existing futures contract position before its expiration date and simultaneously opening a new futures contract position with a later expiration date. This is done to maintain exposure to the underlying asset or commodity without having to take physical delivery or settle the contract in cash

Question 12

How does short selling work?

Answer 12

Short selling a security involves:
believing the security is overpriced.

Finding someone to lend you the security (Traders are charged interest on the stocks borrowed in the short sale) , then immediately sell it to another market participant.

Later when the price of the shares declines, buy the security back & return it to the person you
borrowed it from.

Once the short sale is complete, the trader returns the borrowed shares to the broker who collects fees and any interest. And the trader gets to keep any profit from the transaction.

Question 13

convergence of futures to spot

Answer 13

Over time, the price of the futures and the price of the underlying become equal at the end,
what’s causing that is the interest rate for shorter and shorter periods of time is less money so eventually the futures and the spot are the same, and the prices r the same.

Question 14

Value of futures contract

Answer 14

Prior to maturity, at inception = 0

midstream = difference between the spot price and the futures price
f = S0 - Ke^-rT

Question 15

Convenience Yield

Answer 15

Users of a consumption asset may
obtain a benefit from physically
holding the asset as which is not
obtained from holding the futures
contract.
The additional amount that you are paying to get the thing right now rather than at some point in the future is called the convenience yield

Question 16

Why should companies hedge their exposure?

Answer 16

Most companies produce goods or provide services and may not have particular skills in predicting market prices: things like interest rate, exchange rate, commodity prices, and so on.
If these prices are important drivers of the company’s costs then it makes sense to hedge those exposures just to reduce business uncertainty so that the company can focus on being the best they can at their core expertise of manufacturing goods or services.

The real argument for a company doing at least some hedging is that it allows them to have some visibility to future prices and that allows them to make long-term business plans.

Investors can protect themselves from excess exposures to economic variables either by holding a diversified portfolio or by hedging the exposures themselves.

Question 17

Hedging using futures

Answer 17

short futures hedges are used when a company owns the asset already and expects to sell it in the future.

long futures hedges are used when a company knows it will have to purchase the asset in the future.

Question 18

Cross Hedging

Answer 18

To hedge against price movements in an asset using a different but related financial instrument.

It involves taking a position in a derivative instrument, such as futures or options, that is based on an asset that is not identical to the asset being hedged.

Question 19

Contango & Backwardation

Answer 19

Backwardation = when Futures price < E(S)

when the futures price is less than the spot price is referred to as normal backwardation

Normal backwardation implies that futures prices for certain maturity are increasing over time

Contango = when Futures price > E(S)

Contango where the futures price is higher than the expected spot price. This is often due to the cost of storing and insuring the underlying commodity.

Contango is a condition in which the distant delivery prices for futures exceed spot prices.

Contango implies that futures prices for certain maturity are falling over time.

In a contango situation, hedgers are “willing to pay more now for a commodity at some point in the future than the actual expected price of the commodity at that future point.

This may be due to people’s desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today.