Financial Market

Derivatives Market – Forward & Futures

BUYER

SELLER

Participans:

The deal:

For a specific period of time

BUYER

will have an

OBLIGATION to buy

some

underling security for a price specified today.

Forward

’s features:

gives an obligation to buy (buyer

–

long position

) or to sell

(seller

–

short position

) of a particular security at price specified in contract.

WRITER

has an

OBLIGATION to deliver

the underlying security.

Strike (Exercise price) (K) = price at which the underlying transaction will occur upon exercise.

Expiration date / Settlement date (Maturity) (T) = the day when the forward expiry.

Multiplier (N) = the quantity of the underlying asset.

Underlying security = what security is going to be traded.

FORWARD CONTRACT

=

Financial Market

Derivatives Market - Forward

Today

Maturity

Buyer

and

seller

specify a

contract details.

Buyer

must buy,

Seller

must sell

underlying security at priced specified before.

Example 1:

A is signing a contract with B specifying that in December he will buy 10 Christmas trees
paying 100$ per tree.

Today

December

A

commits to buy 10 Christmas

trees from

B

in December.

A must

buy 10 Christmas trees.

B must

sell 10 Christmas trees.

Financial Market

Derivatives Market - Forward

Data from example 1:

What the

buyer

is about to do at maturity ?

Underlying security = Christmas Tree

N = 10

T = December

K = 100$

Let’s assume that Christmas tree price in December is going to be:

a) S

T

= 150$

b) S

T

= 120$

e) S

T

= 100$

c) S

T

= 80$

d) S

T

= 50$

Even thought the current Christmas tree price is higher, the

buyer will buy

it

for 100$

. His profit will be equal to

a) 50$

or

b) 20$ per tree

if he will sell the Christmas tree at the market immediately.

Totally he will

earn

to

a) 500$

or

b) 200$

.

Even thought the current Christmas tree price is lower, the

buyer will have to

buy

it

for 100$

. He will

lose c) 20$

or

d) 50$ per tree

if he will sell the

Christmas tree at the market immediately. Totally he will

lose c) 200$

or

d) 500$

.

Buyer won’t make any profit or loss.

Financial Market

Derivatives Market - Forward

Forward

’s

buyer

profit function:

K

0

S

T

Profit

In general:

100$

0

S

T

Profit

Data from example 1 (K = 100$, N = 10):

150$

200$

50$

500$

1000$

S

T

– K

Profit function for a

buyer

of a forward =

- 500$

Financial Market

Derivatives Market - Forward

Data from example 1:

What the

seller

is about to do at maturity ?

Underlying security = Christmas tree

N = 10

T = December

K = 100$

Let’s assume that Christmas tree price after T is going to be:

a) S

T

= 150$

b) S

T

= 120$

e) S

T

= 100$

c) S

T

= 80$

d) S

T

= 50$

Even thought the current Christmas tree price is higher, the

seller must sell

it

for

100$

. If the seller doesn

’t own 10 Christmas trees, he needs to buy them from the

market and then sell it to the forward

’s buyer. He will

lose a) 50$

or

b) 20$

per

tree. Totally seller will

lose a) 500$

or

b) 200$.

Even thought the current Christmas tree price is lower, the

seller will sell

it

for

100$

. If the seller doesn

’t own 10 Christmas trees, he needs to buy them from the

market and then sell it to the forward

’s buyer. He will

gain c) 20$

or

d) 50$

per

tree. Totally seller will

gain a) 500$

or

b) 200$.

Seller

won’t make any profit or loss.

Financial Market

Derivatives Market - Forward

K

0

S

T

100$

0

S

T

150$

200$

50$

500$

1000$

K

– S

T

80$

200$

Profit

In general:

Profit

Data from example 1 (K = 100$, N = 10):

Forward

’s

seller

profit function:

Profit function for a

seller

of a forward =

500$

Financial Market

Derivatives Market - Forward

Long vs Short position:

0

S

T

$

K

Financial Market

Derivatives Market - Forward

Futures contract = standardized forward contract.

BUYER

SELLER

Setting contract specification

specifies Futures parameters:

Underlying securities

Quantity

Settlement date

Takes deafault risk

Clears transaction

Financial Market

Derivatives Market - Futures

Indices:

WIG20:

FW20xx

Stocks:

TPSA:

FTPSxx

PKN :

FPKNxx

Currencies:

Euro:

FEURxx

USD:

FUSDxx

F

W20

Z

12

Futures

Underlying instrument sybmol

Maturity:

Month

,

Year

F: January
G: February
H: March

J: April
K: Mai
M: June

V: October
X: November
Z: December

N: July
Q: August
U: September

Examples:

Financial Market

Derivatives Market - Futures

Warsaw Stock Exchange (Friday, 26 XI 2010)

Multiplier: 10

Multiplier: 10 000

Multiplier: 100

Financial Market

Derivatives Market - Futures

Financial Market

Derivatives Market - Backwardation

Backwardation

(normal futures yield)

Financial Market

Derivatives Market - Contango

Contango

(inverted futures yield)

Financial Market

Derivatives Market - Backwardation & Contango

From Backwardation to Contango

Financial Market

Derivatives Market - Backwardation & Contango

How clearing companies maintain the default risk ??

1. Both sides must provide

Initial Margin

SELLER

BUYER

Buyer’s Account

Seller’s Account

Let’s assume TVN stock market price is 9 zł.

FTVNZ13 price is 10

zł (N = 100). Initial margin for TVN stock futures contracts is 15,00%.

Futures price * multiplier * initial margin level * number of contracts =

Initial margin =

= 10 * 100 * 15,00% * 1 = 150

zł

150

zł

150

zł

Financial Market

Derivatives Market - Futures

2. Daily Profit/Loss has to be

paid in cash

by participants (

from Initial Margin

)

When the underlying security price changes rapidly,

initial margin might be not enough to prevent default risk:

SELLER

BUYER

Buyer’s Account

Seller’s Account

Let’s assume that the price of FTVNZ13 raises from 10.00 zł to 10.50 zł at closing.

150

zł

150

zł

50

zł

25

zł

275

zł

The next day FTVNZ13 futures price raises from 10.50

zł to 11.25 zł.

75

zł

100

zł

200

zł

If the price of FTVNZ13 will continue to raise, seller

won’t be able to pay the buyer.

Financial Market

Derivatives Market - Futures

Futures price * multiplier * maintenance margin level * number of contracts =

Maintenance margin =

= 10 * 100 * 10,00% * 1 =

100

zł

Because the futures price can change rapidly until maturity,

clearing companies came up with idea of

maintenance margin

.

Maintenance margin

is just the amount of money, our account cannot go below.

If it will, we are required to refill our account

to the level of initial margin

.

Let’s assume TVN stock market price is 9 zł.

FTVNZ13 price is 10

zł (N = 100).

Initial margin

for TVN stock futures contracts is

15,00%

,

maintenance margin

is

10,00%

.

Initial margin =

10 * 100 * 15,00% * 1 =

150

zł

Financial Market

Derivatives Market - Futures

SELLER

BUYER

Buyer’s Account

Seller’s Account

25

0 zł

150

zł

1. FW20Z11 = 10

zł,

Margins: Initial: 15,00%, Maintenance: 10,00%

2. FW20Z11 = 11

zł,

100 zł

5

0 zł

150

zł

Seller account is below maintenance margin (50

zł < 110 zł).

11

5 zł

16

5 zł

3. FW20Z11 = 11.30

zł,

3

0 zł

135

zł

280

zł

Margins:

Initial: 150

zł,

Maintenance: 100

zł

Margins:

Initial: 165

zł,

Maintenance: 110

zł

It needs to be refill to initial margin level (165

zł).

Maintenance: 113

zł

Margins:

Financial Market

Derivatives Market - Futures

Market

Exchange

OTC

Standardization

Standardized

Negotiable

Risk

Taken by clearinghouse

Default risk

Settlement

Marking to market

At delivery

Initial margin

Yes

No

FUTURES

FORWARD

Financial Market

Derivatives Market – Forward vs Futures