Chapter 1-Fundamentals of Futures and Options Markets

IntroductionDerivatives

The Nature of Derivatives

A derivative is an instrument whose value depends on the values of other more basic underlying variables

Examples of Derivatives

Futures Contracts Forward Contracts Swaps Options

Ways Derivatives are Used

To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another4

Futures Contracts

A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)

Exchanges Trading Futures

CBOT (Chicago Board of Trade)

established in 1848, the world's oldest futures and options exchangehas the largest options and futures contracts open interest (number of contracts outstanding) in the world.

CME (Chicago Mercantile Exchange )

CME GROUP (MERGE OF CBOT AND CME) Intercontinental Exchange

(Known for energy and commodities trading)

EUREX (a leading derivatives exchanges in the world) and many more6

Futures Price

The futures prices for a particular contract is the price at which you agree to buy or sell It is determined by supply and demand in the same way as a spot price

Electronic Trading

Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers

Examples of Futures ContractsAgreement to: buy 100 oz. of gold @ US$1050/oz. in December sell £62,500 @ 1.5500 US$/£ in March sell 1,000 bbl. of oil @ US$75/bbl. in April9

Terminology

The party that has agreed to buy has a long position The party that has agreed to sell has a short position

Example

January: an investor enters into a long futures contract to buy 100 oz of gold @ $1050 in AprilApril: the price of gold $1065 per oz What is the investor’s profit?11

Over-the-Counter Markets

The over-the counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers12

Size of OTC and Exchange Markets

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market 13

Forward Contracts

Forward contracts are similar to futures except that they trade in the over-thecounter market Forward contracts are popular on currencies and interest rates

Foreign Exchange Quotes

for USD/GBP exchange rate on July 17, 2009Spot Bid 1.6382 Offer 1.6386

1-month forward3-month forward 6-month forward

1.63801.6378 1.6376

1.63851.6384 1.638315

OptionsA call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)