Derivatives

Financial futures market

Futures contract Future time predetermined price Transaction to sell something Future price Settlement or delivery date

 Commodity futures Financial futures

 Financial futures 1) stock index futures 2) interest rate futures 3) currency futures

 Derivative instrument- derived from the value of another asset

settlement
Nearby futures contract- closest to maturity date Most distant futures contract- farthest settlement 1) offsetting position 2) Wait until settlement date Cash settlement contracts- settlement is in cash only

clearinghouse
Guaranteeing 2 parties will perform Counterparty risk Takes opposite position For early settlement

Margin requirements
Initial margin- required as a deposit (cash, Tbills) Maintenance margin- minimum level an equity position may fall Variation margin- additional margin deposited (cash)

Futures vs forward
Futures Standardized Clearinghouse Not intended for delivery Mark to market Interim cash flow Less counterparty risk

 Long position/ long futures- buy Short position/ short futures- sell

Buy on leverage, for example buy a contract for $5 something that is worth $20

Pricing of futures contract

XYZ = $100 After 3 months, XYZ pays the holder $3 ($12 annual, dividends) Delivery is 3 months from now 3month interest rate is 8% per year.

 If future price is $107 1) Borrow $100 from bank at 8% annual 2) Buy XYZ now for 100$ 3) Receive dividends of $3 4) Pay interest of $2 5) Sell XYZ at $107 6) Pay back $100 loan

+$100-$100+$3-$2+107$-$100= $8 (sure profit)

 sell futures and bid up XYZ now Cash and carry trade- borrowing cash and carrying XYZ to the future

 If future price is $92 1) Buy futures for $92 2) Short XYZ for $100 3) Lend $100 for 3 mos at 8% 4) Pay $3 to holder of XYZ 5) Receive interest of $2 6) Receive the $100 lent 7) Buy the future for $92 8) Cover the short sale 0+$100-$100-$3+2+$100-$92= $7

 If future price is $99 1) Borrow $100 from bank at 8% annual 2) Buy XYZ now for $100 3) Receive dividends of $3 4) Pay interest of $2 5) Sell XYZ at $99 6) Pay back $100 loan

+$100-$100+$3-$2+$99-$100= $0

 If future price is $99 1) Buy futures for $99 2) Short XYZ for $100 3) Lend $100 for 3 mos at 8% 4) Pay $3 to holder of XYZ 5) Receive interest of $2 6) Receive the $100 lent 7) Buy the future for $99 8) Cover the short sale 0+$100-$100-$3+2+$100-$99= $0

So what is the right price?

$99 is the theoretical futures price Given by the formula F=P+P(r-y) F= future price P= price now (100) R=Interest on loan (0.02, or 0.08/4) Y= dividends or other income (0.03)

 (r-y) Difference between cost of financing and cash yield. Net financing cost/ cost of carry/ carry Positive carry- R>Y Negative carry Y>R

Price convergence at delivery date

At delivery date future price must be equal to market price If positive (y>r) future price will sell at a discount (F<P) If negative (r>y) future price will sell at a premium (P>F) Zero (r=y) future price will be equal to cash price (P=F)

Closer look at theoretical price

No interim cash flow due to variation margin Differences in lending and borrowing rate
Ex. Borrowing rate 8% annual Lending rate 6% annual F(upper)= P+P(0.02-y) F(lower)= P+P(0.015-y)

 Proceeds from short selling Transaction cost

Ignored in equation