W3: forwards, futures, & swaps

• derivatives are tools for changing firm's risk exposure
• participants in derivatives market:

  • hedger
  • arbitrageur
  • speculator
• hedger - a firm that uses derivatives to reduce the risk of its future cash flows
• speculator - derivatives are used with the sole aim to make a profit on the future changes in an asset's value
• arbitrageur - risk-free profit by entering into transactions in two or more markets
• forward contract - agreement to buy or sell an asset at some date in the future at a price agreed today
• unlike an option, parties in forwards, swaps, and futures are obligated to perform under the terms of the contract
• hedgers have a natural exposure to the underlying asset, whereas speculators do not
• future contract positions:

  • long position - buy the asset
  • short position - sell the asset
• forward contract:

  buyer (long position) gain/loss = spot market price - forward price
• forward contract:

  seller (short position) gain/loss = forward price - spot market price
• forwards contracts are only traded over the counter
• disadvantage of forwards:

  • default risk
  • no money is exchange until maturity
• futures contract - exchange-traded, standardised, forward-like contract that is marked to the market daily
• majority of futures contracts do not lead to delivery of the asset because many investors close out their positions prior to delivery
• due to the standardised nature it is difficult to perfectly hedge using futures, unlike the use of forwards
• futures contracts have little counter-party risk
• margin account:

  initial margin - balance in the margin account that must be available to open a futures position
• margin account:

  daily settlement - margin account adjustment to reflect the day's gains or loss
• margin account:

  maintenance margin - minimum amount a futures trader is required to maintain in their margin account to hold a futures position
• swaps contracts - privately negotiated contract that allows one party to exchange cash flows with another party
• margin account:

  variation margin - extra funds deposited to maintain the initial margin level