Derivative

• Futures contracts


  • Standardised contracts traded through a formal exchange
  • Facilitate the management of risk exposures associated with commodities and financial assets
• Futures contract


  An agreement between two parties to buy or sell a specified commodity or financial instrument at a specified date in the future at a price determined today
• Types of futures contracts

  • Commodity (e.g. gold, wheat and cattle)
  • Financial (e.g. shares, government securities and money market instruments)
• Futures market participants

  • Hedgers
  • Speculators
  • Arbitragers
• Hedgers


  • Have an interest in the underlying commodity or asset
  • Attempt to reduce the price risk from exposure to changes in interest rates, exchange rates and share prices
  • Take the opposite position to the underlying, exposed transaction
• Speculators


  • Expose themselves to risk in an attempt to make profit
  • Accepting risk that hedgers need to lay off
  • Enter the market with the expectation that the market price will move in a direction favourable for them
• Arbitragers


  • Attempt to make profit without taking any risk
  • Involves trading in markets which are out of alignment - buy cheap in one and sell expensive in the other (ie. riskless profit)
• Hedging using futures


  1. Hedging the cost of funds (borrowing hedge)

  2. Hedging the value of a share portfolio

  3. Hedging the yield on funds (investment hedge)

  4. Hedging a foreign currency transaction
• Pricing of financial futures

  • All bids are quoted as (100 minus yield)
  • The price is really the face value discounted at the quoted yield
• Conceptualisation of a futures contract risk management strategy

  Spot market position + Futures market position = Hedged position
• Hedging the cost of funds (borrowing hedge)

  1. Enter into a futures contract to sell

  2. If interest rates rise, the futures contract will rise in value, offsetting the loss in the physical market from the rise in interest rates

  3. If interest rates fall, the futures contract will fall in value, offsetting the gain in the physical market from a fall in interest rates
• Hedging the value of a share portfolio

  1. Enter into a futures contract to sell

  2. If the market falls, the loss in the portfolio is offset by the gain in the futures market

  3. If the market rises, the gain in the portfolio is offset by the loss in the futures market
• Risks of using the futures markets for hedging

  • Standard contract size
  • Margin risk
  • Basis risk
  • Cross-commodity hedging
• Forward contracts


  • Over-the-counter risk management products
  • More flexible than futures contracts as the terms and conditions are tailored to suit the parties involved
• Forward Rate Agreements (FRAs)

  • An over-the-counter product enabling the management of an interest rate risk exposure
  • An agreement between two parties on an interest rate level that will apply at a specified future date
  • Allows the lender and borrower to lock in interest rates
  • No exchange of principal occurs, only payment of the difference between the agreed interest rate and the actual interest rate at settlement
• FRA Structure Timeline (2Mv5M)

  2 months from now for 5 months
• Forward Foreign Exchange Contracts

  • Over-the-counter product used to manage foreign exchange risk exposures
  • A contractual agreement between two parties to lock in an agreed future exchange rate for a specified currency
• What are the different types of risk?

  Equity risk, interest rate risk, currency risk, commodity risk, credit risk, liquidity risk, operational risk, regulatory risk, political risk, environmental risk, economic risk, technology risk.
• Hedging is when one takes a position in a financial instrument with the intention of offsetting or reducing the impact of another position held by the investor.
• Speculation is when one takes a position in a financial instrument with the expectation of making a profit based on market movements.
• Arbitrageurs take advantage of price differences across markets to make profits without taking any risks.
• The arbitrageur's goal is to buy low and sell high simultaneously in multiple markets.
• Arbitrageurs take advantage of price discrepancies across markets to make profits without taking any risks.
• If there is no arbitrage opportunity available, it means that all prices are fair and efficient.
• Investors can use derivatives as hedges against their existing positions.
• Investors can use futures contracts as a hedge against their current positions.
• Derivatives allow investors to speculate on future events.
• A call option gives its holder the right but not the obligation to purchase an underlying asset at a specified price (strike price) within a certain time period (expiration date).
• Futures contracts allow investors to lock in the future value of an asset at today's price.
• A long call option gives the holder the right but not the obligation to purchase an underlying asset at a specified price (strike price) by a certain date (expiration).
• What is hedging?


  Risk management strategy.
• what is a zero sum game?

  A zero-sum game in investing is a situation where one investor's gain is exactly balanced by another investor's loss. The total wealth in the system remains unchanged; it is merely redistributed among participants.
• How are futures traded?

  Exchange traded
• What are the 3 important factors of a futures contract?

  Price, expiration date, underlying asset
• What do futures contracts specify?

  Buy or sell, type of contract, delivery month (expiration), price restrictions (limit order) and time limits.
• What is the role of the clearing house?

  Administers deposits and margin calls, registering and clearing contracts.
• What are the margin requirements?

  Both the buyer and seller pay an initial margin, held by the clearing house rather than the full price of the contract.
• What is marking to market?

  Repricing of the contract daily to reflect current market valuations.
• What is a contract multiplier?

  A factor used to determine the total value of a futures contract or options contract. It specifies the quantity of the underlying asset that is represented in a single contract.
• What is a maintenance margin?

  Minimum amount of equity that must be maintained in a margin account. Subsequent margin calls may be made, requiring a contract holder to pay the maintenance margin to top up the initial margin to cover adverse price movements.