This document gives you a summary of the entire course project: financial instruments. It covers all the information as it is given week-by-week. All the terms you need to know are in bold, so you do not need to look for something you cannot find. Furthermore this document contains the answers to t...
Summary of the book Fundamentals of Futures and Options
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Radboud Universiteit Nijmegen (RU)
Economie en bedrijsfeconomie
Project: Financial Instruments
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PFI summary
This document will cover both the content covered in the book week by week, as given in
the in the course manual, and the assignments. These assignments are given after the
weeks.
,Week 1: Futures
Chapter 1: Introduction
A futures contract is an agreement to buy/sell an asset at a certain time in the future for a
certain price. Futures contracts allow people who want to buy/sell assets in the future to
trade with each other.
Long (futures) position: you agree to BUY the underlying asset in the future
Short (futures) position: you agree to SELL the underlying asset in the future
up until maturity, the asset is still yours
if you have a short, somebody else has a long
The price of a future is the futures price, and is the price for which you agree to buy/sell the
asset in the future.
determined by supply and demand
The spot price is the contrast of a futures price: it is the price that needs to be paid/received
in current day purchases.
The over the counter market or OTC is where many trades take place. This differs with
exchange-traded markets. Participants in OTC have contacted each other directly or found
counterparties for their trades.
Banks often act as the middle man to OTC markets, offering a bid price and an offer price,
which is at such a level so they will always take either the long or short position respectively.
Forward contracts are similar to futures contract, but they are traded at the OTC market.
Futures contracts, on the other hand, are traded on the exchange-traded market. Forwards
are popular on foreign exchange markets.
Options are different to forwards and futures. They give you the right, but not the obligation
to perform the action you buy the option for. There are two different types of options: call
options, in which you have the right to buy, and put options, in which you have the right to
sell. Since you have no obligation to perform the action you buy the option for, options have
a limited loss potential. Options are traded on both the exchanges-traded and the OTC
market. We’ll cover options into more detail later.
There are three different types of traders to be identified:
Hedgers use futures, forwards and options to reduce the risk that they face from potential
future movement in a market variable.
- you can use futures/forwards contract if you know you need to pay a certain amount in the
,future. You can accept a long futures that corresponds to the same value of the lending.
- you can use options if you are unsure what assets will do in the future: by buying both
assets and a put option, you can sell the assets for a certain value if their value drops below
the original price, and you make a profit if the asset increases in value.
Speculators use futures, forwards and options to bet on the future direction of a market
variable: will prices go up or down?
- futures/forwards can be used to lock in a certain price. You can short a futures if you think
prices go down, you can long a futures if you think prices go up.
- options can also be used. You can buy a call option if you think prices go up (so that P c < PM)
and buy a put option if you think prices go down (so that Pp > PM)
Arbitrageurs take offsetting positions in 2(+) instruments to lock in a guaranteed profit.
- only sometimes possible, effective market assumes there are no arbitrage opportunities.
- when stock price is higher in one country than in another, you can buy them in the other
country and sell in the one country to make profits without risk.
Chapter 2: Mechanics of Futures markets
a contract needs to specify the asset, contract size (how much of the asset will be delivered
under one contract), where and when delivery will be made.
As the delivery period/maturity for a future is approached, the futures price converges to
the spot price. At maturity, the two prices are even equal.
The Margin account is a measure of security in futures and forwards. There is risk because
one party of the bargain might not keep themselves to the deal, or just doesn’t have the
funding at the end.
The broker will require an investor to deposit funds in a margin account. At the start of the
futures, this initial amount is the initial margin. At the end of each trading day, the margin
account adjusted to reflect the investors gain or loss. This practice is referred to as daily
settlement.
When you make a loss on the underlying asset, this is reflected by a decreasing margin
account. When prices drop too far, a maintenance margin or is activated, forcing you to put
more money into the margin account. The amount of money that needs to be put in extra is
the margin call.
Forward contracts do not have daily settlements. Therefore they also don’t have
maintenance margins.
, Short hedge: hedge that involves a short position in a futures contract.
you already own an asset and expect to sell it some time in the future.
when prices of the asset increase, you make a profit with the asset. However, when prices
decrease you make a loss, and you want to cover for that loss.
to compensate, you short a futures contract. When prices of the asset go up, the asset is
worth more but you sell for the futures price, causing a loss. When prices of the asset go
down, the asset is wort less but you sell for the futures price, causing a profit.
Oil producer wants to sell 1 million barrels of oil, against the price of the market three
months from now.
if prices go up in those three months, that’s extra profit, if they go down it’s a loss.
Spot price on may 15 is $80, and futures price for august 15 is $79.
if company shorts 1000 futures, company is hedged.
on august 15, prices turn out to be $75.
company sells the oil for $75 a barrel, and makes profit of the short futures of $4 per
barrel. total sales come down to $79 per barrel, equals futures price hedged.
However, if prices would have increased to $85, he would have $85 per barrel profit, but a
$6 loss per barrel, also resulting in $79 per barrel.
This is possible because he closes out the deal.
Long hedge: hedge that involves taking a long position in a futures contract.
appropriate when you know you will have to purchase a certain asset in the future and
want to lock the price now.
A company needs 100,000 pounds of copper on may 15. Futures price for May delivery is
320 cents per pound. Each futures contract has a contract size of 25,000.
Say that price on may 15 turns out to be 325 per pound.
you locked in for 320, so 5 cents per pound profit.
total costs are 320 per pound.
Now lets assume market prices to be 305 on may 15. You make a loss of (320 – 305) = 15
cents per pound on the future, but pay 305 for the copper, also resulting in total costs of
320.
the way this works is through closing out the futures contract. This is possible through
placing an order the other way.
Hedging might take risk away, but it also loses you a lot of potential profit. You will only gain
the risk-free rate but none of the risk premium.
Cross-hedging you don’t take a futures contract that underlies the same asset as the one
you are trying to hedge. This happens when the futures of the asset you want to hedge are
not actively being traded.
Hedge ratio is the ratio of the size of the position taken in futures contract, compared to the
size of the exposure. When the asset underlying a future is the same as the asset being
hedged, you use a hedge ratio of one.
When cross hedging is used, a hedge ratio of 1 is not always optimal. Hedger should choose
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