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Project Financial Instruments Summary
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Summary of the course Project; Financial Instruments of the second year of Economics and Business Economics at Radboud University
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Project Financial Instruments – SummaryChapter 1; introduction
Derivatives;
- Exchange market;
o Futures contracts; an agreement to buy or sell an asset at a certain time in the future for a certain
price.
They allow people who want to buy or sell assets in the future to trade with each other at
the futures price; the price for delivery at some time in the future.
The Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and merchants
together. The CBOT developed futures contracts on many different underlying assets. Later
in 1919, the Chicago Mercantile Exchange (CME) reorganized futures trading and in 1972
they started futures trading in foreign currencies.
Open-outcry system; traders physically meeting on the floor of the exchange
(trading pit) and using a complicated set of hand signals to indicate the trades they
would like to carry out.
Electronic trading; traders entering their required trades at a keyboard and a
computer being used to match buyers and sellers. This has lead to a growth in
algorithmic trading (black-box, automated, high-frequendcy, robo trading).
o Options; the holder has the right to do something, but not the obligation (verplichting)
Call option; gives the holder the right to buy an asset by a certain date for a certain price.
Put option; gives the holder the right to sell an asset by a certain date for a certain price.
Exercise price (strike price); the price in the contract
Expiration date; the date in the contract
European option; can be exercised only on maturity date
American option; can be exercised at any time during its life
Option premium; an up-front price for an option contract
We have buyers and sellers of puts and calls. Buyers have long positions and sellers
have positions. Selling an option is known as writing the option.
- Over-the-counter market; banks, financial institutions, fund managers, corporations etc.
Before the credit crisis, OTC markets were largely unregulated, but after the failure of the
Lehman Brothers, there were regulations to improve the transparency and market efficiency
and to reduce the systematic risk.
o Forward contracts; an agreement to buy or sell an asset at a certain time in the future for a certain
price (same as future contracts, but then on OTC market).
o Swaps
o Options; One advantage of options traded in the OTC market is that they can be tailored (aangepast)
to meet the particular needs of a corporate treasurer or fund manager.
The over-the-counter market is much larger than the exchange-traded market.
Types of traders;
- Hedgers; use futures, forwards and options to reduce the risk that they face from potential future
movements in a market variable.
o Forward contracts neutralize risk by fixing the price that the hedger will pay or receive for the
underlying asset. Option contarcts provide insurance by offering a way for investors to protect
themselves.
! Hedging reduces the risk, but it is not necessarily the case that the outcome with hedging will be better
than the outcome without hedging.
- Speculators; use futures, forwards and options to bet on the future direction of a market variable.
o They are either betting that the prices will go up or that the prices will go down.
o When a speculator uses futures the potential loss as well as the potential gain is very large. When
options are used, no matter how bad things get, the speculator’s loss is limited to the amount paid
for the options.
- Arbitrageurs; take offsetting positions in two or more instruments to lock in a riskless profit by
simultaneously entering into transactions in two or more markets.
o They take advantage of the discrepancy between prices in two different markets.
! arbitrage opportunities cannot last for long; very quickly, two prices will become equivalent.
,Derivatives are very versatile (veelzijdig) instruments, but this can cause problems. Sometimes traders who have a
mandate to hedge risks or follow an arbitrage strategy become speculators, which can be disastrous.
Chapter 2; Mechanics of Futures markets
A futures contract is an agreement to buy or sell an asset for a certain price at a certain time in the future.
- The party with the short position chooses when delivery is made.
Forward contracts Future contracts
Private onctract between two parties Traded on an exchange
Not standardized Standardized contracts
Usually one specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final cash settlement usually takes place Contract is usually closed out prior to maturity
Some credit risk Virtually no credit risk
Whereas a forward contract is settled at the end of its life, a futures contract is settled daily. A the end of each day,
the investor’s gain (or loss) is added to (or substracted from) the margin account, bringing the value of the contract
back to zero. A futures contract is thus closed out and rewritten at a new price each day.
Closing a futures position involves entering into an opposite trade to the original one that opened the position.
Taking a long position in the spot market involves buying the asset for immediate delivery.
Taking a short position in the spot market involves selling an asset that you do not own.
Specification of futures contract;
- Specify the asset
- Specify the contract size; the amount of the asset that has to be delivered under one contract
- Specify the delivery arrangements; the place where delivery will be made
- Specify the delivery months; specify the precise period during the month when delivery can be made
- Specify the price quotes; how prices will be quoted
- Specify the price limits and position limits
o If in a day the price moved down from the previous day’s close by an amount equal to the daily price
limit, the contract is said to be limit down. If it moves up by the limit, it is said to be limit up.
o A limit move is a move in either direction equal to the daily price limit.
o The purpose of daily price limits is to prevent large price movements from occuring because of
speculative excesses.
o Position limits are the maximum number of contracts that a speculator may hold.
As the delivery period for a futures contract is approached, the futures price converges to the spot price
of the underlying asset. When the delivery period is reached, the futures price equals or is very close to
the spot price.
- If the futures price is above the spot price during the delivery period, traders have a clear
arbitrage oppurtunity; sell (i.e. short) a futures contract buy the asset make delivery.
Futures price will fall.
- If the futures price is below the spot price during the delivery period, companies interested in
acquiring the asset will find it attractive to buy a futures contract and then wait for delivery to
be made. Futures price will rise.
- The result is that the futures price is very close to the spot price during the delivery period.
One of the key roles of the exchange is to organize trading so that contract defaults are avoided. This is where
margin accounts come in.
Daily settlement (marking to market) in futures trading is the process of settling the profit or loss made by a futures
position at the end of each trading day, hence the term "Daily".
- The investor needs to deposit funds, the initial margin, in a margin account.
- The investor is entitled to withdraw any balance in the margin account in excess of the initial margin.
, - To ensure that the balance in the margin account never becomes negative, a margin is set.
- If the balance in the margin account falls below the maintenance margin, the investor recieves a margin call
and is expected to deposit a variation margin to top up the margin account to the initial margin level.
A clearing house acts as an intermediary in futures transactions. It guarantees the performance of the parties to
each transaction. The main task of the clearing house is to keep track of all the transactions that take place during a
day so that it can calculate the net position of each of its members.
- A clearing house member is required to maintain a margin account with the clearing house (clearing margin)
The purpose of the margining system is to ensure that funds are available to pay traders when they make a profit, so
to reduce credit risk.
In an attempt to reduce credit risk, the OTC market has used some of the procedures of exchange-traded markets.
- Colleteralization (in the form of cash or acceptable marketable securities) reduces the credit risk.
The settlements price is the price used for calculating daily gains and losses and margin requirements.
The trading volume is the number of contracts traded in a day.
Open interest is the number of contracts outstanding
! if there is a large amount of daytraders (enter into a position and close it out on the same day), then the volume of
trading in a day can be greater than either the beginning-of-day or end-of-day open interest.
Patterns of futures;
- Normal market; futures prices are an increasing function of maturity
- Inverted market; futures prices are a decreasing function of maturity
The delivery process;
The decision on when to deliver is made by the party with the short position (investor A). When investor A decides to
deliver, investor’s A broker issues a notice of intention to deliver to the exchange clearing house. The exchange then
chooses a party with a long position to accept delivery. The exchange passes the notice of intention to deliver on to
the party with the oldest outstanding long position. They need to accept it.
- The whole delivery procedure from the issuance of the notice of intention to deliver to the delivery itself
generally takes two to three days; the first notice day, the last notice day and the last trading day.
- To avoid the risk of having to take delivery, an investor with a long position should close out his or her
contracts prior to the first notice day.
Types of trader executing trades;
- Futures commission merchants (FCMs); follow the instructions of their clients and charge a commision for
doing so
- Locals; trade on their own account
- Individuals take position as hedgers, arbitrageurs or speculators;
o Scalpers are watching for very short term trends and attempt to profit from small changes in
contract price. They hold their positions for only a few minutes.
o Day traders hold their positions for less than one trading day
o Position traders hold their positions for much longer periods of time
Types of orders
- Market order; a request that a trade be carried out immediately at the best price available at the market
- Limit order; specifies a particular price
- Stop order or stop-loss order; specifies a particular price, it closes out a position if unfavorable price
movements take place, so it limits the loss that can be incurred.
- Stop-limit order; combination of a stop order and limit order, where the stop price and limit price are the
same.
- Market-if-touched order (MIT); executed at the best available price after a trade occurs at a specified price
or at a price more favorable than the specified price.
o Is also known as a board order
- Discretionary order or market-not-held order; is traded as a market order expect that execution may be
delayed at the broker’s discretion in an attempt to get a better price.
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