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Summary of the book Fundamentals of Futures and Options
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Summary of covered chapters of the book "Fundamentals of Futures and Option Markets" Radboud University
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Chapter 1: Introduction1.1 Futures Contracts
A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price.
Futures exchanges allow people who want to buy or sell assets in the future to trade with each other.
The trader agreed to buy has what is termed a long futures position; the trader who agreed to sell has what is
termed a short futures position. The price is known as the futures price.
A futures price can be contrasted with the spot price: the price for delivery at some time in the future.
1.2 History of Futures Markets
The main task of the Chicago Board of Trade was to standardize the quantities and qualities of the grains that
were traded.
Traditionally futures have been traded using what is known as the open-outcry system. This involves traders
physically meeting on the floor of the exchange and using a complicated set of hand signals to indicate the
trades they would like to carry out.
Exchanges have largely replaced the open outcry system by electronic trading. This involves traders entering
their required trades at a keyboard and a computer being used to match buyers and sellers.
1.3 The Over-the-Counter Market
Banks often act as market makers in the over-the-counter markets for the more commonly traded instruments.
This means that they are always prepared to quote a bid price (at which they are prepared to take one side of a
derivatives transaction) and an offer price (at which they are prepared to take the other side).
The over-the-counter market in some respects is being forced to become more like the exchange-traded
market. Three important changes are:
1. Standardized OTC derivatives in the US must whenever possible be traded on what are referred to as
swap execution facilities (SEFs).
2. There is a requirement in most parts of the world that a central clearing party (CCP) be used for most
standardized derivatives transactions.
3. All trades must be reported to a central registry
1.4 Forward Contracts
A forward contract is similar to a futures contracts in that it is an agreement to buy or sell an asset at a certain
time in the future for a certain price.
Futures contracts are traded on exchanges, forward contracts trade in the over-the-counter market.
1.5 Options
Options are traded both on exchanges and in the over-the-counter markets. There are two types of options:
A call option gives the holder the right to buy an asset by a certain date for a certain price.
A put option gives the holder the right to sell an asset by a certain date for a certain price.
The price in the contracts is known as the exercise price or the strike price; the date in the contract is known as
the expiration date or the maturity date.
A European option can be exercised only on the maturity date; an American option can be exercised at any
time during its life.
,An option gives the holder the right to do something, but it does not have to exercise this right.
This is what distinguishes options from futures contracts.
It costs nothing to enter into a futures contract, but an investor must pay an up-front price for an option
contract: the option premium.
There are four types of participants in options markets:
1. Buyers of calls
2. Buyers of puts
3. Sellers of calls
4. Sellers of puts
Buyers are referred to as having long positions; sellers are referred to as having short positions. Selling an
option is also known as writing the option.
1.6 History of Options Markets
The Put and Call Brokers and Dealers Association suffered from two deficiencies:
1. There was no secondary market.
2. There was no mechanism to guarantee that the writer of the option would honor the contract.
1.7 Types of Traders
Three broad categories of trader can be identified:
Hedgers: use futures, forwards, and options to reduce the risk that they face from potential future
movements in a market variable.
Speculators: use futures, forwards and options to bet on the future direction of a market variable.
Arbitrageurs: take offsetting positions in two or more instruments to lock in a profit.
1.8 Hedgers
A key aspect of hedging: hedging reduces the risk, but it is not necessarily the case that the outcome with
hedging will be better than the outcome without hedging.
There is a fundamental difference between the use of forward contracts and options for hedging.
Forward contracts are designed to neutralize risk by fixing the price that the hedger will pay or receive
for the underlying asset.
o Does not involve an up-front fee
Option contracts provide insurance against adverse price movements in the future while still allowing
them to benefit from favorable price movements.
o Involves an up-front fee
1.9 Speculators
Whereas hedgers want to avoid an exposure to adverse movements in the price of an asset, speculators wish
to take a position in the market.
For a given investment, the use of options magnifies the financial consequences. Good outcomes become very
good, while bad outcomes result in the whole initial investment being lost.
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.
1.10 Arbitrageurs
Arbitrage involves locking in a riskless profit by simultaneously entering into transactions in two or more
markets.
,1.11 Dangers
Derivatives are very versatile instruments, which can cause problems.
Chapter 2: Mechanics of Futures Markets
2.1 Opening and Closing Futures Positions
A futures contracts is an agreement to buy or sell an asset for a certain price at a certain time in the future. It is
usually referred to by its delivery month.
The vast majority of the futures contracts that are initiated do not lead to delivery. The reason is that most
investors choose to close out their positions prior to the delivery period specified in the contract.
Sell these futures contracts to another party
2.2 Specification of a Futures Contract
As a general rule, it is the party with the short position (the party that has agreed to sell the asset) that chooses
what will happen when alternatives are specified by the exchange. When this party is ready to deliver, it files a
notice of intention to deliver with the exchange.
The financial assets in futures contracts are generally well defined and unambiguous.
The contract size specifies the amount of the asset that has to be delivered under one contract.
If the contract size is too large, many investors who wish to hedge relatively small exposures or who
wish to take relatively small speculative positions will be unable to use the exchange.
If the contract size is too small, trading may be expensive as there is a cost associated with each
contract traded.
The place where the delivery will be made must be specified by the exchange. This is particularly important for
commodities that involve significant transportation costs.
A limit move is a move in either direction equal to the daily price limit.
If in a day the price moves 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.
The purpose of daily price limits is to prevent large price movements from occurring because of speculative
excesses.
Position limits are the maximum number of contracts that a speculator may hold. The purpose is to prevent
speculators from exercising undue influence on the market.
2.3 Convergence of Futures Price to Spot Price
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.
To see why this is so, we first suppose that the futures price is above the spot price during the delivery period.
Traders then have a clear arbitrage opportunity:
1. Sell a futures contract
2. Buy the asset
3. Make delivery
, 2.4 The Operation of Margin Accounts
The broker will require the investor to deposit funds in a margin account. The amount that must be deposited
at the time the contract is entered into is known as the initial margin. At the end of each trading day, the
margin account is adjusted to reflect the investor’s gain or loss: daily settlement or marking to market.
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