El juego de rol como propuesta de formación ciudadana en la escuela

Introduction

00.0

Derivative markets and instruments

11.1.1

Types of derivative contracts

00.1

Forward contracts

11.2.1

Characteristics of forward contracts

00.2

Futures contracts

11.3.1

Characteristics of futures contracts

11.3.2

Margin and marking to market

11.3.3

Differences between futures and forward contracts

00.3

Option contracts

11.4.1

Characteristics of option contracts

00.4

Swap contracts

11.5.1

Interest rate swaps

Review questions

Learning objectives

The syllabus for this examination is broken down into a series of learning objectives and is included in the Syllabus Learning Map at the back of this workbook. Each time a learning objective is

INTRODUCTION

This chapter will outline the nature of derivative securities such as options and futures contracts. In addition, the chapter provides some basic features of the markets in which these contracts trade.

11.1 DERIVATIVE MARKETS AND INSTRUMENTS

Securities whose value or payoff depends on other assets are called derivative securities. Two broad types of derivative securities are regularly traded on exchanges around the world - option contracts and futures contracts. Options and futures have payoffs that depend on the value of assets such as commodities, stocks and precious metals. For example, a three month futures contract on West Texas Crude Oil, or an option to buy IBM shares in six months. These securities can be used very effectively to manage risk or can be put to speculative uses. The characteristics of these contracts and the structure of the markets in which they trade are described in this chapter.

11.1.1 TYPES OF DERIVATIVE CONTRACTS

Learning Objective 00.1.1 – Know the basic types of derivative contracts:

 Forwards

 Futures

 Options

 Swaps

Derivative contracts can either trade over the counter (negotiated between two parties) or trade on an organized exchange such as the Chicago Board of Trade. Exchange traded products are relatively easy to access even for small investors, whilst over the counter (OTC) trading normally takes place between large corporate or wealthy individuals.

Forwards and futures involve an agreement today for the purchase and sale of the underlying commodity at some specified future date at a pre-determined price. Both parties to the contract are required to fulfill their obligations under the contract.

Options on the other hand are asymmetric contracts, in that, an option gives the choice to the holder to exercise only if it in his interest to do so. A call option to purchase a share of IBM at the end of 3 months for an exercise price of $50, gives the option holder a choice - he will only exercise the option if the price of IBM shares at the end of 3 months exceeds $50. A put option to sell a share of IBM at the end of 3 months at an exercise price of $50, gives the put holder a choice - he will only exercise the option if the price of IBM less than $50 at the end of three months.

Whereas there is no initial exchange of money between buyer and seller in the case of a forwards or futures contracts, option buyers have to pay a premium to the option sellers at the inception of the contract.

A swap is an over the counter contractual agreement between two parties. The agreement will oblige the parties to exchange periodic payments based on movements on some underlying asset. For example, an interest rate swap obliges the parties to make payments on the basis of specific interest rates on a notional principal amount over a specified period of time.

Derivative securities serve a number of important functions. They allow individuals and firms to hedge their risk by taking appropriate positions in the derivative markets. These markets therefore help in spreading risk across market participants. Investors who wish to speculate on future price movements find it very convenient and cost efficient to use the derivative markets as opposed to the spot market for the underlying asset.

11.2 FORWARD CONTRACTS

A forward contract is a deferred delivery contract, where two parties (buyer and seller) agree to deliver a commodity or financial security at a specific date in the future for a price that is agreed upon today.

11.2.1 CHARACTERISTICS OF FORWARD CONTRACTS

Learning Objective 11.2.1 – Understand the characteristics of Forward Contracts and the risks undertaken by each party

The seller of a forward is agreeing to deliver the underlying asset at the future date, and is called the short side of the contract. The buyer, who agrees to accept delivery and pay the agreed price, is called the long side of the contract. Forward contracts tend to be custom made contracts entered into between the two parties and thus classified as over the counter products.

Example 11.1

Aramco entering into a contract with Saudi American Bank, to purchase €1.25 million, 95 days in the future, for a price of SR 4.22 per € is an example of a forward contract. No exchange takes place at the time of the initiation of the contract. At the end of 95 days, Aramco will pay SR 5.275 million (€1.25 million x 4.22 SR/€) and receive the promised €1.25 million from Saudi American Bank.

Unlike options, in a forward trade both sides to the contract are obliged to meet the contractual terms of the agreement.

Forward contracts can be used as a tool to eliminate risk. These risks may include commodity prices risk, currency exchange rate risk and interest rates risks. Returning to the Aramco example, Aramco can be assured that it will obtain the desired euros at the contracted price of 4.22 SR/€ at the end of 95 days, regardless of whether the price of the € appreciates or depreciates over this

11.3 FUTURE CONTRACTS

Future contracts are in principle identical to forward contracts; they only differ in the ways in which they trade. Whereas forward contracts are custom made to suit the needs of the individual parities to the contract, future contracts are standardized contracts that trade on formalized exchanges according to rules established by the exchange.

11.3.1 CHARACTERISTICS OF FUTURE CONTRACTS

Learning objective 11.3.1 – Understand the characteristics of future contracts and the risks undertaken by each party

Future contracts can be used as a hedging tool to shed price risk. Consider a wheat farmer who is unsure of the price at which the wheat can be sold when it is harvested. By entering into a short futures contract he can effectively lock in the selling price. In contrast, a food processing company that buys wheat can enter into a long futures contract to fix the price at which wheat will be purchased. Futures markets are also used by speculators who trade based likely moves in asset prices. Regardless of the motivation of entering into a futures transaction, the two sides to the contract are entering into obligations. If the buyer decides he no longer wants to take delivery of the underlying, he must take an opposite position by trading the contract in the market. Similarly, the seller is obliged to deliver the underlying asset in exchange for the contracted amount, unless he takes an opposite position.

The authorities of the exchanges on which the futures contracts are traded establish the rules relating to the individual contracts. These include:

a. The unit of the commodity or the financial asset that is to be delivered on each contract. For example, each T-bill futures contract traded at the Chicago Board of Trade is for delivery of one million dollars face value of the 90 day T-bills.

b. The quality of the commodity to be delivered. For example the gold contract traded on COMEX in New York calls for the delivery of 99.9% purity.

c. The delivery months and dates are specified. d. The sequence and mode of delivery.

11.3.2 MARGIN AND MARKING TO MARKET

Learning Objective 11.3.2 – Know how margin is used to reduce risk and the concept of marking to market

When they first get involved in a futures contract, each party to the futures contract must make a good faith deposit equal to a set percentage of the value of the underlying asset. This is the margin. Subsequently, at the end of each trading day, profits and losses to individual traders on each side of the contract are computed. Profits are added to the margin of the winners, and deducted from the margin of the losers.

An illustrative example should help in understanding the marking to market procedure. Example 11.2

Consider a farmer who goes short one contract for December Corn at a futures price of $2.10 per bushel on the Chicago Board of Trade.

The contract size for the corn contract is 5,000 bushels. Assume he paid a margin of 10%, which in this case is $1,050 (= 10% x $2.10 x 5,000). If the futures price of the contract closes at $2.00 at the end of the trading day, the farmer profits by $500 (= 5,000 x [$2.10 - $2.00]). His margin account will be credited the $500 profit, and will now total $1,550.

The trader on the other side of the contract who is long has experienced a loss of $0.10 per bushel or a loss of $500 on the contract. This will be deducted from his margin money.

As seen in the above example, the long side loses and the short side gains when the underlying asset price decreases. Conversely, the long side of a futures contract gains while the short side loses when the price of the underlying asset increases. As losses accumulate and the margin decreases to a critical amount (called the maintenance margin), a trader is likely to get a call from his broker to add more funds to his margin account. In the futures market, margin means that losses are settled as they happen, so margin deposits serve to reduce the risk of default.

It is interesting to note that in the futures markets, unlike the forward markets, contracts rarely reach physical delivery. Instead, participants offset their trades, longs taking short position in the same contract and shorts offsetting their positions by taking out long contracts prior to the delivery date- this is referred to as 'closing out' their positions.

11.3.3 DIFFERENCES BETWEEN FUTURES AND FORWARD CONTRACTS

Learning Objective 11.3.3 – Understand the differences between forward contracts and future contracts: