What is a Derivative?

A derivative is an instrument whose value depends

on, or is derived from, the value of another asset.
Examples: futures, forwards, swaps, options,
exotics
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc

Evolution
First Exchange for trading in derivatives
Royal Exchange in London
First futures contract is traced to the Yodoya
rice market in Osaka , Japan around 1650.
Creation of Chicago Board of Trade in 1848
due to the drastic rise and fall in the price of
the Midwestern grain.
Transfer the price risk associated with the
grain.

Forward Contracts
An agreement between a buyer and seller to
buy or sell an asset at a certain future time for
a certain price.
One of the parties assumes a long position
and agrees to buy the underlying asset on a
certain specified date and price.
The other party assumes short position and
agrees to sell the asset on the same date for
the same price.

Outcomes
Profit from a Long Forward
Position
(K= delivery price=forward price
at time contract is entered into)

Profit from a Short Forward

Position
(K= delivery price=forward price
at time contract is entered into)

Payoff : ST - K

Payoff: K - ST

Example
Suppose that Bob wants to buy a house a year
from now and Andy currently owns a $100,000
house that he wishes to sell a year from now.
Forward contract price agreed upon = $104,000.
At the end of one year, the current market
valuation of Andy's house is $110,000.
Andy is obliged to sell it to Bob for only $104000.
Bob makes a profit of $6000.
Andy has made a potential loss of $6,000 , but an
actual profit of $4,000.

Hedging using Forward Contracts

Suppose on January 1,2012 an Indian textile exporter
receives an order to supply his product to a big retail chain in
US. Spot price of INR/US exchange rate is Rs 45/ dollar.
Exporter will receive $ 1 Million (Rs 4.5 crore) after 6 months.
Exposed to currency risk.
Assume the cost of production is Rs 4 crore.
Enters into a six month forward contract with a bank at Rs 45
to a dollar.
If exchange rate appreciates to Rs 35 after six months, then
the exporter will receive Rs 3.5 crore after converting his $1
million and the rest Rs 1 crore will be provided by the bank.
If exchange rate depreciates to Rs 60/dollar then the exporter
will receive Rs 6 crore after conversion, but has to pay Rs 1.5
crore to the bank.

Futures Contracts
Agreement to buy or sell an asset for a certain price
at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC, a futures
contract is traded on an exchange
Exchanges Trading Futures
CME Group (formerly Chicago Mercantile Exchange and
Chicago Board of Trade)
NYSE Euronext
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)

Speculation using Futures

For E.g. Consider an US speculator who in February thinks that
the British pound will strengthen relative to US $ over the
next 2 months.
Two options:
A)Purchase 250000 in spot market.
B)Take long position in 4 April futures contracts on British Pound
of 62500

(NEED TO EXPLAIN THE DIFF. IN INVESTMENT AMOUNT NEEDED)

Closing Out Positions

Vast Majority of futures contracts do not lead
to delivery.
Closing out a position means entering into the
opposite trade to the original one.

Specification of a futures contract

The Contract Size: It specifies the amount of the asset
that has to be delivered under one contract.
Delivery Arrangements: The place where delivery will be
made must be specified by the exchange.
Delivery Months : The precise period specified by the
Exchange when the delivery can be made. A futures
contract is referred to by its delivery month.
Price Quotes: Exchange defines how the prices of the
asset will be quoted.
Price Limits: The daily price movement limits specified by
the exchange.
Position Limits: Maximum number of contracts that a
speculator may hold.

Daily Settlement and Margins

Margin Account
Initial Margin
Marking to market
Maintenance Margin
Variation Margin
Margin Call

Forward Contracts vs Futures Contracts

FORWARDS
Private contract between 2 parties

FUTURES
Exchange traded

Non-standard contract

Standard contract

Usually 1 specified delivery date

Range of delivery dates

Settled at end of contract

Settled daily

Delivery or final cash

settlement usually occurs

prior to maturity

Some credit risk

Virtually no credit risk

Questions
Consider trader A enters into a forward
contract for 100 kgs of apples with Trader B
with an exercise price of Rs.100 per Kg which
expires at the end of 1 month.
Part A)
At the end of 1 month the price of 1Kg of
apples is Rs.110.

Questions
Part B)
At the end of 1 month the price of 1Kg of
apples is Rs.85