BE 351

Derivative Securities
 Outline

• What is a derivative security

• Types of traders
• Forward contracts
• Futures contracts

Reading
Hull: Chapters 1, 2.1-2.4, 2.7, 2.11
 What is a derivative security?

• It is a financial instrument

• Its value depends on the values of other more basic

assets – the underlying assets
– Its value is derived from other more basic asset: the
underlying asset
 What is a derivative security?

• It is a contract to buy or sell the underlying asset at a

future time, with the price, quantity and other
specifications defined today

• Examples: forward, futures, options, swaps

• Derivative securities allow the creation of complex

(non-linear) payoffs
– financial engineering
 Underlying assets

• One can trade derivative securities on any

underlying:
– financial assets (such as foreign currencies, stocks, stock
indices, bonds)
– economic or financial variables (such as interest rates,
volatility)
– commodities (such as crude oil, silver, corn, live cattle,
cotton)
– and many others (such as temperature, rain, etc.)
 Types of Traders

• The derivatives markets attract three major players

– Hedgers: people that want to avoid risk
– Speculators: people that want to bear risk
– Arbitrageurs: people that take advantage of two or more
securities being mispriced relative to each other

• Derivatives provide a mechanism for allocating risk in

financial markets from those that want to avoid risk to
those that are willing to bear risk
• Trading with derivatives involves smaller transaction
costs for achieving certain risk-return positions relative
to the costs from trading directly the underlying asset
 A Bit of History

• Thales of Miletus (624-547 BC)

– Thales paid deposits on oil-presses i.e. secured an option on their
hire
– As it was winter, this cost him only a small sum as there were no
other bidders
– As the harvest was good there was a sudden and simultaneous
demand for oil-presses
– Thales exercised his option i.e. hired the oil-presses and charged the
producers to use them
• Contracts to buy/sell wool at a future time for a certain price
(medieval England and Japan)
• Tulipomania (early XVII century Holland): forwards on tulip bulbs
 Back to the Derivatives

• The Chicago Board of Trade (CBOT) was established

in 1848 to bring farmers and merchants together

• Call options started to be traded in 1973 in the

Chicago Board of Exchange (CBOE)
 Back to the Derivatives

• Exchanges
– Chicago Board of Trade
– Chicago Mercantile Exchange was established in 1919.
Trading is done electronically and through open outcry in a
trading pit
– The above two rivals have merged to form the CME group in
2007

– NYSE Euronext was formed in 2007 by merging

Euronext.liffe and NYSE
– Japan: Tokyo Grain exchange, Tokyo Financial exchange
– And many more (see list at the end of the book)
 Over-the-Counter markets (OTC)

• The over-the-counter (OTC) market is a telephone

and computer linked network of traders
– trades are done over the phone between financial institutions
– conversations are recorded
– it offers more flexibility in product specification
– it is an important alternative to exchanges
– it is larger than the exchange traded market in terms of the
total trading volume
– involve counterparty risk (credit risk)
Over-the-Counter markets (OTC)

Chart shows total principal amounts for OTC market and value of underlying
assets for exchange market (source: Bank for International Settlements)
 Over-the-Counter markets (OTC)
Interest rate
Turnover in interest rate derivatives markets OTC interest rate derivative
(Notional amounts, daily averages in April) (Turnover in notional amounts, daily av. in April)

Source: BIS Quarterly Review December 2016

 Forward Contracts

• A forward contract is a binding agreement to sell or

buy an asset at a future date, at a price specified
today
– In the spot market we buy an asset today at the market price

• Forward contracts are OTC instruments usually

traded between financial institutions
• The forward contract between two parties
– One party agrees to buy the asset (long position) and the
other party agrees to sell the asset (short position)
 Forward Contracts

• The asset specified in the contract is called the

underlying asset or simply the underlying
• The price specified in the contract is called the
delivery price (denoted by K)
– This is the price at which delivery will be made by the seller
and accepted by the buyer
– It equals the forward price (denoted by F0 ) prevailing at the
time the forward contract is entered into
• The date specified in the contract on which the trade
will take place is called the maturity date of the
contract (usually referred to as time T)
 Forward Contracts

• Forward contracts are traded over the counter (OTC)

usually between financial institutions, corporate
treasurers and fund managers
– Buyer and seller negotiate directly over the underlying asset,
quantity, grade, location, time of delivery, price etc;
– Each contract is potentially unique (i.e. not standardized)

• Forward contracts on foreign exchange and on

interest rates are extremely popular
 Forward Contracts

• The payoff of a long position at the delivery date is

ST – K
where ST is the spot price at maturity time T and K is
the delivery price
• The payoff of a short position at the delivery date is
K – ST
 Forward Contracts

Payoff
A long position

Underlying instrument (ST)

K

The payoff from a long position in a forward contract is (ST - K)

 Forward Contracts

Payoff
A short position

Underlying instrument (ST)

The payoff from a short position in a forward contract is (K - ST)

 Forward Contracts

Example
• A US firm that buys goods from a British supplier
estimate that they will need £1 million in 3 months
time

• The current spot and forward quotes for USD/GBP

are as follows (ignoring bid ask spread):
 Forward Contracts

• Quotes are number of USD per GBP

Spot 1.6173

3-month forward 1.6140

What would you suggest the company to do?

 Forward Contracts

• Suppose the firm decides to hedge the currency risk

by taking a long position in a 3-month forward
contract on GBP to buy £1m
• What are the possible outcomes for the long
position?
• What would happen, for example, if the spot
exchange rate in 3 months time turns out to be:
– 1.6300
– 1.5900
 Forward Contracts

• In 3 months time, the firm has the obligation to buy

£1m at the pre-agreed rate of 1.6140 under the terms
of the forward contract regardless of the spot rate
being 1.6300 or 1.5900

• This suggest that the spot rate fluctuation is irrelevant

to the firm any more due to the forward contract, thus
eliminating exchange risk
 Forward Contracts
Scenario 1 Scenario 2
ST = 1.6300 ST = 1.5900

Without forward
contract the cost 1.6300 x £1m 1.5900 x £1m
would be =$1.63m =$1.59m

With the forward

contract the cost is $1.614m $1.614m

So the forward
contract has a $1.63m - $ 1.614m $1.59m - $1.614m
(payoff) value of = $16,000 = - $24,000
 Short Selling

It is the process of selling an asset that you do not own

You borrow the asset from someone e.g. brokerage
firm
Sell the borrowed asset to someone else for P0
At a later date you purchase the asset for P1
– repay the loan
If P0 > P1 → Profit & if P0 < P1 → Loss
– Short selling is profitable if the asset price declines
Short selling is considered risky
– Potential loss is unlimited
 Arbitrage

• Arbitrage is normally defined as a chance to make

riskless profits with no investment. That is,
– there is a portfolio strategy that requires no investment today
and yet yields non-negative payoffs in the future, and
positive at least in one of the states of nature
– there is a portfolio strategy that earns money today and yet
has no future obligations

• The concept of arbitrage is invaluable for building

pricing models
– In the absence of arbitrage, all portfolios or securities with
identical future payoffs must have identical values today
 Arbitrage

Example 1: Consider the following two securities in a

two-state economy
x1 =
{ 1, up
2, down
, x 2=
{
2, up
4.12, down
p( x 1 )=1, p( x 2 )=2

Short two units of the first security & buy one of the
second security
Initial result: 2⋅p( x 1 ) 1⋅p ( x 2 )=2⋅1 1⋅2=0
Payoff is 2⋅x 1 +1⋅x 2=
{ }
0
0.12
 Arbitrage

Example 2: Consider the following two securities in a

two-state economy
x1=
{ 1, up
1, down
, x2=
{ 2, up
2, down
p( x 1 )=1, p( x 2 )=1.9

Short two units of the first security & buy one of the
second security
Initial result: 2⋅p( x1 ) 1⋅p ( x 2 )=2⋅1 1⋅1.9=0.1
Payoff is 2⋅x 1 +1⋅x 2=
{}
0
0
 Spot and Forward Convergence

• The forward price converges to the spot price when

the delivery period is approached
• This happens in order to prevent arbitrage
opportunities
 Spot and Forward Convergence

• Consider that during the delivery period the forward

price is above the spot price (FT > ST), a clear
arbitrage opportunity exists:
i. Short a forward
ii. Buy the asset
iii. Make delivery

As traders exploit the opportunity the forward price

will….fall!
 Spot and Forward Convergence

• Consider that during the delivery period the forward

price is below the spot price (FT < ST), a clear
arbitrage opportunity exists:
i. Long a forward contract
ii. Receive delivery
iii. Sell on the spot market

As traders exploit the opportunity the forward price

will….rise!
 Futures Contracts
• A futures contract is an agreement to sell or buy an
asset at a future day for a predetermined price
• Futures contracts are similar to forwards contracts
• Futures are standardized, marked to market and
rarely delivered
– Rarely delivered: usually the positions are closed before
expiration
– e.g. an investor buys a June corn futures contract on
15/March. The investor can close his position, let’s say on
10/April by shorting one June corn futures contract. His
profit/loss is determined by the change in futures price
between 15/March and 10/April
 Futures Contracts

• Futures contracts are traded on organised exchanges

• The exchange specifies several rules in order to
guarantee that the terms of the contracts will be
honoured
– Exchange traded products have a contract specification
published by the exchange on which the contract is listed
• Futures contracts are standardized in terms of the
underlying asset, the quantity, the grade, the delivery
period, the delivery place, and so on
• The same or a similar product may be traded on
more than one exchange
 Futures Contracts Specifications

• The Asset:
– In the case where the underlying is a commodity the
exchange stipulates the grades or grade of the commodity
that is acceptable
– In the case of financial assets, the underlying is well defined.
(Some adjustments have to be made in the case of bond
futures)
– Futures contracts are traded on many financial assets and
commodities
• Contract size: The contract size specifies the amount
of asset that underlies each futures contract
 Futures Contracts Specifications

• Delivery arrangements: In the case of commodities

the place and time of the delivery has to be specified
in advance

• Delivery month: This is the maturity of the contract.

For example, currency futures in CME have delivery
months of March, June, September and December
 Forwards Futures

Private contract Exchange traded

Non-standard Standard contract

Settled at end of contract Settled daily

No margin required Margin required – marked to

market

Positions hard to unwind (hard to Highly liquid market (small bid-

close positions) ask spread)

Some credit risk Virtually no credit risk

 The Mechanics of Futures Trading

Four steps

• Step 1: Investor takes a position in the futures

market. A clearing house (3rd party) takes the
opposite position (no counterparty risk)

• Step 2: Long & short investors deposit an initial

margin ‘of good faith’ to their brokers in what is
known as a margin account
 The Mechanics of Futures Trading

• Step 3: As the price of a contract fluctuates, the value

of the investor’s equity in the position changes
– End of each trading day: the margin account is adjusted to
reflect the investor’s gain or loss (marked to market)
• Gains/losses are added/subtracted from the margin account
– To ensure the balance in the margin account never becomes
negative, a maintenance margin, which is somewhat lower
than the initial margin, is set
– If the margin account balance falls below the maintenance
margin (approx. 75% of initial margin), the investor is
required to deposit a variation margin which returns the
deposit to the initial margin
The Mechanics of Futures Trading

Step 4: Closing out a position

– Two choices:
• Close out a position prior to maturity
• Wait until maturity
 Margins

• A margin is cash or marketable securities deposited

by an investor with her broker

• The balance in the margin account is adjusted to

reflect daily settlement

• Margins minimize the possibility of a loss through a

default on a contract
 Margins

• If the investor does not top up his margin account, the

broker will close out the investor’s position

• The investor is entitled to withdraw any balance in the

margin account in excess of the initial margin

• Margining system discourages default as losses are

not carried forward but settled at the end of each
trading day
 Margins

Example

• An investor takes a long position in two gold futures

– contract size is 100 oz.
– futures price is $1,250 per oz
– margin requirement is US$6,000/contract (US$12,000 in
total)
– maintenance margin is US$4,500/contract (US$9,000 in
total)
 Margins

Example: The current spot price for crude oil is £80 per
barrel. The risk-free interest rate is 0.5% p.a. with continuous
compounding. One contract is for delivery of 1,000 barrels of
oil. Suppose the oil refining company has taken a long
position in five 3-month crude oil futures contracts. The initial
margin is £7,000 per contract and the maintenance margin is
£5,000 per contract
(i) How much does the oil price have to change before the
trader receives a margin call?
(ii) How much does the oil price have to change before
£12000 surplus can be withdrawn from the margin account?
 Margins

Example: The current spot price for crude oil is £80 per
barrel. The risk-free interest rate is 0.5% p.a. with continuous
compounding. One contract is for delivery of 1,000 barrels of
oil. Suppose the oil refining company has taken a long
position in five 3-month crude oil futures contracts. The initial
margin is £7,000 per contract and the maintenance margin is
£5,000 per contract
(i) How much does the oil price have to change before the
trader receives a margin call? (7000-5000)/1000=2
(ii) How much does the oil price have to change before
£12000 surplus can be withdrawn from the margin account?
(12000/5)/1000=2.4
 Closing Out A Position

(1) Prior to maturity: Investor closes out a position by

taking an opposite position to the original one

Example:
– Suppose you go long a December gold futures on 15/March
– Then you effectively must buy gold at the agreed price
during the December delivery period
– If you do not want to buy gold, then you need to close out
your position prior to maturity by taking a short position in the
same December gold futures
– Suppose you closed out your position on 10/April. This
cancels the initial long position
 Closing Out A Position

Your profit/loss is determined by the change in futures

price between 15/March and 10/April
Closing out a position can be done because a futures
contract is
standardised
an agreement between an investor and a clearing house,
rather than an investor and an investor
Such logic allows investors to sell futures contracts
without owning the underlying product, providing the
position is closed before the last trading day by buying
an identical contract
 Closing Out A Position

Example: Suppose an investor has a short position in

one gold futures contract for delivery in May. To get
out of this contract, what does the investor need to
do?
Answer: To take a long position in one gold contracts for
delivery in May
e.g. suppose the short position was taken at a futures price
of $340 per ounce and suppose the price at the time of
close-out is $332 per ounce
Then the investor has effectively agreed to sell at $340 per
ounce in May and buy at $332 per ounce in May for a net
profit of $8 per ounce
 Closing Out A Position

(2) Wait until a delivery date:

These contracts will close out with either a physical
delivery or a cash settlement

Physical delivery
For most contracts, the short position holder has the
privilege of initiating a delivery notice
There are a range of delivery dates in the delivery
period
 Closing Out A Position

Cash settlement
● In case of a cash settlement, a final adjustment is

made to the margin accounts of the buyer and the

seller, and then the contract ends
● The amount of the final adjustment equals the

difference between the last trading day’s settlement

price and the settlement price of the previous day
● Note that futures contracts are settled daily and

therefore the payoff from futures contract spreads out

across the whole holding period
 Closing Out A Position
Cash settlement of a long futures contract
Day Trade price Settlement price Daily gain

1 F0
1 F1 F1-F0
2 F2 F2-F1
3 F3 F3-F2
4 F4 F4-F3
… … …
T FT FT-FT-1 Final adjustment
=FT -F0 Total gain/loss

50
 Closing Out A Position

• Long’s payoff = closing futures price-initial futures price

• Short’s payoff = -(closing futures price-initial futures
price)
• Example: suppose that in September 2006 you take a
long position in a May 2007 crude oil futures contract.
You close out your position in March 2007. The futures
price (per barrel) is $18.30 when you entered into the
contract, and $20.50 when you closed out your position.
– What is your payoff from the trade?
– What if it was a short position?
 Closing Out A Position

• Long’s payoff = closing futures price-initial futures price

• Short’s payoff = -(closing futures price-initial futures
price)
• Example: suppose that in September 2006 you take a
long position in a May 2007 crude oil futures contract.
You close out your position in March 2007. The futures
price (per barrel) is $18.30 when you entered into the
contract, and $20.50 when you closed out your position.
– What is your payoff from the trade? 20.50-18.30=2.20
– What if it was a short position? -2.20