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    Maf 630 CHAPTER 7

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    Pablo Ekskoba
    This document discusses futures derivatives, including futures contracts and their key elements. It describes how futures contracts work, are standardized, and derive their value from an underlying asset like a commodity or stock index. The summary also explains how hedging and speculating with futures can help manage risk or seek profits from price changes. Margins, daily marking to market of contracts, and the role of a clearing house are discussed as important parts of the futures trading process.

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    Maf 630 CHAPTER 7

    Uploaded by

    Pablo Ekskoba
    110 views3 pages
    This document discusses futures derivatives, including futures contracts and their key elements. It describes how futures contracts work, are standardized, and derive their value from an underlying asset like a commodity or stock index. The summary also explains how hedging and speculating with futures can help manage risk or seek profits from price changes. Margins, daily marking to market of contracts, and the role of a clearing house are discussed as important parts of the futures trading process.

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    This document discusses futures derivatives, including futures contracts and their key elements. It describes how futures contracts work, are standardized, and derive their value from an underlying asset like a commodity or stock index. The summary also explains how hedging and speculating with futures can help manage risk or seek profits from price changes. Margins, daily marking to market of contracts, and the role of a clearing house are discussed as important parts of the futures trading process.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    110 views3 pages

    Maf 630 CHAPTER 7

    Uploaded by

    Pablo Ekskoba
    This document discusses futures derivatives, including futures contracts and their key elements. It describes how futures contracts work, are standardized, and derive their value from an underlying asset like a commodity or stock index. The summary also explains how hedging and speculating with futures can help manage risk or seek profits from price changes. Margins, daily marking to market of contracts, and the role of a clearing house are discussed as important parts of the futures trading process.

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    CHAPTER 7: FUTURES DERIVATIVES

    DERIVATIVES
    The word derivative implies they derive their value from something.
    It originates from mathematics and it is a variable that derives from another variable.
    Derivatives on its own have little value but when it derives from some other asset, known as
    the underlying, hence, it has its value.
    The underlying can be share prices, prices of commodity, indices and interest rates.
    For example, a derivative of Air Asia shares will derive its value from share price of Air Asia
    (underlying).
    Similarly, a derivative contract on Crude Palm Oil depends on the price of palm oil and the
    derivative of Kuala Lumpur Composite Index (KLCI) will depend on the movement of the
    KLCI.

    FORWARD CONTRACTS
    A contract between two parties agreeing to carry out a transaction at a future date but at a
    price determined today.
    3 steps to a forward contract
    1. Setting the price to be paid, exact specification of quality, quantity and delivery
    logistics, such as time, date and place
    2. Delivering the underlying asset from seller to buyer, and
    3. Payment of cash from buyer to seller.

    FUTURES CONTRACTS
    Exchange-traded form of forward contract
    Basically to overcome 3 problems of forward contract
    1. multiple coincidence needs,
    2. unfair forward price and
    3. counterparty risk
    Standardized contract would have specified:
    1. quantity (or the contract size),
    2. quality (or the grade) of the underlying asset,
    3. delivery date (or the expiry date) and
    4. location of delivery

    KEY ELEMENTS IN FUTURES TRADING


    1. Convergence of Futures and Cash Prices
    Backwardation (Futures prices lower than cash prices)
    Contango (Futures prices higher than cash prices)
    2. Basis and Basis Risk
    Basis the difference between cash price, spot price of financial instrument and
    futures price
    Basis risk futures price and cash prices are not perfectly related, so gains and losses
    do not perfectly cancel out each other
    It arises due to the mismatch of quantity, quality, maturity and location
    3. Margins and Marking to Market
    Initial margin initial amount that must be deposited at the beginning of contract
    Additional margin/variation/maintenance margin payment that would have to be
    paid to reflect the investors loss
    4. Types of orders (market order, limit order, stop loss order)
    5. The Clearing House
    As intermediary in futures transactions to guarantee the performance of the parties
    Novation role to assume the opposite side of transaction of each open contracts
    respectively, minimizes the tendency of default by both seller and buyer
    HEDGING WITH FUTURES CONTRACT
    Types of Hedging:
    1. Anticipatory Hedging
    o Taking a futures position in anticipation of a later cash transaction (sell)
    2. Hedging current market position
    o Taking a futures position opposite to the current physical position held (buy)
    ADVANTAGES
    DISADVANTAGES
    Minimum margin requirements
    Not possible to match exactly the
    allow traders to leverage
    expiry date, amount and quality of
    investments
    commodity
    Does not have to be held until
    May prevent hedgers from
    maturity (freely traded any time)
    benefiting from favourable price
    Low transaction costs
    movement (if it is not as expected)
    Minimize tendency of default by
    Hard to determine the exact amount
    both seller and buyer
    to be hedge (all or portion)
    Improve market liquidity and price
    Difficult to choose delivery month
    discovery role (long/short position)
    SPECULATING WITH FUTURES CONTRACT
    Speculators deal with price changes that occurred in the market.
    They are motivated by the strong desire to make profit on the transaction.
    They will buy the futures at low price and sell at high price.
    Types of speculating strategies:
    1. Outright position
    Takes a view of the change of the futures prices and speculate on it
    2. Spread trading
    Based on expectations of changes in relationship between several futures
    contract
    2

    The speculative traders in the futures market provide the depth and volume of trading that
    allows hedgers and others to enter or exit the market easily.
    Three types of speculators:
    1. Scalpers
    look out for minimum price fluctuations on heavy (large) volumes taking
    small profits at a time. They aim to make small profits on large volumes of
    transaction
    2. Day traders
    do intraday trading and on small volumes of trade (to take long or short
    positions of a few contracts and would close-out their positions later in the
    day when the prices have moved)
    3. Position traders
    look for long-term price trends and may hold over weeks, or months before
    getting out

    ARBITRAGING WITH FUTURES CONTRACT


    The practice of taking advantage of price differentials across different markets
    Simultaneous purchase and sale of the same instruments in different markets to profit from
    temporary difference or inconsistencies
    An arbitrage is a trade that involves buying in the physical market and selling at the futures
    market at a higher price.
    A trader who initiate the arbitrage if observes the prices are traded above the fair values
    will act on by selling the futures where the prices are high and pushes the price back to the
    fair value as determined in the physical market.
    COST OF CARRY MODEL

    F S (1 r c y )t
    where
    F
    S
    r
    c
    y
    t

    = futures price for a contract with maturity from time t to T at maturity


    = cash or spot price of the underlying asset
    = annualized risk-free interest rate (a proxy for opportunity cost)
    = annualized cost of storage (%) (inclusive of shipping, handling, shrinkage,
    spoilage or damaged, etc)
    = convenience yield on the cash commodity
    = time to futures expiry expressed on yearly basis

    SINGLE STOCK FUTURES


    A future contract for an individually listed stock which track the movement of individual
    underlying stock

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