Chapter 1

Hedging = aims to reduce exposure to risk (eg. a farmer sells wheat)

speculation = aims to take on risk for potential profit (eg. investor buys stock)
arbitrage = aims to profit from price discrepancies with minimal risk (eg. trader buys and
sells gold)

if K > S(t) => the investor gains

if K < S(t) => the investor loses

Formula
Profit = [S(t) - S(t0)] - P

Future contract
- A futures contract is an agreement to buy or sell an asset at a certain time in the future
for a certain price
- Futures contracts enable both speculators and hedgers to meet their own financial
goals in the market.

speculation
Advantages of speculation
- Possibility of High Returns
- Liquidity
Disadvantages of speculation
- high risk

Hedging
advantages of hedging
- Price Certainty
- Risk Mitigation
disadvantages of hedging
- Opportunity Cost
- Basis Risk

arbitrage
- Arbitrage is an investment strategy that involves the simultaneous purchase and sale
of an asset in different markets to exploit tiny differences in their prices.
- capitalize on discrepancies in prices for the same asset across different markets.

Derivative
- A derivative instrument is a contract between two counterparties, whose value derives
from the price of something else, referred to as the underlying.
 - Commodity derivatives are available on various tradable commodities such as wheat
or gold.
- Financial derivatives are contracts based on the prices of various financial instruments
or financial indexes such as stock market indexes.
- The holder of a call or put option must exercise the right to sell or buy an asset (not
true)
- The massive growth of the derivatives market since the 1970s
- derivatives can magnify the exposure of companies using them for speculation,
especially where open positions are heavily leveraged.
Terminology

• The party that has agreed to buy has a long position

• The party that has agreed to sell has a short position

Futures Price

● The futures prices for a particular contract is the price at which you agree to buy or
sell.
● It is determined by supply and demand in the same way as a spot price.
● Supply and demand is itself determined by such factors as the possibility of arbitrage
and expectations about the future spot price of the underlying.

forward contract
● Forward contracts are similar to futures except that they trade in the over-the-counter
market
● A company knows it will have to pay a certain amount of a foreign currency to one of
its suppliers in the future = a forward contract can be used to lock in the exchange
rate
● Forward contracts are popular on currencies and interest rates
● A short forward contract on an asset plus a long position in a European call option on
the asset with a strike price equal to the forward price is equivalent to = A long
position in a put option
● a long forward contract => the contract becomes more valuable as the price of the
asset rises
● one year forward contract is an agreement of one side has the obligation to buy an
asset for a certain price in one year's time
● When a CBOE call option on IBM is exercised, IBM issues more stock is not true

There are two basic types of options

● A call option is an option to buy a certain asset by certain date for a certain price (the
strike price)
● A put option is an option to sell a certain asset by certain date for a certain price (the
strike price)
 - The price of a call option increases as the strike price increases (not put
option)
● A futures/forward contract gives the holder the obligation to buy or sell at a certain
price
● approximately true when size is measured in terms of the underlying principal
amounts or value of the underlying assets => the over-the-counter market is ten times
as big as the exchange-traded market
● European options = Exercisable only at maturity

spot price
- The price for immediate delivery
central clearing party
- It stands between two parties in the over-the-counter market

Chapter 2
Futures exchanges
• Exchange Trading
• Daily settlement
• The margin system
• Futures margin account

A limit order
- Is an order that can be executed at a specified price or one more favorable to the
investor

Forward Contracts
● A forward contract is an OTC agreement to buy or sell an asset at a certain time in the
future for a certain price
● There is no daily settlement (but collateral may have to be posted). At the end of the
life of the contract one party buys the asset for the agreed price from the other party
● No money changes hands when first negotiated & the contract is settled at maturity
● the initial value of the contract is zero
● With bilateral clearing, the number of agreements between four dealers, who trade
with each other, is 2

Comparison of Forward and Futures market

Long and Short
● Buying futures is called being long futures.
● Selling futures is called being short futures.

Clearing houses
- Sometimes used in both futures markets and OTC markets

The margin system

● The exchange requires customers to post margin deposits (security deposits) against
their positions
● Daily covering of positions (marking to market) is required
● The party with the short position initiates delivery in a corn futures contract
● Delivery of the underlying occurs at the current spot price (when delivery is made)
● Margin requirements may be greater for speculators or new market participants
● Margin requirements may be varied by the exchange as market volatility varies.
● The frequency with which margin accounts are adjusted for gains and losses is daily
● Margin accounts have the effect of all the option

➢ If the futures price is above the spot price very close to delivery, an arbitrage
mechanism should ensure that the two prices will converge.
➢ If the futures price is below the spot price very close to delivery, simply buying the
underlying via the futures represents a cheaper method of obtaining the underlying.

Trading volume and Open interest

➔ Trading volume is the number of contracts traded in a day.
➔ Open interest is the number of contracts outstanding.
➔ A haircut of 20% means => a bond with a market value of $100 is considered to be
worth $80 when used to satisfy a collateral request

cash settled
- Futures on stock indices
Future contract
- Futures contracts are traded on exchanges, but forward contracts are not (true)
- Futures contracts nearly always last longer than forward contracts(not true)
- flexibility tends decrease the futures price = futures contract a number of different
types of corn can be delivered/ number of different delivery locations
- One futures contract is traded where both the long and short parties are closing out
existing positions = Decrease by one

Commodities Futures Trading Commission (CFTC)

- entity in the United States takes primary responsibility for regulating futures market

For a futures contract trading in April 2012, the open interest for a June 2012 contract, when
compared to the open interest for Sept 2012 contracts, is usually higher

Central clearing parties

- Perform a similar function to exchange clearing houses

Chapter 3

Measuring Interest Rates

● The compounding frequency used for an interest rate is the unit of measurement
● The difference between quarterly and annual compounding is analogous to the
difference between miles and kilometers

Zero Rates
- Azero rate (or spot rate), for maturity T is the rate of interest earned on an investment
that provides a payoff only at time T

Bond Pricing
- To calculate the cash price of a bond we discount each cash flow at the appropriate
zero rate

Bond Yield
- The bond yield is the discount rate that makes the present value of the cash flows on
the bond equal to the market price of the bond

Forward Rates
- The forward rate is the future zero rate implied by today’s term structure of interest
rates

Forward Rate Agreement

 - Aforward rate agreement (FRA)is an agreement that a certain rate will apply to a
certain principal during a certain future time period

Forward Rate Agreement (cont.)

➔ An FRAis equivalent to an agreement where interest at a predetermined rate, RK is
exchanged for interest at the market rate
➔ An FRAcan be valued by assuming that the forward interest rate is certain to be
realized