Chapter 1 Introduction

1.1 futures contracts A futures contract is an agreement to buy or sell an asset at a certain time in the future for certain price. Traded in different exchanges such as CME (after the merger of CME and CBOT), NYSE Euronext, TURKDEX and many others Exchanges bring the traders all together to facilitate trading

1.1 Futures contracts (continued) Some terminology Futures price: the price that is agreed to conclude contract Long Position: the party in which agrees to buy the assets at agreed future price Short Position: the party in which agrees to sell the assets at agreed future price Spot price: current market price for the asset or commodity. In every futures contract there are two parties. One party sells the asset and other party buys the asset.

Basic example for a futures contract At September the long party has to buy 5000 tonnes of wheat even though the futures price is not in favour of him/her. Same is true for short party, he has to sell the assets even the agreed futures price is not in favour of him. Trader takes a long position in a September futures contract to buy 5000 tonnes of wheat and agree the price which the contract will be concluded. A trader who contacts with his/her broker to buy 5000 tonnes of wheat at September. His broker contracts with the one of the exchanges such as CME and finds a counter party.

History of futures markets It can be traced back to the middle ages. But there are some archaeological evidence that some of the trades even happened on ancient times as well. Same principle was followed with the current markets however, only difference was the lack of markets in the ancient times. Every trader has to find the counterparty to have the trade with. Actually Future contracts enabled formation of the Commercial Banks as we know today.

History of futures markets(Continued) The Chicago Board of Trade Established in1948 to bring farmers and merchants together. Main trade was grain trading however, within couple of years future contract principles is formed. Before merging with the Chicago Mercantile Exchange, main forms of assets including corn, oats, soybeans, wheat and many others.

History of futures markets(Continued) The Chicago Mercantile Exchange Formed to trade perishable agriculture products and dairy products in It changed is name to Chicago Mercantile Exchange by This date is also the starting date for futures trading. CME is more focussed on financial futures trading right now in addition to commodity futures.

History of futures markets(Continued) Electronic Trading Previous system for trading was open-outcry system. Traders were physically meeting at the trading floor(trading pit). Open-outcry system involved making complicated hand signals and shouting the orders Nowadays it has been replaced with the electronic trading, which gave chance to birth of Algorithmic Trading. For more information about the Algorithmic Trading you can refer to elective course FINA 417 offered by Banking and Finance Department.

1.3 over-the-counter markets Futures are traded in the Exchanges. We will introduce 2 more derivative instruments during the semester. Options and Forwards. Forwards are traded in the over-the-counter markets and options are traded both on exchanges and over-the-counter markets What is OVER-THE-COUNTER MARKETS?

1.3 over-the-counter markets (Continued) Over-the-counter markets are alternative to the exchanges due to limitations that exists on the exchanges. They give freedom to the traders to conduct specific contract size that we will talk more on CHAPTER 2. Exchanges give predetermined contract sizes however in the OTCs traders determine the contract sizes. This enables the OTCs to have higher volume than the exchanges. The main participants of OTCs are generally banks, mutual fund managers and corporation. Also small time traders participate in the OTCs as well

Comparison between OTC and Exchange Volume

Forward contracts A forward contract is similar to futures contracts in that it is an agreement to buy or sell an asset at a certain time in the future for a certain price. But, whereas futures contracts are traded on exchanges, forward contracts trade in the over-the-counter market. Mostly used for currency trading instead of commodity trade.

Foreign Exchange Quotes for USD/GBP exchange rate on July 17, 2009 BIDOFFER SPOT MONTH FORWARD MONTH FORWARD MONTH FORWARD

1.5 oPTIONS Forward and futures contracts makes trader obliged when you enter to the contract. In contrast with futures and forwards, option gives holder right to exercise the contract not an obligation. There are two kinds of basic options Call Option: gives the holder the right to buy an asset by a certain date for a certain price. A put option gives the holder the right to sell an asset by a certain date for a certain price.

1.5 options( Continued) There will be some terminologies that we ought to know while proceeding with options: Strike or Exercise Price: The price in the contract where enables holder to exercise the contract Expiration Date or Maturity: the date in the contract which shows how long the contract is valid Premium or Price of Option: the price of the option that is paid for acquiring the option contract

1.5 options (continued) example; google option prices, stock price=$430.25

Example on google call and put options Suppose an investor instructs a broker to buy one December call option contract on Google with a strike price of $580. What will be the profit of the option holder if the price of the stock is $650 at the maturity? Suppose an investor instructs a broker to buy one September put option contract on Google with a strike price of $580. What will be the profit of the option holder if the price of the stock is $500 at the maturity?

1.5 Options (Continued) The focus on options will be more detailed on coming chapters but over here we should note that there will be 4 participants in the option markets Buyers of the Calls Sellers of the Calls Buyers of the Puts Sellers of the Puts

Hıstory of optıon markets Earliest record of option trading started at Europe and United States in late 18 th century. At that time only call and put options were traded in the markets. Currently there are more than 100 exchanges which investors can trade the options. The formation of option exchanges are only able to be formed at the early 1970’s. After 1980’s OTCs increased the dominance in the option markets.

Types of traders Three broad categories of trader can be identified: Hedgers Speculators Arbitrageurs

Types of traders Hedgers use futures, forwards, and options to reduce the risk that they face from potential future movements in a market variable. Speculators use them to bet on the future direction of a market variable. Arbitrageurs take o ff setting positions in two or more instruments to lock in a profit.

Hedging examples A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract. US company could hedge its foreign exchange risk by buying pounds (GBP) from the financial institution in the three- month forward market at This would have the e ff ect of fixing the price to be paid to the British exporter at $15,585,000.

Hedging examples An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts. If the price of the stocks are less then 27.50, he exercises the contract and sells shares at a price of $ Using this strategy investor’s wealth will not be affected.

Hedging examples

Speculation example An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of $22.50 is $1 Lets say that this investor believes that stock price will increase to $27 dollars after 2 months. There are two strategies Long the stock Long the call option

Speculation example For illustration purposes we assumed that investor buys the stocks and wait until the maturity. Assuming that two price levels occurs then; Long Stock (1 lot) If stock price is $27 at the maturity investor will make a profit of $700 Long Stock (1 lot) If stock price is $15 at the maturity investor will make a loss of $500

Speculation example Second strategy is to buy call options instead of buying to stock Buy 2000 call options If stock price is $27 at the maturity investor will make a profit of $7000 Buy 2000 call options If stock price is $27 at the maturity investor will make a loss of $2000

Arbitrage Example A stock price is quoted as £100 in London and $162 in New York.The current exchange rate is What is the arbitrage opportunity? Buy 1 lot of shares in New York Sell 1 lot in London to make a profit of $300

The futures price of gold If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r ) T where r is the 1-year (domestic currency) risk-free rate of interest. In our examples, S =1000, T =1, and r =0.05 so that F = 1000(1+0.05) = 1050

1. Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$1000 The quoted 1-year futures price of gold is US$1100 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?

2. Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$1000 The quoted 1-year futures price of gold is US$990 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?

1. Oil: An Arbitrage Opportunity? Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$80 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity ?

2. Oil: An Arbitrage Opportunity? Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$65 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity ?