1 Derivatives Topic #4

Futures Contracts An agreement to buy or sell an asset at a certain time in the future for a certain price Long and Short positions Futures price This eliminates the risk for both participants Exchanges:  CBOT (1848)  Chicago Mercantile Exchange (1874)  London Financial Futures and Options Exchange  Eurex  Over the counter

Profits from Futures Contracts 0 STK 0 K Profit Long PositionShort Position

Contract Specifications The underlying asset  Commodity: exact specification of the quality and the available alternatives  Financial: exact specification, usually without any flexibility Contract size - depends on the likely user Delivery arrangements  Location  Packaging

Contract Specifications Delivery months  Commodity: usually allows some flexibility  Financial: usually is very specific Price quotes Price movement limits  Designed to stabilize the prices Position limits Futures and Spot Prices

Forward Contracts Just like Futures, but not traded on an exchange

Options Contracts Call (Put) options - the right, but not the obligation, to buy (sell) an asset Exercise (strike) price Expiration date (maturity) European vs. American option Each contract is for 100 shares Participants:  Buyers of calls or puts  Sellers of calls or puts (i.e. writing an option)

Options Markets Put and Call Brokers and Dealers Association  Case by case basis  First over-the-counter market CBOE and many other exchanges Recent over-the-counter markets  Large transactions  Contracts tailored to specific needs

Other Derivatives Interest-rate caps  If the interest rate on a floating rate loan exceeds the cap, the seller of the cap provides the difference Convertible bonds  At expiration the bonds can be converted into stock Weather derivatives Real Estate Price Indices

Hedging If you need to make a future foreign currency payment If you are going to receive a future foreign currency payment In general: if you need to deliver or get some asset or commodity in the future Hedging using options  Futures fix the future price, while options provide insurance at some upfront cost

Speculating Expose yourself to price movements Spot vs. Futures transactions Spot vs. Options transactions Arbitrage  Lock-in a riskless profit  Hard to come by  Absence of arbitrage enhances market efficiency