Day 2: Overview of forward, Day 2: Overview of forward, futures, and optionsfutures, and options

Selected discussion from Chapters 8 Selected discussion from Chapters 8 (forwards and futures) and 2 (options)(forwards and futures) and 2 (options)

FIN 441FIN 441Fall 2011Fall 2011

Basics of forward and futures Basics of forward and futures contractscontracts

• Forward contract definition:– Agreement between 2 parties calling for delivery of a specific

asset at a specified future date with a price fixed at contract signing.

• Futures contract definition:– Agreement in which 1 party agrees to sell an asset at a price

fixed at contract inception, and another party agrees to buy the asset at the fixed price. Each party deals with the futures exchange (rather than with each other).

• Forwards and futures are, in many ways, the same “type” of derivative.– Linear payoff structure.– Locks in purchase price of asset for buyer of derivative.– Locks in selling price of asset for seller of derivative.

Differences between forwards Differences between forwards and futuresand futures

• Forward contracts are bilateral (i.e., negotiated directly between buyer and seller) while buyers and sellers of futures contracts do not negotiate with one another.

• Forwards are traded OTC (unregulated) while futures are exchange-traded (regulated).

• Forward contracts can be customized to the needs of the transacting parties while futures contracts are standardized by the exchange.

• Forward contracts are settled at contract maturity while futures are settled daily.

• Forward contracts are typically much less “liquid” than are futures contracts.

• Default risk is managed by exchange (clearinghouse) for futures contracts. This risk must be managed directly by forward contract participants.

• Futures contracts will typically expose “hedgers” to “basis risk” (because of underlying standardization) while basis risk should be minimal for hedgers using forward contracts.

Futures exchangesFutures exchanges

• Historically, non-profits, but evolving into for-profit, publicly-held corporations.

• Constantly looking for assets (or more esoteric underlyings) that could generate sufficient trading interest as futures.

• Many exchanges around the world, trading wide array of products.– See Table 8.1 “Exchanges on Which Futures Trade,

November 2008” in Chance & Brooks.– See Chicago Mercantile Exchange (www.cme.com)

for examples

Some basic mechanics of futures Some basic mechanics of futures tradingtrading

• Market order– Implies “buy @ ask” or “sell @ bid.”

• Limit order– Specifies specific price at which to buy or sell.

• Stop order– Useful in preventing catastrophic loss if market makes sudden

turn.• Day order vs. good-till-canceled order• Figure 8.2 outlines process (NOTE: exchanged-traded

option trading process is almost identical…see Figure 2.2).– Difference between futures and options is that both futures

contract buyer and futures contract seller must deposit margin while only option seller deposits margin.

Daily settlement & margin Daily settlement & margin requirementsrequirements

• Credit risk is a major distinction between OTC forwards and exchange-traded futures.– This distinction is also true for OTC vs. exchange-

traded options

• Exchanges address credit risk by requiring “margin” deposits from buyer & seller.– Exchange “clearinghouse” administers margin.– A lot of potential players in this process (see Figure

8.2 in Chance and Brooks).

Mechanics of futures trading – Mechanics of futures trading – order processorder process

• Order is placed by customer.– Buy (long) futures contracts.– Sell (short) futures contracts.– Market, limit, day order, good-till-canceled, etc.

• Broker calls trading desk on exchange floor.• Order is “run” to the trading floor.

– This process has become mostly “electronic” over the last decade.

• When order is filled, details are relayed back to customer.

Mechanics of future trading – Mechanics of future trading – clearing processclearing process

• After order is filled, customer’s initial margin must be deposited (with clearinghouse).– Margin money reflects good-faith deposit that

customer will satisfy obligation.

• At end of each trading day, “settlement price” of futures contract is established.– Customers’ futures contracts are “marked-to-market.”– Is customer’s margin account greater than

maintenance margin?• If “No,” then customer needs to deposit additional funds into

margin account (“variation margin”).

Examples of daily settlementExamples of daily settlement

• Treasury bond futures example– Example similar to Table 8.2 in textbook– Each 1/32 point = $31.25– Aug 1st: Sell one CBOT T-bond futures contract @ 97-27/32– Aug 18th: Buy one CBOT T-bond futures contract @ 100-

16/32– Initial margin = $2,500, and maintenance margin = $2,000.

• Class example– Crude oil spreadsheet

• Students: do problem 11 in Chance & Brooks– Stock index futures

What happens if customer does not What happens if customer does not place “offsetting” order?place “offsetting” order?

• One of the great advantages of futures over forwards is the ease of entering into an “offsetting” trade (because of differences in liquidity).– Example: Buy October futures on August 5, Sell

October futures before expiration of contract.• If original trade is not offset, then the “long” futures

position must take delivery, and “short” futures position must make delivery.– Exchange matches longs and shorts.– One exception: Exchange for Physical (EFP)

Who are the players in futures Who are the players in futures markets?markets?

• Also applies to option markets.• Commission brokers

– Fee-based• Hedgers (i.e., risk managers)

– Use futures contracts to offset correlated business risk.• Speculators

– Scalpers (similar to floor brokers)– Day traders– Position traders

• Spread traders– Could be a hedger or arbitrage trader

• Arbitrage traders– Might often be hedge funds

Detailed examples of a couple of Detailed examples of a couple of futures contractsfutures contracts

• CME Group – http://www.cmegroup.com– Light, sweet crude oil– #2 Heating oil

Light sweet crude oilLight sweet crude oil• Underlying asset: light sweet crude oil

– Delivery in Cushing, OK.• Exchange• Contract size

– 1,000 US barrels (i.e., 42,000 US gallons)• Tick size

– $0.01 per barrel (i.e., $10 per contract)• Price limits

– ???

• Available delivery dates– See “Product Calendar”

• Expiration date– 3rd business day prior to the 25th calendar day of the month.

• Margin– See “Performance Bonds/Margins.”

• Trading volume & Open Interest– See “Settlements”

Heating oilHeating oil• Underlying asset: #2 heating oil

– Delivery point is New York Harbor.• Exchange

– New York, NY @ New York Mercantile Exchange (NYMEX). Part of the CME Group• Contract size

– 1,000 US barrels (i.e., 42,000 US gallons)• Tick size

– $0.0001 per gallon (i.e., $4.20 per contract)• Price limits

– ??????

• Available delivery dates– See “Product Calendar”

• Expiration date– Last business day of the month preceding the delivery month.

• Margin– See See “Performance Bonds/Margins.”

• Trading volume & Open Interest– See “Settlements.”

What are option contracts What are option contracts (“options”)?(“options”)?

• Definition:– Right (but not obligation) to buy or sell underlying

asset.– Forwards/Futures are obligations to buy or sell!

• Most options are formal contracts– Every financial option has a “buyer” and a “seller.”– In some cases, “options” don’t have to involve formal

contract (example, “real options”).

Basic option terminologyBasic option terminology• Call

– Right to buy underlying.• Put

– Right to sell underlying.• Writer (of option)

– Options do not magically appear. “Writer” = seller.– Writer has an obligation to perform IF the option is exercised.

• Premium– How much does writer receive from buyer?

• Exercise price– What is the fixed price at which option buyer buys or sells

underlying (if option is exercised)?• Expiration

– At what date does the option contract expire?

The basics of option payoffsThe basics of option payoffs

• Hockey stick diagrams– Call– Put– Writer of call– Writer of put

• What do forward and futures contract payoffs look like?

• More terminology:– At-the-money.– In-the-money.– Out-of-the-money

““Where” does option trading Where” does option trading happen?happen?

• Organized exchanges– Standardized contracts– See “Major Options Exchanges” (Table 2.1) in

Chance & Brooks.– Example: Chicago Board Options Exchange (

http://www.cboe.com)• Over-the-counter (OTC)

– Privately negotiated options– Data sources (ISDA & BIS surveys)

• Why do the two venues coexist?– Users differ in their need for contract standardization.– Advantages to each venue.

Option quotes & order processOption quotes & order process

• CBOE example– Look at MSFT options

• Expiration dates• Exercise prices• Premiums

• Order process almost identical to that of exchange-traded futures (see Figure 2.2)

Exiting an option transactionExiting an option transaction

• Placing an offsetting order– Buy, then sell (or sell, then buy).– Exchange-traded options are more conducive to engaging in

offsetting trades than OTC options.

• Exercising an option– Buyer chooses if and when to exercise (writer has no say).– Physical settlement vs. cash settlement.– Realizing option’s “intrinsic value” (NOTE: this is NOT the same

“intrinsic value” mentioned by stock market investors!)

• Letting it expire– Not feasible unless option is out of the money at expiration date.– Good broker should have policy of not letting “valuable” option

expire if it’s in the money!

What are the underlying assets on What are the underlying assets on which options are traded? which options are traded?

• Individual stocks (most popular example)• Stock indices• Currencies, interest rates, and commodities

(primarily OTC-traded)• Credit quality• Options on futures contracts (see Chapter 9 for

discussion of differences from other options)• Real assets (“real options” will receive some

discussion when we cover the applications of option valuation)

Closing commentsClosing comments• Forward contracts are essentially a “price lock”

agreement on a future transaction.– Traded on OTC markets.

• Futures contracts achieve a similar objective to forward contracts, BUT– Futures contracts are exchange-traded.– Futures contracts are typically written on different asset than the one for

which risk is being managed (MORE ON THIS in weeks 2 & 3!), SO– A guaranteed “price lock” is almost never achieved with futures

contracts.

• Options are similar (but not exactly like) insurance contracts.– Traded on both OTC and exchanges.– Risk managers can use options to provide payoffs when “bad”

outcomes occur.– Outcome necessary to receive payoff is very well-defined for options

(unlike insurance).– Options are almost always valuable!

Next classNext class

• Basic principles of pricing and valuing forward and futures contracts– Reading: Most of Chapter 9 (pp. 287 – 312).