Chapter-1 INTRODUCTION TO FUTURES
Introduction Derivatives Based on an underlying asset or portfolio of assets Which may be construed as the primary security Derived from and therefore termed `Derivatives’ Parties who take a position Either are conferred with a right Or else have an obligation imposed on them
Introduction (Cont…) Underlying asset may be A stock A bond A foreign currency A commodity like wheat A precious metal like gold A portfolio of assets such as a stock index
Introduction (Cont…) Basic derivatives may be classified as Forward contracts Futures contracts Options contracts Swaps
Cash or Spot Transaction As soon as the deal is struck The buyer has to immediately hand over the payment to the seller The seller has to immediately transfer the rights to the asset to the buyer
Forward Contract No transaction takes place when the agreement is reached at the outset At the time of negotiating the deal The parties merely agree on the terms at which they will transact in the future Including the price to be paid for the underlying asset Actual transaction will take place at a date decided in advance No money changes hands at the outset
Forward Contract (Cont…) Having negotiated a contract both parties have a binding commitment to perform If the buyer refuses to buy the underlying asset it will tantamount to default If the seller refuses to deliver the underlying asset it will tantamount to default Such contracts are termed as COMMITMENT Contracts
Long and Short Positions The party who agrees to buy the underlying asset as per the forward contract Is termed the LONG The counterparty who agrees to deliver the underlying asset Is termed the SHORT
Options The buyer of such a contract is given a right The seller of such a contract has an obligation imposed on him Unlike forward/futures contracts where both parties have obligations imposed on them Option buyer Is referred to as the LONG Option seller Is referred to as the SHORT
Options (Cont…) A right need be exercised only if it is beneficial So option buyers or holders have no obligation to go through with the contract However the counterparty has an obligation He has to perform if the right is exercised
Options (Cont…) In a contract scheduled for a future date both parties cannot be given rights By the time the transaction date arrives one party will inevitably be at a loss If both parties have rights the contract can never be enforced Thus in forward/futures contracts Obligations are imposed on both parties In the case of options contracts Buyers are given a right and an obligation is imposed on the short
Call and Put Options Call Options Give the holder the right to buy the underlying asset The seller has an obligation to deliver the underlying asset Put Options Give the holder the right to sell the underlying asset The seller has an obligation to acquire the underlying asset
European and American Options An options contract will have a scheduled expiration date European options can be exercised only at expiration American options can be exercised at any point in time up to and including the point of expiration Expiration date is The only point in time at which a European option can be exercised The last point in time at which an American option can be exercised
Option Price or Premium Amount payable by the buyer to the seller or writer of the option at the outset For granting him the right to transact Both call and put buyers Have to pay an option premium at the outset The premium is a SUNK COST Nonrefundable if the option is not exercised subsequently
Exercise Price or Strike Price Amount payable by the option buyer per unit of the underlying asset If a call option is exercised Amount receivable by the option buyer per unit of the underlying asset If a put option is exercised Options may or may not be exercised So the strike price may or may not be paid/received subsequently
Why Option Premiums? In an options contract The writer grants a right to the buyer And takes an obligation upon himself Rights are never given away free So buyers of options have to pay the writers to acquire them
Futures Premium? Forward/futures contracts impose an obligation on both parties The futures price is the price that is set at the outset for the future transaction It is set in such a way that the value of the contract at inception is ZERO for both parties Since there are two equivalent and opposite obligations Neither party has to a pay a premium at the outset
Example of a Call Kevin has taken a long position in a European call on AMEX The exercise price is $50 The premium is $1. 75 per share Premiums are always quoted on a per share basis although the contract is for 100 shares Thus Kevin has to pay $175 at the outset If the stock price at expiration is greater than $50 It makes sense to exercise the option and acquire the stock by paying $50 Else it is better to let the option expire
Example (Cont…) No one can force him to exercise He has been given a right and not an obligation If he were to exercise the counterparty has an obligation Option writers always have a contingent obligation They have to perform if the option is exercised The premium paid at the outset is non-refundable If the option is not exercised the counterparty will not return it
Example of a Put Ross has bought a European put option on IBM with an exercise price of $85 The premium is $1. 10 Thus he has to pay $110 to the writer at the outset If the stock price at expiration is less than $85 It makes sense to exercise the option and deliver the shares for $85 each Else it is better to let the option expire and sell the asset in the spot market The writer once again has a contingent obligation
Swaps An agreement between two parties to exchange cash flows calculated using two different criteria at predefined points in time Cash flows represent interest on a pre-defined principal Using two different yardsticks One interest payment may be based on a fixed rate The counter payment may be based on a variable rate such as LIBOR
Swaps (Cont…) If both cash flows are denominated in the same currency It is termed an INTEREST RATE SWAP If the two cash flows are denominated in two different currencies It is termed a CURRENCY SWAP
Swaps (Cont…) In an interest rate swap There is no exchange of principal However a principal has to be specified to facilitate the calculation of interest Hence the term NOTIONAL PRINCIPAL In a currency swap the principal is exchanged Always at expiration And at time at inception
Swaps (Cont…) Interest rate swaps cannot be on a fixed rate to fixed rate basis So we can have FIXED to FLOATING Or FLOATING to FLOATING In the case of currency swaps we can have all three possible arrangements
Forward versus Futures Contracts Common features Both impose an obligation on both the long as well as the short Require the long to acquire the underlying asset on a future date Require the short to deliver the underlying asset on a future date
Forward versus Futures Contracts (Cont…) Futures contracts are standardized Traded on organized exchanges Forward contracts are customized They are always traded Over-the-Counter (OTC)
Standardization versus Customization In any contract scheduled to be completed on a future date certain terms need to be specified at the outset How many units of the underlying asset have to be delivered per contract Is there only one acceptable grade for delivery or is there a choice Is there only one acceptable location for delivery or is there a choice What is the delivery date or is there a DELIVERY WINDOW
Standardization versus Customization (Cont…) In customized contracts Terms and conditions are decided by bilateral negotiations Parties can incorporate any mutually acceptable terms In standardized contracts A third party will specify the allowable terms In the case of futures contracts it is the Futures Exchange
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