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DERIVATIVE MARKETS. 2.1. Forward Markets 2.2. Futures Markets 2.3. Options FORWARD MARKETS: A forward contract is an agreement between a bank and its client to buy or sell a financial asset for a delivery on a future date at a predetermined price. Pricing Forwards.
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DERIVATIVE MARKETS 2.1. Forward Markets 2.2. Futures Markets 2.3. Options FORWARD MARKETS: A forward contract is an agreement between a bank and its client to buy or sell a financial asset for a delivery on a future date at a predetermined price.
Pricing Forwards Forward price (F) is linked to the spot price (S) by an arbitrage relationship. For FX forwards: Synthetic Forward (long FC): Borrow the domestic currency at r → convert it into FX at St → lend the proceeds at r* . Arbitrage between synthetic and actual forward will ensure that the above equation always holds. Case 1: A Magyar Exporter sold cars to Austria and will receive the proceeds 86 days later. S=268.20, rHUF=8.5% rEUR= 1%. a) What should the Fin.Mngr. of the Magyar exporter do? b) What would be the appropriate forward rate?
The general rule: Benefits and costs of holding the asset should accrue to the buyer; and that of receiving the money to the seller. Forward price should be set accordingly. *Clue: Buyer at denominator; seller at numerator. For Gold: c = cost of depositing T-Bond futures: ytm = yield to maturity Case 2: CNY/USD = 0.1460/67 F200 = 0.1360/95 CNY: r(bor)=4% r(len)=6% USD: r(bor)=0.5% r(len)=1% Is there any arbitrage opportunity?
Bank’s Forward Quotations Forward bid-ask spread is larger than the spot, and gets larger the further the maturity (for 2 reasons: more default risk, less liquidity). Characteristics of Forward Contracts and Markets: OTC market, tailor-made, typically a credit instrument (but sometimes a collateral may be asked)
* Covered interest rate parity (CIP): Forward premium should be equal to interest rate differential. Holds by arbitrage. * Uncovered interest rate parity (UIP): Expected future spot rate should be determined by interest rate differential. In other words, E(ST) = Ft,T
FUTURES MARKETS Futures are standardized forward contracts, traded in organized exchanges and ensured by a central clearing house. A margin is always required, deposited at the Clearing House. (Initial Margin vs. Maintenance margin) Standardized contracts permit centralized trading without market makers. In a futures market, the size, the maturity (delivery) date, and the specifications of the traded asset (for commodities and agriculturals) are standardized.
The differences between forwards and futures • Forward contact is typically a credit instrument between a bank and its client; in futures delivery is reinforced only by depositing a margin. • Forwards are tailor-made (the bank sets the maturity date and the amount by responding to its client’s needs), futures contracts are standardized. • Forwards are an OTC instrument, futures trade in organized centralized exchanges supported by centralized clearing houses. • Thus, settlement and margins are strictly regulated in futures; subject to ‘relations’ in forwards • In futures, there is daily mark-to-market, in forwards not (therefore, the payoff structure with futures is slightly different from forwards; you may gain or lose slightly more with futures) • In futures, the clearing house is the counterparty to alloutstanding contracts.
SOME FUTURES MARKET CONCEPTS: Mark-to-market: daily updating of margin. Basis: F − S Open Interest: The number of outstanding contracts (bets) Cash Settlement vs. Physical Delivery • Eurodollar futures: F = 100 – r (a bet on the interest rate that will prevail on T) Used to hedge interest rate risk.
OPTIONS • An option is the right but not the obligation to buy or sell a financial asset at a predetermined price. It is an agreement whereby the option seller (writer) gives the option buyer this right, in exchange for a premium (called option price) • Two types of options: Call Options: The right to buy Put options: The right to sell • Two styles of options: American options: Can be exercised at any time till expiration, European options can only be exercised on the maturity date.
Options can trade both OTC and in organized exchanges. • Strike (Exercise) Price: X Every option with a different strike price and maturity date is a different instrument. Option Price (Premium): C, P • An option is called: In the money if S > X (call) S < X (put) At the money if S = X Out-of-money if S < X (call) S > X (put) (deep-in-the money, deep out-of-money)
Intrinsic Value (option value on expiration): CT = max (0, ST−X) PT = max (X−ST, 0) These exercise values Ct and Pt are lower bounds on option prices before T. Factors affecting option prices: • St−X • T – t : time to maturity • (expected) volatility • interest rates Delta: ΔCt / ΔSt or ΔPt / ΔSt
Exercise Questions • Do you think an American or European option identical in other respects (type, maturity date, strike price, etc.) should have a higher price ? • How and when would you use options to hedge against exchange rate risk? Give examples. • S=2.29/31. A Bulgarian exporter expects a profit of BGN 50,000 from an export transaction of GBP 500,000. The finance manager of Bulgarian exporter expects GBP to rise, however he would get fired if the export transaction ends up with a loss. What can he do?
