FNCE10002 Lecture Notes - Lecture 10: Forward Price, Call Option, Underlying
19 Jun 2018
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Principles of Finance
Lecture 10: Introduction to Derivative Securities
10.1 Overview of Derivative Markets
Derivative contract- an instrument whose value derives from that of an underlying product.
The underlying product can be commodities, shares, market indices, interest rates, currencies etc.
The three broad categories of derivatives are:
1. Forward and futures contracts
2. Option contracts
3. Swap contracts involving multiple future transactions
Derivatives are traded over-the-counter and on exchanges such as the Chicago Mercantile Exchange (CME)
and the ASX
Forward and Futures Contracts
Forward contract- an agreement to buy or sell the underlying security or product at a pre-specified price
on a pre-specified future date. (costs nothing to buy or sell a forward contract and there is no premium
paid by one party to another)
Long versus short positions
- The party that agrees to buy the underlying asset on a certain pre-specified future date for the pre-
specified price is long a forward contract or has bought the forward contract
- The party who agrees to sell the underlying asset on a certain pre-specified future date for the pre-
specified price is short a forward contract or has sold the forward contract
Spot price: This is the price at which the underlying asset can be bought and sold in the spot market now
Delivery price: This is the pre-specified delivery price on the forward contract
Forward price: The forward price and the delivery price are equal at the time the forward contract is
entered into. With the passage of time, the forward price will change as market conditions change while
the delivery price remains fixed
Maturity or delivery date
- The pre-specified date on which the contract is settled
- The holder of the short position delivers the underlying asset to the holder of the long position in
return for the delivery price
- Some contracts are settled in cash since it is either impossible or impractical to deliver the
underlying asset
Settlement
Physical delivery where the underlying security is exchanged for cash
Cash settlement where payment is made by the buyer to the seller of an amount equal to the delivery price
minus the market price at settlement multiplied by the number of units in the contract. If the market price
at settlement is higher than the delivery price, payment is made by the seller to the buyer
Futures contracts are essentially standardized forward contracts
- Contract is for the exchange of the underlying commodity or security at a pre-specified future date,
at a pre-specified price
find more resources at oneclass.com
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- Contract is standardized in terms of size, maturity, quotations, settlement, delivery, etc.
- The clearing house is always the counter party and it imposes margin requirements or mark to
market to protect themselves.
This standardization of futures contracts is also a major weakness of these contracts!
- Daily marking-to-market in futures contracts implies that a futures contract can be viewed of as a
series of one-day forward contracts
10.2 Speculating and Hedging with Futures
A pure hedger has an exposure to underlying asset (or commodity) and wishes to minimize or eliminate
this exposure
A pure speculator trades in a futures contract based on price expectations without having a direct interest
in the asset underlying the futures contract
- A speculator is affected by the futures price (but not the spot price) of the underlying asset
- By trading in futures contracts, the speculator is exposed to the risks of changes in the futures price
A long hedger is someone who hedges an underlying spot position by buying (or going long in) futures
contracts today
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Derivative contract- an instrument whose value derives from that of an underlying product. The underlying product can be commodities, shares, market indices, interest rates, currencies etc. The three broad categories of derivatives are: forward and futures contracts, option contracts, swap contracts involving multiple future transactions. Derivatives are traded over-the-counter and on exchanges such as the chicago mercantile exchange (cme) and the asx. The party that agrees to buy the underlying asset on a certain pre-specified future date for the pre- specified price is long a forward contract or has bought the forward contract. The party who agrees to sell the underlying asset on a certain pre-specified future date for the pre- specified price is short a forward contract or has sold the forward contract. Spot price: this is the price at which the underlying asset can be bought and sold in the spot market now. Delivery price: this is the pre-specified delivery price on the forward contract.
