Derivatives Lecture 4 15.06.2024

DERIVATIVES
JSC «Kazakh-British Technical University»

Business School
Course 1.
2.
INTRODUCTION TO DERIVATIVES
EXCHANGES AND OTC MARKETS
agenda 3.
4.
CENTRAL CLEARING
FUTURES MARKETS
5. USING FUTURES FOR HEDGING
6. PRICING FINANCIAL FORWARDS AND
FUTURES
7. COMMODITY FORWARDS AND FUTURES
8. OPTIONS MARKETS
9. PROPERTIES OF OPTIONS
10. TRADING STRATEGIES
11. EXOTIC OPTIONS
12. BINOMIAL TREES
13. THE BLACK-SCHOLES-MERTON MODEL
14. OPTION SENSITIVITY MEASURES: THE
“GREEKS
15. INTEREST RATE FUTURES
16. SWAPS
LECTURE 4
FUTURES MARKETS
LEARNING OBJECTIVES
1. Define and describe the key 5. Describe the mechanics of the
features and specifications of a delivery process and contrast it with
futures contract, including the cash settlement.
underlying asset, the contract price
and size, trading volume, open 6. Evaluate the impact of different
interest, delivery, and limits. trading order types.
2. Explain the convergence of futures 7. Describe the application of marking

and spot prices. to market and hedge accounting for
futures.
3. Describe the role of an exchange in
futures transactions. 8. Compare and contrast forward and
futures contracts.
4. Explain the differences between a
normal and inverted futures market.
LO#1 Define and describe the key features and specifications of a futures contract, including the underlying asset,
the contract price and size, trading volume, open interest, delivery, and limits.
THE KEY FEATURES OF A FUTURES CONTRACT

A FUTURES CONTRACT is a standardized, exchange-tradable obligation to buy or sell a certain
amount of an underlying good at a specified price on a specified date.
Exchange-tradable Marking to market OPEN INTEREST
traded on an organized settlement of the gains and ❑ refers to the number of existing
exchange with a designated losses on the contract on a contracts at any point in time.
physical location daily basis ❑ number of long positions always
equals the number of short
Clearinghouse positions
Standardization party between the buyer and ❑ can be described as the number of
build up active secondary the seller net long contracts (short
market ensures the performance of the contracts)
increased liquidity contract ❑ the net interest of trade is zero at
the beginning of the contract
Margins Position limits
TRADING VOLUME
post collateral that can be to prevent speculators from
❑ the number of contracts traded in a
seized in the event of default having an excessive influence
day
in the market
SPECIFICATION OF CONTRACTS
Quality of the When the underlying asset is a commodity, there may be different levels of quality for that good available
underlying asset in the marketplace
Contract size Contract size specifies the quantity of the asset that must be delivered to settle a futures contract (e.g.,
one grain contract = 5,000 bushels).
Delivery location The exchange specifies the place where delivery will take place.
Delivery time Futures contracts are referred to by the month of delivery (e.g., a December corn contract). Some
contracts are not settled by delivery but by payment in cash, based on the difference between the futures
price and the market price at settlement.
Price quotations The exchange determines how the price of a contract will be quoted as well as the minimum price
and tick size fluctuation for the contract, which is referred to as the tick size. For example, grain is quoted in dollars
per bushel, and the minimum tick size is XA cent per bushel. Since a grain contract consists of 5,000
bushels, the minimum tick size is $12.50 (= 5,000 x $0.0025) per contract.
Daily price limits The exchange sets the maximum price movement for a contract during a day. When a contract moves
down by its daily price limit, it is said to be limit down. When the contract moves up by its price limit, it is
said to be limit up.
Position limits The exchange sets a maximum number of contracts that a speculator may hold in order to prevent
speculators from having an undue influence on the market. Such limits do not apply to hedgers.
SPECIFICATION OF CONTRACTS
WTI FUTURES
https://www.cmegroup.com/company/cbot.html
LO#5 Describe the mechanics of the delivery process and contrast it with cash settlement.
TERMINATING A FUTURES CONTRACT

❑ Delivery: A short terminates the position by delivering the goods, and the long pays the
contract price.
❑ Closeout: This is a scenario where the futures trader closes out the contract even before
the expiry. If a trader has a long position, they will take an equivalent short-term
position in the same contract, and both positions will offset each other.
❑ Cash settlement: In this scenario, a trader leaves his position open, and when the
contract expires, his margin account will be marked-to-market for P&L on the final day
of the contract.
❑ Exchange-for-physicals: In this case, a trader finds another trader who has an opposite
position in the same futures contract and delivers the underlying assets to them. This
happens outside the designated trading floor, but the traders are obliged to inform the
clearinghouse of the transaction immediately afterward.
LO#5 Describe the mechanics of the delivery process and contrast it with cash settlement.
DELIVERY MECHANICS
Delivery of the underlying assets rarely happens in the futures markets as traders strive to
close out their positions before the contract’s maturity.
THE DELIVERY PROCESS begins when a member with a short position issues a notice of
intention to deliver to the exchange CCP.
o The exchange must then choose one or more parties with long positions to accept deliveries.
o The price to be paid for the asset is the most recent settlement price (could be adjusted for
grade, delivery location)
o The first notice day is the first day when a notice to deliver can be submitted to the CCP.
o The last trading day is generally a few days before the last notice day.
o The last notice day is the last day when this can happen.
CASH SETTLEMENT
o Futures contracts could be designed so that they are settled in cash.
o Regulators do not like cash settlement (seem like gambling), prefer physical settlements
o Examples include those dependent on weather and real estate prices, Eurodollar futures
contract & S&P 500
LO#2 Explain the convergence of futures and spot prices.
THE CONVERGENCE OF FUTURES AND SPOT PRICES

The spot price is the current market price at
which an instrument or commodity is bought or sold
for immediate payment and delivery.
The futures price is the price of an instrument/
commodity today for delivery at maturity date.
The difference between the two is called the basis.

Basis = Spot Price - Futures Price
AS THE MATURITY DATE NEARS:

❑ the basis converges toward zero
❑ the spot price tends towards the futures price
❑ as long as no arbitrage opportunities exist on the actual maturity date
❑ At maturity, the futures price becomes the current market price
LO#4 Explain the differences between a normal and inverted futures market.
NORMAL AND INVERTED FUTURES MARKETS
NORMAL FUTURES MARKET

❑ contango market
❑ futures contracts are trading at a premium to the
spot
❑ A normal futures curve will show a rising slope
as the prices of futures contracts rise over time
INVERTED FUTURES MARKET

❑ backwardation
❑ futures contracts are trading at a discount to the
spot
❑ An inverted futures curve will show a falling slope
as the prices of futures contracts fall over time.
LO#6 Evaluate the impact of different trading order types.
TRADING ORDER TYPES

❑ Market orders are orders to buy or sell at ❑ Stop-loss orders are used to prevent
the best price available. losses or to protect profits.
❑ Discretionary order is a market order ❑ Stop-limit orders are a combination of a

where the broker has the option to delay stop and limit order
transaction in search of a better price.
❑ Good-till-canceled (GTC) orders (a.k.a.
❑ Limit orders are orders to buy or sell open orders) are orders that remain open
away from the current market price. A until they either transact or are canceled.
limit buy order is placed below the
current price. A limit sell order is placed ❑ Fill-or-kill orders must be executed
above the current price. immediately or the trade will not take
place.
LO#7 Describe the application of marking to market and hedge accounting for futures.
ACCOUNTING FOR FUTURES

o Futures contracts are settled daily, therefore, all gains/losses for a given year would be
o considered realized and, therefore, must recorded each year (i.e., marked to market).
o The mark-to-market process will most likely increase a firm’s earnings volatility.
HEDGE ACCOUNTING
o applied if futures are used to hedge a transaction
o requires the hedge to be fully documented and for the hedge to be effective (reasonable
economic relationship between hedging instrument and hedged item)
o the accounting rules permit gains and losses from the futures (that would otherwise be
reported annually) to be deferred and reported simultaneously with the gains/losses on
the hedged items.
o There are corresponding rules for hedges for tax purposes and because the rules may
differ significantly between jurisdictions, a given transaction might qualify as a hedge for
accounting purposes but not for tax purposes and vice versa.
LO#8 Compare and contrast forward and futures contracts.
FORWARD AND FUTURES CONTRACTS
FUTURES FORWARDS
Traded on an exchange Traded in an OTC market and are thus
more prone to credit risk
Both financial and non-financial variables Mainly traded on interest rates and
can be traded foreign exchange.
Trades are settled on a daily basis Trades are settled at the end of the life of
the asset.
Delivery is rare as traders closeout Actual delivery is made
positions before the delivery date
The delivery date is specified The delivery period is specified and can
be a whole month
PRACTICE TEST
https://forms.office.com/r/SLB9CP1qHa
THANK YOU

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DERIVATIVES

JSC «Kazakh-British Technical University»

2. Explain the convergence of futures 7. Describe the application of marking

THE KEY FEATURES OF A FUTURES CONTRACT

TERMINATING A FUTURES CONTRACT

THE CONVERGENCE OF FUTURES AND SPOT PRICES

The difference between the two is called the basis.

AS THE MATURITY DATE NEARS:

NORMAL AND INVERTED FUTURES MARKETS

NORMAL FUTURES MARKET

INVERTED FUTURES MARKET

TRADING ORDER TYPES

❑ Discretionary order is a market order ❑ Stop-limit orders are a combination of a

ACCOUNTING FOR FUTURES

FORWARD AND FUTURES CONTRACTS

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