Forward Markets & Futures Contracts PDF

**Summary of forwards.** 1. **Spot vs. Forward Markets**: The spot market settles transactions immediately, while the forward market schedules a future settlement, with an agreed-upon price fixed in the present. 2. **Advantages of Forward Contracts**: These contracts provide flexibil...

**Summary of forwards.** 1. **Spot vs. Forward Markets**: The spot market settles transactions immediately, while the forward market schedules a future settlement, with an agreed-upon price fixed in the present. 2. **Advantages of Forward Contracts**: These contracts provide flexibility in terms, quantity, and timing, reducing future price uncertainty. However, they lack cash settlement options and carry higher transaction costs. 3. **Debt Market Forwards**: In debt markets, forward contracts involve debt instruments at fixed interest rates, often calculated using Implied Forward Rates (IFR) to determine fair future values. 4. **Equity Market Forwards**: Investors use forward contracts in the equity market to agree on stock prices in advance. Examples include pension funds securing future share prices, with broker fees and interest rates factored in. 5. **Foreign Exchange Market Forwards**: Foreign exchange forwards allow locking in currency exchange rates, reducing exposure to currency fluctuations. Examples include outright forwards and currency swaps. 6. **Commodities Market Forwards**: Forward contracts for commodities consider additional costs like storage, ensuring price stability despite future market shifts. 7. **Interest Rate Contracts (FRA)**: FRAs in debt markets allow parties to set future interest rates in advance, a strategic move when rates are expected to fluctuate, reducing borrowing or investment risk. 8. **Time Options for Forwards**: Some forward contracts allow flexible settlement dates within a specific period, especially useful in currency hedging when exact future requirements are uncertain. 9. **Forwards on Derivatives**: Derivative forwards include interest rate swaps, where parties lock in future swap terms, allowing hedging for interest rate exposure without an immediate swap commitment. 10. **Risk and Hedging in Forward Markets**: Forward contracts help manage risk, but require thorough understanding and management of default risk, transaction costs, and asset quality. ### Definitions **Futures** 1. **Futures Contract**: A standardized agreement traded on exchanges where two parties commit to buy or sell a specified asset (e.g., commodities, financial instruments) at a predetermined price on a future date. Futures are backed by clearinghouses to minimize default risk​. 2. **In-the-Money (ITM)**: For futures, an ITM position is when the contract\'s underlying spot price (S) is above the strike price (X) in a long position, indicating a positive cash flow for the holder. In a short position, ITM occurs when S \< X​. 3. **Out-of-the-Money (OTM)**: For futures, an OTM long position has a spot price below the strike price, leading to a loss for the contract holder, while a short position is OTM when the spot price is above the strike price​. 4. **At-the-Money (ATM)**: ATM occurs when the spot price equals the strike price (S = X), creating a neutral position with no immediate profit or loss​. 5. **Spot Price & Strike Price**: - **Spot Price**: The current market price of an asset. - **Strike Price**: The agreed-upon price in a futures or options contract at which the asset will be exchanged at a future date​. 6. **Contango & Backwardation**: - **Contango**: A market situation where the futures price of a commodity or asset is above the expected future spot price, often due to carrying costs (e.g., storage). - **Backwardation**: When the futures price is below the expected spot price, indicating limited supply or higher immediate demand​. 7. **Initial & Variation Margin**: - **Initial Margin**: A deposit required by the clearinghouse to open a futures contract, determined by the asset\'s volatility. - **Variation Margin**: Adjustments to maintain margin levels based on daily gains or losses in a contract, marked to market daily​. 8. **Hedge Ratio**: The ratio indicating the optimal number of futures contracts to hedge against price movements of an asset. It's calculated using the correlation between spot and futures price changes and their respective standard deviations​. ### Distinctions 1. **Long vs. Short Futures Position**: - **Long Position**: Buying a futures contract, anticipating a price increase, which benefits when the asset\'s spot price exceeds the strike price. - **Short Position**: Selling a futures contract, expecting a price decrease, which benefits when the spot price falls below the strike price​. 2. **Long vs. Short Market Position**: - **Long Market Position**: Holding an asset or contract, expecting its value to increase. - **Short Market Position**: Selling an asset or contract to repurchase it later at a lower price, profiting from a price decline​. 3. **Contango vs. Backwardation**: - **Contango**: Futures prices are higher than spot prices, common with storage-heavy assets. - **Backwardation**: Futures prices are lower than spot prices, often when demand for immediate delivery is high​. 4. **Initial Margin vs. Variation Margin**: - **Initial Margin**: The initial deposit to open a futures contract. - **Variation Margin**: Daily adjustments based on profit or loss to maintain the contract, calculated from daily price changes​. ### **Options.** ### ### Participants in the Options Market Participants include: - **Hedgers**: Use options to protect against unfavorable price changes. - **Speculators**: Seek profit by betting on future price movements. - **Arbitrageurs**: Exploit price discrepancies between options and their underlying assets to secure risk-free profits​. ### 2. Determinants of Option Premium The option premium is based on: - **Intrinsic Value**: The in-the-money value, or the difference between the asset\'s spot price and the strike price. - **Time Value**: The extra amount paid for the option, covering the uncertainty of potential profit until expiration. - **Volatility**: Higher volatility increases the premium as it implies greater price movement potential. - **Interest Rates** and **Underlying Asset Price**: Changes in these factors also influence option premiums​. ### 3. Different Option Positions Options positions include: - **Long Call**: Buyer gains right to purchase at strike price. - **Short Call**: Seller is obligated to sell if the buyer exercises the option. - **Long Put**: Buyer can sell at strike price, limiting downside. - **Short Put**: Seller must buy if buyer exercises the option​. ### 4. Key Distinctions - **OTC vs. Exchange-Traded Options**: - **OTC Options** are customized and privately traded, with higher counterparty risk. - **Exchange-Traded Options** are standardized, with clearinghouse backing, offering reduced default risk. - **Put vs. Call Option**: - **Put**: Right to sell an asset at a predetermined price. - **Call**: Right to buy an asset at a predetermined price. - **American vs. European Options**: - **American**: Exercisable at any time before expiration. - **European**: Exercisable only at expiration. - **Time Value vs. Intrinsic Value**: - **Time Value**: The premium\'s non-intrinsic portion that diminishes over time. - **Intrinsic Value**: Value from the option being in-the-money, determined by the spot and strike price​. ### 5. Definitions - **Strike Price**: The price at which an option holder can buy (call) or sell (put) the underlying asset​. - **Premium**: The cost paid by the buyer to the seller for the option, influenced by time and intrinsic values​. ### 6. Short/Long Call and Put Options (Description and Diagrams) - **Long Call**: Right to buy; potential unlimited profit, limited to premium cost. - **Short Call**: Obligation to sell if exercised; profit limited to premium, potential losses if price rises. - **Long Put**: Right to sell; profit if the asset\'s price drops below strike price. - **Short Put**: Obligation to buy if exercised; profit limited to premium, with losses if price falls​. ### 7. Hedging with Options Options provide risk management by setting price floors (puts) and caps (calls), limiting exposure to adverse movements while allowing gains. For instance, buying a put option on an asset ensures a minimum selling price, protecting against a drop in value​. ### 8. Benefits of Using Options for Hedging - **Risk Limitation**: Options cap downside risk without fully restricting upside potential. - **Flexibility**: Can hedge specific risks without requiring immediate commitment. - **Cost Management**: Hedgers can limit their initial cost to the premium paid​. ### 9. Option Strategies and Spreads - **Bull Spread**: Combination of two calls (or puts) at different strikes to limit loss. - **Bear Spread**: Inverse of a bull spread; bets on price decline using calls or puts at different strikes. - **Butterfly Spread**: Combines multiple calls or puts, profiting from minimal price movement. - **Straddle**: Buys a call and put at the same strike, profiting from significant price changes. - **Strangle**: Similar to a straddle but uses different strike prices, profiting from wide price movements​. ### 10. Option Greeks - **Delta**: Measures sensitivity to changes in the underlying asset\'s price. - **Gamma**: Tracks the rate of change of Delta. - **Theta**: Indicates the rate of time decay. - **Vega**: Reflects sensitivity to volatility changes. - **Rho**: Represents the effect of interest rate changes on option price​. ### 11. Relationship Between Delta, Theta, and Gamma - **Delta** adjusts with Gamma as the underlying asset price changes. - **Gamma** measures how much Delta shifts, which is important for managing hedging adjustments. - **Theta** reflects the time decay, showing how time erodes the value of options, particularly those that are out-of-the-money​. ### 12. Role of Margins in Exchange-Traded Options Margins ensure that both buyers and sellers maintain adequate capital to cover potential losses. Sellers, in particular, must post a margin to back their obligations if the buyer exercises the option​. ### 13. Black-Scholes Pricing Model Overview The Black-Scholes formula estimates the fair value of European options, factoring in the spot price, strike price, time to expiration, volatility, and the risk-free rate. Its accuracy relies on assumptions, including constant volatility and no dividends during the option\'s life​. 1. **Money Market**: - The money market is a segment of the financial market where short-term borrowing, lending, and investment occur. It deals in highly liquid and low-risk instruments with maturities typically less than one year, such as Treasury Bills, Certificates of Deposit, and Commercial Paper. 2. **Primary Market**: - The primary market is where new financial instruments (like stocks, bonds, or other securities) are issued and sold for the first time. In this market, capital is raised directly by issuers from investors, and transactions generate funds for the issuer. 3. **Secondary Market**: - The secondary market is where existing securities are traded among investors after their initial issuance. This market provides liquidity, allowing investors to buy and sell previously issued securities without directly affecting the issuer. 4. **Interbank Market**: - The interbank market is a subset of the money market where banks trade currencies, loans, and other instruments with each other, usually to manage liquidity and meet regulatory requirements. Transactions here are typically unsecured and short-term. 5. **JIBAR (Johannesburg Interbank Average Rate)**: - JIBAR is the benchmark interest rate in South Africa for unsecured lending between banks, derived from rates quoted by major South African banks. Similar interbank rates include LIBOR (London Interbank Offered Rate) and EURIBOR (Euro Interbank Offered Rate), used in international contexts. 6. **Discount Instruments**: - Discount instruments are securities that are issued at a discount to their face (par) value and mature at face value. The return is effectively the difference between the purchase price and the face value at maturity. Treasury Bills are common discount instruments. 7. **Interest Add-On Instruments**: - These are securities that are issued at their face value, with interest added on at maturity. The interest amount is calculated based on the face value, and the investor receives the face value plus interest at the end of the term. 8. **Bankers\' Acceptance (BAs)**: - A Banker\'s Acceptance is a short-term, negotiable debt instrument issued by a company and guaranteed by a bank. BAs are used primarily in international trade to finance the shipment and storage of goods. 9. **Negotiable Certificate of Deposits (NCDs)**: - NCDs are short-term, negotiable deposit certificates issued by banks, paying interest and typically having fixed maturities. They are often issued at face value or slightly discounted and can be sold in the secondary market before maturity. 10. **Treasury Bills (TBs)**: - Treasury Bills are short-term government debt securities issued at a discount and maturing at face value. They are used by governments to finance short-term funding needs and are considered low-risk due to government backing. ### Distinctions 1. **Primary Market vs. Secondary Market**: - **Primary Market**: New securities are created, issued, and sold directly by the issuer to investors. It raises capital for issuers. - **Secondary Market**: Existing securities are traded among investors without directly affecting the issuer. It provides liquidity and marketability for securities. 2. **Discount Instruments vs. Interest Add-On Instruments**: - **Discount Instruments**: Sold below face value and redeemed at par, with no periodic interest payments. The difference between the purchase price and face value constitutes the return. - **Interest Add-On Instruments**: Issued at face value with interest calculated on the face value, paid along with the principal at maturity. 1. **Bond Market**: - The bond market is a segment of the capital market where participants buy and sell debt securities, primarily bonds. Bonds are fixed-income instruments issued by governments, municipalities, and corporations to raise capital. This market facilitates the trading of existing bonds (secondary market) and the issuance of new bonds (primary market). 2. **Macaulay Duration**: - Macaulay duration is a measure of the weighted average time until a bond's cash flows (interest and principal payments) are received. It is expressed in years and reflects the time it takes for an investor to recover the bond\'s price. It helps gauge the bond\'s sensitivity to interest rate changes. 3. **Modified Duration**: - Modified duration is a measure that adjusts Macaulay duration to estimate the percentage change in a bond's price given a 1% change in interest rates. It is a more practical measure of interest rate risk, as it shows how sensitive a bond\'s price is to interest rate fluctuations. 4. **Convexity**: - Convexity is a measure of the curvature or non-linear relationship between bond prices and changes in interest rates. It accounts for how the duration of a bond changes as interest rates change, indicating that bond prices do not move in a straight line with interest rate changes. A higher convexity means a bond's price is less affected by interest rate volatility, providing more accurate duration estimates for larger rate changes. ### Distinctions 1. **Primary vs. Secondary Capital Market**: - **Primary Capital Market**: In this market, new securities, such as stocks and bonds, are issued and sold directly to investors by the issuer to raise new capital. Transactions result in a capital inflow to the issuer. - **Secondary Capital Market**: In this market, existing securities are traded between investors, providing liquidity and marketability without directly affecting the issuer's capital. Examples include stock exchanges and over-the-counter (OTC) markets. 2. **Macaulay Duration vs. Modified Duration**: - **Macaulay Duration**: Expressed in years, it reflects the weighted average time until a bond's cash flows are received, used mainly as a theoretical measure. - **Modified Duration**: Adjusted from Macaulay duration to reflect price sensitivity, it estimates the percentage price change of a bond in response to a 1% change in interest rates, making it more practical for assessing interest rate risk. Here are comprehensive definitions and explanations of each term you\'ve listed, followed by distinctions and explanations of specific financial instruments and derivative concepts. ### Definitions 1. **Structured Finance**: Structured finance is a specialized segment of financial services focused on complex, non-standardized transactions that provide financing or risk transfer for corporations, governments, and financial institutions. It often involves creating sophisticated financial products, such as collateralized debt obligations (CDOs) or asset-backed securities (ABS), tailored to meet unique needs, manage risk, or enhance liquidity. 2. **Securitization**: Securitization is the process of pooling various types of debt---such as mortgages, auto loans, or credit card receivables---and selling them as consolidated financial instruments to investors. This allows the originating company to offload risk, improve liquidity, and transfer debt off its balance sheet. The securitized assets, known as securities, generate returns for investors based on the cash flows from the underlying debt. 3. **Credit Risk**: Credit risk refers to the risk of financial loss stemming from a borrower's inability or unwillingness to meet contractual debt obligations. Credit risk assessment is fundamental in lending and investing, as it helps institutions decide loan terms, interest rates, and potential mitigation strategies. 4. **Credit Derivatives**: Credit derivatives are financial instruments that transfer credit risk from one party to another without transferring the underlying asset. These derivatives, such as credit default swaps (CDS), enable institutions to manage exposure to credit risk more flexibly and can be used for both hedging and speculative purposes. 5. **Credit Default Swaps (CDS)**: A credit default swap is a financial contract where one party (the protection buyer) pays periodic premiums to another party (the protection seller) in exchange for coverage against the default of a specified reference entity (e.g., a corporation or government). If the reference entity defaults, the protection seller compensates the protection buyer, typically by paying the difference between the bond's face value and its market value after default. 6. **Total Return Swaps (TRS)**: A total return swap is a derivative contract in which one party (the total return receiver) agrees to pay periodic payments to another party (the total return payer) based on a reference asset\'s total return, including interest, capital gains, and losses. The total return payer compensates the receiver with a predetermined rate or spread. TRSs allow institutions to obtain exposure to an asset's performance without owning it directly. 7. **Credit Options**: Credit options are derivatives that provide the buyer with the right, but not the obligation, to sell or buy protection against the deterioration or improvement of an entity's creditworthiness. They are often used to hedge credit exposures or speculate on credit spread changes. ### Distinctions 1. **Credit Default Swaps (CDS) vs. Total Return Swaps (TRS)**: - *CDS*: In a credit default swap, the contract is purely about credit risk. The protection buyer pays premiums to protect against default, and the protection seller compensates only if a credit event, such as default or downgrade, occurs. - *TRS*: A total return swap encompasses all elements of an asset's return (interest, appreciation, depreciation), not just the credit aspect. The receiver gains or loses from the asset's total return, while the payer benefits from the fixed or variable payments, often used for broader financial exposure to the asset. 2. **HDD (Heating Degree Days) vs. CDD (Cooling Degree Days)**: - *Heating Degree Days (HDD)*: A measure used to estimate the demand for heating. It is calculated by comparing a baseline temperature (often 65°F or 18°C) to daily temperatures. If the temperature falls below this baseline, the difference is the HDD value, indicating heating needs. - *Cooling Degree Days (CDD)*: A measure used to estimate cooling demand, calculated similarly to HDD but for temperatures above the baseline. The higher the temperature above the baseline, the greater the cooling demand (CDD value). ### Explanations 1. **How Securitization Works**: - The securitization process begins with a lender or originator that has a pool of illiquid assets (e.g., loans). These assets are then sold to a Special Purpose Vehicle (SPV), which isolates the assets from the originator's balance sheet. The SPV packages the assets into tranches and issues securities to investors, who receive payouts based on the underlying assets\' cash flows. Securitization transforms these illiquid assets into tradable securities, allowing lenders to free up capital while offering investors an income stream. 2. **How Credit Default Swaps (CDSs) and Total Return Swaps (TRSs) Work**: - *CDS*: A CDS functions like insurance on a bond or loan. The protection buyer pays regular premiums, and if a credit event (e.g., default) occurs, the protection seller compensates for the loss in bond value. This transaction allows lenders to offload default risk without selling the asset itself. - *TRS*: In a TRS, the total return receiver pays for the entire return (income and capital gain/loss) of a reference asset. This setup enables institutions to gain or hedge against an asset's total performance without directly holding the asset. TRS contracts are versatile tools used for leverage or accessing an asset's performance without ownership. 3. **How Weather Derivatives Work**: - Weather derivatives are financial instruments used to hedge against or speculate on weather-related risks, such as extreme temperatures or rainfall, impacting sectors like agriculture and energy. The buyer of a weather derivative sets terms based on a weather index (e.g., CDDs, HDDs, or precipitation levels) for a specific period. If the weather outcome differs from the index by a predetermined margin, the seller compensates the buyer. These derivatives offer a flexible way to manage weather exposure in climates with variable conditions. Top of Form Bottom of Form