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IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

R48 Derivative Markets and Instruments

Part 2


 

4.  Types of Derivatives

The following exhibit shows the different types of derivatives.

4.1.     Forward Commitments

A forward commitment is a contract that requires both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon today. The parties establish the identity and quantity of the underlying, the manner in which the contract will be executed or settled when it expires, and the fixed price at which the underlying will be exchanged. Both the parties – the buyer and the seller – have an obligation to engage in the transaction at a future date in a forward commitment.

We will look at the three types of forward commitments: forward contracts, futures contracts, and swaps.

Forward Contracts

A forward contract is an over-the-counter derivative contract in which two parties agree to exchange a specific quantity of an underlying asset at a later date at a fixed price they agree on when the contract is signed. It is a customized and private contract between two parties.

Terms of a forward contract

  • Where the asset will be delivered.
  • Identity of the underlying.
  • Number of units or quantity of the underlying. For example, if the underlying is gold and the price is fixed per gram, the number of grams to be delivered must be specified.
  • It is a customized contract between two parties and not traded over the exchange.

Risk of a forward contract

  • The long hopes the underlying will increase in value while the short hopes the asset will decrease in value. One of the two will happen and whoever owes money may default.
  • With forward contracts, no money is exchanged at the start of the contract. Further, the value of the contract is zero at initiation.

Payoff for long and short:

The diagram below illustrates the payoff diagram for long and short in a forward contract:

Notation:

  • S_0= price of the underlying at time 0;  = price of the underlying at time T
  • F_T= forward price fixed at inception at time t = 0
  • T = when the forward contract expires

Example

Whizz wants to sell 500 shares of beverage maker FTC to Fizz at $50 per share after 180 days. What happens if the market price of FTC at expiry is $50, $60, $70 or $40?

Solution:

Fizz is the long party and Whizz is the short party.

At expiry from Fizz’s perspective (long) when market price is:

$50: payoff is 0 and no one gains or loses

$60: long gains by $10

$70: long gains by $20

$40: long loses by $10 as he can buy the asset cheaper by $10 directly from the market instead of paying $50 to Whizz

From Whizz’s perspective, it is exactly the opposite to that of Fizz. When the share price increases to $70, he loses $20 as he can sell it in market for $70 but is selling for only $50 to Fizz.

The payoff for the long is depicted diagrammatically below:

Futures

A futures contract is a standardized derivative contract created and traded on a futures exchange such as the Chicago Mercantile Exchange (CME). In a futures contract, two parties agree to exchange a specific quantity of the underlying asset at an agreed-upon price at a later date. The buyer agrees to purchase the underlying asset from the other party, the seller. The agreed-upon price is called the futures price.

There are some similarities with a forward contract: two parties agreeing on a contract, an underlying asset, a fixed price called the futures price, a future expiry date, etc. But the following characteristics differentiate futures from a forward:

  • The contracts are standardized.
  • They are traded on a futures exchange.
  • The fixed price is called futures price and is denoted by (Forward prices are usually represented by F.)
  • The biggest difference is that gains or losses are settled on a daily basis by the exchange through its clearinghouse. This process is called mark to market.
  • Settlement price is the average of final futures trades and is determined by the clearinghouse.
  • The futures price converges to a spot price at expiration.
  • At expiry: the short delivers the asset and the long pays the spot price.

Let us take an example. Assume Ann enters into a contract to buy 100 grams of gold at $55 per gram after 90 days. The futures price is $55. At the end of day 1, the futures price is $58. There is a gain of $3. So, $300 ($3 per gram x 100 grams) is credited to Ann’s account. This is called marking to market. The account maintained by Ann is called the margin account.

Swaps

A swap is an over-the-counter contract between two parties to exchange a series of cash flows based on some pre-determined formula. The simplest swap is a plain vanilla interest rate swap. Consider two companies A and B in Hong Kong that enter into a swap agreement; Company A agrees to pay 10% interest per year to company B for three years on a notional principal of HKD 90,000. Company B, in turn, agrees to pay HIBOR + 150 basis points per year to company A for the same period and on the same notional principal.


Derivative Markets and Instruments Part 2