Topic 5: Futures and Derivatives

A futures contract is a derivative, but the futures exchange doesn't call them 'derivatives,' they call them 'futures.'

Myron Scholes

www.brainyquote.com

A. TERMS, THEORIES AND DEFINITIONS                            

Derivatives (phái sinh) are financial contracts whose value derives from the value of underlying security or asset. Futures contracts, forward contracts, options and swaps are the most common types of derivatives.

A forward contract (hợp đồng kỳ hạn) is an agreement between two parties to buy or to sell an asset at a predetermined future point of time at a predefined price. The essence of the contract is that the trade date and delivery date are distinctly different and the delivery date is a future date.

A futures contract (hợp đồng tương lai) is a standardized contract between two parties to buy or sell a
specified asset of standardized quantity and quality for a price agreed upon today with delivery and payment occurring at a specified future date (the delivery date). The contracts are negotiated and traded at a futures exchange. (wikipedia.org)

 An option (hợp đồng quyền chọn) is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlyingasset or instrument at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfill the transaction – that is to sell or buy – if the buyer "exercises" the option. The buyer pays a premium to the seller for this right. (wikipedia.org)

Swap (hợp đồng hoán đổi) refers to an exchange of one financial instrument for another between the parties concerned. This exchange takes place at a predetermined time, as specified in the contract. Currency swaps and interest rates swaps are the two most common kinds of swaps traded on the market. (The Economics Times)

Arbitrage (đầu cơ chênh lệch giá) is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. (investopedia.com)

B. VOCABULARY EXERCISES

Match these terms with their definitions. Example: 1 b

1. futures 2. options 3. commodities 4. derivatives 5. hedging 6. speculation

a, contracts giving the right, but not the obligation, to buy or sell a security, a currency, or a commodity at a fixed price during a certain period of time b, contracts to buy or sell fixed qualities of a commodity, currency, or financial asset at a future date, at a price fixed at the time of making the contract c, a general name for all financial intruments whose price depends on the movement of another price d, buying securities or other assets in the hope of making a capital gain by selling them at a higher price (or selling them in the hope of buying them back at a lower price) e, making contract to buy or sell a commodity or financial asset at a pre – arranged price in the future as a protection or “insurance” against price changes f, raw materials or primary products (metals, cereals, coffee, etc.) that are traded on special markets

C. READING

Reading 1: FUTURES, OPTIONS, SWAPS

Futures

Every weekday, enormous amounts of commodities, currencies and securities are traded for immediate delivery at their current price on spot markets. Yet there are also futures markets on which contracts can be made to buy or sell commodities, currencies and various financial assets, at a future date (e.g. three, six or nine months a head), but with the price fixed at the time of the deal. Standardized deals for fixed quantities and time period (e.g. 25 tons of copper to be delivered next June 30) are called futures; individual, non – standardized, ‘over – the – counter’ deals between two parties are called forward contracts.

Hedging and speculating

Futures, options and other derivatives exist in order that companies and individuals may attempt to diminish the effects of , or profit from, future changes in commodity and asset prices, exchange rates, interest rates, and so on. For example, the prices of foodstuffs such as wheat, maize, cocoa, coffee, tea and orange juice and frequently affected by droughts, floods and other extreme weather conditions. Consequently, many producers and buyers of raw materials want to hedge, in order to guarantee next season’s prices. When commodity prices are expected to rise, future prices are obvisously higher than (at a premium on) spot prices; when they are expected to fall they at a discount on spot prices.

In recent years, especially since financial deregulation, exchange rates and interest rates have also fluctuated wildly. Many businesses, therefore, want to buy or sell currencies at a guaranteed future price. Speculators, anticipating currency appreciations or depreciaitons, or interest movements, are also active in currency futures markets, such as the London International Financial Future Exchange (LIFFE).

Options

As well as currencies and commodities, there is now a huge futures market in stocks and shares. One can buy options giving the right – but not obligation – to buy and sell securities at a fixed price in the future. A call option gives the right to buy securities (or a currency, or a commodity) at a certain price during a certain period of time. A put option gives the right to sell an asset at a certain price during a period of time. These options allow organizations to hedge their equity investments.

For example, if you think a share worth 100 will rise, you can buy a call option giving the right to buy at 100, hoping to sell this option, or to buy and resell the share at a profit. Alternatively, you can write a put option giving someone else the right to sell the shares at 100: if the market price remains above 100, no one will exercise the option, so you earn the premium.

On the contrary, if you expect the value of a share that you own to fall below its current price of 100, you can buy a put option at 100 (or higher): if the price falls, you can still sell your shares as this price. Alternatively, you could write a call option giving someone else the right to buy the share at 100: if the maket price of the underlying security remains below the option’s exercise price or strike price, no one will take up the option, and you earn the premium.

Swaps  

Options are merely one type of deviative instrument, based on another underlying price. Many companies nowadays also arrange currency swaps and interest swaps with other companies or financial institutions. For example, a French company that can borrow francs at a preferential rate, but which also needs yen, can arrange a swap with a Japanese company in the opposite position. Such currency swaps, designed to achieve interest rate savings, are of course open to the risk of exchange rate fluctuations. A company with a lot of fixed interest debt might choose to exchange some of it for another company’s floating rate loans. Whether they save or lose money will depend on the movement of interest rates.

Exercise 1. Choose the correct answer

1. Futures contracts are.....

A. non – standard B. traded on spot markets

C. standardized D. ‘over – the – counter’ deals

 2. The options giving the right to buy securities are called.....

A. put options B. buy options

C. purchase options D. call options

3. If you believe that a share price will rise, you may.....

A. buy a put option B. buy a call option

C. sell a call option D. sell the share now

Exercise 2. Find words in the text that are in an obvious sense the opposite of the terms below:

1. appreciate 2. call 3. discount 4. drought

5. floating 6. hedging 7. spot markets 8. strike price

Reading 2: Derivatives

Derivatives is a collective term for financial market products whose value depends on (i.e. is derived from) the price of another underlying asset such as a stock, a stock index (the average value of representative stocks in a given market), a currency, a commodity, etc. The main derivatives are futures, options and swaps. They were developed to allow companies to reduce uncertainty by guaranteeing future prices, at a reasonable cost. This allows companies to plan more effectively.

Futures contracts are agreements to make or take delivery of specified commodities (foodstuffs, metals, etc.) or financial instruments at a fixed future date, at a price determined when the contract is made. Futures contracts allow both sellers and buyers to hedge or reduce risks. For example, a cocoa grower can agree a price, quantity and delivery date with a chocolate manufacturer. The seller eliminates the risk that the price will drop, and the buyer the risk that it will rise. The same logic led to the development of financial futures: contract to buy and sell stocks, stocks indexes, interest rates and currencies at a future date.

Options differ from futures in that they give the right, but not obligation, to buy or sell an asset at a fixed price on or before a given date. Buying a call option gives you the right to buy an asset; buying a put option gives you the right to sell an asset. For example, if you expect the price of a stock to rise you can buy the right to buy that stock in the future at the current market price. If you think the price of a stock will fall in the next few weeks or months you can buy the right to sell it in the future at the current price. If you are wrong, you do not have to exercise the option to buy or sell the stocks, but you lose the price of the options (i.e. premium) that the writer or seller of the options receives from the buyer. Obviously, the expectations of the writer of an options about the future value of the asset are oppostite to those of the buyer, and the writer does not expect the options to be exercised. Futures and options are traded buy speculators hoping to make a profit from price fluctuations, as well as by companies seeking to hedge. In fact, much more derivative usage is based on speculation than hedging nowadays.

Borrowers and lenders can also swap or exchange future interest payment. A company that has borrowed money at a floating rate could protect itself from a rise in interest rates by exchanging this for a fixed interest rate loan with another company or financial institution. These are interest rate swaps. Companies can also undertake exchange rate swaps, exchanging funds in two different currencies. At a future date the same amount of the currencies is re – exchanged at a predetermined exchange rate. Over the term of the agreement, the counterparties exchange the fixed or floating rate interest payment in their swapped currencies.

Exercise 3. Find the words and phrases in the text to complete the sentences:

1. A _______ ___________  is contract giving the possibility to sell a specified quantity of securities, foreign exchange or commodities in the future, if it is advantageous to do so.

2. _________ are raw materials such as agriculture products and metals that are traded on special exchanges.

3. ____________________  are forward contracts for the fixed – quantity and predetermined – price purchase and sale of securities, precious metals, etc.....

4. A __________________  is a contract giving the buyer the right, but not obligation, to buy an asset in the future.

5. If you______ you make transactions that are designed to reduce risk regarding a particular price, interest rate or exchange rate.

6. An__________________ __________  is an exchange of future payment on borrowed money according to special terms.

7. If you________ an option you use or implement the option, taking up the possibility to buy or sell something.

8. A _________ anticipates future changes in a market and make risky transactions, hoping to make a gain.

9. A _________ is the money the writer of an option receives from the buyer.

10. A__________________  is a measurement of the value of a section of the stock market and computed from the prices of selected stocks.

Exercise 4. Fill in the blanks using words and phrases below:

determine      interest payments       eliminate           option            exercise prices           guarantee         risks          reduce         uncertainty            swap

1. Companies with fixed and floating loans can choose to ___________                                .

2. Futures contracts allow you to ______ short – term_______ .

3. Hedging is the attempt to _______ _________ ; speculating is the opposite.

4. If prices move the wrong way, the buyer of _____  do not_______ them.

5. With futures, you can________________ several months in advance.

D. GUIDE

Exercise 1: 1 – C, 2 – D, 3 – B

Exercise 2:

1. appreciate – depreciate 2. call – put 3. discount – premium 4. drought – flood

5. floating – fixed 6. hedging – speculating 7. spot markets – future makets 8. strike price – market price

Exercise 3:

1. put option 2. commodities 3. futures contracts 4. call option 5. hedge

6. interest rate swap 7. exercise 8. speculator 9. premium 10. stock index

Exercise 4:

1. swap interest payments

2. eliminate .... uncertainty

3. reduce risks

4. option .... exercise

5. guatantee prices

F. FURTHER STUDY

1. Reading:

http://en.wikipedia.org/wiki/Derivative_(finance)

2. Can’t help watching:

Wall Street casino: The derivatives crisis