Forwards and Options

Derivatives contracts come in two basic types: forwards, and options. More complex derivatives contracts build on these basic types.

FORWARDS

A forward contract is an agreement between two parties to trade a specified volume of a specified asset, at a specified price, at a specified future date. It's a binding, legal agreement.

Terms

The asset being traded is called the underlying asset. These can be commodities, shares, indexes, etc. The expiration date is when the contract has been settled. The spot price is the current market price.  The term long is used to refer to the buyer, and short to the seller. 

Payoff on a Forward Contract

Generally, the long party benefits when the (spot) price of the asset goes up (relative to the contract price), and the short party benefits if the price of the asset goes down.

For example, let's say the contract was to purchase a unit of stock index at $1,000 at the end of December. If at the end of December, the spot price for that stock index is $1,500, then:

Long position to the contract makes: $1,500 - $1,000 = $500, because they are able to buy the asset at $1,000 instead of the current market price of $1,500.

Short position to the contact loses: $1,000 - $1,500 = ($500), because they are obligated to sell the asset at $1,000 instead of the current market prices of $1,500.

FUTURES

Futures are forward contracts that can be traded at futures exchanges. Some futures exchanges are the CME (Chicago Mercantile Exchange), ICE (Intercontinental Exchange), LIFFE (London International Financial Futures Exchange), Eurex, SGX (Singapore Exchange), OSE (Osaka Tokyo Exchange), and the HKEx (Hong Kong Exchange and Clearing).

A party may buy a futures contract and become the new party.  The party that sold the contract removes themselves from the trade.

OPTIONS

An options contract gives the buyer of the contract the right (but not the obligation) to trade an asset at the contract price. There are two kinds. The call option gives the buyer of the contract the right to purchase an asset.  The put options gives the buyer the right to sell an asset.

Options Terminology

The strike price is the price the buyer pays for an asset, also called the exercise price. The act of acting on their right is called exercise.  Options contracts indicate the style of exercise allowed:

• American style allows the buyer to exercise their right only at the expiration date.
• European style allows the buyer to exercise their right  at anytime before and on the expiration date.
• Bermuda style allows the buyer to exercise their right during a defined period before and on the expiration date 

Call Options

A call option  that gives the buyer the option to not buy the asset if the contract price is higher than the spot price; ie, if they will lose money.  The seller's obligation remains the same: sell the asset at the contract price.  In a call option, the seller can only lose money, so the payoff comes in the form of a premium.  The seller needs to be paid upfront to put themselves in this exposure.

References

McDonald, Robert Lynch. Derivatives Markets. Boston: Pearson, 2013.

Central Counterparties (Chapter 2)

 

Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC DerivativesBilateral
by Jon Gregory
Published 2014

(Part of my undertaking to read Chapter 2 of books in my library.)

This book was published in 2014, so there will be some contents that are out of date.  A lot of activity has occurred in the central counterparties regulatory world recently.

Many derivatives contracts, such as options, and futures, are traded on an exchange. In an exchange, derivatives contracts are standardised. Standardisation leads to efficiency and tradeability.

While originally, contracts where traded on an exchange where the exchange served merely as a witness, and not a counterparty to the trade.  If a trading party did not live up to the contract, the exchange would fine them or even expel them.

Only approved firms and individuals may trade in an exchange.

Exchanges facilitate margining and netting between trade counterparties, which reduce the magnitude of risk for each side.

There are 3 forms of clearing: direct clearing, ring clearing, and complete clearing. Direct clearing is where each party delivers their contract obligations to the other. If there are offsetting trades, often the practice is to just net the difference, a practice called "netting", or "payment of difference". Ring clearing is an expansion of direct clearing to more than two parties. The parties must agree to join the ring. If A must pay B, who must pay C, then C can receive the payment directly from A. The exchange itself is not a participant other than an enforcer of rules. A disadvantage of rings is that a quality counterparty may be replaced by one that has lower credit quality. Not everyone in the ring benefits. Complete clearing extends and improves the ring by placing the exchange as a central counterparty to all parties. A party no longer has to worry about the credit rating of their counterparty; the exchanges assumes the rights and responsibilites of the counterparty.

Of course, if an exchanges assumes the obligations of a party, it must protect itself from exposures arising from an insolvent party. Two ways to mitigate the exposure is through the practice of initial margins and variation margins.  In addition to margins, a method of loss sharing is also implemented. One practice is requiring all members to make share purchases.

There was resistance to this concept early one: firms with high quality rating felt they lost their advantage over lower quality firms because a firm's credit rating became irrelevant.  The counterparty service can be provided by the exchange, or be provided by another firm offering that service for the eschange.

All derivatives market clearing service became standardised and used central clearing until OTC's arrived on the scene.

To be continued...

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