1. Day 2: Overview of forward, futures, and options
Selected discussion from Chapters 8 (forwards and futures) and 2 (options)
FIN 441
Fall 2011

2. Basics of forward and futures contracts
Forward contract definition:
Agreement between 2 parties calling for delivery of a specific asset at a specified future date with a price fixed at contract signing.
Futures contract definition:
Agreement in which 1 party agrees to sell an asset at a price fixed at contract inception, and another party agrees to buy the asset at the fixed price. Each party deals with the futures exchange (rather than with each other).
Forwards and futures are, in many ways, the same “type” of derivative.
Linear payoff structure.
Locks in purchase price of asset for buyer of derivative.
Locks in selling price of asset for seller of derivative.

3. Differences between forwards and futures
Forward contracts are bilateral (i.e., negotiated directly between buyer and seller) while buyers and sellers of futures contracts do not negotiate with one another.
Forwards are traded OTC (unregulated) while futures are exchange-traded (regulated).
Forward contracts can be customized to the needs of the transacting parties while futures contracts are standardized by the exchange.
Forward contracts are settled at contract maturity while futures are settled daily.
Forward contracts are typically much less “liquid” than are futures contracts.
Default risk is managed by exchange (clearinghouse) for futures contracts. This risk must be managed directly by forward contract participants.
Futures contracts will typically expose “hedgers” to “basis risk” (because of underlying standardization) while basis risk should be minimal for hedgers using forward contracts.

4. Futures exchanges
Historically, non-profits, but evolving into for-profit, publicly-held corporations.
Constantly looking for assets (or more esoteric underlyings) that could generate sufficient trading interest as futures.
Many exchanges around the world, trading wide array of products.
See Table 8.1 “Exchanges on Which Futures Trade, November 2008” in Chance & Brooks.
See Chicago Mercantile Exchange ( for examples

5. Some basic mechanics of futures trading
Market order
Implies ask” or bid.”
Limit order
Specifies specific price at which to buy or sell.
Stop order
Useful in preventing catastrophic loss if market makes sudden turn.
Day order vs. good-till-canceled order
Figure 8.2 outlines process (NOTE: exchanged-traded option trading process is almost identical…see Figure 2.2).
Difference between futures and options is that both futures contract buyer and futures contract seller must deposit margin while only option seller deposits margin.

7. Daily settlement & margin requirements
Credit risk is a major distinction between OTC forwards and exchange-traded futures.
This distinction is also true for OTC vs. exchange-traded options
Exchanges address credit risk by requiring “margin” deposits from buyer & seller.
Exchange “clearinghouse” administers margin.
A lot of potential players in this process (see Figure 8.2 in Chance and Brooks).

8. Mechanics of futures trading – order process
Order is placed by customer.
Buy (long) futures contracts.
Sell (short) futures contracts.
Market, limit, day order, good-till-canceled, etc.
Broker calls trading desk on exchange floor.
Order is “run” to the trading floor.
This process has become mostly “electronic” over the last decade.
When order is filled, details are relayed back to customer.

9. Mechanics of future trading – clearing process
After order is filled, customer’s initial margin must be deposited (with clearinghouse).
Margin money reflects good-faith deposit that customer will satisfy obligation.
At end of each trading day, “settlement price” of futures contract is established.
Customers’ futures contracts are “marked-to-market.”
Is customer’s margin account greater than maintenance margin?
If “No,” then customer needs to deposit additional funds into margin account (“variation margin”).

10. Examples of daily settlement
Treasury bond futures example
Example similar to Table 8.2 in textbook
Each 1/32 point = $31.25
Aug 1st: Sell one CBOT T-bond futures 97-27/32
Aug 18th: Buy one CBOT T-bond futures /32
Initial margin = $2,500, and maintenance margin = $2,000.
Class example
Crude oil spreadsheet
Students: do problem 11 in Chance & Brooks
Stock index futures

12. What happens if customer does not place “offsetting” order?
One of the great advantages of futures over forwards is the ease of entering into an “offsetting” trade (because of differences in liquidity).
Example: Buy October futures on August 5, Sell October futures before expiration of contract.
If original trade is not offset, then the “long” futures position must take delivery, and “short” futures position must make delivery.
Exchange matches longs and shorts.
One exception: Exchange for Physical (EFP)

13. Who are the players in futures markets?
Also applies to option markets.
Commission brokers
Fee-based
Hedgers (i.e., risk managers)
Use futures contracts to offset correlated business risk.
Speculators
Scalpers (similar to floor brokers)
Day traders
Position traders
Spread traders
Could be a hedger or arbitrage trader
Arbitrage traders
Might often be hedge funds

14. Detailed examples of a couple of futures contracts
CME Group
Light, sweet crude oil
#2 Heating oil

15. Light sweet crude oil Underlying asset: light sweet crude oil
Delivery in Cushing, OK.
Exchange
Contract size
1,000 US barrels (i.e., 42,000 US gallons)
Tick size
$0.01 per barrel (i.e., $10 per contract)
Price limits
???
Available delivery dates
See “Product Calendar”
Expiration date
3rd business day prior to the 25th calendar day of the month.
Margin
See “Performance Bonds/Margins.”
Trading volume & Open Interest
See “Settlements”

16. Heating oil Underlying asset: #2 heating oil
Delivery point is New York Harbor.
Exchange
New York, New York Mercantile Exchange (NYMEX). Part of the CME Group
Contract size
1,000 US barrels (i.e., 42,000 US gallons)
Tick size
$ per gallon (i.e., $4.20 per contract)
Price limits
??????
Available delivery dates
See “Product Calendar”
Expiration date
Last business day of the month preceding the delivery month.
Margin
See See “Performance Bonds/Margins.”
Trading volume & Open Interest
See “Settlements.”

17. What are option contracts (“options”)?
Definition:
Right (but not obligation) to buy or sell underlying asset.
Forwards/Futures are obligations to buy or sell!
Most options are formal contracts
Every financial option has a “buyer” and a “seller.”
In some cases, “options” don’t have to involve formal contract (example, “real options”).

18. Basic option terminology
Call
Right to buy underlying.
Put
Right to sell underlying.
Writer (of option)
Options do not magically appear. “Writer” = seller.
Writer has an obligation to perform IF the option is exercised.
Premium
How much does writer receive from buyer?
Exercise price
What is the fixed price at which option buyer buys or sells underlying (if option is exercised)?
Expiration
At what date does the option contract expire?

19. The basics of option payoffs
Hockey stick diagrams
Call
Put
Writer of call
Writer of put
What do forward and futures contract payoffs look like?
More terminology:
At-the-money.
In-the-money.
Out-of-the-money

20. “Where” does option trading happen?
Organized exchanges
Standardized contracts
See “Major Options Exchanges” (Table 2.1) in Chance & Brooks.
Example: Chicago Board Options Exchange (
Over-the-counter (OTC)
Privately negotiated options
Data sources (ISDA & BIS surveys)
Why do the two venues coexist?
Users differ in their need for contract standardization.
Advantages to each venue.

21. Option quotes & order process
CBOE example
Look at MSFT options
Expiration dates
Exercise prices
Premiums
Order process almost identical to that of exchange-traded futures (see Figure 2.2)

23. Exiting an option transaction
Placing an offsetting order
Buy, then sell (or sell, then buy).
Exchange-traded options are more conducive to engaging in offsetting trades than OTC options.
Exercising an option
Buyer chooses if and when to exercise (writer has no say).
Physical settlement vs. cash settlement.
Realizing option’s “intrinsic value” (NOTE: this is NOT the same “intrinsic value” mentioned by stock market investors!)
Letting it expire
Not feasible unless option is out of the money at expiration date.
Good broker should have policy of not letting “valuable” option expire if it’s in the money!

24. What are the underlying assets on which options are traded?
Individual stocks (most popular example)
Stock indices
Currencies, interest rates, and commodities (primarily OTC-traded)
Credit quality
Options on futures contracts (see Chapter 9 for discussion of differences from other options)
Real assets (“real options” will receive some discussion when we cover the applications of option valuation)

25. Closing comments
Forward contracts are essentially a “price lock” agreement on a future transaction.
Traded on OTC markets.
Futures contracts achieve a similar objective to forward contracts, BUT
Futures contracts are exchange-traded.
Futures contracts are typically written on different asset than the one for which risk is being managed (MORE ON THIS in weeks 2 & 3!), SO
A guaranteed “price lock” is almost never achieved with futures contracts.
Options are similar (but not exactly like) insurance contracts.
Traded on both OTC and exchanges.
Risk managers can use options to provide payoffs when “bad” outcomes occur.
Outcome necessary to receive payoff is very well-defined for options (unlike insurance).
Options are almost always valuable!

26. Next class
Basic principles of pricing and valuing forward and futures contracts
Reading: Most of Chapter 9 (pp. 287 – 312).