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Instruments and financial markets – part 3

Another way of dividing financial instruments is between spot market financial instruments (which we talked about in the previous article) and derivatives. These are financial instruments whose price depends on an underlying asset – an instrument which is traded on the spot market. Derivatives also have maturity.

Another way of dividing financial instruments is between spot market financial instruments (which we talked about in the previous article) and derivatives. These are financial instruments whose price depends on an underlying asset – an instrument which is traded on the spot market. Derivatives also have maturity.

The most popular derivatives are:

  • Futures (or delivery term contracts)
  • Options

Of course there are derivatives with a more complex working system.

Futures

For these instruments, the underlying asset can be:

  • The exchange rate
  • A tradeable commodity such as: oil, gold, coffee, wheat etc.
  • Stock index
  • A bond
  • A bond index

For example if we have a futures contract in EUR/USD then the EUR/USD exchange rate is the underlying. Futures contracts can be traded through exchanges and are standardized. Their characteristics include:

  • trading hours
  • the value of the contract
  • maturity
  • tick size
  • daily variation limit
  • method of delivery
  • the quality of the goods which are to be delivered (in the case of contracts on goods)
  • margin requirement

All these details are established by the exchange through which they are traded and are found in the contract specifications – documents which are available to the public on the website of the exchange. These details cannot be changed and players can trade only the contracts with maturities that are available on that particular exchange.

Futures contracts have a maturity of between one month and 5 years. Very frequently financial markets use the March cycle. This means that the maturity of a futures contract can only be in the months of March, June, September and December – usually on the third Friday of that month.

If the stock market assumes the obligation of always maintaining 4 available contracts in the March cycle, this means that when the contract that matures in March expires (reaches maturity), on the next working day the stock market will initiate a new contract that matures in March the following year.

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The tick size refers to the minimum price variation. For example if the increment step is 0.50, we can only introduce prices such as 10.00, 10.50, 11.00, 11.50, 12.00, 12.50, etc. The electronic trading system will not let players introduce prices in other forms.

The daily variation limit refers to the percentage of price variation that is accepted for a particular instrument compared with the closing price the day before. For example if the variation limit is ±15% and the price before was 100, this means that the price can vary between 85 and 115.

The delivery method is a very important detail. We can have physical delivery and cash delivery.

In the case of physical delivery, when the futures contract matures the seller has the obligation to deliver the goods and the buyer is obligated to pay for them. The goods being delivered must respect the conditions imposed by the exchange.

In the case of cash delivery, the seller of the futures contract doesn’t deliver the goods, and the buyer doesn’t pay the money. Rather, there is a final settlement price established according to the specification of the contract whereby the side that losses pays the difference to the side that wins. Let’s take a very simple example whereby we have one seller and one buyer on the stock market which traded a futures contract at the price of 100$ for the 20th of March. Let’s assume the final settlement price is 105$. This will be the price at which the two sides will close:

  • The buyer will sell at 105$ and win 5$
  • The seller will buy at 105$ and lose 5$

In case the final settlement price would have been 95$, then the buyer would lose 5$ and the seller would win 5$. Please note that in the case of a cash settlement, the asset is not delivered, but the side that loses will pay the difference to the side that wins.

A major difference between financial instruments being traded on the spot market and derivatives is the way in which the money in the players’ accounts are being used. On the spot market the money is used to pay for the instruments, but on the derivative market they are used as a guarantee.

Many wonder how is it possible that in a futures transaction someone can sell something they don’t have. What must be understood is that in a futures transaction (or any derivative transaction in general) the parties involved have an obligation to sell or buy the particular financial instruments when the contract matures. Basically, at the moment of the transaction, the two sides make a promise: one of them saying that it will buy when it matures and one that it will sell. For this promise the two sides must have a guarantee, also called a collateral or margin – which is set by the exchange. In case one of the sides can’t respect their promise, the broker will execute the collateral.

Each player must deposit the guarantee before initiating any transaction. The side that assumes the obligation to buy on maturity has the LONG position and the side who assumes the obligation to sell has a SHORT position.

Each day the broker analyzes the players’ positions by comparing the opening price and the market price at that particular time. Thus, the broker determines whether the guarantee in the account covers the losses. This process is known as mark to market. If, as a result of this process, the potential loss reaches a certain level of the guarantee, the broker issues a margin call: requires the client to deposit more cash. If the client refuses, the broker can close the client’s positions.

Generally there are two reasons why futures contracts are traded (or derivatives):

  • Speculation
  • Hedging

If the first concept is easy to understand, let’s take a closer look at hedging. Let’s assume we have a farmer that will harvest wheat in July and a factory who makes bread. The farmer must sell his wheat but there is a risk that the price of wheat might fall. On the other hand, in the case of the factory, there is a risk that the price of wheat might rise. In order to protect itself it must initiate a long position for the futures contract on wheat. For both sides this is a hedging operation (risk covering operation). Both sides will lock their buy / sell price at the price that they initiate their futures position.

We should also add the fact that the futures price is almost always different from the price of the underlying asset traded on the spot market, the difference being almost zero when the futures contract has little time until maturity. The futures prices only reflect the players’ expectation with regard to the assets upon maturity:

  • Players who think that the spot price will rise until maturity, buy futures contracts
  • Players who think the price will fall, sell future contracts

There is no algorithm on which future prices are established.

 A specific type of derivative is the forward contract. This is similar to the futures contract but:

  • The details of the contract aren’t standardized
  • It is traded through the OTC (not the exchange), so one of the counterparties is a bank
  • Banks that offer the possibility of forward contracts use a mathematical formula to calculate the price they can offer

Most forward contracts are based on exchange rates. Basically, the forward contract is an agreement between two sides where one side has the obligation to buy and the other one has the obligation to sell a sum in a certain currency for a sum in another currency, at a future date and a price that is established now. It looks like a future contract but:

  • The sums are established by mutual agreement between the two sides
  • It can be traded whenever the bank is open
  • There is no tick size
  • There are no standard maturities, any maturity that is longer than three days can be set
  • There is no daily variation limit

For forward contracts, the bank asks the client to deposit a guarantee, and the mark to market process is also mandatory. For the forward contract banks use a mathematic formula to establish the prices and the details of the contract are mutually established.

In the fourth part of this article we will look at options. Keep close.

Valentin Cioraneanu
Investment Banking Specialist

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