Define what a forward contract is
A contract between a buyer and seller to exchange an underlying asset on a future date at a price agreed today - Traded OTC
Define Futures Contract
Exchange traded forward with standardised contract specifications
Outline differences between Futures/Forwards
Futures - exchange traded, standard contract, liquid, low credit risk (CCP) and therefore margin requirements
Forwards - OTC, Negotiable, Flexible, Not Liquid, Credit risk, margin sometimes required.
Define what a Swap is
A swap or contract for difference - Agreement to exchange a series of cashflows, traded OTC.
Define what an Option is
A contract between a buyer and seller giving the right to exchange an underlying asset for a pre-agreed price.
How do clearing houses manage risk and guarantee the performance of contracts.
Act as CCP, novate trades and collect initial margin and variation margin - marking to market of contracts.
How are uncleared/non clearing house OTC derivative contracts managed
ISDA SIMM - Standard Initial Margin Model
Aggregate average notional amount (AANA) of non-cleared derivatives is 8bn euro.
You’re required to meet certain margining obligations.
Initial Margin covered max daily probable loss.
Variation margin covers daily unrealised profit and loss.
Detailed definition of a financial futures contract
a contract between two parties to make or take delivery of:
A specific quantity and quality of a specified asset.
On a fixed future date.
At a price agreed today.
Who is the long?
Buyer - gains if price rises
Who is the short?
Seller - gains if price falls
What is delivery?
Expiry date
What are costs of carry?
when dealing in futures there are additional costs, e.g., cocoa
Storage, Insurance, Interest rates
What is Theoretical Fair Value of an asset (in terms of futures)
TFV = Cash (todays price) + Costs of Carry
If TFV is > than actual future price - what would you do?
buy the cocoa future and sell held cocoa (you’re not making a bet on direction of market, you’re betting on carry cost correction).
“Reverse cash and Carry”
If TFV < Futures price - what would you do?
Sell the future today and buy cash underlying
“Cash and Carry”
What is basis?
Basis = cost of carry
Basis = cash price - futures price
If basis is a negative value, the market is in…
Contango - should be normal as future price should be greater than cash due to carry
if the basis value is positive, the market is in…
Backwardation
In respect of equity cost of carry, if the Benefit/Dividend yield of an equity is > cost/interest rate, the market is in..
Backwardation.
What are the uses of futures?
Speculation and Hedging
What is STIR as a futures contract example
“Short Sterling” - Short term interest rate futures.
Fix an interest rate on a notional deposit of £500k for 3 months (3 months SONIA)
Priced at £100 - the rate.
Cash Settled
“Long” profits if rates fall - used to hedge a deposit
“Short” profits if rates rise - Used to hedge a loan
What are Long Bond Futures?
Take or make delivery of £100,000 nominal of a UK Gilt.
Physically delivered.
Actual Gilt delivered, (CTD - Cheapest to deliver)
(Buying/Selling futures contracts because you expect bond prices to rise (and yields to fall))
What are equity index futures?
EG FTSE 100 Future
Cash Settled, Contract valued at £10 per index point
What are options contracts?
A contract which gives a right/not obligation t buy/or sell -
An asset
At a particular price (Strike/K)
On or before the specified date
