F&O Business Terminology
Derivatives
Financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying value on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI)), weather conditions, or other items. Credit derivatives are based on loans, bonds or other forms of credit.
The main types of derivatives are forwards, futures, options, and swaps.
Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation. Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.
Forwards
A forward contract or simply a "forward" is an agreement between two parties to buy or sell an asset at a specified point of time in the future. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. The most typical forward is a forward foreign currency contract, which is a type of security (finance), and involves the contemplated exchange of or spreads in exchange rates among two currencies such as U.S. dollars and Canadian dollars. Currency forwards conducted in the are typically not exchange traded arrangements but rather over-the-counter (finance) or "private" trades among an investor and a brokerage firm or bank. Currency forwards are a type of derivative security.
The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.
This process is used in financial operations to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.
A closely related contract is a futures contract; they differ in certain respects. A principal difference is that forwards (as mentioned above) in the are not exchange traded arrangements whereas futures are typically regulated contracts trading on an exchange. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures - such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. A forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.
Futures
A futures contract, in finance, refers to a standardized contract to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (the futures price). The contracts are traded on a futures exchange. Futures Contracts are not "direct" securities like stocks, bonds, rights or warrants as outlined by the Uniform Securities Act. They are still securities however, though they are type of derivative contract.
The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract.
In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all-- that is, for "financial futures", the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates.
The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange at a price specified today.
A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, (but not future or future contracts) are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement.
Options
An option is a contract between a buyer and a seller that gives the buyer the right—but not the obligation—to buy or to sell a particular asset (the underlying asset) at a later day at an agreed price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option gives the buyer the right to buy the underlying asset; a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, or shares of stock or some other security, such as, among others, a futures contract. For example, buying a call option provides the right to buy a specified quantity of a security at a set agreed amount, known as the 'strike price' at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote the option, must fulfill the terms of the contract.
The theoretical value of an option can be evaluated according to several models. These models, which are developed by quantitative analysts, attempt to predict how the value of the option will change in response to changing conditions. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other. Another important class of options, particularly in the , are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.
Swaps
A swap is a derivative in which two counterparties agree to exchange one stream of cash flow against another stream. These streams are called the legs of the swap. The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.
Hedging
In finance, a hedge is a position established in one market in an attempt to offset exposure to the price risk of an equal but opposite obligation or position in another market — usually, but not always, in the context of one's commercial activity. Hedging is a strategy designed to minimize exposure to such business risks as a sharp contraction in demand for one's inventory, while still allowing the business to profit from producing and maintaining that inventory. A typical hedger might be a farmer with 2000 acres of unharvested wheat in the ground, who would rather tend his crop without the distraction of uncertain prices. He's a farmer, not a speculator, yet his unharvested "inventory" may have lost 35% of its value ($285,000) in the three months he's been planning his planting. He might have decided he could live with a price of only eight or nine dollars a bushel, and to offset his planted position with an approximately equal but opposite position in the market for wheat on the Minneapolis Grain Exchange by selling ten wheat futures contracts for December delivery. This farmer is thereby a hedger indifferent to the movements of the market as a whole, and has reduced his price risk to the difference between the price he will receive from a local buyer at harvest time, and the price at which he will simultaneously liquidate his obligation to the Exchange. If that difference widens, he earns a little more at harvest time. If that difference narrows, he earns a little less. He has mitigated, but not eliminated, the risk of losing the value of his wheat as of the day he established his hedge.
Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, expects to face natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.
A hedger (such as a manufacturing company) is thus distinguished from an arbitrageur or speculator in derivative purchase behavior.
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit. A person who engages in arbitrage is called an arbitrageur such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies. If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage-free market. Arbitrage equilibrium is a precondition for a general economic equilibrium. The assumption that there is no arbitrage is used in quantitative finance to calculate a unique risk neutral price for derivatives.
Over-the-counter (OTC)
OTC trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e. exchanges), such as futures exchanges or stock exchanges.
An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. Forwards and swaps are prime examples of such contracts. It is mostly done via the computer or the telephone. For derivatives, these agreements are usually governed by an International Swaps and Derivatives Association agreement. This segment of the OTC market is occasionally referred to as the "Fourth Market."
The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.
Strategies
Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads.
Going Long
When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase.
For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, Joe is going long, with the expectation that the price of gold will rise by the time the contract expires in September.
By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and the profit would be $2,000. Given the very high leverage (remember the initial margin was $2,000), by going long, Joe made a 100% profit!
Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have realized a 100% loss. It's also important to remember that throughout the time that Joe held the contract; the margin may have dropped below the maintenance margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit.
Going Short
A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator.
Let's say that Sara did some research and came to the conclusion that the price of oil was going to decline over the next six months. She could sell a contract today, in November, at the current higher price, and buy it back within the next six months after the price has declined. This strategy is called going short and is used when speculators take advantage of a declining market.
Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000.
By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made a different decision, her strategy could have ended in a big loss.
Spreads
Going long and going short are positions that basically involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. Another common strategy used by futures traders is called “spreads.”
Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short (naked) futures contracts.
There are many different types of spreads, including:
- Calendar Spread - This involves the simultaneous purchase and sale of two futures of the same type, having the same price, but different delivery dates. Sometimes referred to as an interdelivery, intramarket, time or horizontal spread.
- Intermarket Spread - The simultaneous purchase of a given delivery month of a futures contract on one exchange, and the simultaneous sale of the same delivery month of the same futures contract on another exchange in the hope the sale price is greater than the purchase price.
- Inter-Exchange Spread - This is any type of spread in which each position is created in different futures exchanges. For example, the investor may create a position in the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).
Investment Strategy Examples
- Collar – this uses options to limit the range of possible positive or negative returns on an investment in an asset to a specific range. To do this, an investor who owns an asset simultaneously buys a put option and sells (writes) a call option on the same asset. The strike price on the call needs to be above the strike price for the put, and the expiration dates should be the same. After establishing the portfolio in this manner, the market value of the portfolio will be between the strike price on the call and the strike price on the put. Thus possible gains and losses (the value of the portfolio minus the cost of acquiring it) are confined within a specified range.
- Covered Call - a transaction in which the seller of call options already owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. These owned shares provide the "cover" as they can be handed over to the buyer of the options when he decides to exercise them, instead of having to buy the optioned shares at unfavorable market prices in the case of "uncovered" or short call. Thus, the covered call limits the (potentially unlimited) loss that results from a short call when the price of the underlying stock moves above the strike price of the option.
- Straddle - involves the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement. The purchase of particular option derivatives is known as a long straddle, while the sale of the option derivatives is known as a short straddle.