Derivatives

Content

Futures, Options, SWAPS & Forwards.

Futures Contract & Definition
Margin Requirements
Difference between a Futures Contract and a Forward Contract
Derivatives - Forward Contracts
Derivatives - Future Contracts
Derivatives - Options: Calls and Puts
Derivatives - Swaps
Derivatives - Other Types of Derivatives
Derivatives - Exchange Traded Options
Derivatives - Swap Markets and Contracts
Derivatives - Currency Swaps
Derivatives - Interest Rate and Equity Swaps
SOP Swaps: An Overview

What is a 'Bond'
The Repo Market
Securities lending
Mark To Market - MTM

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DEFINITION of 'Futures Contract'

A contractual agreement, generally made on the trading floor of a futures exchange, to buy or
sell a particular commodity or financial instrument at a pre-determined price in the future.
Futures contracts detail the quality and quantity of the underlying asset; they are standardized
to facilitate trading on a futures exchange. Some futures contracts may call for physical
delivery of the asset, while others are settled in cash.
BREAKING DOWN 'Futures Contract'
The terms "futures contract" and "futures" refer to essentially the same thing. For example,
you might hear somebody say they bought "oil futures", which means the same thing as "oil
futures contract". If you want to get really specific, you could say that a futures contract refers
only to the specific characteristics of the underlying asset, while "futures" is more general and
can also refer to the overall market as in: "He's a futures trader."
Futures contract
In finance, a futures contract (more colloquially, futures) is a standardized forward contract
which can be easily traded between parties other than the two initial parties to the contract.
The parties initially agree to buy and sell an asset for a price agreed upon today (the forward
price) with delivery and payment occurring at a future point, the delivery date. Because it is a
function of an underlying asset, a futures contract is a derivative product.
Contracts are negotiated at futures exchanges, which act as a marketplace between buyers
and sellers. The buyer of a contract is said to be long position holder, and the selling party is
said to be short position holder. As both parties risk their counterparty walking away if the
price goes against them, the contract may involve both parties lodging a margin of the value
of the contract with a mutually trusted third party. For example in gold futures trading, the
margin varies between 2% and 20% depending on the volatility of the spot market.
The first futures contracts were negotiated for agricultural commodities, and later for natural
resources such as oil. Financial futures were introduced in 1972, and in recent decades,
currency futures, interest rate futures and stock market index futures have played an
increasingly large role in the overall futures markets.
The original use of futures contracts was to mitigate the risk of price or exchange rate
movements by allowing parties to fix prices or rates in advance for future transactions. This
could be advantageous when (for example) a party expects to receive payment in foreign
currency in the future, and wishes to guard against an unfavorable movement of the currency
in the interval before payment is received.
However futures contracts also offer opportunities for speculation in that a trader who predicts
that the price of an asset will move in a particular direction can contract to buy or sell it in the
future at a price which (if the prediction is correct) will yield a profit.
Definition of 'Futures Contract'
Futures contract is a contract where both parties agree to buy and sell a particular asset of
specific quantity and at a predetermined price.

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Definition: A futures contract is a contract between two parties where both parties agree to
buy and sell a particular asset of specific quantity and at a predetermined price, at a specified
date in future.
Description: The payment and delivery of the asset is made on the future date termed as
delivery date. The buyer in the futures contract is known as to hold a long position or simply
long. The seller in the futures contracts is said to be having short position or simply short.
The underlying asset in a futures contract could be commodities, stocks, currencies, interest
rates and bond. The futures contract is held at a recognized stock exchange. The exchange
acts as mediator and facilitator between the parties. In the beginning both the parties are
required by the exchange to put beforehand a nominal account as part of contract known as
the margin.
Since the futures prices are bound to change every day, the differences in prices are settled on
daily basis from the margin. If the margin is used up, the contractee has to replenish the
margin back in the account. This process is called marking to market. Thus, on the day of
delivery it is only the spot price that is used to decide the difference as all other differences
had been previously settled.
Futures Markets - What is a Futures Contract?
Unlike a stock, which represents equity in a company and can be held for a long time, if not
indefinitely, futures contracts have finite lives. They are primarily used for hedging commodity
price-fluctuation risks or for taking advantage of price movements, rather than for the buying
or selling of the actual cash commodity. The word "contract" is used because a futures contract
requires delivery of the commodity in a stated month in the future unless the contract is
liquidated before it expires.
The buyer of the futures contract (the party with a long position) agrees on a fixed purchase
price to buy the underlying commodity (wheat, gold or T-bills, for example) from the seller at
the expiration of the contract. The seller of the futures contract (the party with a short
position) agrees to sell the underlying commodity to the buyer at expiration at the fixed sales
price. As time passes, the contract's price changes relative to the fixed price at which the trade
was initiated. This creates profits or losses for the trader.
In most cases, delivery never takes place. Instead, both the buyer and the seller, acting
independently of each other, usually liquidate their long and short positions before the
contract expires; the buyer sells futures and the seller buys futures.
Arbitrageurs in the futures markets are constantly watching the relationship between cash and
futures in order to exploit such mispricing. If, for example, an arbitrageur realized that gold
futures in a certain month were overpriced in relation to the cash gold market and/or interest
rates, he would immediately sell those contracts knowing that he could lock in a risk-free
profit. Traders on the floor of the exchange would notice the heavy selling activity and react by
quickly pushing down the futures price, thus bringing it back into line with the cash market. For
this reason, such opportunities are rare and fleeting. Most arbitrage strategies are carried out
by traders from large dealer firms. They monitor prices in the cash and futures markets from
"upstairs" where they have electronic screens and direct phone lines to place orders on the
exchange floor
Who Trades Futures and Why?
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There are two basic categories of futures participants: hedgers and speculators.
In general, hedgers use futures for protection against adverse future price movements in the
underlying cash commodity. The rationale of hedging is based upon the demonstrated
tendency of cash prices and futures values to move in tandem.
Hedgers are very often businesses, or individuals, who at one point or another deal in the
underlying cash commodity. Take, for instance, a major food processor who cans corn. If corn
prices go up. he must pay the farmer or corn dealer more. For protection against higher corn
prices, the processor can "hedge" his risk exposure by buying enough corn futures contracts to
cover the amount of corn he expects to buy. Since cash and futures prices do tend to move in
tandem, the futures position will profit if corn prices rise enough to offset cash corn losses.
Speculators are the second major group of futures players. These participants include
independent floor traders and investors. Independent floor traders, also called "locals", trade
for their own accounts. Floor brokers handle trades for their personal clients or brokerage
firms.
For speculators, futures have important advantages over other investments:
a. If the trader's judgment is good. he can make more money in the futures market faster
because futures prices tend, on average, to change more quickly than real estate or
stock prices, for example. On the other hand, bad trading judgment in futures markets
can cause greater losses than might be the case with other investments.
b. Futures are highly leveraged investments. The trader puts up a small fraction of the
value of the underlying contract (usually 10%-15% and sometimes less) as margin, yet
he can ride on the full value of the contract as it moves up and down. The money he
puts up is not a down payment on the underlying contract, but a performance bond. The
actual value of the contract is only exchanged on those rare occasions when delivery
takes place. (Compare this to the stock investor who generally has to put up at least
50% of the value of his stocks.) Moreover the commodity futures investor is not charged
interest on the difference between the margin and the full contract value.
c. In general, futures are harder to trade on inside information. After all, who can have the
inside scoop on the weather or the Chairman of the Federal Reserve's next proclamation
on the money supply? The open outcry method of trading - as opposed to a specialist
system - insures a very public, fair and efficient market.
d. Commission charges on futures trades are small compared to other investments, and the
investor pays them after the position is liquidated.
e. Most commodity markets are very broad and liquid. Transactions can be completed
quickly, lowering the risk of adverse market moves between the time of the decision to
trade and the trade's execution.
What is traded?
A cash commodity must meet three basic conditions to be successfully traded in the futures
market:
1. It has to be standardized and, for agricultural and industrial commodities, must be in a
basic, raw, unprocessed state. There are futures contracts on wheat, but not on flour.
Wheat is wheat (although different types of wheat have different futures contracts). The
miller who needs a wheat futures to help him avoid losing money on his flour
transactions with customers wouldn't need a flour futures. A given amount of wheat
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yields a given amount of flour and the cost of converting wheat to flour is fairly fixed.
hence predictable.
2. Perishable commodities must have an adequate shelf life, because delivery on a futures
contract is deferred.
3. The cash commodity's price must fluctuate enough to create uncertainty, which means
both risk and potential profit.
Futures Contract
What it is:
Futures contracts give the buyer an obligation to purchase an asset (and the seller an
obligation to sell an asset) at a set price at a future point in time.
How it works (Example):
The assets often traded in futures contracts include commodities, stocks, and bonds. Grain,
precious metals, electricity, oil, beef, orange juice, and natural gas are traditional examples of
commodities, but foreign currencies, emissions credits, bandwidth, and certain financial
instruments are also part of today's commodity markets.
There are two kinds of futures traders: hedgers and speculators. Hedgers do not usually seek a
profit by trading commodities futures but rather seek to stabilize the revenues or costs of their
business operations. Their gains or losses are usually offset to some degree by a
corresponding loss or gain in the market for the underlying physical commodity.
For example, if you plan to grow 500 bushels of wheat next year, you could either grow the
wheat and then sell it for whatever the price is when you harvest it, or you could lock in a price
now by selling a futures contract that obligates you to sell 500 bushels of wheat after the
harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat
prices. On the other hand, if the season is terrible and the supply of wheat falls, prices will
probably rise later -- but you will get only what your contract entitled you to. If you are a bread
manufacturer, you might want to purchase a wheat futures contract to lock in prices and
control your costs. However, you might end up overpaying or (hopefully) underpaying for the
wheat depending on where prices actually are when you take delivery of the wheat.
Speculators are usually not interested in taking possession of the underlying assets. They
essentially place bets on the future prices of certain commodities. Thus, if you disagree with
the consensus that wheat prices are going to fall, you might buy a futures contract. If your
prediction is right and wheat prices increase, you could make money by selling the futures
contract (which is now worth a lot more) before it expires (this prevents you from having to
take delivery of the wheat as well). Speculators are often blamed for big price swings, but they
also provide a lot of liquidity to the futures market.
Futures contracts are standardized, meaning that they specify the underlying commodity's
quality, quantity and delivery so that the prices mean the same thing to everyone in the
market. For example, each kind of crude oil (light sweet crude, for example) must meet the
same quality specifications so that light sweet crude from one producer is no different from
another and the buyer of light sweet crude futures knows exactly what he's getting.

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The ability to trade futures contracts relies on clearing members, which manage the payments
between buyer and seller. They are usually large banks and financial services companies.
Clearing members guarantee each trade and thus require traders to make good-faith deposits
(called margins) in order to ensure that the trader has sufficient funds to handle potential
losses and will not default on the trade. The risk borne by clearing members lends further
support to the strict quality, quantity and delivery specifications of futures contracts.
Why it Matters:
Futures trading is a zero-sum game; that is, if somebody makes a million dollars, somebody
else loses a million dollars. The downside is unlimited. Because futures contracts can be
purchased on margin, meaning that the investor can buy a contract with a partial loan from his
broker, traders have an incredible amount of leverage with which to trade thousands or
millions of dollars worth of contracts with very little of his own money. Further, futures
contracts require daily settlement, meaning that if the futures contract bought on margin is out
of the money on a given day, the contract holder must settle the shortfall that day. The
unpredictable price swings for the underlying commodities and the ability to use margins
makes trading futures a risky proposition that takes a tremendous amount of skill, knowledge
and risk tolerance
Futures Trading Basics
A futures contract is a standardized contract that calls for the delivery of a specific quantity of
a specific product at some time in the future at a predetermined price. Futures contracts are
derivative instruments very similar to forward contracts but they differ in some aspects.
Futures contracts are traded in futures exchanges worldwide and covers a wide range of
commodities such as agriculture produce, livestock, energy, metals and financial products such
as market indices, interest rates and currencies.
Why Trade Futures?
The primary purpose of the futures market is to allow those who wish to manage price risk (the
hedgers) to transfer that risk to those who are willing to take that risk (the speculators) in
return for an opportunity to profit.
Hedging
Producers and manufacturers can make use of the futures market to hedge the price risk of
commodities that they need to purchase or sell in order to protect their profit margins.
Businesses employ a long hedge to lock in the price of a raw material that they wish to
purchase some time in the future. To lock in a selling price for a product to be sold in the
future, a short hedge is used.
Speculation
Speculators assume the price risk that hedgers try to avoid in return for a possibility of profits.
They have no commercial interest in the underlying commodities and are motivated purely by
the potential for profits. Although this makes them appear to be mere gamblers, speculators
do play an important role in the futures market. Without speculators bridging the gap between
buyers and sellers with a commercial interest, the market will be less fluid, less efficient and
more volatile.
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Futures speculators take up a long futures position when they believe that the price of the
underlying will rise. They take up a short futures position when they believe that the price of
the underlying will fall.
Example of a Futures Trade
In March, a speculator bullish on soybeans purchased one May Soybeans futures at $9.60 per
bushel. Each Soybeans futures contract represents 5000 bushels and requires an initial margin
of $3500. To open the futures position, $3500 is debited from his trading account and held by
the exchange clearinghouse.
Come May, the price of soybeans has gone up to $10 per bushel. Since the price has gone up
by $0.40 per bushel, the speculator can exit his futures position with a profit of $0.40 x 5000
bushels = $2000.
Futures Contract Details
Every futures contract is an agreement that represents a specific quantity of the underlying
commodity to be delivered some time in the future for a pre-agreed price.
Unlike options, buyers and sellers of futures contracts are obligated to take or make delivery of
the underlying asset on settlement date.
Futures Contract Specifications
The Underlying
Each futures contract represents a specific underlying asset to be delivered on the delivery
date. Besides commodities, other instruments such as interest rates, currencies and stock
indices are also traded in the futures exchanges.
Symbol
Each futures contract traded in a futures exchange is identified by a unique ticker symbol.
Contract Size (or Trading Unit)
The contract size states the amount and unit of the underlying commodity represented by
each futures contract (E.g. 1000 barrels of crude oil or 50 troy ounces of platinum).
Price Quotation
The quoted price of a futures contract is the agreed price (per unit) of the underlying asset
that the buyer has to pay to the seller in order to take delivery of the goods. Correspondingly,
it is also the price at which the seller must sell the underlying asset to the buyer. Depending on
the type of futures contract, the price can be quoted in cents, dollars or even in a foreign
currency.
Grade of Deliverable
The grade not only specifies the quality of the underlying but also the manner and the exact
place(s) of delivery.

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Delivery Date
Each futures contract has a specific delivery date where the seller of the futures contract is
required to make delivery of the underlying product being traded and the buyer of the futures
contract is required to take delivery.
Last Trading Day
Trading shuts down some time before the delivery date to give the futures contract seller
sufficient time to prepare the underlying products for delivery. Futures positions which have
not been closed out (offset) before end of the last trading day will have to be settled by
making or taking delivery of the underlying product.
Delivery Months
Every futures contract has standardized months at which the underlying can be traded for
delivery.
Futures Exchanges
A futures exchange is a financial exchange where futures contracts are traded. Futures
exchanges are usually commodity exchanges. This is because all derivatives, including
financial derivatives, are often traded at commodity exchanges. The reason for this has to do
with the history of the development of these exchanges.
In the 19th century, the first exchanges were opened in Chicago to trade forward contracts on
commodities. Exchange traded forward contracts are called futures contracts. Thus, futures
trading was synonymous with commodity trading and it has been the case for around a
hundred years.
In the 1970s, these commodity exchanges started offering future contracts on other products,
such as stocks, options contracts and interest rates. Products such as these are called financial
futures. Trading in this new class of futures contracts quickly outgrown the traditional
commodities markets. In recognition of this development, commodity exchanges are now
generally known as futures exchanges.
Major Global Exchanges
Today, global exchanges can be found all over the world in both developed and developing
countries. The following table lists some of the largest futures exchanges in the world and the
principle commodities that are traded at each of these exchanges.
Exchange

Headquart
Principle Commodities
er

Chicago Board of Trade (CBOT)

Chicago,
USA

Grains, Energy

Chicago Mercantile Exchange

(CME)

Chicago,
USA

Livestock

New York Mercantile Exchange New York,

(NYMEX)
USA

Softs, Base Metals, Energy, Precious

Metals

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London Metal Exchange (LME) London, UK Base Metals

NYSE Euronext (Euronext)

Paris,
France

Grains, Softs

Tokyo Commodity Exchange

(TOCOM)

Tokyo,
Japan

Softs, Base Metals, Energy, Precious

Metals

Tokyo Grain Exchange (TGE)

Tokyo,
Japan

Grains, Softs

Margin Requirements
To ensure the smooth running of the futures market, participants in a futures contract are
required to post a performance bond of sorts as a form of guarantee. This is known as the
margin. The amount of margin required can vary depending on the perceived volatility of the
underlying asset.
Futures Margins
Participants in a futures contract are required to post performance bond margins in order to
open and maintain a futures position.
Futures margin requirements are set by the exchanges and are typically only 2 to 10 percent of
the full value of the futures contract.
Margins are financial guarantees required of both buyers and sellers of futures contracts to
ensure that they fulfill their futures contract obligations.
Initial Margin
Before a futures position can be opened, there must be enough available balance in the
futures trader's margin account to meet the initial margin requirement. Upon opening the
futures position, an amount equal to the initial margin requirement will be deducted from the
trader's margin account and transferred to the exchange's clearing firm. This money is held by
the exchange clearinghouse as long as the futures position remains open.
Maintenance Margin
The maintenance margin is the minimum amount a futures trader is required to maintain in his
margin account in order to hold a futures position. The maintenance margin level is usually
slightly below the initial margin.
If the balance in the futures trader's margin account falls below the maintenance margin level,
he or she will receive a margin call to top up his margin account so as to meet the initial
margin requirement.
Example
Let's assume we have a speculator who has $10000 in his trading account. He decides to buy
August Crude Oil at $40 per barrel. Each Crude Oil futures contract represents 1000 barrels
and requires an initial margin of $9000 and has a maintenance margin level set at $6500.
Since his account is $10000, which is more than the initial margin requirement, he can
therefore open up one August Crude Oil futures position.
One day later, the price of August Crude Oil drops to $38 a barrel. Our speculator has suffered
an open position loss of $2000 ($2 x 1000 barrels) and thus his account balance drops to
$8000.

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Although his balance is now lower than the initial margin requirement, he did not get the
margin call as it is still above the maintenance level of $6500.
Unfortunately, on the very next day, the price of August Crude Oil crashed further to $35,
leading to an additional $3000 loss on his open Crude Oil position. With only $5000 left in his
trading account, which is below the maintenance level of $6500, he received a call from his
broker asking him to top up his trading account back to the initial level of $9000 in order to
maintain his open Crude Oil position.
This means that if the speculator wishes to stay in the position, he will need to deposit an
additional $4000 into his trading account.
Otherwise, if he decides to quit the position, the remaining $5000 in his account will be
available to use for trading once again.
Long Futures Position
The long futures position is an unlimited profit, unlimited risk position that can be entered by
the futures speculator to profit from a rise in the price of the underlying.
The long futures position is also used when a manufacturer wishes to lock in the price of a raw
material that he will require sometime in the future. See long hedge.
Long Futures Position Construction
Buy 1 Futures Contract
To construct a long futures position, the trader must have enough balance in his account to
meet the initial margin requirement for each futures contract he wishes to purchase.

Unlimited Profit Potential

There is no maximum profit for the long futures position. The futures trader stands to profit as
long as the underlying futures price goes up.
Unlimited Risk
Large losses can occur for the long futures position if the underlying futures price falls
dramatically.
Breakeven Point(s)
The underlier price at which break-even is achieved for the long futures position position can
be calculated using the following formula.

Breakeven Point = Purchase Price of Futures Contract

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Example
Suppose June Crude Oil futures are trading at $40 and each futures contract covers 1000
barrels of Crude Oil. A futures trader enters a long futures position by buying 1 contract of June
Crude Oil futures at $40 a barrel.
Scenario #1: June Crude Oil futures rise to $50
If June Crude Oil futures instead rally to $50 on delivery date, then the long futures position will
gain $10 per barrel. Since the contract size for Crude Oil futures is 1000 barrels, the trader will
achieve a profit of $10 x 1000 = $10000.
Scenario #2: June Crude Oil futures drops to $30
If June Crude Oil futures is trading at $30 on delivery date, then the long futures position will
suffer a loss of $10 x 1000 barrel = $10000 in value.
Daily Mark-to-Market & Margin Requirement
The value of a long futures position is marked-to-market daily. Gains are credited and losses
are debited from the future trader's account at the end of each trading day.
If the losses result in margin account balance falling below the required maintenance level, a
margin call will be issued by the broker to the futures trader to top up his or her account in
order for the futures position to remain open.
Short Futures Position
The short futures position is an unlimited profit, unlimited risk position that can be entered by
the futures speculator to profit from a fall in the price of the underlying.
The short futures position is also used by a producer to lock in a price of a commodity that he
is going to sell in the future. See short hedge.
Short
Futures
Position
Construction
Sell 1 Futures Contract
To create a short futures position, the trader must have enough balance in his account to meet
the initial margin requirement for each futures contract he wishes to sell.

Unlimited Profit Potential

There is no maximum profit for the short futures position. The futures trader stands to profit as
long as the underlying asset price goes down.
The formula for calculating profit is given below:

Maximum Profit = Unlimited

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Profit Achieved When Market Price of Futures < Selling Price of Futures

Profit = (Selling Price of Futures - Market Price of Futures) x Contract Size

Unlimited Risk
Heavy losses can occur for the short futures position if the underlying asset price rises
dramatically.
The formula for calculating loss is given below:

Maximum Loss = Unlimited

Loss Occurs When Market Price of Futures > Selling Price of Futures

Loss = (Market Price of Futures - Selling Price of Futures) x Contract Size +

Commissions Paid

Breakeven Point(s)
The underlier price at which break-even is achieved for the short futures position position can
be calculated using the following formula.

Breakeven Point = Selling Price of Futures Contract

Example
Suppose June Crude Oil futures is trading at $40 and each futures contract covers 1000 barrels
of Crude Oil. A futures trader enters a short futures position by selling 1 contract of June Crude
Oil futures at $40 a barrel.
Scenario #1: June Crude Oil futures drops to $30
If June Crude Oil futures is trading at $30 on delivery date, then the short futures position will
gain $10 per barrel. Since the contract size for Crude Oil futures is 1000 barrels, the trader will
net a profit of $10 x 1000 = $10000.
Scenario #2: June Crude Oil futures rises to $50
If June Crude Oil futures instead rallies to $50 on delivery date, then the short futures position
will suffer a loss of $10 x 1000 barrel = $10000 in value.
Daily Mark-to-Market & Margin Requirement
The value of a short futures position is marked-to-market daily. Gains are credited and losses
are debited from the future trader's account at the end of each trading day.
If the losses result in margin account balance falling below the required maintenance level, a
margin call will be issued by the broker to the futures trader to top up his or her account in
order for the futures position to remain open.
Long Hedge

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The long hedge is a hedging strategy used by manufacturers and producers to lock in the price
of a product or commodity to be purchased some time in the future. Hence, the long hedge is
also known as input hedge.
The long hedge involves taking up a long futures position. Should the underlying commodity
price rise, the gain in the value of the long futures position will be able to offset the increase in
purchasing costs.
Long Hedge Example
In May, a flour manufacturer has just inked a contract to supply flour to a supermarket in
September. Let's assume that the total amount of wheat needed to produce the flour is 50000
bushels. Based on the agreed selling price for the flour, the flour maker calculated that he
must purchase wheat at $7.00/bu or less in order to breakeven.
At that time, wheat is going for $6.60 per bushel at the local elevator while September Wheat
futures are trading at $6.70 per bushel, and the flour maker wishes to lock in this purchase
price. To do this, he enters a long hedge by buying some September Wheat futures.
With each Wheat futures contract covering 5000 bushels, he will need to buy 10 futures
contracts to hedge his projected 50000 bushels requirement.
In August, the manufacturing process begins and the flour maker need to purchase his wheat
supply from the local elevator. However, the price of wheat have since gone up and at the local
elevator, the price has risen to $7.20 per bushel. Correspondingly, prices of September Wheat
futures have also risen and are now trading at $7.27 per bushel.
Loss in Cash Market...
Since his breakeven cost is $7.00/bu but he has to purchase wheat at $7.20/bu, he will lose
$0.20/bu. At 50000 bushels, he will lose $10000 in the cash market.
So for all his efforts, the flour maker might have ended up with a loss of $10000.
... is Offset by Gain in Futures Market.
Fortunately, he had hedge his input with a long position in September Wheat futures which
have since gained in value.
Value of September Wheat futures purchased in May = $6.70 x 5000 bushels x 10 contracts =
$335000
Value of September Wheat futures sold in August = $7.27 x 5000 bushels x 10 contracts =
$363500
Net Gain in Futures Market = $363500 - $335000 = $28500
Overall profit = Gain in Futures Market - Loss in Cash Market = $28500 - $10000 = $18500
Hence, with the long hedge in place, the flour maker can still manage to make a profit of
$18500 despite rising Wheat prices.
Short Hedge

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The short hedge is a hedging strategy used by manufacturers and producers to lock in the
price of a product or commodity to be delivered some time in the future. Hence, the short
hedge is also known as output hedge.
The short hedge involves taking up a short futures position while owning the underlying
product or commodity to be delivered. Should the underlying commodity price fall, the gain in
the value of the short futures position will be able to offset the drop in revenue from the sale of
the underlying.
Short Hedge Example
In March, a wheat farmer is planning to plant 100000 bushels of wheat, which will be ready for
harvesting by late August and delivery in September. The farmer knows from past years that
the total cost of planting and harvesting the crops is about $6.30 per bushel.
At that time, September Wheat futures are trading at $6.70 per bushel, and the wheat farmer
wishes to lock in this selling price. To do this, he enters a short hedge by selling some
September Wheat futures.
With each Wheat futures contract covering 5000 bushels, he will need to sell 20 futures
contracts to hedge his projected 100000 bushels production.
By mid-August, his wheat crops are ready for harvesting. However, the price of wheat have
since fallen and at the local elevator, the price has dropped to $6.20 per bushel.
Correspondingly, prices of September Wheat futures have also fallen and are now trading at
$6.33 per bushel.
Loss in Cash Market...
Selling his harvest of 100000 bushels of wheat at the local elevator yields $6.20/bu x 100000
bushels = $620000.
But the cost of growing the crops is $6.30/bu x 100000 bushels = $630000
Hence, his net profit from the farming business = Revenue Yield - Cost of Growing Crops =
$620000 - $630000 = -$10000
For all his efforts, the wheat farmer might have ended up with a loss of $10000.
... is Offset by Gain in Futures Market.
Fortunately, he had hedge his output with a short position in September Wheat futures which
have since gained in value.
Value of Wheat futures Sold in March = $6.70 x 20 contracts x 5000 bushels = $670000
Value of Wheat futures Purchased in August = $6.33 x 20 contracts x 5000 bushels = $633000
Net Gain in Futures Market = $670000 - $633000 = $37000
Overall profit = Gain in Futures Market - Loss in Cash Market = $37000 - $10000 = $27000
Hence, with the short hedge in place, the farmer can still manage to make a profit of $27000
despite falling Wheat prices.
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The basis tracks the relationship between the cash market and the futures market. Hedgers
should pay attention to the basis when deciding when to enter the hedge as they are said to
have taken up a position in the basis once a hedge is in place. See basis.
Futures Basis
The basis reflects the relationship between cash price and futures price. (In futures trading, the
term "cash" refers to the underlying product). The basis is obtained by subtracting the futures
price from the cash price.
The basis can be a positive or negative number. A positive basis is said to be "over" as the
cash price is higher than the futures price. A negative basis is said to be "under" as the cash
price is lower than the futures price.

Basis Calculation Example

Spot (Cash) Price
August
Price
Basis

$42

Futures $47
-5 (In market lingo, the basis is "$5 under
August".)

Strong or Weak Basis

The basis changes from time to time. If the basis gains in value (say from -4 to -1), we say the
basis has strengthened. On the other hand, if basis drops in value (say from 8 to 2), we say the
basis has weakened.
Short term demand and supply situations are generally the main factors responsible for the
change in the basis. If demand is strong and the available supply small, cash prices could rise
relative to futures price, causing the basis to strengthen. On the other hand, if the demand is
weak and a large supply is available, cash prices could fall relative to the futures price, causing
the basis to weaken.
However, although the basis can and does fluctuate, it is still generally less volatile than either
the cash or futures price.
Basis Risk
Basis risk is the chance that the basis will have strengthened or weakened from the time the
hedge is implemented to the time when the hedge is removed. Hedgers are exposed to basis
risk and are said to have a position in the basis.

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Long Basis Position

A long basis position stand to gain from a strengthening basis. Short hedges have a long basis
position.
Short Basis Position
A short basis position stand to gain from a weakening basis. Long hedges have a short basis
position.
Difference between a Futures Contract and a Forward Contract
Futures and forwards are financial contracts which are very similar in nature but there exist a
few important differences:

Futures contracts are highly standardized whereas the terms of each forward contract
can be privately negotiated.

Futures are traded on an exchange whereas forwards are traded over-the-counter.

Counterparty risk
In any agreement between two parties, there is always a risk that one side will renege on the
terms of the agreement. Participants may be unwilling or unable to follow through the
transaction at the time of settlement. This risk is known as counterparty risk.
In a futures contract, the exchange clearing house itself acts as the counterparty to both
parties in the contract. To further reduce credit risk, all futures positions are marked-to-market
daily, with margins required to be posted and maintained by all participants at all times. All
this measures ensures virtually zero counterparty risk in a futures trade.
Forward contracts, on the other hand, do not have such mechanisms in place. Since forwards
are only settled at the time of delivery, the profit or loss on a forward contract is only realized
at the time of settlement, so the credit exposure can keep increasing. Hence, a loss resulting
from a default is much greater for participants in a forward contract.
Secondary Market
The highly standardized nature of futures contracts makes it possible for them to be traded in
a secondary market.
The existence of an active secondary market means that if at anytime a participant in a futures
contract wishes to transfer his obligation to another party, he can do so by selling it to another
willing party in the futures market.
In contrast, there is essentially no secondary market for forward contracts
Derivatives - Fundamental Differences Between Futures and Forwards
The fundamental difference between futures and forwards is that futures are traded on
exchanges and forwards trade OTC. The difference in trading venues gives rise to notable
differences in the two instruments:

Futures are standardized instruments transacted through brokerage firms that hold a
"seat" on the exchange that trades that particular contract. The terms of a futures
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contract - including delivery places and dates, volume, technical specifications, and
trading and credit procedures - are standardized for each type of contract. Like an
ordinary stock trade, two parties will work through their respective brokers, to transact a
futures trade. An investor can only trade in the futures contracts that are supported by
each exchange. In contrast, forwards are entirely customized and all the terms of the
contract are privately negotiated between parties. They can be keyed to almost any
conceivable underlying asset or measure. The settlement date, notional amount of the
contract and settlement form (cash or physical) are entirely up to the parties to the
contract.

Forwards entail both market risk and credit risk. Those who engage in futures
transactions assume exposure to default by the exchange's clearing house. For OTC
derivatives, the exposure is to default by the counterparty who may fail to perform on a
forward. The profit or loss on a forward contract is only realized at the time of
settlement, so the credit exposure can keep increasing.

With futures, credit risk mitigation measures, such as regular mark-to-market and
margining, are automatically required. The exchanges employ a system whereby
counterparties exchange daily payments of profits or losses on the days they occur.
Through these margin payments, a futures contract's market value is effectively reset to
zero at the end of each trading day. This all but eliminates credit risk.

The daily cash flows associated with margining can skew futures prices, causing them to
diverge from corresponding forward prices.

Futures are settled at the settlement price fixed on the last trading date of the contract
(i.e. at the end). Forwards are settled at the forward price agreed on at the trade date
(i.e. at the start).

Futures are generally subject to a single regulatory regime in one jurisdiction, while
forwards - although usually transacted by regulated firms - are transacted across
jurisdictional boundaries and are primarily governed by the contractual relations
between the parties.

In case of physical delivery, the forward contract specifies to whom the delivery should
be made. The counterparty on a futures contract is chosen randomly by the exchange.

In a forward there are no cash flows until delivery, whereas in futures there are margin
requirements and periodic margin calls.

Forward Contract vs. Futures Contract

A forward contract is a customized contractual agreement where two private parties agree
to trade a particular asset with each other at an agreed specific price and time in the future.
Forward contracts are traded privately over-the-counter, not on an exchange.
A futures contract often referred to as futures is a standardized version of a forward
contract that is publicly traded on a futures exchange. Like a forward contract, a futures
contract includes an agreed upon price and time in the future to buy or sell an asset usually
stocks, bonds, or commodities, like gold.
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The main differentiating feature between futures and forward contracts that futures are
publicly traded on an exchange while forwards are privately traded results in several
operational differences between them. This comparison examines differences like counterparty
risk, daily centralized clearing and mark-to-market, price transparency, and efficiency.
Comparison chart
Forward Contract
A forward contract is an agreement
between two parties to buy or sell an
Definitio
asset (which can be of any kind) at a
n
pre-agreed future point in time at a
specified price.

Futures Contract
A futures contract is a standardized
contract, traded on a futures exchange,
to buy or sell a certain underlying
instrument at a certain date in the
future, at a specified price.

Structure Customized to customer needs. Usually

Standardized. Initial margin payment
&
no initial payment required. Usually
required. Usually used for speculation.
Purpose used for hedging.
Transacti
Negotiated directly by the buyer and
on
seller
method

Quoted and traded on the Exchange

Market
regulatio Not regulated
n

Government regulated market (the

Commodity Futures Trading Commission
or CFTC is the governing body)

Institutio
nal
The contracting parties
guarante
e

Clearing House

Risk

Low counterparty risk

High counterparty risk

Both parties must deposit an initial

No guarantee of settlement until the
guarantee (margin). The value of the
Guarante date of maturity only the forward price,
operation is marked to market rates
es
based on the spot price of the
with daily settlement of profits and
underlying asset is paid
losses.
Contract Forward contracts generally mature by Future contracts may not necessarily
Maturity delivering the commodity.
mature by delivery of commodity.
Expiry
date

Depending on the transaction

Standardized

Method Opposite contract with same or

of predifferent counterparty. Counterparty risk
Opposite contract on the exchange.
terminati remains while terminating with different
on
counterparty.

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Contract Depending on the transaction and the

Standardized
size
requirements of the contracting parties.
Market

Primary & Secondary

Primary

Contents: Forward Contract vs Futures Contract

1 Trade Procedure 1.1 Closing a Position 1.2 Risk 1.3 Margin Calls 2 Prices 3 Liquidity
and Price Transparency 4 Regulation 5 Volumes 6 References

Trade Procedure
In a forward contract, the buyer and seller are private parties who negotiate a contract that
obligates them to trade an underlying asset at a specific price on a certain date in the future.
Since it is a private contract, it is not traded on an exchange but over the counter. No cash or
assets change hands until the maturity date of the contract. There is usually a clear "winner"
and "loser" in forward contracts, as one party will profit at the point of contract maturity, while
the other party will take a loss. For example, if the market price of the underlying asset is
higher than the price agreed in the forward contract, the seller loses. The contract may be
fulfilled either via delivery of the underlying asset or a cash settlement for an amount equal to
the difference between the market price and the price set in the contract. For an intro to
forward contracts, watch this video from Khan Academy.
Whereas a forward contract is a customized contract drawn up between two parties, a futures
contract is a standardized version of a forward contract that is sold on an exchange. The terms
that are standardized include price, date, quantity, trading procedures, and place of delivery
(or terms for cash settlements). Only futures for assets standardized and listed on the
exchange can be traded. For example, a farmer with a corn crop might want to lock in a good
market price to sell his harvest, and a company that makes popcorn might want to lock in a
good market price to buy corn. On the futures exchange, there are standard contracts for such
situations say, a standard contract with the terms of "1,000 kg of corn for $0.30/kg for
delivery on 10/31/2015." here are even futures based on the performance of certain stock
indices, like the S&P 500.
Investors trade futures on the exchange through brokerage firms, like E*TRADE, that have a
seat on the exchange. These brokerage firms take responsibility for fulfilling contracts.
Closing a Position
To close a position on a futures trade, a buyer or seller makes a second transaction that takes
the opposite position of their original transaction. In other words, a seller switches to buying to
close his position, and a buyer switches to selling. For a forward contract, there are two ways
to close a position either sell the contract to a third party, or get into a new forward contract
with the opposite trade.
Standardizing a contract and trading it on an exchange provides some valuable benefits to
futures contracts, as discussed below.
Risk
Forward contracts are subject to counterparty risk, which is the risk that the party on the other
side of the trade defaults on their contractual obligation. For example, AIG's insolvency during
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the 2008 crisis subjected many other financial institutions to counterparty risk because they
had contracts (called credit default swaps) with AIG.
The futures exchange's clearinghouse guarantees transactions, thereby eliminating
counterparty risk in futures contracts. Of course, there is the risk that the clearinghouse itself
will default, but the mechanics of trading are such that this risk is very low. Futures traders are
required to deposit money usually 10% to 20% of the contract value in a margin account
with the brokerage firm that represents them on the exchange to cover their exposure. The
clearinghouse takes positions on both sides of a futures trade; futures are marked to market
every day, with the brokers making sure there are enough assets in margin accounts for
traders to cover their positions.
Margin Calls
Futures and forwards also carry market risk, which varies depending on the underlying asset it.
Investors in futures, however, are more vulnerable to volatility in the price of the underlying
asset. Because futures are marked to market daily, investors are liable for losses incurred daily.
If the asset price fluctuates so much that the money in an investor's margin account falls
below the minimum margin requirement, their broker issues a margin call. This requires the
investor to either deposit more money in the margin account as collateral against further
losses, or be forced to close their position at a loss. If the underlying asset swings in the
opposite direction after the investor is forced to close their position, they lose out on a
potential gain.
With forward contracts, no cash is exchanged until the maturity date. So in that scenario, the
holder of a forward contract would still end up ahead.
Prices
The price of a futures contract resets to zero at the end of every day because daily profits and
losses (based on the prices of the underlying asset) are exchanged by traders via their margin
accounts. In contrast, a forward contract starts to become less or more valuable over time until
the maturity date, the only time when either contracting party profits or loses.
So on any given trading day, the price of a futures contract will be different from a forward
contract that has the same maturity date and strike price. The following video explains price
divergence between futures and forward contracts:
Liquidity and Price Transparency
It is easy to buy and sell futures on the exchange. It is harder to find a counterparty over-thecounter to trade in forward contracts that are non-standard. The volume of transactions on an
exchange is higher than OTC derivatives, so futures contracts tend to be more liquid.
Futures exchanges also provide price transparency; prices for forward contracts are only
known to the trading parties.
Regulation
Futures are regulated by a central regulatory authority like the CFTC in the United States. On
the other hand, forwards are governed by the applicable contract law.

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Volumes
The majority of futures trading takes place in North America and Asia and deals with individual
equities.
Derivatives - Forward Contracts
A forward is an agreement between two counterparties - a buyer and seller. The buyer agrees
to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at
a later time, but the price is determined at the time of purchase. Key features of forward
contracts are:

Highly customized - Counterparties can determine and define the terms and features to
fit their specific needs, including when delivery will take place and the exact identity of
the underlying asset.

All parties are exposed to counterparty default risk - This is the risk that the other party
may not make the required delivery or payment.

Transactions take place in large, private and largely unregulated markets consisting of
banks, investment banks, government and corporations.

Underlying assets can be a stocks, bonds, foreign currencies, commodities or some

combination thereof. The underlying asset could even be interest rates.

They tend to be held to maturity and have little or no market liquidity.

Any commitment between two parties to trade an asset in the future is a forward
contract.

Example: Forward Contracts

Let's assume that you have just taken up sailing and like it so well that you expect you might
buy your own sailboat in 12 months. Your sailing buddy, John, owns a sailboat but expects to
upgrade to a newer, larger model in 12 months. You and John could enter into a forward
contract in which you agree to buy John's boat for $150,000 and he agrees to sell it to you in
12 months for that price. In this scenario, as the buyer, you have entered a long forward
contract. Conversely, John, the seller will have the short forward contract. At the end of one
year, you find that the current market valuation of John's sailboat is $165,000. Because John is
obliged to sell his boat to you for only $150,000, you will have effectively made a profit of
$15,000. (You can buy the boat from John for $150,000 and immediately sell it for $165,000.)
John, unfortunately, has lost $15,000 in potential proceeds from the transaction.
Like all forward contracts, in this example, no money exchanged hands when the contract was
negotiated and the initial value of the contract was zero
Derivatives - Future Contracts
Future contracts are also agreements between two parties in which the buyer agrees to buy an
underlying asset from the other party (the seller). The delivery of the asset occurs at a later
time, but the price is determined at the time of purchase.
Terms and conditions are standardized.
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Trading takes place on a formal exchange wherein the exchange provides a place to
engage in these transactions and sets a mechanism for the parties to trade these
contracts.
There is no default risk because the exchange acts as a counterparty, guaranteeing
delivery and payment by use of a clearing house.
The clearing house protects itself from default by requiring its counterparties to settle
gains and losses or mark to market their positions on a daily basis.
Futures are highly standardized, have deep liquidity in their markets and trade on an
exchange.
An investor can offset his or her future position by engaging in an opposite transaction
before the stated maturity of the contract.
Derivatives - Options: Calls and Puts
An option is common form of a derivative. It's a contract, or a provision of a contract, that
gives one party (the option holder) the right, but not the obligation to perform a specified
transaction with another party (the option issuer or option writer) according to specified terms.
Options can be embedded into many kinds of contracts. For example, a corporation might
issue a bond with an option that will allow the company to buy the bonds back in ten years at a
set price. Standalone options trade on exchanges or OTC. They are linked to a variety of
underlying assets. Most exchange-traded options have stocks as their underlying asset but
OTC-traded options have a huge variety of underlying assets (bonds, currencies, commodities,
swaps, or baskets of assets).
There are two main types of options: calls and puts:

Call options provide the holder the right (but not the obligation) to purchase an
underlying asset at a specified price (the strike price), for a certain period of time. If the
stock fails to meet the strike price before the expiration date, the option expires and
becomes worthless. Investors buy calls when they think the share price of the underlying
security will rise or sell a call if they think it will fall. Selling an option is also referred to
as ''writing'' an option.

Put options give the holder the right to sell an underlying asset at a specified price (the
strike price). The seller (or writer) of the put option is obligated to buy the stock at the
strike price. Put options can be exercised at any time before the option expires. Investors
buy puts if they think the share price of the underlying stock will fall, or sell one if they
think it will rise. Put buyers - those who hold a "long" - put are either speculative buyers
looking for leverage or "insurance" buyers who want to protect their long positions in a
stock for the period of time covered by the option. Put sellers hold a "short" expecting
the market to move upward (or at least stay stable) A worst-case scenario for a put
seller is a downward market turn. The maximum profit is limited to the put premium
received and is achieved when the price of the underlyer is at or above the option's
strike price at expiration. The maximum loss is unlimited for an uncovered put writer.

To obtain these rights, the buyer must pay an option premium (price). This is the amount of
cash the buyer pays the seller to obtain the right that the option is granting them. The
premium is paid when the contract is initiated.

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In Level 1, the candidate is expected to know exactly what role short and long positions take,
how price movements affect those positions and how to calculate the value of the options for
both short and long positions given different market scenarios. For example:
Q. Which of the following statements about the value of a call option at expiration is
FALSE?
A. The short position in the same call option can result in a loss if the stock price
exceeds the exercise price.
B. The value of the long position equals zero or the stock price minus the exercise
price, whichever is higher.
C. The value of the long position equals zero or the exercise price minus the stock
price, whichever is higher.
D. The short position in the same call option has a zero value for all stock prices
equal to or less than the exercise price.
A. The correct answer is "C". The value of a long position is calculated as exercise price
minus stock price. The maximum loss in a long put is limited to the price of the premium
(the cost of buying the put option). Answer "A" is incorrect because it describes a gain.
Answer "D" is incorrect because the value can be less than zero (i.e. an uncovered put
writer can experience huge losses).
Derivatives - Options: Basic Characteristics
Both put and call options have three basic characteristics: exercise price, expiration date and
time to expiration.

The buyer has the right to buy or sell the asset.

To acquire the right of an option, the buyer of the option must pay a price to the seller.
This is called the option price or the premium.

The exercise price is also called the fixed price, strike price or just the strike and is
determined at the beginning of the transaction. It is the fixed price at which the holder of
the call or put can buy or sell the underlying asset.

Exercising is using this right the option grants you to buy or sell the underlying asset.
The seller may have a potential commitment to buy or sell the asset if the buyer
exercises his right on the option.

The expiration date is the final date that the option holder has to exercise her right to
buy or sell the underlying asset.

Time to expiration is the amount of time from the purchase of the option until the
expiration date. At expiration, the call holder will pay the exercise price and receive the
underlying securities (or an equivalent cash settlement) if the option expires in the
money. (We will discuss the degrees of moneyness later in this session.) The call seller
will deliver the securities at the exercise price and receive the cash value of those
securities or receive equivalent cash settlement in lieu of delivering the securities.

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Defaults on options work the same way as they do with forward contracts. Defaults on
over-the counter option transactions are based on counterparties, while exchangetraded options use a clearing house.

Example: Call Option

IBM is trading at 100 today. (June 1, 2005)
The call option is as follows:Strike price = 120, Date = August 1, 2005,Premium on the call =
$3
In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for the right
to purchase IBM at $125 on or before August 1, 2005. If the buyer decides to exercise the
option on or before August 1, 2005, the seller will have to deliver IBM shares at a price of $125
to the buyer.
Example: Put Option
IBM is trading at 100 today (June 1, 2005)
Put option is as follows:Strike price = 90, Date = August 1, 2005, Premium on the put = $3.00
In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the right to sell
IBM at $90 on or before August 1, 2005. If the buyer of the put decides to exercise the option
on or before August 1, 2005, the seller will have to purchase IBM shares at a price of $90.
A typical question about this diagram might be:
Q: Ignoring transaction costs, which of the following statements about the value of the
put
option
at
expiration
is
TRUE?
A. The value of the short position in the put is $4 if the stock price is $76.
B. The value of the long position in the put is $4 if the stock price is $76.
C. The long put has value when the stock price is below the $80 exercise price.
D. The value of the short position in the put is zero for stock prices equaling or
exceeding $76.
The correct answer is "C". A put option has positive monetary value when the underlying
instrument has a current price ($76) below the exercise price ($80).
Derivatives - Swaps
A swap is one of the most simple and successful forms of OTC-traded derivatives. It is a cashsettled contract between two parties to exchange (or "swap") cash flow streams. As long as
the present value of the streams is equal, swaps can entail almost any type of future cash flow.
They are most often used to change the character of an asset or liability without actually
having to liquidate that asset or liability. For example, an investor holding common stock can
exchange the returns from that investment for lower risk fixed income cash flows - without
having to liquidate his equity position.

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The difference between a forward contract and a swap is that a swap involves a
series of payments in the future, whereas a forward has a single future payment.
Two of the most basic swaps are:
Interest Rate Swap - This is a contract to exchange cash flow streams that might be
associated with some fixed income obligations. The most popular interest rate swaps are fixedfor-floating swaps, under which cash flows of a fixed rate loan are exchanged for those of a
floating rate loan.
Currency Swap - This is similar to an interest rate swap except that the cash flows are in
different currencies. Currency swaps can be used to exploit inefficiencies in international debt
markets.
For example, assume that a corporation needs to borrow $10 million euros and the best rate it
can negotiate is a fixed 6.7%. In the U.S., lenders are offering 6.45% on a comparable loan.
The corporation could take the U.S. loan and then find a third party willing to swap it into an
equivalent euro loan. By doing so, the firm would obtain its euros at more favorable terms.
Cash flow streams are often structured so that payments are synchronized, or occur on the
same dates. This allows cash flows to be netted against each other (so long as the cash flows
are in the same currency). Typically, the principal (or notional) amounts of the loans are netted
to zero and the periodic interest payments are scheduled to occur on that same dates so they
can also be netted against one another.
As is obvious from the above example, swaps are private, negotiated and mostly unregulated
transactions (although FASB 133 has begun to impose some regulations).
Derivatives - Purposes and Benefits of Derivatives
Today's sophisticated international markets have helped foster the rapid growth in derivative
instruments. In the hands of knowledgeable investors, derivatives can derive profit from:
Changes in interest rates and equity markets around the world
Currency exchange rate shifts
Changes in global supply and demand for commodities such as agricultural products,
precious and industrial metals, and energy products such as oil and natural gas.
Adding some of the wide variety of derivative instruments available to a traditional portfolio of
investments can provide global diversification in financial instruments and currencies, help
hedge against inflation and deflation, and generate returns that are not correlated with more
traditional investments. The two most widely recognized benefits attributed to derivative
instruments are price discovery and risk management.
1. Price Discovery
Futures market prices depend on a continuous flow of information from around the world
and require a high degree of transparency. A broad range of factors (climatic conditions,
political situations, debt default, refugee displacement, land reclamation and
environmental health, for example) impact supply and demand of assets (commodities
in particular) - and thus the current and future prices of the underlying asset on which
the derivative contract is based. This kind of information and the way people absorb it
constantly changes the price of a commodity. This process is known as price discovery.
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With some futures markets, the underlying assets can be geographically dispersed,
having many spot (or current) prices in existence. The price of the contract with the
shortest time to expiration often serves as a proxy for the underlying asset.
Second, the price of all future contracts serve as prices that can be accepted by those
who trade the contracts in lieu of facing the risk of uncertain future prices.
Options also aid in price discovery, not in absolute price terms, but in the way the
market participants view the volatility of the markets. This is because options are a
different form of hedging in that they protect investors against losses while allowing
them to participate in the asset's gains.
As we will see later, if investors think that the markets will be volatile, the prices of
options contracts will increase. This concept will be explained later.
2. Risk Management
This could be the most important purpose of the derivatives market. Risk management
is the process of identifying the desired level of risk, identifying the actual level of risk
and altering the latter to equal the former. This process can fall into the categories of
hedging and speculation.
Hedging has traditionally been defined as a strategy for reducing the risk in holding a
market position while speculation referred to taking a position in the way the markets
will move. Today, hedging and speculation strategies, along with derivatives, are useful
tools or techniques that enable companies to more effectively manage risk.
3. They Improve Market Efficiency for the Underlying Asset
For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock
index fund or replicate the fund by buying S&P 500 futures and investing in risk-free
bonds. Either of these methods will give them exposure to the index without the
expense of purchasing all the underlying assets in the S&P 500.
If the cost of implementing these two strategies is the same, investors will be neutral as
to which they choose. If there is a discrepancy between the prices, investors will sell the
richer asset and buy the cheaper one until prices reach equilibrium. In this context,
derivatives create market efficiency.
4. Derivatives Also Help Reduce Market Transaction Costs
Because derivatives are a form of insurance or risk management, the cost of trading in
them has to be low or investors will not find it economically sound to purchase such
"insurance" for their positions
Derivatives - Currency Forward Contracts
Foreign currency forward contracts are used as a foreign currency hedge when an investor has
an obligation to either make or take a foreign currency payment at some point in the future. If
the date of the foreign currency payment and the last trading date of the foreign currency
forwards contract are matched up, the investor has in effect "locked in" the exchange rate
payment amount.
By locking into a forward contract to sell a currency, the seller sets a future exchange rate with
no upfront cost. For example, a U.S. exporter signs a contract today to sell hardware to a
French importer. The terms of the contract require the importer to pay euros in six months'
time. The exporter now has a known euro receivable. Over the next six months, the dollar
value of the euro receivable will rise or fall depending on fluctuations in the exchange rate. To
mitigate his uncertainty about the direction of the exchange rate, the exporter may elect to
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lock in the rate at which he will sell the euros and buy dollars in six months. To accomplish this,
he hedges the euro receivable by locking in a forward.
This arrangement leaves the exporter fully protected should the currency depreciate below the
contract level. However, he gives up all benefits if the currency appreciates. In fact, the seller
of a forward rate faces unlimited costs should the currency appreciate. This is a major
drawback for many companies that consider this to be the true cost of a forward contract
hedge. For companies that consider this to be only an opportunity cost, this aspect of a
forward is an acceptable "cost". For this reason, forwards are one of the least forgiving hedging
instruments because they require the buyer to accurately estimate the future value of the
exposure amount.
Like other future and forward contracts, foreign currency futures contracts have standard
contract sizes, time periods, settlement procedures and are traded on regulated exchanges
throughout the world. Foreign currency forwards contracts may have different contract sizes,
time periods and settlement procedures than futures contracts. Foreign currency forwards
contracts are considered over-the-counter (OTC) because there is no centralized trading
location and transactions are conducted directly between parties via telephone and online
trading platforms at thousands of locations worldwide.
Key Points:

Developed and grew in the late '70s when governments relaxed their control over their
currencies
Used mainly by banks and corporations to mange foreign exchange risk
Allows the user to "lock in" or set a future exchange rate.
Parties can deliver the currency or settle the difference in rates with cash.

Example: Currency Forward Contracts

Corporation A has a foreign sub in Italy that will be sending it 10 million euros in six months.
Corp. A will need to swap the euro for the euros it will be receiving from the sub. In other
words, Corp. A is long euros and short dollars. It is short dollars because it will need to
purchase them in the near future. Corp. A can wait six months and see what happens in the
currency markets or enter into a currency forward contract. To accomplish this, Corp. A can
short the forward contract, or euro, and go long the dollar.
Corp. A goes to Citigroup and receives a quote of .935 in six months. This allows Corp. A to buy
dollars and sell euros. Now Corp. A will be able to turn its 10 million euros into 10 million x .935
= 935,000 dollars in six months.
Six months from now if rates are at .91, Corp. A will be ecstatic because it will have realized a
higher exchange rate. If the rate has increased to .95, Corp. A would still receive the .935 it
originally contracts to receive from Citigroup, but in this case, Corp. A will not have received
the benefit of a more favorable exchange rate.
Derivatives - Futures vs. Forwards
Futures differ from forwards in several instances:

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1. A forward contract is a private transaction - a futures contract is not. Futures contracts

are reported to the future's exchange, the clearing house and at least one regulatory
agency. The price is recorded and available from pricing services.
2. A future takes place on an organized exchange where the all of the contract's terms and
conditions, except price, are formalized. Forwards are customized to meet the user's
special needs. The future's standardization helps to create liquidity in the marketplace
enabling participants to close out positions before expiration.
3. Forwards have credit risk, but futures do not because a clearing house guarantees
against default risk by taking both sides of the trade and marking to market their
positions every night. Mark to market is the process of converting daily gains and losses
into actual cash gains and losses each night. As one party loses on the trade the other
party gains, and the clearing house moves the payments for the counterparty through
this process.
4. Forwards are basically unregulated, while future contract are regulated at the federal
government level. The regulation is there to ensure that no manipulation occurs, that
trades are reported in a timely manner and that the professionals in the market are
qualified and honest.
Characteristics of Futures Contracts
In a futures contract there are two parties:
1. The long position, or buyer, agrees to purchase the underlying at a later date or at the
expiration date at a price that is agreed to at the beginning of the transaction. Buyers
benefit from price increases.
2. The short position, or seller, agrees to sell the underlying at a later date or at the
expiration date at a price that is agreed to at the beginning of the transaction. Sellers
benefit from price decreases.
Prices change daily in the marketplace and are marked to market on a daily basis.
At expiration, the buyer takes delivery of the underlying from the seller or the parties can
agree to make a cash settlement.
Derivatives - Futures Markets Margin
In the stock market, a margin is a loan that is made to the investor. It helps the investor to
reduce the amount of her own cash that she uses to purchase securities. This creates leverage
for the investor, causing gains and losses to be amplified. The loan must be paid back with
interest.

Margin % = Market Value of the stock - Market value of the debt divided by the market
value of the stock

An initial margin loan in the U.S can be as much as 50%. The market value of the
securities minus the amount borrowed can often be less than 50%, but the investor must
keep a balance of 25-30% of the total market value of the securities in the margin
account as a maintenance margin.

A margin in the futures market is the amount of cash an investor must put up to open an
account to start trading. This cash amount is the initial margin requirement and it is not a loan.
It acts as a down payment on the underlying asset and helps ensure that both parties fulfill
their
obligations.
Both
buyers
and
sellers
must
put
up
payments.
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Initial Margin
This is the initial amount of cash that must be deposited in the account to start trading
contracts. It acts as a down payment for the delivery of the contract and ensures that the
parties
honor
their
obligations.
Maintenance Margin
This is the balance a trader must maintain in his or her account as the balance changes due to
price fluctuations. It is some fraction - perhaps 75% - of initial margin for a position. If the
balance in the trader's account drops below this margin, the trader is required to deposit
enough funds or securities to bring the account back up to the initial margin requirement. Such
a demand is referred to as a margin call. The trader can close his position in this case but he is
still responsible for the loss incurred. However, if he closes his position, he is no longer at risk
of the position losing additional funds.
Futures (which are exchange-traded) and forwards (which are traded OTC) treat margin
accounts differently. When a trader posts collateral to secure an OTC derivative obligation such
as a forward, the trader legally still owns the collateral. With futures contracts, money
transferred from a margin account to an exchange as a margin payment legally changes
hands. A deposit in a margin account at a broker is collateral. It legally still belongs to the
client, but the broker can take possession of it any time to satisfy obligations arising from the
client's
futures
positions
Variation Margin
This is the amount of cash or collateral that brings the account up to the initial margin amount
once it drops below the maintenance margin.

Settlement Price
Settlement price is established by the appropriate exchange settlement committee at the
close of each trading session. It is the official price that will be used by the clearing house to
determine net gains or losses, margin requirements and the next day's price limits. Most often,
the settlement price represents the average price of the last few trades that occur on the day.
It is the official price set by the clearing house and it helps to process the day's gains and loses
in marking to market the accounts. However, each exchange may have its own particular
methodology. For example, on NYMEX (the New York Mercantile Exchange) and COMEX (The
New York Commodity Exchange) settlement price calculations depend of the level of trading
activity. In contract months with significant activity, the settlement price is derived by
calculating the weighted average of the prices at which trades were conducted during the
closing range, a brief period at the end of the day. Contract months with little or no trading
activity on a given day are settled based on the spread relationships to the closest active

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contract month, while on the Tokyo Financial Exchange settlement price is calculated as the
theoretical value based on the expected volatility for each series set by the exchange.
Derivatives - The Futures Trade Process
Most U.S. futures exchanges offer two ways to enact a trade - the traditional floor-trading
process (also called "open outcry") and electronic trading. The basic steps are essentially the
same in either format: Customers submit orders that are executed - filled - by other traders
who take equal but opposite positions, selling at prices at which other customers buy or buying
at prices at which other customers sell. The differences are described below.
Open outcry trading is the more traditional form of trading in the U.S. Brokers take orders
(either bids to buy or offers to sell) by telephone or computer from traders (their customers).
Those orders are then communicated orally to brokers in a trading pit. The pits are octagonal,
multi-tiered areas on the floor of the exchange where traders conduct business. The traders
wear different colored jackets and badges that indicate who they work for and what type of
traders they are (FCM or local). It's called "open outcry" because traders shout and use various
hand signals to relay information and the price at which they are willing to trade. Trades are
executed (matches are made) when the traders agree on a price and the number of contracts
either through verbal communication or simply some sort of motion such as a nod. The traders
then turn their trade tickets over to their clerks who enter the transaction into the system.
Customers are then notified of their trades and pertinent information about each trade is sent
to the clearing house and brokerages.
In electronic trading, customers (who have been pre-approved by a brokerage for electronic
trading) send buy or sell orders directly from their computers to an electronic marketplace
offered by the relevant exchange. There are no brokers involved in the process. Traders see the
various bids and offers on their computers. The trade is executed by the traders lifting bids or
hitting offers on their computer screens. The trading pit is, in essence, the trading screen and
the electronic market participants replace the brokers standing in the pit. Electronic trading
offers much greater insight into pricing because the top five current bids and offers are posted
on the trading screen for all market participants to see. Computers handle all trading activity the software identifies matches of bids and offers and generally fills orders according to a firstin, first-out (FIFO) process. Dissemination of information is also faster on electronic trades.
Trades made on CME Globex, for example, happen in milliseconds and are instantaneously
broadcast to the public. In open outcry trading, however, it can take from a few seconds to
minutes to execute a trade.

Price Limit
This is the amount a futures contract's price can move in one day. Price limits are usually set in
absolute dollar amounts - the limit could be $5, for example. This would mean that the price of
the contract could not increase or decrease by more than $5 in a single day.
Limit Move
A limit move occurs when a transaction takes place that would exceed the price limit. This
freezes the price at the price limit.
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Limit Up
The maximum amount by which the price of a futures contract may advance in one trading
day. Some markets close trading of these contracts when the limit up is reached, others allow
trading to resume if the price moves away from the day's limit. If there is a major event
affecting the market's sentiment toward a particular commodity, it may take several trading
days before the contract price fully reflects this change. On each trading day, the trading limit
will be reached before the market's equilibrium contract price is met.
Limit Down
This is when the price decreases and is stuck at the lower price limit. The maximum amount by
which the price of a commodity futures contract may decline in one trading day. Some markets
close trading of contracts when the limit down is reached, others allow trading to resume if the
price moves away from the day's limit. If there is a major event affecting the market's
sentiment toward a particular commodity, it may take several trading days before the contract
price fully reflects this change. On each trading day, the trading limit will be reached before
the market's equilibrium contract price is met.
Locked Limit
Occurs when the trading price of a futures contract arrives at the exchange's predetermined
limit price. At the lock limit, trades above or below the lock price are not executed. For
example, if a futures contract has a lock limit of $5, as soon as the contract trades at $5 the
contract would no longer be permitted to trade above this price if the market is on an uptrend,
and the contract would no longer be permitted to trade below this price if the market is on a
downtrend. The main reason for these limits is to prevent investors from substantial losses that
can occur as a result of the volatility found in futures markets.
The Marking to Market Process

At the initiation of the trade, a price is set and money is deposited in the account.

At the end of the day, a settlement price is determined by the clearing house. The
account is then adjusted accordingly, either in a positive or negative manner, with funds
either being drawn from or added to the account based on the difference in the initial
price and the settlement price.

The next day, the settlement price is used as the base price.

As the market prices change through the next day, a new settlement price will be
determined at the end of the day. Again, the account will be adjusted by the difference in
the new settlement price and the previous night's price in the appropriate manner.

If the account falls below the maintenance margin, the investor will be required to add
additional funds into the account to keep the position open or allow it to be closed out. If the
position is closed out the investor is still responsible for paying for his losses. This process
continues until the position is closed out.

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Derivatives - Computing the Margin Balance for a Futures Account

This concept will be better explained by using an example to compute the margin balance.
Let's start with a future's price of $200. The initial margin requirement is $10 and the
maintenance margin is $6. The trader buy five contracts and deposits $50 (5 contacts x $10)
Day 0 - The ending balance is $50.
Day 1 - The price moves to $199.50. The adjustment that needs to be made is -$2.50 (200199.5 x 5 contracts). The ending balance is now $47.50 ($50 - 2.50). Since this is above the
maintained margin ($30) no funds need to be added to the account.
Day 2 - The price moves down to $195. The loss, based on five contracts, is $22.50, so the
account balance is $25. This is below the maintenance margin. The trader will receive a margin
call and will need to deposit $25 into the account to bring it back up to the initial margin
requirement.
This continues over the course of the trade until it is closed out. Please follow the following
charts:
Derivatives - Closing and Terminating a Futures Position
As we discussed previously, when a trader goes long or short on a position, he can close his
position prior to expiration by executing a reversing transaction that is exactly the same as his
original trade. The clearing house views the trader as holding a long and short position that
offset each other, causing the trader's position to be flat. This is the same as having no
position at all.
Example: Closing a Futures Position
You have entered a long position in 30 December S&P 250 contracts, in August. Come
September, you decide that you want to close your position before the contract expires. To
accomplish this, you must short, or sell the 30 December S&P 250 contract. The clearing house
sees your position as flat because you are now long and short the same amount and type of
contract.
Terminating Futures Contracts

Close-Out (offset) at Expiration - If a trader holds a long position, she can go short
the same contract with regards to the terms of the original trade and vice versa for the
short position trader. Prices may differ because of market conditions.

Delivery - Here, the long position keeps the position open at the end of trading on the
expiration date. This requires the long holder to accept delivery of the underlying asset
and pay the short position the Pre agreed Future price.

Equivalent Cash Settlement - Some contracts are designated as cash-settle

contracts. At expiration, the trader keeps his position open. When the contract expires,
the margin account is marked to market and the gain is posted in the account. The
reason that a gain is posted is because in most cases the trader would close out the
position prior to expiration if it is a loser.
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Exchange-for-Physicals - These are used for futures participants. Here the long and
short holders arrange alternative delivery procedures. For example, if the exchange
requires the physical delivery of the asset in Chicago, the parties may agree to make
settlement outside of the required area, say Pittsburgh. The parties will have to report to
the Chicago Board of Trade that the transaction was settled outside the normal
procedures. This is satisfactory to the exchange

Derivatives - Other Types of Derivatives

Eurodollar Futures
Eurodollar futures work the same as T-bill contracts except the rate is based on LIBOR.

Price quotes and actual price is determined the in the same way as for T-bills.

Settles in cash

One of most active contracts in the markets

Instead of add-on interest, (for example a 100 @ 10% for a year and the bank would owe
$110 dollars), the rate is subtracted from 100, just as it is with T-bills

With T-bills the investor would receive $1 million per contract, while in the Eurodollar
futures market the firm would pay 1 million euros

Treasury Bond Contracts

A contract based on the delivery of a U.S. Treasury bond with any coupon and at least 15 years
to maturity.

There are many different bonds that fit the above description.

To give some type of standardization, the markets use a conversion factor to achieve a
hypothetical bond with a 6% coupon.

Because bond prices do not move in a linear fashion, there is a chance to use arbitrage
to capitalize on the deviance of a bond when compared to the 6% standardized bond. To
do this, traders look for the cheapest to deliver bond (CTD). This is the least expensive
underlying product that can be delivered upon expiry to satisfy the requirements of a
derivative contract. This helps minimize the slippage between the conversation factor
and the actual price.

The CTD bond is always changing because prices and yields are always changing.

A contract covers $100,000 par value of U.S. Treasuries.

Contract expires March, June, September and December

Stock Index Contracts

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Investors trading index options are essentially betting on the overall movement of the stock
market as represented by a basket of stocks. Options on the S&P 500 are some of the most
actively traded options in the world.

Quoted in terms equal to the index itself. For example if the S&P 500 is trading at 1050
the one-month contract may be at 1060.

Each contract has a multiplier. For the S&P 500, it is 250. The actual price in the above
point would equal 1060 x 250 = $265,000.

S&P 500 contracts expire in March, June, September and December and can have
maturity dates as far away as two years.

Settlement is in cash.

The FTSE 100 and Japan's Nikkei 225 are other types of indexes upon which stock index
contracts are based.

Currency Contracts
Currency contracts function in the same way as forward contracts for currency.

They are typically much smaller than forward contracts.

Each contract has a stated size and quotation unit.

Future price for euros = 0.92, which leads to a contract price of 125,000(this is the
contract size)(.92) = 115,000

Calls for actual delivery through book entry of the underlying currency.

Derivatives - Exchange Traded Options

Over the Counter Options
Many derivative instruments such as forwards, swaps and most exotic derivatives are traded
OTC.

OTC Options are essentially unregulated

Act like the forward market described earlier
Dealers offer to take either a long or short position in option and then hedge that risk with
transactions in other options derivatives.
Buyer faces credit risk because there is no clearing house and no guarantee that the seller
will perform
Buyers need to assess sellers' credit risk and may need collateral to reduce that risk.
Price, exercise price, time to expiration, identification of the underlying, settlement or
delivery terms, size of contract, etc. are customized
The two counterparties determine terms.

Exchange-Traded Options
An option traded on a regulated exchange where the terms of each option are standardized by
the exchange. The contract is standardized so that underlying asset, quantity, expiration date
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and strike price are known in advance. Over-the-counter options are not traded on exchanges
and allow for the customization of the terms of the option contract.

All terms are standardized except price.

The exchange establishes expiration date and expiration prices as well as minimum price
quotation unit.
The exchange also establishes whether the option is American or European, its contract size
and whether settlement is in cash or in the underlying security.
Usually trade in lots in which 100 shares of stock = 1 option
The most active options are the ones that trade at the money, while deep-in-the-money and
deep-out-of-the money options don't trade very often.
Usually have short-term expirations (one to six months out in duration) with the exception of
LEAPS, which expire years in the future
Can be bought and sold with ease and holder decides whether or not to exercise. When
options are in the money or at the money they are typically exercised.
Most have to deliver the underlying security.
Regulated at the federal level

Types of Exchange Traded Options

1. Financial Options: Financial options have financial assets, such as an interest rate or a
currency, as their underlying assets. There are several types of financial options:
Stock Option - Also known as equity options, these are a privileges sold by one party to
another. Stock options give the buyer the right, but not the obligation, to buy (call) or sell (put)
a stock at an agreed-upon price during a certain period of time or on a specific date.
Index Option - A call or put option on a financial index, such as the Nasdaq or S&P 500.
Investors trading index options are essentially betting on the overall movement of the stock
market
as
represented
by
a
basket
of
stocks.
Bond Option - An option contract in which the underlying asset is a bond. Other than the
different characteristics of the underlying assets, there is no significant difference between
stock and bond options. Just as with other options, a bond option allows investors to hedge the
risk of their bond portfolios or speculate on the direction of bond prices with limited risk.
A buyer of a bond call option is expecting a decline in interest rates and an increase in bond
prices. The buyer of a put bond option is expecting an increase in interest rates and a decrease
in
bond
prices.
Interest Rate Option - Option in which the underlying asset is related to the change in an
interest rate. Interest rate options are European-style, cash-settled options on the yield of U.S.
Treasury securities. Interest rate options are options on the spot yield of U.S. Treasury
securities. They include options on 13-week Treasury bills, options on the five-year Treasury
note and options on the 10-year Treasury note. In general, the call buyer of an interest rate
option expects interest rates will go up (as will the value of the call position), while the put
buyer hopes rates will go down (increasing the value of the put position.) Interest rate options
and other interest rate derivatives make up the largest portion of the worldwide derivatives
market. It's estimated that $60 trillion dollars of interest rate derivatives contracts had been
exchanged by May 2004. And, according to the International Swaps and Derivatives
Association, 80% of the world's top 500 companies (as of April 2003) used interest rate
derivatives to control their cash flow. This compares with 75% for foreign exchange options,
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25%
for
commodity
options
and
10%
for
stock
options.
Currency Option - A contract that grants the holder the right, but not the obligation, to buy or
sell currency at a specified price during a specified period of time. Investors can hedge against
foreign currency risk by purchasing a currency option put or call.
2. Options on Futures: Like other options, an option on a futures contract is the right but not
the obligation, to buy or sell a particular futures contract at a specific price on or before a
certain expiration date. These grant the right to enter into a futures contract at a fixed price. A
call option gives the holder (buyer) the right to buy (go long) a futures contract at a specific
price on or before an expiration date. The holder of a put option has the right to sell (go short)
a futures contract at a specific price on or before the expiration date.
Learn more about the product specifications of options on futures in our article Becoming
Fluent
In
Options
On
Futures
3. Commodity Options: These are options in which the underlying asset is a commodity such
as wheat, gold, oil and soybeans. The CFA Institute focuses on financial options on the CFA
exam. All you need to know regarding commodity options is that they exist.
4. Other Options: As with most things, as time goes on procedures and products undergo
drastic changes. The same goes for options. New options have underlying assets such as the
weather. Weather derivatives are used by companies to hedge against the risk of weatherrelated losses. The investor who sells a weather derivative agrees to bear this risk for a
premium. If nothing happens, the investor makes a profit. However, if the weather turns bad,
the company owns the derivative claims the agreed amount.
If weather derivatives have caught your eye, check out the following article: Introduction to
Weather
Derivatives
Another option gaining popularity is real options. These options are not actively traded. The
real-options approach applies financial options theory to large capital expenditures such as
manufacturing plants, product line extensions and research and development. Where a
financial option gives the owner the right, but not the obligation, to buy or sell a security at a
given price, a real option gives companies that make strategic investments the right, but not
the obligation, to exploit these opportunities in the future.
Again, for your upcoming exam, all you need to know regarding these instruments is that they
exist.
Derivatives - Swap Markets and Contracts
Swaps are non-standardized contracts that are traded over the counter (OTC). However, to
facilitate trading, market participants have developed the ISDA Master Agreement, which
covers the 'non-economic' terms of a swap contract, such as representations and warranties,
events of default and termination events. Parties to the trade still need to negotiate the rate or
price, notional amount, maturity, collateral, etc.
Swaps are contracts that exchange assets, liabilities, currencies, securities, equity
participations and commodities. Some are simple, such as floating-for-fixed-rate loans or
Japanese yen for British pound sterling, while others are quite complex incorporating multiple
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currencies, interest rates, commodities and options. Both types are flexible in terms of
specifications such as pricing or evaluation benchmarks, timing or contractual horizons,
settlement procedures, resets, and other variables.
Generally, swaps are used for risk management by institutions such as banks, brokers, dealers
and corporations. Some qualified individuals may also be suitable users of these basic
derivatives products. The following lists highlight common swaps transactions.

Commodities: agricultural, energy, metals

Currencies: amortization or amortizing, differential, forward rates, forward start
Equities: basket, differential or spread, indexed, individual security related
Interest Rates: amortization or amortizing, arrears, basis, fixed for floating, forward start,
inverse floater, zero coupon
Swap Characteristics

Most involve multiple payments, although one-payment contracts are possible

A series of forward contracts.
When initiated, neither party exchanges any cash; a swap has zero value at the beginning.
One party tends to pay a fixed rate while the other pays on the movement of the underlying
asset. However, a swap can be structured so that both parties pay each other on the
movement of an underlying asset.
Parties make payments to each other on a settlement date. Parties may decide to agree
to just exchange the difference that is due to each other. This is called netting.
Final payment is made on the termination date.
Usually traded in the over-the-counter market. This means they are subject credit risk.

Terminating a Swap Contract

The easiest way to terminate the contract is to hold it to maturity. However, if one or both
parties in a swap contract wish to terminate, there are several methods:
1 Enter into a separate and offsetting swap. For example, an entity has a swap on its
books that pays a fixed rate and receives a floating rate based on LIBOR on January 1
and July 1. The entity can enter into a new swap that pays a floating rate based on
LIBOR and receives a fixed rate with payments on January 1 and July 1. With this new
transaction, your fixed rates may be different because of market rates, while the LIBOR
payments will wash out over the transaction's life. Credit risk will also increase because
you could have a new counterparty for the new swap.
2 The other way is to have a cash settlement based on market value. For example,
assume that a party holds a swap with a market value of $65,000. The contract could be
terminated if the other party pays the market value of the contract to the holder. Said
another way, if the party holding the swap has a negative value, it can terminate the
swap by paying its counterparty the market value of the swap. This terminates the
contract for both parties, but this is usually available only if it is stated before the
contract is entered into or agree upon by both parties at a later date.
3 Another way to terminate a swap is to sell the swap to another party. This usually
requires permission from the other party. This is not commonly used in the market place.
4 The last way to terminate a contract is to use a swaption. A swaption works like an
option by giving the owner the right to enter into another swap at terms that are set in
advance. By executing the swaption, the party can offset its current swap as explained
in the first way to terminate a contract.
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Derivatives - Currency Swaps

Like an interest rate swap, a currency swap is a contract to exchange cash flow streams from
some fixed income obligations (for example, swapping payments from a fixed-rate loan for
payments from a floating rate loan). In an interest rate swap, the cash flow streams are in the
same currency, while in currency swaps, the cash flows are in different monetary
denominations. Swap transactions are not usually disclosed on corporate balance sheets.
As we stated earlier, the cash flows from an interest rate swap occur on concurrent dates and
are netted against one another. With a currency swap, the cash flows are in different
currencies, so they can't net. Instead, full principal and interest payments are exchanged.
Currency swaps allow an institution to take leverage advantages it might enjoy in specific
countries. For example, a highly-regarded German corporation with an excellent credit rating
can likely issue euro-denominated bonds at an attractive rate. It can then swap those bonds
into, say, Japanese yen at better terms than it could by going directly into the Japanese market
where its name and credit rating may not be as advantageous.
At the origination of a swap agreement, the counterparties exchange notional principals in the
two currencies. During the life of the swap, each party pays interest (in the currency of the
principal received) to the other. At maturity, each makes a final exchange (at the same spot
rate) of the initial principal amounts, thereby reversing the initial exchange. Generally, each
party in the agreement has a comparative advantage over the other with respect to fixed or
floating rates for a certain currency. A typical structure of a fixed-for-floating currency swap is
as follows:

Calculating the Payments on a Currency Swap

Let's consider an example:
Firm A can borrow Canadian currency at a rate of 10% or can borrow U.S. currency at a floating
rate equal to six-month LIBOR. Firm B can borrow Canadian currency at a rate of 11% or U.S.
currency at a rate of floating rate equal to six-month LIBOR. Although Firm A can borrow
Canadian currency at a cheaper rate than Firm B, it needs a floating-rate loan. Additionally,
Firm B needs a fixed-rate Canadian dollar loan. The loan is for US$20 million, and will mature in
two years.
Who has the comparative advantage?

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To determine who has the comparative advantage, consider the fixed rates for each firm for
the currency required. In this case, Firm A's rate of 10% is less than Firm B's rate of 11%, so
Firm A has a comparative advantage in the fixed currency. That leaves Firm B to have a
comparative advantage with respect to the floating rate.
Derivatives - Interest Rate and Equity Swaps
Plain Vanilla Interest Rate Swap
In general, an interest rate swap is an agreement to exchange rate cash flows from interestbearing instruments at specified payment dates. Each party's payment obligation is computed
using a different interest rate. Although there are no truly standardized swaps, a plain vanilla
swap typically refers to a generic interest rate swap in which one party pays a fixed rate and
one party pays a floating rate (usually LIBOR).
For each party, the value of an interest rate swap lies in the net difference between the
present value of the cash flows one party expects to receive and the present value of the
payments the other party expects to make. At the origination of the contract, the value for
both parties is usually zero because no cash flows are exchanged at that point. Over the life of
the contract, it becomes a zero-sum game. As interest rates fluctuate, the value of the swap
creates a profit on one counterparty's books, which results in a corresponding loss on the
other's
books.
Example
A portfolio manager with a $1 million fixed-rate portfolio yielding 3.5% believes rates may
increase and wants to decrease his exposure. He can enter into an interest rate swap and
trade his fixed rate cash flows for floating rate cash flows that have less exposure when rates
are rising. He swaps his 3.5% fixed-rate interest stream for the three-month floating LIBOR rate
(which is currently at 3%). When this happens, he will receive a floating rate payment and pay
a fixed rate that is equivalent to the rate the portfolio is receiving, making his portfolio a
floating-rate portfolio instead of the fixed-rate return he was receiving. There is no exchange of
the principal amounts and the interest payments are netted against one another. For example,
if LIBOR is 3%, the manager receives 0.5%. The actual amounts calculated for semiannual
payments are shown below. The fixed rate (3.5% in this example) is referred to as the swap
rate.
A typical exam question concerning interest rate swaps follows:
Q. Two parties enter a three-year, plain-vanilla interest rate swap agreement to
exchange the LIBOR rate for a 10% fixed rate on $10 million. LIBOR is 11% now, 12% at
the end of the first year, and 9% at the end of the second year. If payments are in
arrears, which of the following characterizes the net cash flow to be received by the
fixed-rate payer?
A. $100,000 at the end of year two.
B. $100,000 at the end of year three.
C. $200,000 at the end of year two.
D. $200,000 at the end of year three.
A. The correct answer is "C". What's important to remember is that the payments are in
arrears, so the end-of-year payments depend on the interest rate at the beginning of the
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year (or prior year end). The payment at the end of year two is based on the 12%
interest rate at the end of year one. If the floating rate is higher than the fixed rate, the
fixed rate payer receives the interest rate differential times the principal amount
($10,000 x (0.12-0.10) = $200,000).
Calculate the Payments on an Interest Rate Swap
Consider the following example:
Notional amount = $1 million, payments are made semiannually. The corporation will pay a
floating rate of three-month LIBOR, which is at 3% and will receive a fixed payment of 3.5%.
Answer:
Floating rate payment is $1 million(.03)(180/365) = $14,790
Fixed payment is $1 million(.035)(180/365) = $17,225
The corporation will receive a net payment of $2,435.
Equity Swaps
An equity swap is an agreement between counterparties to exchange a set of payments,
determined by a stock or index return, with another set of payments (usually an interestbearing (fixed or floating rate) instrument, but they can also be the return on another stock or
index). Equity swaps are used to substitute for a direct transaction in stock. The two cash flows
are usually referred to as "legs". As with interest rate swaps, the difference in the payment
streams is netted.
Equity swaps have many applications. For example, a portfolio manager with XYZ Fund can
swap the fund's returns for the returns of the S&P 500 (capital gains, dividends and income
distributions.) They most often occur when a manager of a fixed income portfolio wants the
portfolio to have exposure to the equity markets either as a hedge or a position. The portfolio
manager would enter into a swap in which he would receive the return of the S&P 500 and pay
the counterparty a fixed rate generated form his portfolio. The payment the manager receives
will be equal to the amount he is receiving in fixed-income payments, so the manager's net
exposure is solely to the S&P 500. These types of swaps are usually inexpensive and require
little in term of administration.
For individuals, equity swaps offer some tax advantages. The owner of $1 million worth of XYZ
stock watches his stock value increase by 25% over 12 months. He wants to take some of the
profit but does not want to actually sell his shares. In this case, he can enter into an equity
swap in which he pays a counterparty (perhaps his brokerage) the total return he receives from
his XYZ shares annually for the next three years. In return, he'll take the three-month LIBOR
rate. In this scenario, the owner of XYZ does not have to report any capital gains on his stock
and retains ownership of those stocks as well.

A total return equity swaps includes capital gains and dividends paid on the underlying
stock or stock index. No principal is exchanged and payments are set off by a notional
amount.

Calculate the Payments on an Equity Swap

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Consider the following example:

Notional principal amount = $1 million Payments made semi-annual Fund manager will pay the
broker/dealer the return of the S&P 500 and will receive an interest payment of 5% every six
months Index is at 10,500 at the start of the swap
Results:
Six months from now the index is at 11,000.

The fixed payment the fund will receive is:

$1 million (0.05) 182/365 = $24,931.51

The index payment the fund must make is:

(11,000/10,500 -1) $1 million = $47,619.04

The net payment the fund must make at the end of the first six months is $22,687.50
(47,619.04 - 24,931.51).

Stock Option Basics

Definition:
A stock option is a contract between two parties in which the stock option buyer (holder)
purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a
predetermined price from/to the option seller (writer) within a fixed period of time.
Option Contract Specifications
The following terms are specified in an option contract.
Option Type
The two types of stock options are puts and calls. Call options confers the buyer the right to
buy the underlying stock while put options give him the rights to sell them.
Strike Price
The strike price is the price at which the underlying asset is to be bought or sold when the
option is exercised. It's relation to the market value of the underlying asset affects the
moneyness of the option and is a major determinant of the option's premium.
Premium
In exchange for the rights conferred by the option, the option buyer have to pay the option
seller a premium for carrying on the risk that comes with the obligation. The option premium
depends on the strike price, volatility of the underlying, as well as the time remaining to
expiration.
Expiration Date
Option contracts are wasting assets and all options expire after a period of time. Once the
stock option expires, the right to exercise no longer exists and the stock option becomes
worthless. The expiration month is specified for each option contract. The specific date on
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which expiration occurs depends on the type of option. For instance, stock options listed in the
United States expire on the third Friday of the expiration month.
Option Style
An option contract can be either american style or european style. The manner in which
options can be exercised also depends on the style of the option. American style options can
be exercised anytime before expiration while european style options can only be exercise on
expiration date itself. All of the stock options currently traded in the marketplaces are
american-style options.
Underlying Asset
The underlying asset is the security which the option seller has the obligation to deliver to or
purchase from the option holder in the event the option is exercised. In the case of stock
options, the underlying asset refers to the shares of a specific company. Options are also
available for other types of securities such as currencies, indices and commodities.
Contract Multiplier
The contract multiplier states the quantity of the underlying asset that needs to be delivered in
the event the option is exercised. For stock options, each contract covers 100 shares.
The Options Market
Participants in the options market buy and sell call and put options. Those who buy options are
called holders. Sellers of options are called writers. Option holders are said to have long
positions, and writers are said to have short positions.
Call Option
Definition:
A call option is an option contract in which the holder (buyer) has the right (but not the
obligation) to buy a specified quantity of a security at a specified price (strike price) within a
fixed period of time (until its expiration).
For the writer (seller) of a call option, it represents an obligation to sell the underlying security
at the strike price if the option is exercised. The call option writer is paid a premium for taking
on the risk associated with the obligation.
For stock options, each contract covers 100 shares.
Buying Call Options
Call buying is the simplest way of trading call options. Novice traders often start off trading
options by buying calls, not only because of its simplicity but also due to the large ROI
generated from successful trades.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price
of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will
rise sharply in the coming weeks after their earnings report. So you paid $200 to purchase a
single $40 XYZ call option covering 100 shares.
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Say you were spot on and the price of XYZ stock rallies to $50 after the company reported
strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in
the underlying stock price, your call buying strategy will net you a profit of $800.
Let us take a look at how we obtain this figure.
If you were to exercise your call option after the earnings report, you invoke your right to buy
100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50
a share. This gives you a profit of $10 per share. As each call option contract covers 100
shares, the total amount you will receive from the exercise is $1000.
Since you had paid $200 to purchase the call option, your net profit for the entire trade is
$800. It is also interesting to note that in this scenario, the call buying strategy's ROI of 400%
is very much higher than the 25% ROI achieved if you were to purchase the stock itself.
This strategy of trading call options is known as the long call strategy. See our long call
strategy article for a more detailed explanation as well as formulae for calculating maximum
profit, maximum loss and breakeven points.
Selling Call Options
Instead of purchasing call options, one can also sell (write) them for a profit. Call option
writers, also known as sellers, sell call options with the hope that they expire worthless so that
they can pocket the premiums. Selling calls, or short call, involves more risk but can also be
very profitable when done properly. One can sell covered calls or naked (uncovered) calls.
Covered Calls
The short call is covered if the call option writer owns the obligated quantity of the underlying
security. The covered call is a popular option strategy that enables the stockowner to generate
additional income from their stock holdings thru periodic selling of call options. See our
covered call strategy article for more details.
Naked (Uncovered) Calls
When the option trader write calls without owning the obligated holding of the underlying
security, he is shorting the calls naked. Naked short selling of calls is a highly risky option
strategy and is not recommended for the novice trader. See our naked call article to learn more
about this strategy.
Call Spreads
A call spread is an options strategy in which equal number of call option contracts are bought
and sold simultaneously on the same underlying security but with different strike prices and/or
expiration dates. Call spreads limit the option trader's maximum loss at the expense of
capping his potential profit at the same time.
Put Option
Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the
obligation) to sell a specified quantity of a security at a specified price (strike price) within a
fixed period of time (until its expiration).
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For the writer (seller) of a put option, it represents an obligation to buy the underlying security
at the strike price if the option is exercised. The put option writer is paid a premium for taking
on the risk associated with the obligation.
For stock options, each contract covers 100 shares.
Buying Put Options
Put buying is the simplest way to trade put options. When the options trader is bearish on
particular security, he can purchase put options to profit from a slide in asset price. The price
of the asset must move significantly below the strike price of the put options before the option
expiration date for this strategy to be profitable.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price
of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will
drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a
single $40 XYZ put option covering 100 shares.
Say you were spot on and the price of XYZ stock plunges to $30 after the company reported
weak earnings and lowered its earnings guidance for the next quarter. With this crash in the
underlying stock price, your put buying strategy will result in a profit of $800.
Let's take a look at how we obtain this figure.
If you were to exercise your put option after earnings, you invoke your right to sell 100 shares
of XYZ stock at $40 each. Although you don't own any share of XYZ company at this time, you
can easily go to the open market to buy 100 shares at only $30 a share and sell them
immediately for $40 per share. This gives you a profit of $10 per share. Since each put option
contract covers 100 shares, the total amount you will receive from the exercise is $1000. As
you had paid $200 to purchase this put option, your net profit for the entire trade is $800.
This strategy of trading put option is known as the long put strategy. See our long put strategy
article for a more detailed explanation as well as formulae for calculating maximum profit,
maximum loss and breakeven points.
Protective Puts
Investors also buy put options when they wish to protect an existing long stock position. Put
options employed in this manner are also known as protective puts. Entire portfolio of stocks
can also be protected using index puts.
Selling Put Options
Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers,
also known as sellers, sell put options with the hope that they expire worthless so that they
can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable
if done properly.

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Covered Puts
The written put option is covered if the put option writer is also short the obligated quantity of
the underlying security. The covered put writing strategy is employed when the investor is
bearish on the underlying.
Naked Puts
The short put is naked if the put option writer did not short the obligated quantity of the
underlying security when the put option is sold. The naked put writing strategy is used when
the investor is bullish on the underlying.
For the patient investor who is bullish on a particular company for the long haul, writing naked
puts can also be a great strategy to acquire stocks at a discount.
Put Spreads
A put spread is an options strategy in which equal number of put option contracts are bought
and sold simultaneously on the same underlying security but with different strike prices and/or
expiration dates. Put spreads limit the option trader's maximum loss at the expense of capping
his potential profit at the same time.
Strike Price
Definition:
The strike price is defined as the price at which the holder of an options can buy (in the case of
a call option) or sell (in the case of a put option) the underlying security when the option is
exercised. Hence, strike price is also known as exercise price.
Strike Price, Option Premium & Moneyness
When selecting options to buy or sell, for options expiring on the same month, the option's
price (aka premium) and moneyness depends on the option's strike price.
Relationship between Strike Price & Call Option Price
For call options, the higher the strike price, the cheaper the option. The following table lists
option premiums typical for near term call options at various strike prices when the underlying
stock is trading at $50
Relationship between Strike Price & Put Option Price
Conversely, for put options, the higher the strike price, the more expensive the option. The
following table lists option premiums typical for near term put options at various strike prices
when the underlying stock is trading at $50
Strike Price Intervals
The strike price intervals vary depending on the market price and asset type of the underlying.
For lower priced stocks (usually $25 or less), intervals are at 2.5 points. Higher priced stocks
have strike price intervals of 5 point (or 10 points for very expensive stocks priced at $200 or
more). Index options typically have strike price intervals of 5 or 10 points while futures options
generally have strike intervals of around one or two points.
Options Premium
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The price paid to acquire the option. Also known simply as option price. Not to be confused
with the strike price. Market price, volatility and time remaining are the primary forces
determining the premium. There are two components to the options premium and they are
intrinsic value and time value.
Intrinsic Value
The intrinsic value is determined by the difference between the current trading price and the
strike price. Only in-the-money options have intrinsic value. Intrinsic value can be computed
for in-the-money options by taking the difference between the strike price and the current
trading price. Out-of-the-money options have no intrinsic value.
Time Value
An option's time value is dependent upon the length of time remaining to exercise the option,
the moneyness of the option, as well as the volatility of the underlying security's market price.
The time value of an option decreases as its expiration date approaches and becomes
worthless after that date. This phenomenon is known as time decay. As such, options are also
wasting assets.
For in-the-money options, time value can be calculated by subtracting the intrinsic value from
the option price. Time value decreases as the option goes deeper into the money. For out-ofthe-money options, since there is zero intrinsic value, time value = option price.
Typically, higher volatility give rise to higher time value. In general, time value increases as the
uncertainty of the option's value at expiry increases.
Effect of Dividends on Time Value
Time value of call options on high cash dividend stocks can get discounted while similarly, time
value of put options can get inflated. For more details on the effect of dividends on option
pricing, read this article.
Moneyness
Moneyness is a term describing the relationship between the strike price of an option and the
current trading price of its underlying security. In options trading, terms such as in-the-money,
out-of-the-money and at-the-money describe the moneyness of options.
In-the-Money (ITM)
A call option is in-the-money when its strike price is below the current trading price of the
underlying asset.
A put option is in-the-money when its strike price is above the current trading price of the
underlying asset.
In-the-money options are generally more expensive as their premiums consist of significant
intrinsic value on top of their time value.
Out-of-the-Money (OTM)
Calls are out-of-the-money when their strike price is above the market price of the underlying
asset.
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Puts are out-of-the-money when their strike price is below the market price of the underlying
asset.
Out-of-the-money options have zero intrinsic value. Their entire premium is composed of only
time value. Out-of-the-money options are cheaper than in-the-money options as they possess
greater likelihood of expiring worthless.
At-the-Money (ATM)
An at-the-money option is a call or put option that has a strike price that is equal to the market
price of the underlying asset. Like OTM options, ATM options possess no intrinsic value and
contain only time value which is greatly influenced by the volatility of the underlying security
and the passage of time.
Often, it is not easy to find an option with a strike price that is exactly equal to the market
price of the underlying. Hence, close-to-the-money or near-the-money options are bought or
sold instead.
Options Expiration
All options have a limited useful lifespan and every option contract is defined by an expiration
month. The option expiration date is the date on which an options contract becomes invalid
and the right to exercise it no longer exists.
When do Options Expire?
For all stock options listed in the United States, the expiration date falls on the third Friday of
the expiration month (except when that Friday is also a holiday, in which case it will be
brought forward by one day to Thursday).
Expiration Cycles
Stock options can belong to one of three expiration cycles. In the first cycle, the JAJO cycle, the
expiration months are the first month of each quarter - January, April, July, October. The second
cycle, the FMAN cycle, consists of expiration months Febuary, May, August and November. The
expiration months for the third cycle, the MJSD cycle, are March, June, September and
December.
At any given time, a minimum of four different expiration months are available for every
optionable stock. When stock options first started trading in 1973, the only expiration months
available are the months in the expiration cycle assigned to the particular stock.
Later on, as options trading became more popular, this system was modified to cater to
investors' demand to use options for shorter term hedging. The modified system ensures that
two near-month expiration months will always be available for trading. The next two expiration
months further out will still depend on the expiration cycle that was assigned to the stock.
Determining the Expiration Cycle
As there is no set pattern as to which expiration cycle a particular optionable stock is assigned
to, the only way to find out is to deduce from the expiration months that are currently available
for trading. To do that, just look at the third available expiration month and see which cycle it
belongs to. If the third expiration month happens to be January, then use the fourth expiration
month to check.
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The reason we need to double check January is because LEAPS expire in January and if the
stock has LEAPS listed for trading, then that January expiration month is the additional
expiration month added for the LEAPS options.
Option Exercise & Assignment
Exercise
To exercise an option is to execute the right of the holder of an option to buy (for call options)
or sell (for put options) the underlying security at the striking price.
American Style vs European Style
American style options can be exercised anytime before the expiration date. European style
options on the other hand can only be exercised on the expiration date itself. Currently, all of the
stock options traded in the marketplaces are American-Style options.
When an option is exercised by the option holder, the option writer will be assigned the obligation
to deliver the terms of the options contract.

Assignment
Assignment takes place when the written option is exercised by the options holder. The options
writer is said to be assigned the obligation to deliver the terms of the options contract.
If a call option is assigned, the options writer will have to sell the obligated quantity of the
underlying security at the strike price.
If a put option is assigned, the options writer will have to buy the obligated quantity of the
underlying securty at the strike price.
Once an option is sold, there exist a possibility for the option writer to be assigned to fulfil his
or her obligation to buy or sell shares of the underlying stock on any business day. One can
never tell when an assignment will take place. To ensure a fair distribution of assignments, the
Options Clearing Corporation uses a random procedure to assign exercise notices to the
accounts maintained with OCC by each Clearing Member. In turn, the assigned firm must use
an exchange approved way to allocate those notices to individual accounts which have the
short positions on those options.
Options are usually exercised when they get closer to expiration. The reason is that it does not
make much sense to exercise an option when there is still time value left. Its more profitable to
sell the option instead.
Over the years, only about 17% of options have been exercised. However, it does not mean
that only 17% of your short options will be exercised. Many of those options that were not
exercised were probably out-of-the-money to begin with and had expired worthless. In any
case, at any point in time, the deeper into-the-money the short options, the more likely they
will be exercised.
Getting Started in Options Trading
To start trading options, you will need to have a trading account with an options brokerage.
Once you have setup your account, you can then place options trades with your broker who
will execute it on your behalf.
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Opening a Trading Account

When opening a trading account with a brokerage firm, you will be asked whether you wish to
open a cash account or a margin account.
Cash Account vs. Margin Account
The difference between a cash account and a margin account is that a margin account allows
you to use your existing holdings (eg. stocks or long-term options) as collaterals to borrow
funds from the brokerage to finance additional purchases. With cash accounts, you can only
use the available cash in your account to pay for all your stock and options trades.
Minimum Deposit
There is usually a minimum deposit required to open a trading account. The amount required
depends on the type of account that you are opening as well as the brokerage firm. Little or no
deposit is required to open a cash account while federal regulations require a deposit of at
least $2000 to open a margin-enabled account.
Online Brokerage vs. Offline Brokerage
To trade options effectively, I find it necessary to trade via an online brokerage account as
there are simply too many variables in a typical options trade, as compared to a stock trade.
Having to communicate too many details in one trade to your broker over the phone also
increases the chance of miscommunication which can prove very costly.
With technology so advanced these days, online brokerages for options now offer highly
intuitive user interfaces where it is far easier to place option trades online than having to do it
over the phone. Moreover, while a human broker can only handle one client at a time, online
brokerages can handle thousands of orders simultaneously. Thus, it is no coincidence that the
rise of option trading also coincide with the rapid advancement of internet technologies.
Options Transactions
Unlike stock trading, the contractual nature of options offer four different ways for entering and
exiting positions. There is an options seller (writer) and an options buyer (holder). The option
seller can enter or exit a transaction, and so can an option buyer.
Opening Transactions
Buy-to-Open
This is the transaction the options buyer make to enter a long position on an option. For
example, if you want to buy a call option, you would enter a "buy-to-open" transaction.
Sell-to-Open
This is the transaction the options seller make when he wish to enter a short position on an
option. For example, if you are writing call options to earn premiums, you would enter a "sellto-open" transaction.
Closing Transactions
Buy-to-Close
This is the transaction the options writer make when he wish to exit a short position on an
option. For example, if you wish to buy back the calls you had previously sold, you would enter
a "buy-to-close" transaction.

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Sell-to-Close
This is the transaction the options holder make to exit a long position on an option. For
example, if you want to sell a previously purchased call option, you would enter a "sell-toclose" transaction.
Types of Orders
Online brokerages provide many types of orders to cater to the various needs of the investors.
The common types of orders available are market orders, limit orders and stop orders.
Market Order
With market orders, you are instructing your broker to buy or sell the options at the current
market price. If you are buying, you will be paying the asking price. If selling, you will be selling
at the bid price. The advantage of using market orders is that you will fill your order fast (often
instantly) but the disadvantage is that you will usually end up paying slightly more, especially
when the order is large and the trading volume thin.
Limit Order
With limit orders, you will specify the price you wish to transact. If you are buying, you are
instructing your broker to buy at no higher than the specified price. If selling, you are telling
him to sell at no less than your stated price. The advantage of using limit orders is that you are
in full control of the price at which you buy or sell your options. The disadvantage is that filling
the order will take some time, or the entire order may not get filled at all because the
underlying stock price has moved way beyond your desired price.
Stop Loss Order
Stop loss orders are orders that only gets executed when the market price of the underlying
stock reaches a specified price. They are used to reduce losses when the underlying asset
price moves sharply against the investor.
Stop Market Order
A stop market order, or simply stop order, is a market order that only executes when the
underlying stock price trades at or through a designated price. Buy stops, designed to limit
losses on short positions, are placed above current market price. Sell stops are used to protect
long positions and are placed below current market price.
While the stop market order guarantees execution, the actual transacted price maybe slightly
lower or higher than desired, especially when the underlying price movement is very volatile.
Stop Limit Order
A stop limit order is a limit order that gets activated only when the underlying stock price
trades at or through a specifed price. While a stop limit order provides complete control over
the transaction price, it may not get executed if the underlying price moves too quickly and
the limit price is never reached.
Margin Requirements
In options trading, "margin" also refers to the cash or securities required to be deposited by an
option writer with his brokerage firm as collateral for the writer's obligation to buy or sell the
underlying security, or in the case of cash-settled options to pay the cash settlement amount,
in the event that the option gets assigned.
Margin requirements for option writers are complicated and not the same for each type of
underlying security. They are subject to change and can vary from brokerage firm to brokerage
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firm. As they have significant impact to the risk/reward profiles of each trade, writers of options
(whether they be calls or puts alone or as part of multiple position strategies such as spreads,
straddles or strangleslong-straddle.aspx) should determine the applicable margin requirements
from their brokerage firms and be sure that they are able to meet those requirements in case
the market turns against them.
SOP
============================
Swaps: An Overview
A swap is a derivative instrument involving the exchange of a series of future cash flows
between two parties over a period of time. This contract has offsetting obligations each party
pays a series of cash flows at various future dates, while receiving another series of cash flows
in exchange. Note that the cash flows do not need to be paid on the same dates. The cash flow
amounts are either set in advance or calculated before each payment with reference to some
observed underlying market variables.
The usual exchange of cash flows in a swap is fixed for floating, though other structures
(floating for floating or fixed for fixed) are also possible. Single currency swaps are the most
common type of swap and are often given the generic term "interest rate swaps" (IRS). There
is also a thriving market for cross-currency swaps, where values are also dependent on interest
rates. However, the biggest market (by far) is that for interest rate swaps.
Swaps: Pricing
A swap is simply a collection of cash flows (paid or received today or in the future). As a
consequence, the underlying pricing principle is straightforward at inception, the net present
value (NPV) of the sum of all cash flows (paid or received) must be zero. In theory:
Present Value of Payments = Present Value of Receipts
To price a swap, you need only to be able to answer two questions:

What are the future cash flows?

What is the present value of those future cash flows?

Present Value of Future Cash Flows

Computing this present value is not a trivial task. The difficulty arises from the fact that the
forward amounts on the floating/variable leg of the swap are generally unknown at inception.
As a consequence, in order to discount the cash flows some method is first needed to estimate
the future value of the floating leg payments.
Prior to the financial crisis, interest rate swaps used the same rates to calculate forward
floating amounts and to discount those amounts when finding a present value. Since the
financial crisis, things have changed. The estimated future floating rates (generating the
floating amounts) are now different from those used for discounting.
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Swap Pricing: Effect of Price Change

At inception, the present value of the interest rate swap is zero. But as prices change, the
value of the swap changes.
Example
Party A agrees to pay party B a series of floating rate payments, and receives a series of fixed
rate payments in return. Assume that interest rates fall just after the initiation of the swap.
Party A continues to receive payments at the fixed rate, so the swap now has a positive value
for Party A. In addition, the fixed rate is being discounted at the lower interest rate, so the
present value of the future cash flows is higher.
Party B is receiving variable rate payments. The floating rate for the first payment would have
been set at the start of the swap. Discounting the first payment by the lower interest rates will
increase the present value of that payment. But future payments will be reduced as each
payment will be based on the lower interest rate at the next observation (reset) date. The
swap has a negative value for party B.
We saw in our example that, since the interest rate movement, Party A has been receiving a
relatively higher fixed rate than the variable rate it has been paying. It could monetize this
swap value by entering into an offsetting swap at the new lower rate. In other words, it could
enter a swap where it is now receiving floating and paying fixed. The variable rates will cancel
out between the two swap contracts. This then leaves party A to receive an annuity equal to
the difference between the fixed rates of the two swap contracts. (Accounting treatments
mean that this benefit is usually booked as a profit equal to the PV of the annuity instead of
being treated on an accrual basis.)
=========================================================
=========
What is a 'Bond'
A bond is a debt investment in which an investor loans money to an entity (typically corporate
or governmental) which borrows the funds for a defined period of time at a variable or fixed
interest rate. Bonds are used by companies, municipalities, states and sovereign governments
to raise money and finance a variety of projects and activities. Owners of bonds are
debtholders, or creditors, of the issuer
Bonds are commonly referred to as fixed-income securities and are one of the three main
generic asset classes, along with stocks (equities) and cash equivalents. Many corporate and
government bonds are publicly traded on exchanges, while others are traded only over-thecounter (OTC).
How Bonds Work
When companies or other entities need to raise money to finance new projects, maintain
ongoing operations, or refinance existing other debts, they may issue bonds directly to
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investors instead of obtaining loans from a bank. The indebted entity (issuer) issues a bond
that contractually states the interest rate (coupon) that will be paid and the time at which the
loaned funds (bond principal) must be returned (maturity date).
The issuance price of a bond is typically set at par, usually $100 or $1,000 face value per
individual bond. The actual market price of a bond depends on a number of factors including
the credit quality of the issuer, the length of time until expiration, and the coupon rate
compared to the general interest rate environment at the time.
Example
Because fixed-rate coupon bonds will pay the same percentage of its face value over time, the
market price of the bond will fluctuate as that coupon becomes desirable or undesirable given
prevailing interest rates at a given moment in time. For example if a bond is issued when
prevailing interest rates are 5% at $1,000 par value with a 5% annual coupon, it will generate
$50 of cash flows per year to the bondholder. The bondholder would be indifferent to
purchasing the bond or saving the same money at the prevailing interest rate.
If interest rates drop to 4%, the bond will continue paying out at 5%, making it a more
attractive option. Investors will purchase these bonds, bidding the price up to a premium until
the effective rate on the bond equals 4%. On the other hand, if interest rates rise to 6%, the
5% coupon is no longer attractive and the bond price will decrease, selling at a discount until
it's effective rate is 6%.
Because of this mechanism, bond prices move inversely with interest rates.
Characteristics of Bonds

Most bonds share some common basic characteristics including:

Face value is the money amount the bond will be worth at its maturity, and is also the
reference amount the bond issuer uses when calculating interest payments.

Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond,
expressed as a percentage.

Coupon dates are the dates on which the bond issuer will make interest payments.
Typical intervals are annual or semi-annual coupon paymets.

Maturity date is the date on which the bond will mature and the bond issuer will pay the
bond holder the face value of the bond.

Issue price is the price at which the bond issuer originally sells the bonds.

Two features of a bond credit quality and duration are the principal determinants of a bond's
interest rate. If the issuer has a poor credit rating, the risk of default is greater and these
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bonds will tend to trade a discount. Credit ratings are calculated and issued by credit rating
agencies. Bond maturities can range from a day or less to more than 30 years. The longer the
bond maturity, or duration, the greater the chances of adverse effects. Longer-dated bonds
also tend to have lower liquidity. Because of these attributes, bonds with a longer time to
maturity typically command a higher interest rate.
When considering the riskiness of bond portfolios, investors typically consider the duration
(price sensitivity to changes in interest rates) and convexity (curvature of duration).
Bond Issuers
There are three main categories of bonds.

Corporate bonds are issued by companies.

Municipal bonds are issued by states and municipalities. Municipal bonds can offer taxfree coupon income for residents of those municipalities.

U.S. Treasury bonds (more than 10 years to maturity), notes (1-10 years maturity) and
bills (less than one year to maturity) are collectively referred to as simply "Treasuries."

Varieties of Bonds

Zero-coupon bonds do not pay out regular coupon payments, and instead are issued at a
discount and their market price eventually converges to face value upon maturity. The
discount a zero-coupon bond sells for will be equivalent to the yield of a similar coupon
bond.

Convertible bonds are debt instruments with an embedded call option that allows
bondholders to convert their debt into stock (equity) at some point if the share price
rises to a sufficiently high level to make such a conversion attractive.

Some corporate bonds are callable, meaning that the company can call back the bonds
from debtholders if interest rates drop sufficiently. These bonds typically trade at a
premium to non-callable debt due to the risk of being called away and also due to their
relative scarcity in today's bond market. Other bonds are putable, meaning that creditors
can put the bond back to the issuer if interest rates rise sufficiently.

The majority of corporate bonds in today's market are so-called bullet bonds, with no
embedded options whose entire face value is paid at once on the maturity date.
Bond (finance)
In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a
debt security, under which the issuer owes the holders a debt and, depending on the terms of
the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later
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date, termed the maturity date. Interest is usually payable at fixed intervals (semiannual,
annual, sometimes monthly). Very often the bond is negotiable, that is, the ownership of the
instrument can be transferred in the secondary market. This means that once the transfer
agents at the bank medallion stamp the bond, it is highly liquid on the second market.
Thus, a bond is a form of loan or IOU: the holder of the bond is the lender (creditor), the issuer
of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the
borrower with external funds to finance long-term investments, or, in the case of government
bonds, to finance current expenditure. Certificates of deposit (CDs) or short term commercial
paper are considered to be money market instruments and not bonds: the main difference is in
the length of the term of the instrument.
Bonds and stocks are both securities, but the major difference between the two is that (capital)
stockholders have an equity stake in the company (i.e., they are investors), whereas
bondholders have a creditor stake in the company (i.e., they are lenders). Being a creditor,
bondholders have priority over stockholders. This means they will be repaid in advance of
stockholders, but will rank behind secured creditors in the event of bankruptcy. Another
difference is that bonds usually have a defined term, or maturity, after which the bond is
redeemed, whereas stocks are typically outstanding indefinitely. An exception is an
irredeemable bond, such as a consol, which is a perpetuity, that is, a bond with no maturity.
Issuance
Bonds are issued by public authorities, credit institutions, companies and supranational
institutions in the primary markets. The most common process for issuing bonds is through
underwriting. When a bond issue is underwritten, one or more securities firms or banks,
forming a syndicate, buy the entire issue of bonds from the issuer and re-sell them to investors.
The security firm takes the risk of being unable to sell on the issue to end investors. Primary
issuance is arranged by bookrunners who arrange the bond issue, have direct contact with
investors and act as advisers to the bond issuer in terms of timing and price of the bond issue.
The bookrunner is listed first among all underwriters participating in the issuance in the
tombstone ads commonly used to announce bonds to the public. The bookrunners' willingness
to underwrite must be discussed prior to any decision on the terms of the bond issue as there
may be limited demand for the bonds.
In contrast, government bonds are usually issued in an auction. In some cases, both members
of the public and banks may bid for bonds. In other cases, only market makers may bid for
bonds. The overall rate of return on the bond depends on both the terms of the bond and the
price paid. The terms of the bond, such as the coupon, are fixed in advance and the price is
determined by the market.
In the case of an underwritten bond, the underwriters will charge a fee for underwriting. An
alternative process for bond issuance, which is commonly used for smaller issues and avoids
this cost, is the private placement bond. Bonds sold directly to buyers and may not be
tradeable in the bond market.
Historically an alternative practice of issuance was for the borrowing government authority to
issue bonds over a period of time, usually at a fixed price, with volumes sold on a particular
day dependent on market conditions. This was called a tap issue or bond tap. [6] Components:
A bond is divided into components that make it a bond. You start with the boarder. This makes
the bond bounded. All parts of the contract are bound in the boarders. Sometimes the price of
the bond is in the boundary this shows the price to be negotiable and not bound. Then you
have the seals. The picture of the corporate seal and the family seal of the CEO or owner. You
have the value of the bond and the currency it is in. You also have the terms and conditions of
the bond. I recommend placing the terms and conditions in Amens. This means "let it be so".
Then both parties sign the terms and conditions. The holder of the bond only signs the bond if
he does not want to trade or sell it.
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Principal
Nominal, principal, par, or face amount is the amount on which the issuer pays interest, and
which, most commonly, has to be repaid at the end of the term. Some structured bonds can
have a redemption amount which is different from the face amount and can be linked to
performance of particular assets.
Maturity
The issuer has to repay the nominal amount on the maturity date. As long as all due payments
have been made, the issuer has no further obligations to the bond holders after the maturity
date. The length of time until the maturity date is often referred to as the term or tenor or
maturity of a bond. The maturity can be any length of time, although debt securities with a
term of less than one year are generally designated money market instruments rather than
bonds. Most bonds have a term of up to 30 years. Some bonds have been issued with terms of
50 years or more, and historically there have been some issues with no maturity date
(irredeemable). In the market for United States Treasury securities, there are three categories
of bond maturities:

short term (bills): maturities between one to five year; (instruments with maturities less
than one year are called Money Market Instruments)

medium term (notes): maturities between six to twelve years;

long term (bonds): maturities greater than twelve years.

Coupon
The coupon is the interest rate that the issuer pays to the holder. Usually this rate is fixed
throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or
it can be even more exotic. The name "coupon" arose because in the past, paper bond
certificates were issued which had coupons attached to them, one for each interest payment.
On the due dates the bondholder would hand in the coupon to a bank in exchange for the
interest payment. Interest can be paid at different frequencies: generally semi-annual, i.e.
every 6 months, or annual.
Yield
The yield is the rate of return received from investing in the bond. It usually refers either to

the current yield, or running yield, which is simply the annual interest payment divided
by the current market price of the bond (often the clean price), or to

the yield to maturity or redemption yield, which is a more useful measure of the return
of the bond, taking into account the current market price, and the amount and timing of
all remaining coupon payments and of the repayment due on maturity. It is equivalent to
the internal rate of return of a bond.

Credit quality
The quality of the issue refers to the probability that the bondholders will receive the amounts
promised at the due dates. This will depend on a wide range of factors. High-yield bonds are
bonds that are rated below investment grade by the credit rating agencies. As these bonds are

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riskier than investment grade bonds, investors expect to earn a higher yield. These bonds are
also called junk bonds.
Market price
The market price of a tradeable bond will be influenced amongst other things by the amounts,
currency and timing of the interest payments and capital repayment due, the quality of the
bond, and the available redemption yield of other comparable bonds which can be traded in
the markets.
The price can be quoted as clean or dirty. ("Dirty" includes the present value of all future cash
flows including accrued interest. "Dirty" is most often used in Europe. "Clean" does not include
accrued interest. "Clean" is most often used in the U.S.)
The issue price at which investors buy the bonds when they are first issued will typically be
approximately equal to the nominal amount. The net proceeds that the issuer receives are thus
the issue price, less issuance fees. The market price of the bond will vary over its life: it may
trade at a premium (above par, usually because market interest rates have fallen since issue),
or at a discount (price below par, if market rates have risen or there is a high probability of
default on the bond).
Types
Bond certificate for the state of South Carolina issued in 1873 under the state's Consolidation
Act.
Railroad obligation Moscow-Kiev-Voronezh
The following descriptions are not mutually exclusive, and more than one of them may apply to
a particular bond.

Fixed rate bonds have a coupon that remains constant throughout the life of the bond. A
variation are stepped-coupon bonds, whose coupon increases during the life of the bond.

Floating rate notes (FRNs, floaters) have a variable coupon that is linked to a reference
rate of interest, such as LIBOR or Euribor. For example, the coupon may be defined as
three-month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically
every one or three months.

Zero-coupon bonds (zeros) pay no regular interest. They are issued at a substantial
discount to par value, so that the interest is effectively rolled up to maturity (and usually
taxed as such). The bondholder receives the full principal amount on the redemption
date. An example of zero coupon bonds is Series E savings bonds issued by the U.S.
government. Zero-coupon bonds may be created from fixed rate bonds by a financial
institution separating ("stripping off") the coupons from the principal. In other words, the
separated coupons and the final principal payment of the bond may be traded
separately. See IO (Interest Only) and PO (Principal Only).

High-yield bonds (junk bonds) are bonds that are rated below investment grade by the
credit rating agencies. As these bonds are riskier than investment grade bonds,
investors expect to earn a higher yield.

Convertible bonds let a bondholder exchange a bond to a number of shares of the

issuer's common stock. These are known as hybrid securities, because they combine
equity and debt features.
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Exchangeable bonds allows for exchange to shares of a corporation other than the
issuer.

Inflation-indexed bonds (linkers) (US) or Index-linked bond (UK), in which the principal
amount and the interest payments are indexed to inflation. The interest rate is normally
lower than for fixed rate bonds with a comparable maturity (this position briefly reversed
itself for short-term UK bonds in December 2008). However, as the principal amount
grows, the payments increase with inflation. The United Kingdom was the first sovereign
issuer to issue inflation linked gilts in the 1980s. Treasury Inflation-Protected Securities
(TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.

Other indexed bonds, for example equity-linked notes and bonds indexed on a business
indicator (income, added value) or on a country's GDP.

Asset-backed securities are bonds whose interest and principal payments are backed by
underlying cash flows from other assets. Examples of asset-backed securities are
mortgage-backed securities (MBSs), collateralized mortgage obligations (CMOs) and
collateralized debt obligations (CDOs).

Subordinated bonds are those that have a lower priority than other bonds of the issuer in
case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the
liquidator is paid, then government taxes, etc. The first bond holders in line to be paid
are those holding what is called senior bonds. After they have been paid, the
subordinated bond holders are paid. As a result, the risk is higher. Therefore,
subordinated bonds usually have a lower credit rating than senior bonds. The main
examples of subordinated bonds can be found in bonds issued by banks, and assetbacked securities. The latter are often issued in tranches. The senior tranches get paid
back first, the subordinated tranches later.

Covered bonds are backed by cash flows from mortgages or public sector assets.
Contrary to asset-backed securities the assets for such bonds remain on the issuers
balance sheet.

Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date.
The most famous of these are the UK Consols, which are also known as Treasury
Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade
today, although the amounts are now insignificant. Some ultra-long-term bonds
(sometimes a bond can last centuries: West Shore Railroad issued a bond which matures
in 2361 (i.e. 24th century) are virtually perpetuities from a financial point of view, with
the current value of principal near zero.

Bearer bond is an official certificate issued without a named holder. In other words, the
person who has the paper certificate can claim the value of the bond. Often they are
registered by a number to prevent counterfeiting, but may be traded like cash. Bearer
bonds are very risky because they can be lost or stolen. Especially after federal income
tax began in the United States, bearer bonds were seen as an opportunity to conceal
income or assets.[8] U.S. corporations stopped issuing bearer bonds in the 1960s, the
U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were
prohibited in 1983.[9]

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Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded
by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest
payments, and the principal upon maturity are sent to the registered owner.

A government bond, also called Treasury bond, is issued by a national government and is
not exposed to default risk. It is characterized as the safest bond, with the lowest
interest rate. A treasury bond is backed by the full faith and credit of the relevant
government. For that reason, for the major OECD countries this type of bond is often
referred to as risk-free.

Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their
agencies. Interest income received by holders of municipal bonds is often exempt from
the federal income tax and from the income tax of the state in which they are issued,
although municipal bonds issued for certain purposes may not be tax exempt.

Build America Bonds (BABs) are a form of municipal bond authorized by the American
Recovery and Reinvestment Act of 2009. Unlike traditional US municipal bonds, which
are usually tax exempt, interest received on BABs is subject to federal taxation.
However, as with municipal bonds, the bond is tax-exempt within the US state where it is
issued. Generally, BABs offer significantly higher yields (over 7 percent) than standard
municipal bonds.[10]

Book-entry bond is a bond that does not have a paper certificate. As physically
processing paper bonds and interest coupons became more expensive, issuers (and
banks that used to collect coupon interest for depositors) have tried to discourage their
use. Some book-entry bond issues do not offer the option of a paper certificate, even to
investors who prefer them.[11]

Lottery bonds are issued by European and other states. Interest is paid as on a
traditional fixed rate bond, but the issuer will redeem randomly selected individual
bonds within the issue according to a schedule. Some of these redemptions will be for a
higher value than the face value of the bond.

War bond is a bond issued by a government to fund military operations during war time.
This type of bond has low return rate.

Serial bond is a bond that matures in installments over a period of time. In effect, a
$100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.

Revenue bond is a special type of municipal bond distinguished by its guarantee of

repayment solely from revenues generated by a specified revenue-generating entity
associated with the purpose of the bonds. Revenue bonds are typically "non-recourse",
meaning that in the event of default, the bond holder has no recourse to other
governmental assets or revenues.

Climate bond is a bond issued by a government or corporate entity in order to raise

finance for climate change mitigation- or adaptation-related projects or programmes.

Dual currency bonds

[12]

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Retail bonds are a type of corporate bond mostly designed for ordinary investors. [13] They
have become particularly attractive since the London Stock Exchange (LSE) launched an
order book for retail bonds.[14]

Social impact bonds are an agreement for public sector entities to pay back private
investors after meeting verified improved social outcome goals that result in public
sector savings from innovative social program pilot projects.

Foreign currencies
Some companies, banks, governments, and other sovereign entities may decide to issue bonds
in foreign currencies as it may appear to be more stable and predictable than their domestic
currency. Issuing bonds denominated in foreign currencies also gives issuers the ability to
access investment capital available in foreign markets. The proceeds from the issuance of
these bonds can be used by companies to break into foreign markets, or can be converted into
the issuing company's local currency to be used on existing operations through the use of
foreign exchange swap hedges. Foreign issuer bonds can also be used to hedge foreign
exchange rate risk. Some foreign issuer bonds are called by their nicknames, such as the
"samurai bond". These can be issued by foreign issuers looking to diversify their investor base
away from domestic markets. These bond issues are generally governed by the law of the
market of issuance, e.g., a samurai bond, issued by an investor based in Europe, will be
governed by Japanese law. Not all of the following bonds are restricted for purchase by
investors in the market of issuance.

Eurodollar bond, a U.S. dollar-denominated bond issued by a non-U.S. entity outside the
U.S[15]

Baklava bond, a bond denominated in Turkish Lira and issued by a domestic or foreign
entity in the Turkish market[16]

Yankee bond, a US dollar-denominated bond issued by a non-US entity in the US market

Kangaroo bond, an Australian dollar-denominated bond issued by a non-Australian entity

in the Australian market

Maple bond, a Canadian dollar-denominated bond issued by a non-Canadian entity in the

Canadian market

Samurai bond, a Japanese yen-denominated bond issued by a non-Japanese entity in the

Japanese market

Uridashi bond, a non-yen-denominated bond sold to Japanese retail investors.

Shibosai Bond, a private placement bond in the Japanese market with distribution limited
to institutions and banks.

Shogun bond, a non-yen-denominated bond issued in Japan by a non-Japanese

institution or government[17]

Bulldog bond, a pound sterling-denominated bond issued in London by a foreign

institution or government.
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Matryoshka bond, a Russian rouble-denominated bond issued in the Russian Federation

by non-Russian entities. The name derives from the famous Russian wooden dolls,
Matrioshka, popular among foreign visitors to Russia

Arirang bond, a Korean won-denominated bond issued by a non-Korean entity in the

Korean market[18]

Kimchi bond, a non-Korean won-denominated bond issued by a non-Korean entity in the

Korean market[19]

Formosa bond, a non-New Taiwan Dollar-denominated bond issued by a non-Taiwan

entity in the Taiwan market[20]

Panda bond, a Chinese renminbi-denominated bond issued by a non-China entity in the

People's Republic of China market[21]

Dim sum bond, a Chinese renminbi-denominated bond issued by a Chinese entity in

Hong Kong. Enables foreign investors forbidden from investing in Chinese corporate debt
in mainland China to invest in and be exposed to Chinese currency in Hong Kong. [22]

Huaso bond, a Chilean peso-denominated bond issued by a non-Chilean entity in the

Chilean market.[23]

Bond valuation
At the time of issue of the bond, the interest rate and other conditions of the bond will have
been influenced by a variety of factors, such as current market interest rates, the length of the
term and the creditworthiness of the issuer.
These factors are likely to change over time, so the market price of a bond will vary after it is
issued. The market price is expressed as a percentage of nominal value. Bonds are not
necessarily issued at par (100% of face value, corresponding to a price of 100), but bond
prices will move towards par as they approach maturity (if the market expects the maturity
payment to be made in full and on time) as this is the price the issuer will pay to redeem the
bond. This is referred to as "Pull to Par". At other times, prices can be above par (bond is priced
at greater than 100), which is called trading at a premium, or below par (bond is priced at less
than 100), which is called trading at a discount. Most government bonds are denominated in
units of $1000 in the United States, or in units of 100 in the United Kingdom. Hence, a deep
discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold.
(Often, in the US, bond prices are quoted in points and thirty-seconds of a point, rather than in
decimal form.) Some short-term bonds, such as the U.S. Treasury bill, are always issued at a
discount, and pay par amount at maturity rather than paying coupons. This is called a discount
bond.
The market price of a bond is the present value of all expected future interest and principal
payments of the bond discounted at the bond's yield to maturity, or rate of return. That
relationship is the definition of the redemption yield on the bond, which is likely to be close to
the current market interest rate for other bonds with similar characteristics. (Otherwise there
would be arbitrage opportunities.) The yield and price of a bond are inversely related so that
when market interest rates rise, bond prices fall and vice versa.
The market price of a bond may be quoted including the accrued interest since the last coupon
date. (Some bond markets include accrued interest in the trading price and others add it on
separately when settlement is made.) The price including accrued interest is known as the
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"full" or "dirty price". (See also Accrual bond.) The price excluding accrued interest is known as
the "flat" or "clean price".
The interest rate divided by the current price of the bond is called the current yield (this is the
nominal yield multiplied by the par value and divided by the price). There are other yield
measures that exist such as the yield to first call, yield to worst, yield to first par call, yield to
put, cash flow yield and yield to maturity.
The relationship between yield and term to maturity (or alternatively between yield and the
weighted mean term allowing for both interest and capital repayment) for otherwise identical
bonds is called a yield curve. The yield curve is a graph plotting this relationship.
Bond markets, unlike stock or share markets, sometimes do not have a centralized exchange
or trading system. Rather, in most developed bond markets such as the U.S., Japan and
western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such
a market, market liquidity is provided by dealers and other market participants committing risk
capital to trading activity. In the bond market, when an investor buys or sells a bond, the
counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some
cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory",
i.e. holds it for his own account. The dealer is then subject to risks of price fluctuation. In other
cases, the dealer immediately resells the bond to another investor.
Bond markets can also differ from stock markets in that, in some markets, investors sometimes
do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, the
dealers earn revenue by means of the spread, or difference, between the price at which the
dealer buys a bond from one investorthe "bid" priceand the price at which he or she sells
the same bond to another investorthe "ask" or "offer" price. The bid/offer spread represents
the total transaction cost associated with transferring a bond from one investor to another.
Investing in bonds
Bonds are bought and traded mostly by institutions like central banks, sovereign wealth funds,
pension funds, insurance companies, hedge funds, and banks. Insurance companies and
pension funds have liabilities which essentially include fixed amounts payable on
predetermined dates. They buy the bonds to match their liabilities, and may be compelled by
law to do this. Most individuals who want to own bonds do so through bond funds. Still, in the
U.S., nearly 10% of all bonds outstanding are held directly by households.
The volatility of bonds (especially short and medium dated bonds) is lower than that of equities
(stocks). Thus, bonds are generally viewed as safer investments than stocks, but this
perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks,
and bonds' interest payments are sometimes higher than the general level of dividend
payments. Bonds are often liquid it is often fairly easy for an institution to sell a large
quantity of bonds without affecting the price much, which may be more difficult for equities
and the comparative certainty of a fixed interest payment twice a year and a fixed lump sum
at maturity is attractive. Bondholders also enjoy a measure of legal protection: under the law
of most countries, if a company goes bankrupt, its bondholders will often receive some money
back (the recovery amount), whereas the company's equity stock often ends up valueless.
However, bonds can also be risky but less risky than stocks:

Fixed rate bonds are subject to interest rate risk, meaning that their market prices will
decrease in value when the generally prevailing interest rates rise. Since the payments
are fixed, a decrease in the market price of the bond means an increase in its yield.
When the market interest rate rises, the market price of bonds will fall, reflecting
investors' ability to get a higher interest rate on their money elsewhere perhaps by
purchasing a newly issued bond that already features the newly higher interest rate. This
does not affect the interest payments to the bondholder, so long-term investors who
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want a specific amount at the maturity date do not need to worry about price swings in
their bonds and do not suffer from interest rate risk.
Bonds are also subject to various other risks such as call and prepayment risk, credit risk,
reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk,
sovereign risk and yield curve risk. Again, some of these will only affect certain classes of
investors.
Price changes in a bond will immediately affect mutual funds that hold these bonds. If the
value of the bonds in their trading portfolio falls, the value of the portfolio also falls. This can
be damaging for professional investors such as banks, insurance companies, pension funds
and asset managers (irrespective of whether the value is immediately "marked to market" or
not). If there is any chance a holder of individual bonds may need to sell his bonds and "cash
out", interest rate risk could become a real problem (conversely, bonds' market prices would
increase if the prevailing interest rate were to drop, as it did from 2001 through 2003. One way
to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk
are called immunization or hedging.

Bond prices can become volatile depending on the credit rating of the issuer for instance
if the credit rating agencies like Standard & Poor's and Moody's upgrade or downgrade the
credit rating of the issuer. An unanticipated downgrade will cause the market price of the
bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments
(provided the issuer does not actually default), but puts at risk the market price, which
affects mutual funds holding these bonds, and holders of individual bonds who may have to
sell them.

A company's bondholders may lose much or all their money if the company goes bankrupt.
Under the laws of many countries (including the United States and Canada), bondholders
are in line to receive the proceeds of the sale of the assets of a liquidated company ahead
of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking
institution such as a bank) and trade creditors may take precedence.

There is no guarantee of how much money will remain to repay bondholders. As an example,
after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications
company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar [citation
needed]
. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation,
bondholders may end up having the value of their bonds reduced, often through an exchange
for a smaller number of newly issued bonds.

Some bonds are callable, meaning that even though the company has agreed to make
payments plus interest towards the debt for a certain period of time, the company can
choose to pay off the bond early. This creates reinvestment risk, meaning the investor is
forced to find a new place for his money, and the investor might not be able to find as good
a deal, especially because this usually happens when interest rates are falling

Bonds
Bond is a debt security, in which the authorized issuer owes the holders a debt and, depending
on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the
principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money
with interest at fixed intervals (ex semi annual, annual, sometimes monthly).

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Bonds provide the borrower with external funds to finance long-term investments, or, in the
case of government bonds, to finance current expenditure. Bonds and stocks are both
securities, but the major difference between the two is that (capital) stockholders have an
equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake
in the company (i.e., they are lenders). Another difference is that bonds usually have a defined
term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding
indefinitely.
The Repo Market
The over-the-counter repo market is now one of the largest and most active sectors in the US
money market. Repos are widely used for investing surplus funds short term, or for borrowing
short term against collateral. Dealers in securities use repos to manage their liquidity, finance
their inventories, and speculate in various ways. The Fed uses repos to manage the aggregate
reserves of the banking system.
What are Repos?
Repos, short for repurchase agreements, are contracts for the sale and future repurchase of a
financial asset, most often Treasury securities. On the termination date, the seller repurchases
the asset at the same price at which he sold it, and pays interest for the use of the funds.
Although legally a sequential pair of sales, in effect a repo is a short-term interest-bearing loan
against collateral.
The annualized rate of interest paid on the loan is known as the repo rate. Repos can be of
any duration but are most commonly overnight loans. Repos for longer than overnight are
known as term repos. There are also open repos that can be terminated by either side on a
days notice. In common parlance, the seller of securities does a repo and the lender of funds
does a reverse. Because money is the more liquid asset, the lender normally receives a
margin on the collateral, meaning it is priced below market value, usually by 2 to 5 percent
depending on maturity.
The overnight repo rate normally runs slightly below the Fed funds rate for two reasons: First a
repo transaction is a secured loan, whereas the sale of Fed funds is an unsecured loan.
Second, many who can invest in repos cannot sell Fed funds. Even though the return is
modest, overnight lending in the repo market offers several advantages to investors. By
rolling overnight repos, they can keep surplus funds invested without losing liquidity or
incurring price risk. They also incur very little credit risk because the collateral is always high
grade paper.
Repos are not for Small Investors
The largest users of repos and reverses are the dealers in government securities. As of June
2008 there were 20 primary dealers recognized by the Fed, which means they were authorized
to bid on newly-issued Treasury securities for resale in the market. Primary dealers must be
well-capitalized, and often deal in hundred million dollar chunks. In addition there are several
hundred dealers who buy and sell Treasury securities in the secondary market and do repos
and reverses in at least one million dollar chunks.
The balance sheet of a government securities dealer is highly leveraged, with assets typically
50 to 100 times its own capital. To finance the inventory, there is a need to obtain repo money
in large amounts on a continuing basis. Big suppliers of repo money are money funds, large
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corporations, state and local governments, and foreign central banks. Generally the
alternative of investing in securities that mature in a few months is not attractive by
comparison. Even 3-month Treasury bills normally yield less than overnight repos.
Clearing Banks and Dealer Loans
A securities dealer must have an account at a clearing bank to settle his trades. For example,
suppose ABC company has $20 million to invest short term. After negotiating the terms with
the dealer, ABC has its bank wire $20 million to the clearing bank. On receipt, the clearing
bank recovers the funds it loaned the dealer to acquire the securities being sold, plus interest
due on the loan. It then transfers the sold securities to a special custodial account in the name
of ABC. Since government securities exist as book entries on a computer, this is a trivial
operation.
The next morning the dealer repurchases the securities from ABC, pays the overnight interest
on the repo, and regains possession of the securities. Assuming a 5% repo rate, the interest
due on the $20 million overnight loan would be $2,777.78, which is based on a 360-day year. If
both parties agree, the repo could be rolled over instead of paid off, thus providing another day
of funds for the dealer and another day of interest for ABC.
If the dealer is short on funds needed to repurchase the securities, the clearing bank will
advance them with little or no interest if repaid the same day. Otherwise the bank will charge
the dealer interest on the loan and hold the securities as collateral until payment is made.
Since dealer loans typically run at least 25 basis points above the Fed funds rate, dealers try to
finance as much as they can by borrowing through repos. By rolling over repos day by day,
the dealer can finance most of his inventory without resorting to dealer loans. It is sometimes
advantageous to repo for a longer period, using a term repo to minimize transaction costs.
Clearing banks charge a fee for executing dealer transactions. They prefer not to issue large
dealer loans because it ties up the banks own reserves at little profit. In truth, there is not
enough capacity in all of the clearing banks in New York to provide dealer loans sufficient to
cover the financing needs of the large securities dealers.
Matched Books in Repos
A dealer who holds a large position in securities takes a risk in the value of his portfolio from
changes in interest rates. Position plays are where the largest profits can be made. However
many dealers now run a nearly matched book to minimize market risk. This involves creating
offsetting positions in repos and reverses by reversing in securities and at the same time
hanging out identical securities with repos. The dealer earns a profit from the bid-ask
spread. Profits can be improved by mismatching maturities between the asset and liability
side, but at increasing risk.
As dealers move from simply using repos to finance their positions to using them in running
matched books, they become de facto financial intermediaries. In borrowing funds at one rate
and relending them at a higher rate, a dealer is operating like a finance company, doing forprofit intermediation.
Eurodollars
Many foreign banks as well as foreign branches of U.S. banks accept deposits of U.S. dollars
and grant the depositor an account denominated in dollars. Those dollars are called
Eurodollars. As we will see, they exist under quite different constraints from domestic dollars.
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While Eurodollar banking got its start in Europe, such banking is now active in major financial
centers around the world.
Importance of Eurodollars
Today the Eurodollar market is the international capital market of the world. It includes U.S.
corporations funding foreign operations, foreign corporations funding foreign or domestic
operations, and foreign governments funding investment projects or general balance-ofpayment deficits.
Overseas branches of a U.S. bank are treated as an integral part of the parent bank. In its
published statements the parent bank consolidates the assets and liabilities of all branches,
domestic and overseas, and it has just one account at the Fed, held by the head office.
However each overseas branch keeps its own books for day-to-day operations.
An Example
Suppose the AAA Corporation draws a check for five million dollars on Citibank, its New York
bank, and deposits it at a London Eurodollar bank. The result is that the ownership of five
million U.S. dollars has passed from AAA to the London bank in exchange for a Eurodollar time
deposit. The London bank now holds a deposit at Citibank balanced by a liability, the time
deposit credited to AAA.
Since that money earns no interest at Citibank, the London bank will use the funds to make a
loan, say to the BBB Corporation which banks at Wells Fargo. Citibank will then show a
decrease of five million dollars on deposit at the Fed and a decrease in liability of that amount
to the London bank. Wells Fargo will gain that deposit at the Fed and an equal liability as a
deposit for BBB. The London bank will record a loan of five million dollars to BBB balanced by
a time deposit owed to AAA.
The Money Market
The Money Market by Marcia Stigum is the definitive book on a not widely known aspect of
our monetary system. An introductory description given here consists mainly of excerpts from
the 3rd edition, published in 1990 by McGraw Hill.
The U.S. money market is a huge and major part of the nation's financial system in which
banks and other participants trade hundreds of billions of dollars every working day. It is a
wholesale market for low-risk, highly liquid, short-term debt instruments. They include short
term U.S. Treasury and federal agency debt, negotiable bank CDs, bank deposit notes, bankers'
acceptances, short-term participations in bank loans, municipal notes, commercial paper,
Federal funds, and Eurodollars.
The heart of the money market is in the trading rooms of dealers and brokers. In truth it is not
one market but several markets for distinct and different instruments which nevertheless have
close interrelationships. A notable feature is the speed of transactions involving hundred
million dollar blocks and the trust that exists among the traders. Trades are negotiated by
phone or computer terminal within seconds and no one reneges. The motto is: my word is my
bond.
Borrowers in the market include domestic and foreign banks, the Treasury, corporations of all
types, the Federal Home Loan Banks and other federal agencies, dealers in money market
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instruments, and many states and municipalities. The lenders include most of the above plus
insurance companies, pension funds, and various other financial institutions.
The money market accomplishes several vital functions. One is shifting vast sums of money
between banks. This is required because most large banks need more funds than they obtain
in deposits, whereas many smaller banks have more deposits than they can profitably use
internally. The money market also provides a means by which funds of cash-rich corporations
and other institutions can be funneled to banks that need short-term money.
The money market is where the U.S. Treasury can sell huge quantities of debt with ease. It is
also where the Fed carries out its open market operations to control interest rates and provide
for growth of the money supply. The market is where participants determine the term
structure of short term interest rates affecting the yields on Treasury bills and commercial
paper of different maturities. It has also become an international short-term capital market
where much of the dollar denominated trade by foreign entities is financed.
For details about market participants, instruments, and trading methods in the money market,
Stigum's book is highly recommended.
Bond Values and Interest Rates
Many people are confused about the relation between interest rates and the market value of
bonds. For the long-term investor who can hold his bonds to maturity, that doesnt matter
very much. But if he may have to sell before maturity, it is important that he understand how
the market value of his bond is affected by changes in interest rates.
Buying a Bond
Suppose you bought a newly-issued 10-year bond at par for $1,000 that pays interest at 6%.
You would receive $60 per year in two payments of $30 each. The interest payment is known
as the coupon, a holdover from the days when paper bonds were issued with coupons
attached. The bearer would clip off a coupon as it came due and present it to the borrower to
claim the interest payment. When the bond matured, the principal part would be returned to
claim the par value of the bond, thereby ending the borrowers liability.
The coupon rate on a new-issue bond is governed by the yield on bonds of the same maturity
in the secondary market at the time. Why? Because the borrower must offer a coupon rate
that is at least equal to the yield on existing bonds, otherwise there would be no takers.
Yield on the Bond
The term "yield" is shorthand for the yield-to-maturity which takes into account any difference
between what is paid for the bond and its value at maturity. The yield on a new bond bought
at par is normally the same as the coupon rate. Thereafter, as the general level of interest
rates changes, the value of the bond in the secondary market will move in the opposite
direction.
What matters to the buyer is the yield, which is a reflection of the prevailing interest rate. The
coupon rate is set when the bond is issued. If the general interest rate then falls below the
coupon rate, the bond will command a premium because its yield at par would be higher than
the prevailing interest rate. The converse also applies.
Effect of a Change in Market Interest Rates

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Suppose after two years, the interest rate on bonds of 8-year maturity is 5%. Since that is less
than the 6% coupon rate on your bond which now has 8-years to maturity, its market value
would be higher than the $1,000 price you paid. In fact it would be $1,065.
If you sold the bond at that price, you would realize a capital gain of $65. The return on your
investment would therefore be greater than the 6% you expected when you bought the bond.
But if you then reinvested the proceeds in another bond of 8-year maturity, the yield would be
only about 5%, the going rate on bonds at the time.
The buyer of your bond would receive the coupon payments of $60 per year. If he held the
bond to maturity, he would receive the face value, $1,000, as promised by the borrower. That
means he would have taken a capital loss of $65, the equivalent of about one year of coupon
payments. However he would have enjoyed a coupon rate that is higher than the yield on
existing bonds of that maturity. The net effect is that his total return would be about 5%, the
going rate on bonds at the time.
Stocks vs Bonds
How risky are stocks compared to bonds? The answer may surprise you. It depends on what
your investment horizon is. Listed below are the returns on three classes of investment for
different holding periods. The record covers Jan 1926 through Dec 1994, a total of 69 years.
Each holding period starts at the beginning of the year, and periods longer than 1 year
successively overlap each other. Only the maximum and minimum returns for each case are
shown. The data came from the 1995 Yearbook of Ibbotson Associates. Large company stocks
comprise those in the S&P500 index.
Annualized Return in Percent vs Holding Period
.

1-yr

5-yrs

10-yrs

15-yrs

20-yrs

Maximum return

54.0

23.9

20.1

18.2

16.9

Minimum return

-43.3

-12.5

-0.9

0.6

3.1

Maximum return

40.4

21.6

15.6

11.7

10.1

Minimum return

-9.2

-2.1

-0.1

0.4

0.7

Maximum return

14.7

11.1

9.2

8.3

7.7

Minimum return

0.1

0.1

0.2

0.4

Large company stocks

Long Term T-bonds

Treasury bills

.
Risk is often measured in terms of short term volatility, but that is not the best measure for the
long term investor. The record shows that for holding periods of 15-years and longer, the
worst case return on large company stocks was always greater than the return on bills and
bonds, even though the range between minimum and maximum was greater for stocks.
Further, the returns for the longer periods were never negative.
It would be safe to conclude that anyone with an investment horizon of 15 years or longer will
likely suffer an opportunity cost by investing in bonds. This is also true for bond funds, even
more so because the fund expenses are paid by the investor.
Repo and Securities Lending
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The markets for repurchase agreements (repos) and securities lending (sec lending) are part of
the collateralized U.S.-dollar-denominated money markets. The markets for repos and sec
lending are crucial for the trading of fixed-income securities and equities.3 Repos are
especially important for allowing arbitrage in the Treasury, agency, and agency mortgagebacked securities markets, thus enhancing price discovery and market liquidity. Securities
lending markets play key roles in allowing shorting, both in fixed-income and equity markets.
Given the essential role of these markets to the functioning and efficiency of the financial
system, it is important to better understand and monitor repo and sec lending.
The key question addressed in this paper is, what are the data requirements for
monitoring repo and sec lending markets so as to inform policymakers and researchers
about firm-level and systemic risk?
One conclusion emerging from the paper is the need to better understand the
institutional arrangements in these markets.
To that end, we find that existing data sources are incomplete. More comprehensive data
collection would both deepen our understanding of the repo and sec lending markets
and facilitate monitoring firm-level and systemic risk in these markets.
Specifically, we argue that, at a minimum, six shared characteristics of repo and sec
lending trades would need to be collected at the firm level: 1) principal amount, 2)
interest rate (or lending fee for certain securities loan transactions), 3) collateral type, 4)
haircut, 5) tenor, and 6) counterparty.
In addition, we believe there would be value in collecting data at the firm level on the
instruments in which securities lending cash collateral is invested. The reinvestment of
cash collateral as practiced by securities lending agents potentially introduces a source
of risk in addition to the run risk that also exists in repo markets.
Definition of repurchase agreement
A repurchase agreement, or repo for short, is a type of short-term loan much used in the
money markets, whereby the seller of a security agrees to buy it back at a specified price and
time. The seller pays an interest rate, called the repo rate, when buying back the securities.
Repo is a generic name for both repurchase agreements and sell/buy-backs.*
In a repo, one party sells an asset (usually fixed-income securities) to another party at one
price at the start of the transaction and commits to repurchase the fungible assets from the
second party at a different price at a future date or (in the case of an open repo) on demand.**
If the seller defaults during the life of the repo, the buyer (as the new owner) can sell the asset
to a third party to offset his loss. The asset therefore acts as collateral and mitigates the credit
risk that the buyer has on the seller.
Although assets are sold outright at the start of a repo, the commitment of the seller to buy
back the fungible assets in the future means that the buyer has only temporary use of those
assets, while the seller has only temporary use of the cash proceeds of the sale. Thus,
although repo is structured legally as a sale and repurchase of securities, it behaves
economically like a collateralised loan or secured deposit (and the principal use of repo is in
fact the borrowing and lending of cash).
The difference between the price paid by the buyer at the start of a repo and the price he
receives at the end is his return on the cash that he is effectively lending to the seller. In
repurchase agreements, this return is quoted as a percentage per annum rate and is called the
repo rate. Although not legally correct, the return is usually referred to as repo interest.
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Example
Central banks often use repos to boost money supply, buying Treasury bills or other
government paper from commercial banks so the banks can boost their reserves, and selling
the paper back at a later date. When the central bank wants to tighten money supply, it sells
the paper first, and buys it back later - this is called a reverse repo, an agreement to lend
securities rather than funds.
An example of a repo is illustrated below.

The buyer in a repo is often described as doing a reverse repo (ie buying, then selling).
A repo not only mitigates the buyers credit risk. Provided the assets being used as collateral
are liquid, the buyer should be able to refinance himself at any time during the life of a repo by
selling or repoing the assets to a third party (he would, of course, subsequently have to buy
the collateral back in order to return it to his repo counterparty at the end of the repo). This
right of use therefore mitigates the liquidity risk that the buyer takes by lending to the seller.
Because lending through a repo exposes the buyer to lower credit and liquidity risks, repo
rates should be lower than unsecured money market rates.
Repurchase agreement
A sale (and) repurchase agreement, also known as a (currency) repo, RP, or sale and
repurchase agreement, is a transaction concluded on a deal date tD between two parties A
and B:
(i) A will on the near date tN sell a specified security S at an agreed price PN to B
(ii) A will on the far date tF (after tN) re-purchase S from B at a price PF which is already preagreed on the deal date.
If we assume positive interest rates, the repurchase price P F can be expected to be greater
than the original sale price PN.
The (time-adjusted) difference (PF-PN)/PN/(tF-tN)*365 is called the repo rate; it can be interpreted
as the interest rate for the period between near date and far date.
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Ambiguity in the usage of the term repo[edit]

The term repo has given rise to a lot of misunderstanding: there are two types of transactions
with identical cash flows
(i) a sell-and-buy-back as well as
(ii) a collateralized borrowing.
The sole difference is that in (i) the asset is sold (and later re-purchased), whereas in (ii) the
asset is instead pledged as a collateral for a loan: in the sell-and-buy-back transaction the
ownership and possession of S are transferred at tN from a A to B and in tF transferred back
from B to A; conversely, in the repo only the possession is temporarily transferred to B whereas
the ownership remains with A.
Repo
Participant
Near leg
Far leg

Borrower
Seller
Cash receiver
Sells securities
Buys securities

Reverse repo
Lender
Buyer
Cash provider
Buys securities
Sells securities

Maturities of repos[edit]
There are two types of repo maturities: term, and open repo.
Term refers to a repo with a specified end date: although repos are typically short-term (a few
days), it is not unusual to see repos with a maturity as long as two years.
Open has no end date which has been fixed at conclusion. Depending on the contract, the
maturity is either set until the next business day and the repo matures unless one party
renews it for a variable number of business days. Alternatively it has no maturity date - but
one or both parties have the option to terminate the transaction within a pre-agreed time
frame.
Securities lending[edit]
In securities lending, the purpose is to temporarily obtain the security for other purposes, such
as covering short positions or for use in complex financial structures. Securities are generally
lent out for a fee and securities lending trades are governed by different types of legal
agreements than repos.
Repos have traditionally been used as a form of collateralized loan and have been treated as
such for tax purposes. Modern Repo agreements, however, often allow the cash lender to sell
the security provided as collateral and substitute an equivalent security at repurchase. In this
way, the cash lender acts as a security borrower and the Repo agreement can be used to take
a short position in the security very much like a security loan might be used.
Repurchase Agreement - Repo
A repurchase agreement (repo) is a form of short-term borrowing for dealers in government
securities. The dealer sells the government securities to investors, usually on an overnight
basis, and buys them back the following day.
For the party selling the security (and agreeing to repurchase it in the future) it is a repo; for
the party on the other end of the transaction, (buying the security and agreeing to sell in the
future) it is a
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Money Market: Repos

Repo is short for repurchase agreement. Those who deal in government securities use repos as
a form of overnight borrowing. A dealer or other holder of government securities (usually Tbills) sells the securities to a lender and agrees to repurchase them at an agreed future date at
an agreed price. They are usually very short-term, from overnight to 30 days or more. This
short-term maturity and government backing means repos provide lenders with extremely low
risk.
Repos are popular because they can virtually eliminate credit problems. Unfortunately, a
number of significant losses over the years from fraudulent dealers suggest that lenders in this
market have not always checked their collateralization closely enough.
There are also variations on standard repos:

Reverse Repo - The reverse repo is the complete opposite of a repo. In this case, a
dealer buys government securities from an investor and then sells them back at a later
date for a higher price

Term Repo - exactly the same as a repo except the term of the loan is greater than 30
days.

Mark To Market - MTM

Mark to market (MTM) is a measure of the fair value of accounts that can change over time,
such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an
institution's or company's current financial situation.
2. The accounting act of recording the price or value of a security, portfolio or account to
reflect its current market value rather than its book value.
3. When the net asset value (NAV) of a mutual fund is valued based on the most current
market valuation.
BREAKING DOWN 'Mark To Market - MTM'
1. Problems can arise when the market-based measurement does not accurately reflect the
underlying asset's true value. This can occur when a company is forced to calculate the selling
price of these assets or liabilities during unfavorable or volatile times, such as a financial crisis.
For example, if the liquidity is low or investors are fearful, the current selling price of a bank's
assets could be much lower than the actual value. The result would be a lowered shareholders'
equity.
This issue was seen during the financial crisis of 2008/09 where many securities held on banks'
balance sheets could not be valued efficiently as the markets had disappeared from them. In
April of 2009, however, the Financial Accounting Standards Board (FASB) voted on and
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approved new guidelines that would allow for the valuation to be based on a price that would
be received in an orderly market rather than a forced liquidation, starting in the first quarter of
2009.
2. This is done most often in futures accounts to make sure that margin requirements are
being met. If the current market value causes the margin account to fall below its required
level, the trader will be faced with a margin call.
3. Mutual funds are marked to market on a daily basis at the market close so that investors
have an idea of the fund's NAV.
Mark-to-market accounting
Mark-to-market or fair value accounting refers to accounting for the "fair value" of an
asset or liability based on the current market price, or for similar assets and liabilities, or based
on another objectively assessed "fair" value. [1] Fair value accounting has been a part of
Generally Accepted Accounting Principles (GAAP) in the United States since the early 1990s,
and is now regarded as the "gold standard" in some circles. [2]
Mark-to-market accounting can change values on the balance sheet as market conditions
change. In contrast, historical cost accounting, based on the past transactions, is simpler, more
stable, and easier to perform, but does not represent current market value. It summarizes past
transactions instead. Mark-to-market accounting can become volatile if market prices fluctuate
greatly or change unpredictably. Buyers and sellers may claim a number of specific instances
when this is the case, including inability to value the future income and expenses both
accurately and collectively, often due to unreliable information, or over-optimistic or overpessimistic expectations of cash flow and earnings.[3]
Definition of Mark-to-Market
Meet Marge. Marge has decided to take some college business courses to help her with a new
business venture. Her first course is learning about mark-to-market. This is a new concept for
Marge, so she decides to commit to making it to every class and taking good notes. Marge
knows that if she hopes to be successful with her new venture, she is going to need to learn all
about mark-to-market. Come along with Marge as she learns the definition of mark-to-market,
how to calculate it and how to apply it to some examples.
Marge decides that before she can go any further, she first needs to define the term. Mark-tomarket is a term used to describe an accounting method that measures accounts that change
often based on the current market price. Marge learns that these accounts often include
assets, securities, portfolios and/or liabilities, and can change as often as daily.
The goal of mark-to-market is to come up with the most accurate appraisal of a company's
finances. She decides to think of it as a snapshot of the current value of a company. It is
important to point out that a company will want to take a snapshot daily as the stock market
changes daily and thus so does the appraisal of the company's finances.
Example of Mark-to-Market
After Marge learns the definition, she decides to try to apply it to an example that might help
her better understand the concept. She remembers that she currently has stocks, which are
often appraised using the mark-to-market accounting method.
You see, each day her stock prices change as the market closes. The price of the stocks is
based on what buyers and sellers do each day with their stocks. Therefore, Marge knows that

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the only way to come up with the closest value of her stocks is to take that snapshot at the
end of the day.
Calculations
Now, Marge decides to apply mark-to-marketing to a calculation.
Let's say that a company sells 8 shares of stock for $50 per share. The next day, the price for
the stock is $60 per share. This means that the company, or trader, gains a profit of $10 per
share for a grand total of $80. Let's calculate it:
mark-to-market = ((60-50) x 8) = (10) x 8 = 80.
Here's another example: a company sells 20 barrels of oil for $50 a barrel. At the end of the
day, the price for a barrel of oil is $130. This means that the trader gains a profit of $80 per
barrel for a grand total of $1600. Let's calculate it:
mark-to-market = ((130-50) x20) = (80) x 20 = 1600.
Lesson Summary
Mark-to-market is the accounting method that determines the value of accounts that change
based on the market price. These accounts often include things like assets, securities and
portfolios, to name a few. Because the stock market can change daily, so can the value of
accounts. Thus, using mark-to-market allows companies to take a snapshot of the financial
value of accounts on a given day.
What is the Mark-to-Market calculation method and how does it work?
Overview:
Mark-to-market (MTM) is a method of valuing positions and determining profit and loss which is
used by IB for TWS and statement reporting purposes. Under MTM, positions are valued in the
Market Value section of the TWS Account Window based upon the price which they would
currently realize in the open market. Positions are also valued using the MTM method for
statement purposes and it is one of the methods by which profit or loss is computed. Other
methods available include First In, First Out (FIFO), Last In, First Out (LIFO), and Maximum
Loss.
MTM P&L shows how much profit or loss was made over the statement period, regardless of
whether positions are open or closed and with no requirement that closing transactions be
matched to an opening transaction. The MTM methodology rather assumes that all open
positions and transactions are settled at the end of each day and new positions are opened the
next day. For purposes of simplification, MTM calculations are split into two calculations: 1)
calculations for transactions which took place during the statement period, referred to as
Transaction MTM on the statement; and 2) calculations for positions which were open prior to
the start of the period, referred to as Prior Period MTM on the statement.
Background:
For example, assume 100 shares of hypothetical stock XYZ are purchased at $50.00 on Day 1;
another 200 shares are purchased on Day 2 at $52.00; 200 shares are sold on Day 3 at $53.00
and another 100 on Day 4 at $53.50. Also assume that the closing prices for XYZ on Days 1, 2,
3 and 4 are $50.50, $51.50, $54.00 and $54.00, respectively. The MTM statement calculations
for each day are as follows:
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Day 1
Transaction MTM
Prior Period MTM
Total MTM Day 2
Transaction MTM
Prior Period MTM
Total MTM Day 3
Transaction MTM
Prior Period MTM
Total MTM Day 4
Transaction MTM
Prior Period MTM
Total MTM Total - $550.00

- $50.00 ((50.50 50.00) * 100 )

- $0.00
$50.00
- ($100.00) ((51.50 52.00) * 200 )
- $100.00 ((51.50 50.50) * 100 )
$0.00
- ($200.00) ((54.00 53.00) * -200 )
- $750.00 ((54.00 51.50) * 300 )
$550.00
- ($50.00) ((53.50 54.00) * 100 )
$0.00 ((54.00 54.00) * 100 )
($50.00)

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