QUANTITATIVE METHODS

1. DERIVATIVE CONTACTS

Derivatives are financial contracts whose value is dependent on an underlying asset or a

group of assets. A few examples of derivatives are futures, forwards, options and
swaps. These contracts are often used for hedging risk, speculating on price movements,
or arbitraging between price differences in markets.

2. FORWARD CONTRACTS

A relatively simple derivative is a forward contract. It is an agreement to buy or sell an asset

at a certain future time for a certain price. A forward contract is traded in the over-the-
counter market-usually between two financial institutions or between a financial institution
and one of its clients. Forward contracts can be used to hedge foreign currency risk.
Example: A farmer and a food processing company agree today on a price for
wheat to be delivered in six months.

3. FUTURE CONTRACTS

A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future for a certain price. Futures contracts are normally traded on an exchange.
Example: An investor trades oil futures on a commodities exchange to speculate
on the future price of oil.

4. OPTIONS

An option is a derivative contract in which the option buyer pays a sum of money to the
option seller, and receives the right to either buy or sell an underlying asset at a fixed price
at some time in the future. There are two types of option. A call option gives the holder
the right to buy the underlying asset by a certain date for a certain price. A put option
gives the holder the right to sell the underlying asset by a certain date for a certain price.
5. DISTINGUISH BETWEEN FORWARD CONTRACTS AND FUTURE
CONTRACTS

Basis for
Forward Future
comparison
1. Meaning Private contact between two Traded on an exchange
parties
2. Standardization Not standardized Standardized contract
3. Delivery date Usually one specified delivery Range of delivery dates
date
4. Settlement Settled at end of contract Settled daily
5. Settlement type Delivery or final cash settlement Contract is usually closed out
6. Closing Usually takes place Prior to maturity
7. Credit risk Some credit risk Virtually no credit risk
8. Market type Over-the-counter (OTC) Exchange-traded
9. Liquidity Lower liquidity High liquidity
10. Risk Higher counterparty risk Lower due to exchange
guarantees
11. Regulation Minimal regulation Highly regulated

6. HEDGERS

Hedgers use derivatives to reduce the risk that they face from potential future markets in a
market variable. The purpose of hedging is to reduce risk.
For example, a farmer hedges by using futures contracts to lock in the price of
wheat before harvest to avoid losses if prices drop.

Hedgers use two types of contracts forward contracts and options.

Hedging Using Forward Contracts: Forward contracts are designed to neutralize risk by
fixing the price that the hedger will pay or receive for the underlying asset.

Hedging Using Options: Option contracts offer investors insurance against future price
fluctuations while still allowing them to benefit from favorable price movements, requiring
an upfront fee.
7. SPECULATTORS

Speculators are market participants who take on risk in the hope of making a profit from
price movements in the underlying asset.
For example, a trader might speculate by buying oil futures, expecting prices to
rise and selling them at a higher price for profit.

Speculators use two types of contracts such as, futures and options..

Speculation Using Futures: When a speculator uses futures, the potential loss as well as
the potential gain is very large.

Speculation Using Options: When options are used, no matter how bad things get, the
speculator’s loss is limited to the amount paid for the options.

8. THE OPERATION OF MARGINS

The operation of margins refers to how collateral is used to manage risks in futures and
options trading:

1. Daily Settlement: Open positions are settled daily based on the current market
price, adjusting traders’ margin accounts for profits and losses to manage risk
continuously.
2. The Clearing House and Clearing Margins: The clearing house acts as an
intermediary between buyers and sellers, ensuring trades are honored. Clearing
margins are collateral posted by clearing members to secure obligations and manage
potential losses.
3. Credit Risk: Margins help mitigate credit risk by ensuring traders have enough funds
to cover potential losses, and the clearing house guarantees the performance of
trades to reduce counterparty risk.
9. SPECIFICATION OF A FUTURE CONTRACT

1. The Asset: The future contract specifies the type of asset that is being traded, such
as commodities (e.g., oil, gold, wheat), financial instruments (e.g., stock, bonds,
interest rates), stock index, or currency.
2. The Contract Size: The contract size specifies the amount of the asset that has to
be delivered under one contract.
3. Delivery Date: Futures contracts have standardized delivery dates, typically
monthly or quarterly, depending on the asset.
4. Delivery Arrangements: The place where delivery will be made must be specified
by the exchange.
5. Price Quotes: The exchange defines how prices will be quoted.
6. Price Limits and Position Limits: Price limits are specified by the exchange.
Additionally, position limits are the number of contracts that a speculator may hold.
7. Exchange: Futures contracts are traded on regulated exchanges, such as the
Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE).

10. MARKET QUOTES

Market quotes refer to the current prices at which financial instruments are traded in the
market.

1. Prices: This includes opening price, the highest price and the lowest price.
2. Settlement price: Final price at which a security is settled at the end of a trading
day, used to determine gains and losses.
3. Trading volume and open interest: The trading volume is the number of
contracts traded during a specific time period. The open interest is the number of
contracts outstanding.

11. DELIVERY

Delivery in financial markets refers to the process of transferring the underlying asset or
cash associated with a futures or options contract upon expiration. There are three critical
days for a contract such as first notice day, last notice day and last trading day.

➢ Cash settlement: Cash settlement is a method where, instead of transferring the

underlying asset, the parties settle their obligations by exchanging cash based on the
difference between the contract price and the market price at expiration.
12. CONVERGENCE OF FUTURE PRICE TO SPOT PRICE

As the delivery period for a futures contract is approached, the futures price converges to
the spot price of the underlying asset. When the delivery period is reached, the futures
price equals the spot price

(a) Futures price is above the spot price during the delivery period. Traders then have a
clear arbitrage opportunity:

1. Sell (i.e., short) a futures contract

2. Buy the asset
3. 3. Make delivery

These steps lead to a profit equal to the amount by which the futures. Price exceeds the
spot price. As traders exploit this arbitrage opportunity, the futures price will fall.

(b) Futures price is below the spot price during the delivery period.

1. Buy (i.e. long) a future contract

2. Wait for delivery to be made and pay the future price
3. Sell at spot price

These steps lead to a profit equal to the amount by which the spot price exceeds the future
price. As they do so, the futures price will tend to rise.
13. OTC MARKETS

OTC Markets (Over-the-Counter Markets) are decentralized markets where securities and
derivatives are traded directly between parties without a centralized exchange, typically
involving higher credit risk due to the absence of a central clearinghouse.

• Collateralization: Collateralization is the practice of using collateral in OTC

markets to reduce credit risk, similar to posting margin in futures markets. It ensures
obligations are met by securing funds between parties involved in a transaction, with
payments adjusting daily based on value changes.

14. Exchange Traded Markets

Exchange-traded markets are regulated financial markets where securities such as stocks,
bonds and options are bought and sold on organized exchanges. An example of an
exchange-traded market is the New York Stock Exchange (NYSE), where investors can
trade shares of publicly listed companies like Apple or Microsoft in a centralized and
transparent environment.

15. DIFFERENCE BETWEEN OTC MARKETS AND EXCHANGE TRADED

MARKETS

Basis for
OTC Markets Exchange Traded Markets
comparison
1. Meaning Traded directly between parties Traded on a formal exchange
such as the New York Stock
Exchange
2. Nature of the Decentralized Centralized
market
3. Nature contract Customized Standardized
4. Counterparty risk High No counterparty risk
5. Liquidity Less liquid More liquid
6. Transparency Low High
7. Regulation Minimal Regulated by government
agencies

16. TYPES OF TRADERS

There are two main types of traders executing trades.

• Future commission merchants (FCMs): FCMs are following the instructions of

their clients and charge a commission for doing so
• Locals: Locals are trading on their own account.
17. TYPES OF ORDERS

1. Limit Order: An order to buy or sell a security at a specific price or better.

Example: You want to buy a stock at $50. If the current price is higher (60), the
order will only be executed when the stock falls to $50 or below.

2. Stop-Loss Order: An order to sell a security when it reaches a certain price (the stop
price). It converts to a market order once the stop price is hit.
Example: You own a stock that is currently trading at $100. You set a stop-loss
order at $90. If the price drops to $90, the stock will be sold at the best available
market price.

3. Stop-Limit Order: An order that combines the features of a stop order and a limit
order. When the stop price is reached, the order becomes a limit order instead of a market
order.
Example: You place a stop-limit order to sell a stock if it drops to $90 (stop price),
but only if it can be sold at $89 or better (limit price). If the stock drops to $90 but
no buyer is willing to pay at least $89, the order will not be executed.

4. Market If Touched (MIT) Order: An order to buy or sell a security when it reaches a
specific trigger price. When the trigger price is touched, the order becomes a market order.
You want to buy a stock when its price reaches $50, expecting a reversal. You
place a MIT order with a trigger price of $50. If the stock hits $50, the MIT order
becomes a market order, and the stock is bought at the best available price.

5. Discretionary Order: An order that allows the broker discretion to execute the order at
a price better than the specified price, if possible, within a certain range.
Example: You place a buy order for a stock at $100 with a discretionary range of
$2. The broker has the discretion to execute the order between $98 and $100,
depending on the market conditions.