DERIVATIVES

Week 2
 “Derivatives are like sex.
It’s not who we’re sleeping with, it’s who they’re sleeping with that’s
the problem”
Warren Buffet

What does this quote mean?

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 DISCUSSION TOPICS

• Status • Forward Rate Agreements

• Roll Call & Presentation

• Next Steps
• Derivative & Physical Market Relationship

• Questions
• Futures

• Payoff Diagrams

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STATUS

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 STATUS

Week Topic Status Week Topic Status

Week 1 Introduction to Derivatives Complete Week 8 Mid-Semester Break

Week 2 Futures and Forwards Week 9 Black-Scholes-Merton Option

Pricing
Week 3 Interest Rate Futures Week 10 Mid-semester Test

Week 4 Quiz & Margin, Trading & Week 11 Debt Pricing & Yield Curves
Closing out
Week 5 Options Week 12 Hedging & Basis Risk

Week 6 Put-call Parity & Arbitrage Week 13 Swaps

Week 7 Binomial Tree Option Pricing Week 14 Lessons from the Real World
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ROLL CALL

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7
PRESENTATION

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PRESENTATION

Who’s First?

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DERIVATIVE & PHYSICAL MARKET
RELATIONSHIP

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 DERIVATIVE & PHYSICAL MARKET
RELATIONSHIP
At this level, price
Derivative Market information from the physical
(Futures, options, swaps,…) market is used to determine
derivative prices

Price information

At this level, capital is

allocated and cashflows
Physical Market
occur between security
(Money market, fixed income, real estate, equity, unlisted,
issuer and security holder.
venture capital)
Cashflows at this level
remain at this level
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FUTURES

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 FUTURES

A futures contract is a legal agreement to buy or sell a

particular commodity or asset at a predetermined
price at a specified time in the future

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 FUTURES

Futures contracts • Commodity or asset

• Common everyday items

• Legal agreement
• Legally binding obligation • Predetermined price
• You must perform • Price agreed today

• Buy or sell • At a specified future time

• You can sell something you don’t own • On a future date
• Although enter into that agreement today

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 FUTURES

Contract SPI 200 Index Bank Bills 3-year Bond 5-year Bond 10-year Bond 20-year Bond

Physical S&P/ASX 200 Price $1m 90 day bank CGS basket 3- CGS backet 5- CGS basket 10- CGS basket 20-
Index bill years to maturity years to maturity years to maturity years to maturity
Face value Index x $25 $1m $100,000 $100,000 $100,000 $65,000

Quoted price Points (ie $25) 100-yield in points 100-yield in ½ 100-yield in ½ 100-yield in ½ 100-yield in ½
points points points points
Contract March, June, Sept, March, June, Sept, March, June, Sept, March, June, Sept, March, June, Sept, March, June Sept,
months Dec Dec Dec Dec Dec Dec
Expiration 12pm on the 3rd 12pm on the 12pm on the 15th of 12pm on the 15th of 12pm on the 15th of 12pm on the 15th of
Thursday of the Thursday before the month the month the month the month
month the second Friday
of the month
Settlement Cash Cash Cash Cash Cash Cash

Coupon 6% 2% 6% 4%

Term 90 days 3 years 5 years 10 years 20 years

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 FUTURES

The price of a futures contract is the price of the underlying security TODAY, PLUS

The time value of money, MINUS

Any missed cashflows associated with the underlying security

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 FUTURES

Pricing Futures Futures price Where

𝐾𝑡 = 𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 𝑡𝑜𝑑𝑎𝑦

The trader has a choice… 𝐾𝑡 = 𝐸 𝑆𝑇 𝐸 𝑆𝑇 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑇

• Spend cash and buy the physical, or 𝑟𝑐𝑐 −𝑟𝑑𝑖𝑣 +𝑟𝑐𝑜𝑠𝑡𝑠 ×𝑇 𝑆0 = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 𝑡𝑜𝑑𝑎𝑦
𝐾𝑡 = 𝑆0 × 𝑒
• Invest the cash and buy futures
𝑟𝑐𝑐 = 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠𝑙𝑦 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛

• Both must have the same outcome or OR

arbitrageurs will enter the market to 𝑟𝑒𝑓𝑓 = 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑒𝑡𝑢𝑟𝑛
ensure they do
𝑇
• Until expiry, futures trade at a premium 𝐾𝑡 = 𝑆0 × 1 + 𝑟𝑒𝑓𝑓 − 𝑟𝑑𝑖𝑣 + 𝑟𝑐𝑜𝑠𝑡𝑠 𝑟𝑑𝑖𝑣 = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑
or discount to the physical market
• At expiry, the futures is settled at the
physical price 𝑟𝑐𝑜𝑠𝑡𝑠 = 𝑠𝑡𝑜𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠

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 FUTURES
Futures price Where
• 𝐾𝑡 = 𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 𝑡𝑜𝑑𝑎𝑦
• 𝐾𝑡 = 𝐸 𝑆𝑇 • 𝐸 𝑆𝑇 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑇

• 𝑆0 = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑎𝑠𝑠𝑒𝑡 𝑡𝑜𝑑𝑎𝑦

𝑟𝑐𝑐 −𝑟𝑑𝑖𝑣 +𝑟𝑐𝑜𝑠𝑡𝑠 ×𝑇
• 𝐾𝑡 = 𝑆0 × 𝑒 • 𝑟𝑐𝑐 = 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠𝑙𝑦 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛

• 𝑟𝑒𝑓𝑓 = 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑒𝑡𝑢𝑟𝑛

• OR
• 𝑟𝑑𝑖𝑣 = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑

• 𝑟𝑐𝑜𝑠𝑡𝑠 = 𝑠𝑡𝑜𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠

𝑇
• 𝐾𝑡 = 𝑆0 × 1 + 𝑟𝑒𝑓𝑓 − 𝑟𝑑𝑖𝑣 + 𝑟𝑐𝑜𝑠𝑡𝑠

Hint: Commit these equations to memory

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 FUTURES
Important Note

• Just because your calculator gives you a

number it does not mean that is the
answer…

• You need to stop and interpret what your

calculator tells you

• Some contracts trade in whole points

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 FUTURES

Exercise 1: Futures price Exercise 2: Futures price

• Calculate the price of the SPI200 • Same question as exercise 1 except the
expiring 2 years in the future when the effective rate of return is 1.1566%pa
physical market is trading at 6200 and
the continuously compounded return is
1.15%

• A: 6344 • A: 6344

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 FUTURES

Futures payoff Long futures payoff

Before expiry: 𝑓𝑡,𝐿𝐹 = 𝐾𝑡 − 𝐾0
• Before expiry is the difference between the purchase price At expiry: 𝑓𝑇,𝐿𝐹 = 𝑆𝑇 − 𝐾0
and the sale price
Short futures payoff
Before expiry: 𝑓𝑡,𝑆𝐹 = 𝐾0 − 𝐾𝑡
• If held to expiry is the difference between the purchase/sale
price and the settlement price At expiry: 𝑓𝑇,𝑆𝐹 = 𝐾0 − 𝑆𝑇

Where

• Settlement price is the price of the physical at expiry 𝑓𝑇 , 𝑓𝑡 is the payoff or profit at time T, t
LF, SF: Long futures, short futures
𝐾𝑡 is the price of the futures contract when traded at time t
𝑆𝑇 is the settlement price of the physical at time T

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 FUTURES

Exercise 3: Futures Payoff Exercise: 4 Futures Payoff

• A trader shorts 5 SPI200 futures • A trader sells 5 SPI200 futures contracts

contracts at 6200 and buys them back at at 6200 and holds them to expiry. The
the end of the day at 6192. How much settlement price is 6203. How much
profit was made in total? profit was made in total?

• A: $1000 • A: Loss of $375

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PAYOFF DIAGRAMS

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 PAYOFF DIAGRAMS

Long Futures Payoff Short Futures Payoff

50 50
40 40
Profit / Loss (points)

Profit / Loss (points)

30 30
20 20
10 10
0 0
-10 -10
-20 -20
-30 -30
-40 -40
-50 -50
6100 6110 6120 6130 6140 6150 6160 6170 6180 6190 6200 6100 6110 6120 6130 6140 6150 6160 6170 6180 6190 6200
Market price Market Price

Payoff Payoff

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FORWARD RATE AGREEMENTS

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 FORWARD RATE AGREEMENTS

• A forward rate agreement is a transaction in the physical market where the buyer
agrees to purchase the physical security from the seller on a future date for a price
agreed today

• FRAs are very similar to a futures transaction except…

• The buyer pays the full market value of the security
• The transaction occurs in the physical market
• The transaction occurs OTC

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NEXT STEPS

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 NEXT STEPS

Homework 6. Is the point value for debt futures contracts variable? Yes or no?

1. On what date in June 2025 do the following June futures contracts 7. Calculate the price of the SPI200 expiring in 79 days in the future
expire: when the physical market is trading at 7215.263 and the continuously
• SPI 200 Index compounded return is 0.24126% when the annual dividend yield on
the market is 2.745%
• 90-day Bank Bill
• 3-Year Bond 8. Calculate the price of a 13-day futures contract over a stock that is
trading at $25.84 and the effective interest rate is 0.25%
• 5-Year Bond
• 10-Year Bond 9. Calculate the price of a 138-day futures contract over a stock that is
• 20-Year Bond trading at $39.72 and the effective interest rate is 0.75% and the
dividend yield is 2.45%
2. A trader shorts 20 SPI 200 contracts at 7745 but the market rallies to
7757 before she sells an additional 20 contracts. The market 10. If, 22 days later, the same stock in the above question is trading at
subsequently falls to 7734 at which point she buys back 32 contracts. $39.12, what price would the futures contract theoretically be trading
How many contracts does she have? at?

3. Draw the payoff diagram for a long SPI200 futures position at 7732. 11. Calculate the price of the SPI200 expiring in 118 days in the future
On the same chart, draw the payoff diagram for a short SPI 200 when the physical market is trading at 7397.778 and the effective
futures position at 7755 interest rate is 0.75% when the annual dividend yield on the market
is 3.105%
4. What is negotiated when trading a futures contract?
12. To how many decimal places does the SPI200 contract trade on
5. What is the point value of the SPI200 futures contract? ASX24? 28
 NEXT STEPS

13. Calculate the price of a 113-day futures contract over a stock that is trading at $147.94 and the continuously compounded
interest rate is 0.4978% and the dividend yield is 4.55%
14. Explain the differences between a futures contract and a forward rate agreement
15. Explain what has to happen for a trader who purchases 15 SPI200 futures contracts at 7144 to make a profit
16. If the above trader makes a profit, explain who pays money to them?
17. If the above trader made a loss, explain to whom they pay money
18. Explain what “continuously compounded cash rate” means
19. What flows between the physical and derivatives markets?
20. Does any money ever flow between the derivatives and physical markets? Explain your answer
21. When you enter into a futures contract to sell something, what are you contracting to do?
22. When you enter into a futures contract to buy something, what are you contracting to do?
23. What type of items are futures contracts traded over?
24. Is it possible to walk away from your obligations from a futures contract? Explain your answer 29
QUESTIONS