Introduction: forward contracts
The first part of this introduction is based on a summary
of the first chapter of
Options, Futures and other derivative securities by
John C. Hull (Prentice Hall).
Let us start first with a general definition of a derivative security,
also shortened by derivative.
A derivative security is a security whose value depends on the
values of other more basic underlying variables.
As one can see, the name is to some extent self-explanatory:
the value of the derivative is
derived from the underlying asset.
Derivative securities are also known as contingent claims.
Forward contract
A forward contract is an example of a (simple) derivative
security. It is an agreement to buy or sell an asset (the underlier)
at a certain future time for a certain price. A forward contract can
be entered at no cost. A forward contract gives one the right
to buy or sell, but one is not obliged to exercise
this contract if it is not profitable.
In conjunction with forward contracts, the following
definitions are commonly used:
-
Underlier = asset.
-
Long position: you take a long position
when you agree to buy the underlying asset on a certain specified
future date for a certain specified price. Basically, you are the buyer.
-
Short position: the opposite of a long position, where you
agree to sell instead of buy.
-
Delivery price is the price as mentioned in the forward contract,
symbol K. The delivery price is the price which would make the contract
zero, and is also known as the forward price.
-
Maturity, date when the contrat is settled.
A forward contract is worth zero when it is first entered into and can
be entered at no costs. Therefore, the sum of all the long positions
must be equal to the sum of all the short positions. In other words,
risk is transferred from one party to another.
The payoff from a long position in a forward contract on
one unit of an asset is
ST - K,
where
ST is the spot price of the asset. For a
short position it is
K - ST.
Futures contract
A futures contract is a forward contract traded on an exchange,
the delivery date is usually not specified, but instead as a time interval
in a month. The short position holder may say when the contract is exercised.
Note that future prices are determined by demand & supply, and not by
the value of the underlier.
OTC
Tailor made derivatives, that are not traded on a futures exchange,
are traded on over-the-counter markets (OTC), e.g.
investment banks. The main advantage of an OTC traded
derivative is that it can be tailored by a financial institution to
meet the needs of a corporate client.
