Futures, Forwards, and Related Derivatives
In This Chapter
- Learning about futures and forwards
- The mark to market process
- Swaps, CDOs, and other nonstandard contracts
- Using options with other derivatives
Just as with options, futures contracts are derivatives. They derive their value from the price of something else. They are standardized contracts traded on organized exchanges, used by both hedgers and speculators. They are valued based on the price of the underlying asset, the exercise price, the expiration date, interest rates, and the volatility of the underlying asset—the same as options.
However, one key difference is the holder of a futures contract carries the obligation to buy or sell. An option holder does not have this same obligation. Futures are sometimes used in conjunction with options as part of a trading strategy.
Futures contracts are one of the most common types of derivatives. Along with options, they are standardized and trade on organized exchanges. In fact, the options market is an outgrowth of the futures market.
This chapter will cover some of the other derivatives in the financial markets and discuss how they work with options to help people create new strategies. All of them are making bets on how prices differ from the spot price—that is, the price of a given item in the market today.
A futures contract is an obligation to buy or sell a predetermined amount of a given item at a future date, and at a price determined today. The big difference between a future and an option is that with a futures contract, you must buy or sell if you hold the contract until expiration. (Most futures contracts are closed out with an offsetting position prior to expiration, so buying cattle futures doesn’t mean a bunch of cows will show up in your backyard.) In some cases, the settlement of the future is in cash, meaning the buyer and seller exchange the cash value of the item involved. In other cases, though, the settlement is in the physical asset.
Futures contracts are standardized by the exchanges. The contracts are traded in preset amounts, and they have set expiration dates. Traders use a clearinghouse account in order to mark to market.
Definition
Mark to market is the process of updating the value of trading accounts at the end of the day to reflect the official closing price for the day.
When trading closes for the day, the futures clearinghouse (the organization that manages the money for the exchange) will value all traders’ accounts to reflect the official price at the end of the trading session, also known as the settlement price. (This is usually the price of the last sale.) The process is known as marking to market, and it is a key way to ensure traders have the money to settle up when expiration occurs. After all, if they have to come up with a little money every night, they can’t be in denial about the value of their position.
Almost all futures contracts are closed out before expiration with an offsetting trade. Someone who is long a future sells an identical contract to close out the position, for 0 net exposure to the asset price.
Types of Futures Contracts
The futures markets were established to create markets for agricultural commodities, and that’s still a large component of the market. Grain, cattle, and pork bellies (yes, that’s a thing, it’s the futures market for bacon) trade electronically these days, rather than on the floor of the Chicago exchanges. Over the years, the futures markets expanded to include financial futures. The market now has futures on currencies, interest rates, and market indexes. They often trade in mini-sized contracts, which are smaller value positions for individual investors.
The futures market has expanded to include options on futures, a way to trade options on agricultural commodities and currencies. These trade like other options. The difference is the value is drawn from the value of another derivative, rather than the value of the asset itself. Settlement is in cash, not the underlying asset.
Forward Contracts
A forward contract is similar to a futures contract. Both involve a commitment to exchange an item at a date in the future at a price determined today. The difference is a forward contract is not standardized.
People often use forwards in their lives. A simple example is making a hotel reservation. You agree today you will receive the use of the room in the future, at a price agreed upon today. You then use your credit card to guarantee that settlement.
Some types of forward contracts trade amongst institutional investors in the over-the-counter market. For example, banks might trade different currency forward contracts. As an independent options trader, it is unlikely you will be working in forward contracts.
Did You Know?
If there’s a stream of payments and time period, there’s a valuation. As long as traders can value a contract, they are willing to trade it.
Environmental Credits
One of the more interesting derivatives markets is in environmental credits. It started in 1990 under an amendment to the Clean Air Act. The goal was to reduce the amount of sulfur dioxide electric utilities could emit in order to reduce the incidence of acid rain, an effect of pollution that damaged trees. Each utility was given a number of allowances for pollution. A utility could use those or sell them to another utility. If a utility emitted more sulfur dioxide than it was allowed, it could either spend money on technology to reduce the emissions or buy more credits from other utilities. Thus, a utility didn’t have to make changes; it had alternatives to consider.
And alternatives add value.
This system, called cap and trade, was a huge success—so much so people figured it would be used for other types of pollution. For whatever reason, that didn’t happen.
That being said, there is a voluntary market in environmental credits, the Chicago Climate Exchange, operated by ICE. It can be expanded at any time regulators in the U.S. or elsewhere establish a new cap and trade program—and that creates a potential opportunity for traders.
Did You Know?
The founder of the Chicago Climate Exchange, Richard Sandor, had been an executive at the Chicago Board of Trade. He is passionate about the power of the financial markets to create change. He says that the agricultural futures markets have gone a long way to improving the distribution of food in the world to alleviate hunger, and that cap and trade programs could do the same thing for the environment.
Swaps
A swap is a contract that allows someone to trade one type of contract for another. For example, suppose you have a floating rate bond, and you’d rather receive fixed interest payments. Someone else has a fixed-rate bond but would rather receive floating rate payments. You swap your payments, and everyone is happy.
Did You Know?
A swap is not a matter of aesthetics. There are sound economic reasons for trading payments. For example, if you have liabilities with floating interest rates, you might want to receive income in the same way in order to match the risk. If you have expenses in one currency, you might want income in the same currency to better manage exchange rates.
Swaps are almost always negotiated contracts, often with the bank as the counterparty and with a variety of unique features. However, there are some standard practices that allow banks to trade swaps with each other.
Currency Swaps
Currency swaps allow two parties to trade commitments to pay in one currency for another. This is a way to manage exchange-rate risk and to get around problems of currency controls, which is an issue in some emerging markets.
Interest rate swaps are usually exchanges of fixed-rate payments for floating-rate payments. They are based on a predetermined amount of principal, called the notational principal amount. Only interest payments are exchanged, not the underlying. This can help portfolio managers hedge interest rate risks.
Commodity Swaps
Commodity swaps are contracts based on the price of an underlying commodity. They are similar to futures contracts in that they allow parties to lock in the price of a sale. These are useful for commodities that are not covered by exchange-traded futures contracts.
Swaptions
A swaption is an option on a swap. Clever, huh? A payer swaption gives the holder the right, but not the obligation, to enter into an interest rate swap at a predetermined fixed rate at a predetermined time. A receiver swaption gives the purchaser the right, but not the obligation, to receive fixed payments at a predetermined time.
Collateralized Debt Obligations
A collateralized debt obligation isn’t a true derivative, but it is often included in lists of derivatives. It’s a bond issued against a pool of loans. A bank or mortgage company collects a group of loans and then sells bonds on it. The loans might be mortgages, car loans, credit card debts—anything that generates cash flow.
Instead of the lender keeping the principal and interest payments it receives, it passes shares of those onto the bond holders. In a sense, the bond buyers are receiving payments derived from the value of the underlying loans. Collateralized debt obligations are also the reason for the development of another type of derivative, the credit default swap, as buyers were looking for a form of insurance.
Credit Default Swaps
Credit default swaps, also known as CDSs, are contracts in which a bond holder insures the position against default by the issuer. If the bond goes into default, the seller of the swap must pay the buyer the funds. In exchange, the seller keeps the premium. These contracts then trade over the counter. As long as the loan does not default, everyone is happy.
If the loan defaults, though, problems can arise.
Did You Know?
Credit default swaps on mortgage-backed securities were a major contributor to the financial crisis of 2008. Many of those who sold credit default swaps did so under the assumption there was no risk to residential mortgages. As defaults increased, they were on the hook to pay more than they could afford to insure the CDS buyers. Many of these sellers were brokerage firms, banks, and insurance companies made insolvent by their CDS position.
Repurchase Agreements
A repurchase agreement, also called a repo, is an agreement between a buyer and a seller in which the seller agrees to buy back the asset at an agreed-upon price at a future time. In most repos, the asset in question is a U.S. government security, so there is virtually no risk on the value of the underlying asset. In essence, a repo is a loan structured as a forward contract. The treasury bond is the collateral. The seller is receiving money and agrees to repay it in the future at a price high enough to compensate the buyer—the lender—for the use of the funds.
Repos are common transactions between banks and large corporations that need to borrow money for short-term purposes, such as meeting payroll, often for as short a time period as overnight.
LEAPS and Weeklys
LEAPs and weeklys are both types of options, but they have very different time periods than traditional options. (Weeklys are covered in a bit more detail in Chapter 7.)
For years, option expirations had a range limited from 30 days to 2 years into the future. In recent years, the exchanges have introduced a wide range of new products with different expiration dates. The cleverly named Long-term Equity AnticiPation Securities—or LEAPs (it’s a trademark of the CBOE)—have expiration dates from 1 to 5 years into the future. This means they have a large time value relative to the intrinsic value.
Weekly options, on the other hand, are issued on a Monday and expire on Friday of the same week. They have a huge intrinsic value and very little time value when issued, then show a rapid rate of time value (theta decay as the week goes on). Many traders like them as a way to speculate on short-term news events that affect the value of common stock with less of a capital commitment. Because of their fast expiration, they don’t make a good stock replacement other than for a day trader.
- Futures and forwards give holders the obligation to buy or sell an asset at a predetermined price on a predetermined date.
- Swaps give the parties involved the right to trade payments in different currencies or different interest rate structures.
- Credit Default Swaps are insurance contracts against a bond default.
- Newer types of options have longer expirations than other types of options.