Chartered Institute Securities & Investment
(CISI): Capital Markets Programme
Derivatives
Rodrigo Antón García
London, 2023
Derivatives
,Chapter 1 – Introduction to Derivatives (6 Questions).
o Futures Basics: Terminology & Types, Uses, Profiles and Risks.
A Futures contract is an exchange traded legal agreement/obligation to buy/sell a
specified quantity of specified asset on a specified future date at a price agreed today.
Note: Nothing bought/sold today. T&C fixed today for transaction to be completed in
the future. Note: The exchange sets all the terms of a futures contract except price.
The risk is limited to price of future. However, risk in such is unlimited. No Max/Min.
Side: Buyer (Take Delivery) LONG position. Seller (Make Delivery) SHORT position.
Contingent Liability: Transaction describing derivative position where investor may
lose more money than originally invested. All Futures have a contingent liability.
However, Not All Derivatives have contingent liability. E.g. Exception: Long Option.
A Forward contract is not exchange traded Future, Forwards typically available OTC
Non-OTC Exception: London Metals Exchange (LME). All Futures exchange traded.
Advantages over Future: T&C not Exchange Set, Flexible & Range Underlying Asset.
Future: Only Price to be Set (Standardized Contract). Forward: Flexibility and Varied.
A Contract for Difference (CFD) is cash-settled (Brent & physically-settle) contract.
No hand exchange. P/L at expiry. Designed when physical delivery is impossible or
impractical. Applies to: Interest Rates (Impossible) E.g. Short Term Interest Rate
Future (STIR)) and Indices (Impractical) E.g. FTSE 100 Index Future, LMEX Future.
A Spread Betting Strategy. Similar to CFD BUT: 1) Realised Gains on Spread Bets
are tax-free, whereas CFDs are subject to capital gains tax, 2) Spread Bets are sold
at the spread, whereas CFDs typically subject to commission, 3) Spread Bets have
an end date, CFDs typically no end date. Note: Both prohibited in the US. E.g. STIR.
- Uses of Futures.
- Speculation. Seek to make profits from price movements. Take on risk. Bet.
- Hedging. Protection against price movement. Risk Management. Reduce risk.
- Arbitrage. Profiting from differing prices of equivalent assets. Riskless Profit.
o Intertemporal. E.g. ‘Out-of-line’ prices in 1mo & 6mo LME zinc contract.
o Geographic. Arbitrage identical contracts across multiple exchanges.
E.g. Price of Singapore EX June Eurodollar future different from CME’s June contract.
o Value-Chain. E.g. Arbitrage of prices of crude oil and refined product.
o Cash and Carry. Exploit price differences for arbitrage opportunities.
o Profile of Futures. Pay-off Diagrams. Zero-Sum Game. Distribution Profits.
Assumption: Speculative Purposes. Ignore Transactions Costs, Charges Taxed, Etc.
,Long Future. Bull Position: Price Up (Gain). Bear Position: Prices Down (Loss).
Assume prices positive (CISI Assumption, Not Real), Max Price pay is the Specified
Price (If asset goes to a price of zero, E.g. Pay 500), whereas Max Price earn infinite.
Long Future makes money in rising bull market; loses money in bear falling market.
Breakeven
Short Future. Bear Position: Price Down (Gain). Bull Position: Prices Up (Loss).
Assume prices positive (CISI Assumption, Not Real), Max Price pay infinite, whereas
Max Price earn is the Specified Price (If asset goes to a price of zero, E.g. Earn 500).
Short Future makes money in falling bear market; loses money in rising bull market.
An investor with an Open Future position, either long or short, has two choices:
o Hold future to expiry & make delivery of the underlying, or cash (where CFD).
o Sell/buy the future before expiry (closing out). Closing out achieved by
entering into an equal but opposite contract in order to offset the terms of the first.
Summary.
o Risks. Forward More Risk than Future (Standard Clear & Exchange Trade).
o Market Risk. General Risk in price movements.
, o Counterparty Risk. Credit Risk of counterparty not meeting their obligations.
o Liquidity Risk. Risk unable enter/exit at fair price within reasonable timeframe.
o Operational Risk. Risk of fail or inadequate internal process, external event,
people & system. Reduced through Automation: Straight Through Processing (STP).
o Speculation and Hedging with Futures. BUY/SELL FUTURE TO HEDGE.
Speculation & Closing Out. Most speculators will close out position before delivery.
Consequences: Prevents Physical Delivery, Locking Profits and Limiting Losses.
Process: Enter to an equal but opposite position to one already held through OTHER.
E.g. Close out 10 long Sept. natural gas future with 10 short Sept. natural gas future.
Speculators not have real interest in underlying asset. They take position on price
of an underlying asset and hope that their belief as to whether the price will rise or fall
is proved correct. Closing out offsets the risk-reward profile and creates a flat position.
Aggregate of individual profits/losses is zero (sum game) (each person's profits must
come from someone else's losses). Even when there are more than two participants.
Hedging. Allows participants in physical markets to offset price risk using derivatives.
Process: Enter into a derivative contract that gives opposite exposure to the one held.
Asset that underlies contract should match exposure as closely as possible. E.g. Bond
portfolio manager uses bond futures, Electrical company uses copper futures to hedge
Hedgers do have real interest in underlying asset. Do not make a money-making
exercise. They want to remove uncertainty of potential price movements. Flat position.
𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨
∗ 𝐁𝐞𝐭𝐚
𝐅𝐮𝐭𝐮𝐫𝐞 𝐓𝐫𝐚𝐝𝐢𝐧𝐠 𝐕𝐚𝐥𝐮𝐞 ∗ 𝐓𝐢𝐜𝐤 𝐕𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐈𝐧𝐝𝐞𝐱 𝐏𝐨𝐢𝐧𝐭 (𝟏𝟎 𝐏𝐨𝐮𝐧𝐝𝐬 𝐅𝐓𝐒𝐄𝟏𝟎𝟎)
o Options Basics: Terminology & Types, Uses, Profiles and Risks.
(CISI): Capital Markets Programme
Derivatives
Rodrigo Antón García
London, 2023
Derivatives
,Chapter 1 – Introduction to Derivatives (6 Questions).
o Futures Basics: Terminology & Types, Uses, Profiles and Risks.
A Futures contract is an exchange traded legal agreement/obligation to buy/sell a
specified quantity of specified asset on a specified future date at a price agreed today.
Note: Nothing bought/sold today. T&C fixed today for transaction to be completed in
the future. Note: The exchange sets all the terms of a futures contract except price.
The risk is limited to price of future. However, risk in such is unlimited. No Max/Min.
Side: Buyer (Take Delivery) LONG position. Seller (Make Delivery) SHORT position.
Contingent Liability: Transaction describing derivative position where investor may
lose more money than originally invested. All Futures have a contingent liability.
However, Not All Derivatives have contingent liability. E.g. Exception: Long Option.
A Forward contract is not exchange traded Future, Forwards typically available OTC
Non-OTC Exception: London Metals Exchange (LME). All Futures exchange traded.
Advantages over Future: T&C not Exchange Set, Flexible & Range Underlying Asset.
Future: Only Price to be Set (Standardized Contract). Forward: Flexibility and Varied.
A Contract for Difference (CFD) is cash-settled (Brent & physically-settle) contract.
No hand exchange. P/L at expiry. Designed when physical delivery is impossible or
impractical. Applies to: Interest Rates (Impossible) E.g. Short Term Interest Rate
Future (STIR)) and Indices (Impractical) E.g. FTSE 100 Index Future, LMEX Future.
A Spread Betting Strategy. Similar to CFD BUT: 1) Realised Gains on Spread Bets
are tax-free, whereas CFDs are subject to capital gains tax, 2) Spread Bets are sold
at the spread, whereas CFDs typically subject to commission, 3) Spread Bets have
an end date, CFDs typically no end date. Note: Both prohibited in the US. E.g. STIR.
- Uses of Futures.
- Speculation. Seek to make profits from price movements. Take on risk. Bet.
- Hedging. Protection against price movement. Risk Management. Reduce risk.
- Arbitrage. Profiting from differing prices of equivalent assets. Riskless Profit.
o Intertemporal. E.g. ‘Out-of-line’ prices in 1mo & 6mo LME zinc contract.
o Geographic. Arbitrage identical contracts across multiple exchanges.
E.g. Price of Singapore EX June Eurodollar future different from CME’s June contract.
o Value-Chain. E.g. Arbitrage of prices of crude oil and refined product.
o Cash and Carry. Exploit price differences for arbitrage opportunities.
o Profile of Futures. Pay-off Diagrams. Zero-Sum Game. Distribution Profits.
Assumption: Speculative Purposes. Ignore Transactions Costs, Charges Taxed, Etc.
,Long Future. Bull Position: Price Up (Gain). Bear Position: Prices Down (Loss).
Assume prices positive (CISI Assumption, Not Real), Max Price pay is the Specified
Price (If asset goes to a price of zero, E.g. Pay 500), whereas Max Price earn infinite.
Long Future makes money in rising bull market; loses money in bear falling market.
Breakeven
Short Future. Bear Position: Price Down (Gain). Bull Position: Prices Up (Loss).
Assume prices positive (CISI Assumption, Not Real), Max Price pay infinite, whereas
Max Price earn is the Specified Price (If asset goes to a price of zero, E.g. Earn 500).
Short Future makes money in falling bear market; loses money in rising bull market.
An investor with an Open Future position, either long or short, has two choices:
o Hold future to expiry & make delivery of the underlying, or cash (where CFD).
o Sell/buy the future before expiry (closing out). Closing out achieved by
entering into an equal but opposite contract in order to offset the terms of the first.
Summary.
o Risks. Forward More Risk than Future (Standard Clear & Exchange Trade).
o Market Risk. General Risk in price movements.
, o Counterparty Risk. Credit Risk of counterparty not meeting their obligations.
o Liquidity Risk. Risk unable enter/exit at fair price within reasonable timeframe.
o Operational Risk. Risk of fail or inadequate internal process, external event,
people & system. Reduced through Automation: Straight Through Processing (STP).
o Speculation and Hedging with Futures. BUY/SELL FUTURE TO HEDGE.
Speculation & Closing Out. Most speculators will close out position before delivery.
Consequences: Prevents Physical Delivery, Locking Profits and Limiting Losses.
Process: Enter to an equal but opposite position to one already held through OTHER.
E.g. Close out 10 long Sept. natural gas future with 10 short Sept. natural gas future.
Speculators not have real interest in underlying asset. They take position on price
of an underlying asset and hope that their belief as to whether the price will rise or fall
is proved correct. Closing out offsets the risk-reward profile and creates a flat position.
Aggregate of individual profits/losses is zero (sum game) (each person's profits must
come from someone else's losses). Even when there are more than two participants.
Hedging. Allows participants in physical markets to offset price risk using derivatives.
Process: Enter into a derivative contract that gives opposite exposure to the one held.
Asset that underlies contract should match exposure as closely as possible. E.g. Bond
portfolio manager uses bond futures, Electrical company uses copper futures to hedge
Hedgers do have real interest in underlying asset. Do not make a money-making
exercise. They want to remove uncertainty of potential price movements. Flat position.
𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨
∗ 𝐁𝐞𝐭𝐚
𝐅𝐮𝐭𝐮𝐫𝐞 𝐓𝐫𝐚𝐝𝐢𝐧𝐠 𝐕𝐚𝐥𝐮𝐞 ∗ 𝐓𝐢𝐜𝐤 𝐕𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐈𝐧𝐝𝐞𝐱 𝐏𝐨𝐢𝐧𝐭 (𝟏𝟎 𝐏𝐨𝐮𝐧𝐝𝐬 𝐅𝐓𝐒𝐄𝟏𝟎𝟎)
o Options Basics: Terminology & Types, Uses, Profiles and Risks.
