Forward contracts

• customized: no active secondary market
• long: obligated to buy; short: obligated to sell
• specified date of future
• if asset price > forward price, long gains
• if asset price < forward price, short gains
• contract settlement
  • delivery: short delivers underlying to long for payment of the forward price
  • cash settlement
• early termination
  • cash settlement (buy out)
  • enter into an offsetting contract, with a different/same counterparty
• end user: typically a corporation or institution seeking to transfer an existing risk
• Forward Rate Agreement
  • FRA settlement payment to long

• Currency forward contracts: commitments to buy/sell foreign currency for a fixed amount of another currency for specified exchange rate

Futures contracts

• exchange traded:minimum price fluctuation(tick), daily price limit
• standardized, regulated contract: quality and quantity of good, delivery time, manner of delivery
• clearinghouse acts as counterparty on all contracts, no default risk
• margin requirements
  • initial margin: deposited before trade occurs
  • maintenance margin: minimum margin that must be maintained in a future account
  • variation margin: funds needed to restore future account to initial margin
  • settlement price: average of trades during closing period, used to calculate margin
• marking to market: process of adjusting margin balance in a futures account each day for the change in the futures price (add gains, subtract losses)
• termination methods: reversal(offsetting trade), asset delivery, cash settlement, exchange for physicals(off exchange)
• Eurodollar futures: add-on yield based on 90-day LIBOR
  • minimum price change = one 'tick' = price change of 0.01% = $25 per $1 million contract
• S&P 500 index futures: 250 times the level of the index, $250 per change in index point

Option contracts

• Call option: right to buy

• Put option: right to sell
  • American put option- may be exercised on any trading day on or before expiration
    
  • European put option- may only be exercised on expiration

• Moneyness
  • at the money : current price = strike price
  • in the money : high prices relative to original price
  • out of the money : option has no intrinsic value
• option value = intrinsic value + time value
  • intrinsic value = payoff at expiration
  • time value = option premium - intrinsic value

• Interest rate options: payoff based on the difference between a floating rate(LIBOR) and the strike rate
  • payoff on interest rate call = Max[0, (LIBOR-strike rate)] x notional amount (long gains when rates rise)
  • payoff on interest rate put = Max[0, (strike rate-LIBOR)] x notional amount (long gains when rates fall)
  • payoffs made at the end of the interest rate term, after expiration

• cap: maximum on an issuer's payments on a floating rate debt
  • equivalent to series of long interest rate calls
  • makes payments to issuer when floating rate > cap rate
• put: minimum on an issuer's payments on a floating rate debt
  • equivalent to series of short interest rate puts
  • receives payments from issuer when floating rate < floor rate

• Put-Call parity S+P = C+X(discounted)

• Option values increase when

1. time to expiration increases
2. greater price volatility
3. increase in RFR

• if the asset has positive cash flows, cost of the asset is reduced by the PV of the cash flows

Swaps

• equivalent to a series of forward contracts
  • notional principal: used to calculate periodic payments
  • floating rate: usually LIBOR
  • tenor: time period covered by swap
  • settlement dates: payment due dates

• Interest rate swap : one party exchanges a stream of interest payments for another party's stream of cash flows
• Plain Vanilla Interest Swap
  • fixed interest rate payments in exchange for floating rate psyments
  • notional amount not exchanged
  • interest payments are netted
  • payment is made at end of period based on beginning of period LIBOR
• Equity swap: equity returns exchanged with fixed/floating rate payments
  • equity return payer: receives interest payment, pays on positive equity return
  • interest payer: pays interest payment, pays any negative equity return
• Total return swap : party A pays the total return of an asset, and party B makes periodic interest payments
• Currency swap : a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amounts swapped

Option strategies

• covered call: writer owns the stock and sells a call, any loss will be reduced by premium received; writer trades the stock's upside potential for the fixed option premium
• protective put: put buyer owns the stock and a put; put buyer pays for protection against any stock price below the strike price