1. cisi.org
CISI – Financial Products, Markets & Services
Topic – Derivatives
(6.1, 6.2 and 6.4)Uses of derivatives, Futures and
Terminology
2. cisi.org
A Derivative is……
A financial instrument where the value is derived from the price of
an underlying asset.
The underlying asset could be financial or a commodity.
They have been around hundreds of years – originating back to
agricultural markets
What are Derivatives?
3. cisi.org
£
Jet Fuel
The airline has
safeguarded against
future rises in oil
prices
The farmer has a
guaranteed buyer and
price for the hops and
guards against falling
hop prices
What can be the underlying asset and why are
derivatives used?
The oil company has a
guaranteed buyer and
price for the fuel and
guards against oil
prices falling
£
Hops
The brewery has
guaranteed hops to
produce beer and can
guard against
increasing hop prices
£
Wheat
The farmer has a
guaranteed buyer and
price for the wheat
and guards against
falling wheat prices
The bakery has
guaranteed wheat to
make products and
can guard against
increasing wheat prices
£
Copper
The mining company
has a guaranteed
buyer and price for
the copper and
guards against falling
copper prices
The manufacturer has the
raw materials to produce
products and guards
against rises in the price of
copper
£
Interest rates
The Investment
bank will swap the
type of interest rate
offered on the
company’s
borrowings for a fee
The company will
guard against the risk of
interest rate rises and
an increase in the cost
of borrowing
4. cisi.org
A Derivative is……
A financial instrument where the value is
derived from the price of an underlying
asset.
The underlying asset could be financial or a
commodity.
They have been around hundreds of years
– originating back to agricultural markets
Financial Assets
Bonds
Shares
Stock market
indices
Interest rates
Commodities
Oil
Silver
Wheat
Trading of derivatives can take place:
Either directly between counterparts - known as over-the-counter (OTC)
Or, on an exchange - known as exchange-traded
Hedging
Reduces the risk of
adverse price
movements for the buyer
and the seller
Speculating
The motive of a party is to make
money – they have no interest in the
underlying asset e.g. Banks
Financial instruments are used to give
exposure to price movements
FUTURES FORWARDS OPTIONS SWAPS
Derivatives and their uses
5. cisi.org
Futures – A history
Derivatives have been around for hundreds of year, traced back to
agricultural markets:
Farmers often needed a mechanism to guard against price
fluctuations (From produce shortages and droughts)
Farmers and merchants entered into forward contracts before the
harvest period – this removed much of the risk previously faced.
Because these they were very popular and led to the opening of the
world’s first derivatives exchange, the Chicago Board of Trade
(CBOT), in 1848.
The exchange introduced a futures contract. They involved the
purchase or sale of:
A standardised quantity
and quality of grain (such as 100 bushels of wheat containing no
more than 5% moisture)
for a price agreed now and for delivery on a stated future
delivery date, such as three months later.
Unlike the forward contracts that preceded it, these futures contract
are traded on the exchange, rather than over the counter.
1975 saw CBOT introduce the world’s first financial futures contract.
6. cisi.org
Futures – Features
We have already seen examples of futures contracts in the last activity.
Buyer Seller
1. Futures Contract
It is a Legally binding
obligation between
two parties
2. Agrees to pay a pre-specified
amount for the delivery of a pre-
specified quantity of an asset at a
pre-specified future date (XXX of Jet
fuel at £xxx on 10.10.15)
3. Agrees to deliver the asset (Jet
fuel) at the future date, in exchange
for the pre-specified amount of
money
5. Standardised terms
Only the price is negotiable – quality,
quantity, date and location is set by
the exchange
4. Exchange Traded
e.g. NYSELiffe or ICE
7. cisi.org
Futures - terminology
Futures Contract
Legally binding obligation
between two parties
Buyer
Seller
Long
The buyer
Committed to buying
the underlying asset at
the pre-agreed price at
a future date.
Short
The seller
Committed to delivering the
underlying asset in exchange
for the pre-agreed price on
the specified future date.
Open
The initial trade.
The trade is ‘opened’
when it first enters a
future.
Can be a buyer
(Opening a long
position) or a seller
(Opening a short
position)
Covered
The seller has the underlying
asset that will be needed for
the physical delivery to take
place. (Often the seller does
not have ownership at the
time)
Naked
The seller of the future
does not have the asset
that will be needed if
physical delivery of the
commodity is required.
Close
Most physical assets don’t
end up being delivered.
A closing sale is made by the
buyer before delivery date.
If it is not closed, the buyer
receives the asset.
8. cisi.org
Futures Terminology - Naked and Covered
Seller
Naked Position
The seller of the future does
not have the asset that will
be needed if physical
delivery of the commodity is
required.
If the futures contract is not
‘closed out’, Shell would need to
fulfil the delivery of the specified
quantity of jet fuel on the date
specified at the specified price
but would need to purchase the
oil to fulfil the contract.
If the futures contract is not ‘closed out’,
Shell would need to fulfil the delivery of
the specified quantity of jet fuel on the
date specified at the specified price. If
they are in this position, they already
have the asset to fulfil the contract.
Why would a buyer ‘close out’ a futures contract?
It goes back to the purpose of the futures contract and who the buyer is.
In the case of the airline and oil company, the contract is not likely to be ‘closed out’ as
the airline has a genuine interest in the underlying asset (jet fuel) – they need it to do
business. Both parties are hedging.
But the buyer could be a financial institution speculating on the price of the underlying
asset and have no interest in the asset itself, therefore do not want physical possession of
it.
Covered Position
The seller has the underlying asset
that will be needed for the physical
delivery to take place. (Often the
seller does not have ownership at
the time)
