30 years: Risk management & derivatives trading

“Derivatives” is a catch all term for a wide range financial products. In this series, Lindsey will cover what forwards and futures are and how to price a forward trade.

“Derivatives” is a catch all term for a wide range financial products. In this series, Lindsey will cover what forwards and futures are and how to price a forward trade.

10 mins 54 secs

Overview

Derivatives is a catch all term for a wide range of financial products, including futures and options, interest rate swaps, oil options, FX forwards, equity swaps and credit default swaps. Forwards contracts can be used in circumstances where prices are uncertain, and thus traders lock in and hedge their risk. The calculation of the fair forward price is outlined below.

Key learning objectives:

Define forwards and futures contracts

Learn the formula for calculating the fair forward price

Identify what the price of a 3 month forward NOT involve

Summary#### Which assets can options apply to?

#### What are forwards and futures contracts?

#### How does a forwards contract work?

#### What is an example of a forwards contract transaction?

#### What is a “zero-sum game”?

#### LMCorp stock is trading at $36 per share, and pays a dividend of $1.48 in 2 month’s time. The interest rate is 2% per annum. What would be the fair price for a 3 month forward stock on LMCorp stock?

#### What is the formula for calculating the fair forward price?

#### What does the pricing of a 3 month forward NOT involve?

Equities, interest rates, bonds, currencies, gold and oil.

Allow users to trade an asset today, at a price and in a quantity agreed today, but for a settlement at an agreed point in the future. Entering into a forwards contract eliminates the risk of a price rise, hence they are hedging this risk.

For example, for a company making jewellery, they need platinum at a point in the future, and are concerned that the price may rise well above today’s level to a level they are unable to pay. By entering into a forward contract, they can fix the price today, to purchase the platinum in the future. All of the details are agreed upfront, and then the settlement occurs say 3 months later.

- For example: “We R Jewels” buys 1000 ounces of Platinum from “Mynah Co Ltd” for settlement in 3 months time, for $1000 per troy ounce
- At trade date, the 2 parties agree to the terms of the trade and sign contracts. After 3 months, We–R-jewels pays $1m to Mynah CO, and Mynah Co delivers 1000 ounces of Platinum to We-R-Jewels

Many people say that derivatives, such as the forward contract above are a “zero-sum game” - one party makes and the other loses in opposite amounts. If the platinum price rises, the jeweller makes money on the trade and the miner loses money - and they exactly offset each other - making it “zero sum”.

The way to think about this is to make your own forward trade. Imagine buying LMCorp stock now and holding the position for 3 months - how much would this cost in total?

- Borrow $36 and buy 1 share of LMCorp stock
- Over 3 months, the interest on the borrowing would be 2% x 0.25 x $36 = $0.18, so you would need to pay back $36.18
- But you would earn the dividend, which would reduce the total cost by $1.48
- Giving you a total cost of $34.70 - hence this is the fair price of 3 month forward

*Spot Price + Costs of Holding - Benefits of Holding*

Does not involve any discussion, prediction or guessing of the price of LMCorp shares in 3 months time. We are using the spot-forward arbitrage to price the forward contract - where the arbitrageur would trade the spot an drudge with the forward and so be left with no exposure to the price of the underlying.

Lindsey runs Perfordiant, an investment risk and performance consulting firm. He has worked in financial markets since 1992. Lindsey became an MD in fixed income and equities, ran a Risk function, and was on the management team of an Asset Management fintech business. Lindsey is now a Visiting Fellow at the Henley Business School, and resides on the board of CFA UK.

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