derivatives. Trading does not occur in a central location but, rather, is quite dispersed. Although new national securities laws are tightening the regulation of OTC derivatives, the degree of regulation is less than that of exchange-listed derivatives.
Solution to 3: C is correct. Market makers buy at one price (the bid), sell at a higher price (the ask), and hedge whatever risk they otherwise assume. Market makers do not charge a commission. Hence, A and B are both incorrect.
Solution to 4: B is correct. Standardization of contract terms is a characteristic of exchange-traded derivatives. A is incorrect because credit risk is well-controlled in exchange markets. C is incorrect because the risk management uses are not limited by being traded over the counter.
4. TYPES OF DERIVATIVES
As previously stated, derivatives fall into two general classifications: forward commitments and contingent claims. The factor that distinguishes forward commitments from contingent claims is that the former obligate the parties to engage in a transaction at a future date on terms agreed upon in advance, whereas the latter provide one party the right but not the obligation to engage in a future transaction on terms agreed upon in advance.
4.1. Forward Commitments
Forward commitments are contracts entered into at one point in time that require both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start. The parties establish the identity and quantity of the underlying, the manner in which the contract will be executed or settled when it expires, and the fixed price at which the underlying will be exchanged. This fixed price is called the forward price.
As a hypothetical example of a forward contract, suppose that today Markus and Johannes enter into an agreement that Markus will sell his BMW to Johannes for a price of €30,000. The transaction will take place on a specified date, say, 180 days from today. At that time, Markus will deliver the vehicle to Johannes’s home and Johannes will give Markus a bank-certified check for €30,000. There will be no recourse, so if the vehicle has problems later, Johannes cannot go back to Markus for compensation. It should be clear that both Markus and Johannes must do their due diligence and carefully consider the reliability of each other. The car could have serious quality issues and Johannes could have financial problems and be unable to pay the €30,000. Obviously, the transaction is essentially unregulated. Either party could renege on his obligation, in response to which the other party could go to court, provided a formal contract exists and is carefully written. Note finally that one of the two parties is likely to end up gaining and the other losing, depending on the secondary market price of this type of vehicle at expiration of the contract.
This example is quite simple but illustrates the essential elements of a forward contract. In the financial world, such contracts are very carefully written, with legal provisions that guard against fraud and require extensive credit checks. Now let us take a deeper look at the characteristics of forward contracts.
The following is the formal definition of a forward contract:
A forward contract is an over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a fixed price they agree on when the contract is signed.
In addition to agreeing on the price at which the underlying asset will be sold at a later date, the two parties also agree on several other matters, such as the specific identity of the underlying, the number of units of the underlying that will be delivered, and where the future delivery will occur. These are important points but relatively minor in this discussion, so they can be left out of the definition to keep it uncluttered.
As noted earlier, a forward contract is a commitment. Each party agrees that it will fulfill its responsibility at the designated future date. Failure to do so constitutes a default and the non-defaulting party can institute legal proceedings to enforce performance. It is important to recognize that although either party could default to the other, only one party at a time can default. The party owing the greater amount could default to the other, but the party owing the lesser amount cannot default because its claim on the other party is greater. The amount owed is always based on the net owed by one party to the other.
To gain a better understanding of forward contracts, it is necessary to examine their payoffs. As noted, forward contracts – and indeed all derivatives – take (derive) their payoffs from the performance of the underlying asset. To illustrate the payoff of a forward contract, start with the assumption that we are at time t = 0 and that the forward contract expires at a later date, time t = T.5 The spot price of the underlying asset at time 0 is S0 and at time T is ST. Of course, when we initiate the contract at time 0, we do not know what ST will ultimately be. Remember that the two parties, the buyer and the seller, are going long and short, respectively.
At time t = 0, the long and the short agree that the short will deliver the asset to the long at time T for a price of F0(T ). The notation F0(T) denotes that this value is established at time 0 and applies to a contract expiring at time T. F0(T) is the forward price. Later, you will learn how the forward price is determined. It turns out that it is quite easy to do, but we do not need to know right now.6
So, let us assume that the buyer enters into the forward contract with the seller for a price of F0(T ), with delivery of one unit of the underlying asset to occur at time T. Now, let us roll forward to time T, when the price of the underlying is ST. The long is obligated to pay F0(T ), for which he receives an asset worth ST. If ST > F0(T ), it is clear that the transaction has worked out well for the long. He paid F0(T) and receives something of greater value. Thus, the contract effectively pays off ST ‒ F0(T) to the long, which is the value of the contract at expiration. The short has the mirror image of the long. He is required to deliver the asset worth ST and accept a smaller amount, F0(T ). The contract has a payoff for him of F0(T) ‒ ST, which is negative. Even if the asset’s value, ST, is less than the forward price, F0(T ), the payoffs are still ST ‒ F0(T) for the long and F0(T) ‒ ST for the short. We can consolidate these results by writing the short’s payoff as the negative of the long’s, ‒[ST ‒ F0(T )], which serves as a useful reminder that the long and the short are engaged in a zero-sum game, which is a type of competition in which one participant’s gains are the other’s losses. Although both lose a modest amount in the sense of both having some costs to engage in the transaction, these costs are relatively small and worth ignoring for our purposes at this time. In addition, it is worthwhile to note how derivatives transform the performance of the underlying. The gain from owning the underlying would be ST ‒ S0, whereas the gain from owning the forward contract would be ST ‒ F0(T ). Both figures are driven by ST, the price of the underlying at expiration, but they are not the same.
Exhibit 1 illustrates the payoffs from both buying and selling a forward contract.
EXHIBIT 1 Payoffs from a Forward Contract
Such notations as
This point is covered more fully elsewhere in the readings on derivatives, but we will see it briefly later in this reading.
