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									Table of Contents

    CHAPTER          5

    Primary and Derivative Products          2

    Forward Market                           2

    Futures Market                           3

    Difference between forward and futures   5

    Options Market                           6

    Margins                                  6   5
I C O N    K E Y

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Key Point

 Currency Derivatives
 Speculators and Hedgers are like opposite sides of the same coin

            urrency derivatives are built on currency forward contracts, currency futures, and
            currency options. Speculators often use currency derivatives simply to make profit.
            MNCs commonly use currency derivatives to cover their foreign currency positions.
            There are primary and derivative products offered in the market place

 Primary and Derivative Products
 Primary Products (assets and securities): Their values are determined by their own cash flows
 and an ―appropriate‖ discount rate. Examples are stocks and bonds, commodities, real estate,
 currencies etc.

 Derivative Products: Their values are dependent on the value of primary products. Examples
 are forward contracts, futures, options, swaps, insurance, etc.
 Why derivative products? They are efficient (low-cost) and effective tools to hedge or speculate.
 Hedging and Speculation are like opposite sides of the same coin. Derivatives could be used to
 achieve either hedging or speculation depending on the position taken (e.g. insurance company vs.
 insurance policy holders). ―Guns don’t kill people, people kill people.‖

 Hedging: The purchase or sale of a commodity, security or other financial instrument for the
 purpose of offsetting the profit or loss of another security or investment. Thus, any loss on the
 original investment will be hedged, or offset, by a corresponding profit from the hedging

 Forward Market
 The forward market was founded in Chicago in the 1850s and is an over-the-counter (OTC)
 market. The foundations for forward contracts are banks that are willing to enter into contracts
 with corporations.

 The forward market allows an MNC to lock in the exchange rate (forward rate) for a specific time
 period. The MNC can then buy or sell currency at the rate during the specific period. A forward
 contract is a contract to buy or sell a predetermined amount of currency at a future time for a

―locked-in‖ exchange rate. Most forward contracts are for 30, 60, 90, 180, or 360 days. MNCs
use the forward market when they have a future transaction and want to be certain of the
exchange rate.

Like spot rates, forward rates have a bid/ask spread. The spread between the bid and the ask is
the profit for the bank willing to conduct the contract. Typically the spread is larger for currencies
in developing countries, and forward rates are available only for the short term.

CBOT-Chicago Board of Trade
The Chicago Board of Trade (CBOT), established in 1848, is the world’s oldest derivatives (futures and
futures-options) exchange. More then 3,600 CBOT members trade 47 different futures and
options products at the CBOT, resulting in annual trading volume of more than 260 million
contracts in 2001. Initially CBOT listed only agricultural instruments for trading —such as
wheat, corn and oats. In 1975, the CBOT expanded its offerings to include financial
contracts. The first financial contracts traded were US Treasury Bonds. They are now one
of the worlds most actively traded futures. The CBOT listings expanded again in 1982, when
options on futures contracts were introduced, and on October 6, 1997, the CBOT made
history again when it launched one of its most successful contracts—futures and futures-
options on the Dow Jones Industrial Average.

For more then 150 years, the primary method of trading at the CBOT had been open outcry,
during which traders meet fact-to-face in trading pits to buy and sell futures contracts. Then, in
1994 the CBOT launched an electronic trading system, and most recently, in August 2000, an
ectronic trading platform.

The CBOT’s market provides opportunities for risk management for users who include farmers,
corporations, small business owners, and others. Risk management, in the form of hedging, is the
practice of offsetting the price risk inherent in any cash market position by taking an equal but
opposite position in the futures market. Hedgers use CBOT futures markets to protect their
businesses from adverse price changes that could have a negative impact on their bottom line.

The CBOT presently is a self-governing, self-regulated Delaware not-for-profit, non-stock
corporation that serves individuals and member firms. There are several types of memberships
within the CBOT, which allow access to all or some of the markets listed at the exchange. Of the
CBOT’s 3,600 members, 1,400 are full members who have traded access to all of the exchange’s


Futures Market
The Mecca of futures is Chicago, just like the financial center of the world is New York City.
There are two major futures exchanges in Chicago. One is the Chicago Board of Trade (CBOT)
and the other is the Chicago Mercantile Exchange (CME) which recently merged into one single

Futures contracts for agricultural commodities have been traded in the U.S. for more than 100
years and have been under Federal regulation since the 1920s. In the last 20 years, futures trading
has expanded rapidly into many new markets beyond the domain of traditional physical and
agricultural commodities.

Futures and options are now offered on many energy commodities such as crude oil, gasoline,
heating oil, and natural gas, as well as on a vast array of financial instruments, including foreign
currencies, U.S. and foreign government securities, and U.S. and foreign stock indexes. In
addition, in recent years, new futures contracts have been offered in non-traditional commodity
areas such as electricity, seafood, dairy products, crop yields, and weather derivatives.

Trading starts at 7:20 am (CT) and ends at 2:00 pm (CT). Orders are placed with a brokerage
firm, who contracts with a floor broker at the CME. A participant needs to establish an initial
margin, which is usually 2% of the contract value, and there is normally a 50-dollar commission
for a roundtrip trade. A roundtrip trade occurs when a participant both buys and sells or sells and
buys. This is referred to as canceling their position

The floor broker stands at a specific spot in the trading pit where the type of contract is traded.
He attempts to find a counterpart who wishes to fulfill the order. Contracts are typically around
the 100,000-dollar mark. Contracts come to term on the third Wednesday in the months of
March, June, September, or December.

A future contract is an agreement to buy or sell in the futures a specific quantity of a commodity
at a specific price. Most futures contracts contemplate that actual deliver of the commodity can
take place to fulfill the contract. However, some futures contracts (index, weather, etc) require a
cash settlement in lieu of the actual delivery. In reality, most contracts are liquidated before the
delivery date. An option on a commodity futures contract gives the buyer of the option the right
to convert the option into a futures contract. Futures and options must be executed on the floor
of a commodity exchange.

Most of the participants in the futures and option markets are commercial or institutional users of
the commodities they trade. These users, most of whom are called ―hedgers,‖ want the value of
their assets to increase and also want to limit, if possible, any loss in value. Hedgers may use the
commodity markets to take a position that will reduce the risk of financial loss in their assets due
to a change in price. Other participants are ―speculators‖ who hope to profit from changes in the
price of the futures or option contract.

CME-Chicago Mercantile Exchange

Founded as a not-for-profit corporation in 1898, CME became the first publicity traded U.S.
financial exchange in December 2002 when the Class A shares of their parent company, Chicago
Mercantile Exchange Holdings Inc. began trading on the New York Stock Exchange under the
ticker symbol CME.

Chicago Mercantile Exchange is an international marketplace that brings together buyers and
sellers of derivatives products, which trade on their trading floors, electronic trading system and
through privately negotiated transactions. The Exchange offers futures and options in four basic
product areas: interest rates, stock indexes, foreign exchange, and commodities.


Commodity Futures Trading Commission (CFTC)\

Congress created the Commodity Futures Trading Commission (CFTC) in 1974 as an
independent agency with the mandate to regulate commodity futures and options markets in the
United States. The agency protects market participants against manipulation, abusive trade
practices and fraud. Through effective oversight and regulation, the CFTC enables the markets to
serve better their important functions in the nation’s economy—providing a mechanism for price
discovery and a means of offsetting price risk.


NFA-National Futures Association

Founded on October 1, 1982, the National Futures Association began its mission to protect the
public investor by maintaining the integrity of the marketplace. Industry leaders began to contract
an organization that would establish and enforce high standards of business conduct.
Congressional legislation that established the CTFC in 1974 also authorized the creation of
―registered futures associations.‖ This provision gave the industry the opportunity to develop a
self-regulatory organization that would work in conjunction with government oversight.


Differences between Forwards and Futures
There are many practical differences between forwards and futures although conceptually they are
the same.

                                            Forward                           Futures

Regulations                      Self-regulated (banks)            CFTC, NFA

Limits on Price Change           No Limit                          Daily Limit

Delivery Date                    No set delivery date              Set date (3rd Wed of the
                                                                   delivery month)

Currencies Used                  Any currencies                    Select currencies

Transaction Cost                 Bid/Ask Spread                    20-50 U.S dollars

Margins                          No margin                         Margin Min. = Your equity

Contract Sizes                   No set size                       Set size

Location                         OTC                               Futures exchanges

Options Market
The Options Market was established in 1982. The U.S. Securities and Exchange Commission
regulates it. Currency options are offered by the Chicago Mercantile Exchange and the Chicago
Board Options Exchange. Currency Options are available in many, but not all currencies.

    http://www.ino.com Latest information for options and futures

A currency option is a right to buy or to sell at a specified price (exercise price or strike price) with
no obligation over a specific period of time. This places the obligation on the seller while the
buyer enjoys the right to use the option. When an option is used it is referred to as ―exercising‖
the option. The fee paid to purchase an option is called the premium. A real life example of a call
option is a rain check, which is given free as a strategy to attract customers.

A margin is the trading $ amt or % of your equity in your investment. 60% margin means 60% of
the investment is financed by your equity and 40% is through debt. 100% margin means no
borrowing. The minimum margin required for stock trading is 50%, but could be higher for
different brokerage firms and for risky stocks.

A low margin is an inviting way to control a large value in an investment. This is called a leverage
effect. The brokerage firms in the futures market usually allows you to purchase a position with a
minimum of 2% down. So if you put down 2,000 dollars you can control 100,000 dollars in the
market. If the product goes up or down, great gains/losses can be realized.


If you are buying a house with $300K and you are taking a loan, and have 20% to put down.

        300 * 0.2 = $60K

Here you don’t need to buy PMI, you need to borrow $240K

        If the value of the house increases 10% then:

        $300K * 0.1 + $300 = 330K this is divided in two parts with no effect on the liability:

                          $90K is yours and $240K is for liability

Assets = Liability (L) + Owner/Equity (O/E)

If your Assets change, O/E can be changed. This change is caused by the market condition. But
you keep the liability which is unchangeable.

Assets (A) – Liability (L) = Owner/Equity (O/E) in this case it is 90K

The new margin is:

        90/330 * 100 = 27.3%

        The return on this investment is: (90-60)/60 * 100 = 50%.

This happens with only a 10% increase on the value of the house. This is caused by margin

But if the value of the house has dropped by 10%.

The new value of the house is:

        270K (L=240K and O/E = 30K) the return on the investment is then:

                (30-60)/60 = -50%.

Once again due to margin leverage, you have is a big loss. On conclusion leverage is riskier.


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