A Financial System That Creates Economic Opportunities • Capital Markets
110
Types of Derivatives
Derivative Features Simplified Example
Futures
Contracts
248
n
A highly standardized, exchange-traded
contract to buy or sell a commodity for
delivery in the future
n
The exchange specifies certain
standardized features of the contract, such
as quality and quantity of goods to be
delivered
n
Both buyer and seller are obligated to
fulfill the contract at the price agreed at the
initiation of the contract, whether profitable
or not
n
May be settled by delivery of the
underlying commodity, by cash, or by
purchasing an offsetting contract through
the exchange
n
Regulated by the Commodity Futures
Trading Commission (CFTC) (exclusive
jurisdiction)
An airline that expects fuel prices to rise
wants to hedge its costs for an upcoming
purchase of jet fuel. To do so, the airline
takes a long position in exchange-traded,
cash-settled oil futures contracts that are
correlated with cash-market jet fuel prices.
When it is time to purchase the jet fuel, the
airline takes an offsetting short position in
the oil futures contracts. If oil prices have
increased, the airline will earn a profit on
its oil futures position, which should serve
to offset the “loss” arising from purchasing
the jet fuel it needs at the higher price.
The converse happens if oil prices have
decreased. The better the correlation
between the cash and futures markets
prices, the more effective the hedge will be.
Options
n
A contract that gives the buyer the right,
but not the obligation, to buy (a call option)
or sell (a put option) a specified quantity
of a commodity or other instrument at a
specific price within a specified period of
time, regardless of the market price of that
instrument
n
The buyer of an option pays a premium for
the right to buy or sell
n
Traded both on exchanges and over-the-
counter
n
Regulated either by the CFTC or the
Securities and Exchange Commission,
depending on underlying asset or index
A currency trader believes the U.S. dollar/
euro exchange rate is trending upward.
Hoping to profit from her view, she buys
a call option on euros expiring in three
months which gives her the right, but
not the obligation, to buy euros at the
option’s strike price. The trader has to pay
a premium for this right. (Conversely, the
seller of the option receives the premium,
but is obligated to sell euros at the strike
price if the trader exercises the option.)
Three months later, if the U.S. dollar/euro
exchange rate is above the strike price (i.e.,
the option is in-the-money), the trader will
exercise the option and realize a gain on
the currency trade. Her gain, however, is
offset by the premium she paid for the call
option. She will not exercise the call option
at maturity if the U.S. dollar/euro exchange
rate is below the strike price (it is out-of-the-
money), in which case her loss is limited to
the premium paid.
248. The CFTC and the SEC jointly regulate “security futures,” a statutorily defined separate class of deriva-
tives. Security futures are contracts for the sale or future delivery of a single security or of a narrow-based
security index and can be based on a variety of reference securities or prices.