CFD is an agreement between two parties to exchange the difference in value of the underlying asset, usually a share or index, between the time at which a contract is opened and the time at which it is closed.
Contracts for difference (CFDs) offer great leverage opportunities. This instrument offers the exposure to the markets at a small percentage of the cost of actually owning the share. This allows investors to buy or sell the instrument which usually costs about 10% of the price of the underlying asset.
CFDs have no restriction on the entry or exit price and there is no time limit on when this exchange happens. When applied to equities, CFD is a an equity derivative that offers the possibility to speculate and benefit from the price movements of the underlying assets without having to physically own them.
CFDs are not suitable for “buy and forget” trading
While the contract remains open, your account with the provider will be debited or credited to reflect interest and dividend adjustments. You can choose to “long” or “short” a position – if you are long, you receive dividends and pay interest, if you are short you do the exact reverse. Commission is paid on either side of the contract and you can close a contract at any time.
CFDs are not suitable for the so called “buy and forget” trading or long-term positions. As explained above, each day a long position is maintained will costs money, and there is a time when a CFD becomes expensive to hold. Generally speaking, CFDs have advantages for short-term trading.
Collateralized Debt Obligation (CDO) is a type of asset backed security (ABS) whose value and payment is derived from an underlying pool of fixed income assets.
Compared to other type of ABS securities, CDOs are unique because they represent different types of debt and therefore bare different types of credit risk. These different types of debt are often referred to as tranches that are made available to the investors, where each tranche has a different maturity and risk associated with it. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupons or lower prices to compensate for additional risk they bear. Losses are first borne by the equity securities, next by the junior securities, and finally by the senior securities. Usually, higher risk means lower seniority and higher return on the CDO.
CDOs are typically constructed and issued by Special Purpose Vehicles (SPV/SPE), corporate entities constructed solely with the aim of acquiring and holding assets as collateral, and selling packages of cashflows coming from the underlying portfolio to the investors. Common underlying assets held typically include other mortgage backed securities, commercial real estate bonds and corporate loans.
The CDOs usually mean big money for all parties involved. Originators of the loans were happy because they could turn their assets into cash. Investment Banks were happy because they earned a commission at the time of issue and kept earning management fees during the life of the CDO. Rating agencies were happy because they were paid to rate the tranches (usually not adequatly). Law firms and consultancies were happy because such a complex construtction required complex solutions concerning legal and tax issues. To cut the long story short, the ability to transfer credit risk from the originator of the loans to the investors stimulated the shift of incentive from loan quality to loan volumes – and many people nowdays believe that the whole idea took a wrong turn as contracts of this kind instead of reducing risk through diversification contributed to the spread of risk and uncertainty about the value of the underlying assets.
An option contract is an agreement between a buyer and a seller, that gives the right, but not not the obligation, to the contract buyer to buy or sell the underlying asset at a certain point in future at an agreed price that is called the strike price. The price of the option that buyer of the contract pays to the seller is called the premium.
Holding the call option gives us the right to buy the underlying asset, while holding a put option gives us the right to sell the underlying asset at a predetermined strike price. Holder of the option can decide to exercise the option, or let it expire. Based on the exercise time, we can make a distinction between European and American options. European options can be exercised only at maturity, while American options can be exercised in any moment during the life of the contract.
Specifications of the contract
As mentioned above, options are contracts between two counterparties with the terms of the option specified in a so called term sheet. Although options may be quite complicated, at minimum they usually contain the following specifications: type of the option, whether the option gives the right to buy or sell (call or put), the quantity and the type of the underlying asset, the strike price – the predetermined price at which the transaction will done if the contract is exercised, the expiration date, settlement terms and of course the premium to be paid to the writer of the contract.
Long call positions
Investor holding a European call option can profit from the increase in the price of the underlying at the maturity of the contract. Profit can be made if the spot price of the underlying at maturity (S) is higher than the sum of the strike price (K) and the premium that was paid for purchasing the option.
Call option payoff: max[(S-K);0]
Long Call Position
Long put positions
In a similar way, an investor holding a European put option can profit from the decrease in the price of the underlying at the maturity of the contract. Profit can be made if the strike price (K) is higher than the sum of the spot price at maturity (S) and the premium that was paid for purchasing the contract.
Put option payoff: max[(K-S);0]
Long Put Position
Futures are standardized contracts that give the obligation to buy or sell a predefined quantity of the underlying at a given date in the future, at a market determined price.
Unlike forward contracts that are traded over-the-counter, futures contracts are exchange traded. Consequently, futures are highly standardized in terms of the notional, underlying and maturity. Thanks to the margining mechanism of organized futures exchanges, futures have far less credit risk than the forwards.
Futures prices are not so easy to analyze as forwards, as futures assume a daily settlement while in the case of forwards there is only a single payment at maturity. However, futures and forward prices of a given asset are very close to eachother when the maturities of these two contracts are the same. Therefore, specific formulas for getting the futures price on different underlyings will be presented in separate articles, while this one will serve as a general introduction to futures contracts.
Convergence of the futures prices to the spot price
As the delivery month of a futures contract approaches, the futures price converges to the spot price of the underlying. When the delivery period is reached, the price of the futures contract should be the same or very close to the spot price. If this doesn’t hold, then there is an arbitrage opportunity. By exploiting these opportunities, the price will gradually converge to the spot price.
Standardization of futures contracts
As already mentioned, futures contracts are highly standardized derivatives. Typically, the following elements of the futures contract are subject to standardization: underlying asset (commodities, stocks, rates, etc), type of settlement (cash or physical settlement), notional amount of the contract, currency in which the contract is quoted, delivery month, last trading date, etc…
More about the margining mechanism
To minimize the credit risk to the exchange, futures traders must post a margin which is typically 5%-15% of the contract’s value. To minimize the counterparty risk to futures traders, trades executed on regulated future exchanges are guaranteed by a clearing house. In simple words, the clearing house acts as the buyer to each seller, and as the seller to each buyer. Therefore, in the case of a counterparty default the clearing house assumes the risk of loss.
Where to trade future contracts?
Futures contract are now widely traded all over the world. In particular, CBOT (Chicago Board of Trade), CME (Chicago Mercantile Exchange), LIFFE (London International Financial Futures and Options Exchange), Eurex and many others…
Forward contract is an agreement between two parties to buy or sell an asset at a given future point in time (T) for a predetermined delivery price (K).
Forwards are traded on OTC (Over the counter) markets, usually between two financial institutions or a financial institution and one of its clients. Although the delivery is made in the future, the delivery price is determined on the initial trade date. Therefore, the agreed delivery price should be such that at inception, the value of the forward contract for both parties is equal to zero.
As forwards are a zero sum game as one party takes long and the other party takes a short position, the gain of the buyer is loss for the seller and vice versa. Because of this property, valuation formulas presented later in the text will be assuming a long position. In case you want to get the value of a short position, simply place a minus in front of the formula used for a long one.
Determining forward price and delivery price
It is very important to make the distinction between forward price and the delivery price. When the contract is signed, the forward price for a given date is locked in and it becomes the delivery price. In other words, delivery price is defined as the forward price which makes the initial value of the contract equal to zero.
Depending on the type of the underlying, different formula is used to obtain the forward price of the asset. Although the forward price formula changes with the characteristics of the underlying, the main pricing logic remains unchanged.
The forward (delivery) price for an underlying asset that provides no income, or better to say generates no cash inflows until the maturity of the contract, can be obtained using the following formula:
Forward price for the underlying that provides no income: F(0)=S(0)*e^rT
Where F(t0) is the price of the forward at the inception – at time zero, S(t0) is the spot price of the underlying at the inception, r is the continuously compounded risk free rate of return, and T is the time to maturity.
On the other hand, some assets may pay a known income until the maturity. In this case, we need to account for these known cash inflows and include them in the forward price accordingly. In the case of known income, there are two ways to obtain the forward price: dicrete and continuous.
Discrete – Underlying that provides known income: F(0)=(S(0)-I)*e^rT
Where I is the present value of the discrete income at time t1 (t1<T)
Continuous – Underlying that provides known income: F(0)=S(0)*(r-q)T
Where q is the continuous divident yield over the life of the forward contract.
But that’s not all… Forward prices can also be calculated for commodities, currencies, etc. In each of the cases the formula for obtaining a forward price is different due to the specific properties of the underlying, and these formulas together with much deeper explanations will be presented in separate articles.
Valuation of forward contracts
Depending on the position type, value of a forward contract can be calculated based on the relationship between the delivery price and the spot price at maturity. With respect to the time of the valuation, generally speaking there are three different moments in which we can make the evaluation:
Value of a forward at inception: f(0)=S(0) – K*e^-rT
As S(0) and K*e^-rT are the same, the value of the contract at inception is zero.
Value of a forward at a given time t: f(t)=S(t) – K*e^-r(T-t)
Value of a forward at maturity: f(T)=S(T)-K