A series of logically arranged questions and answers designed in response to a simulated readers' mind. The book covers the entire gamut from valuation and hedging and speculation related issues to the intricacies of order placement and execution on future exchanges. While emphasizing conceptual clarity, it does not shy away from discussing intricate technicalities where the authors think that such coverage is essential to reinforce the presentation. Includes sufficient examples designed to cater to an international audience.
Chapter 1: The Fundamentals.The chapter starts with an introduction to futures and forward contracts, options, and swaps. The similarities and differences between forward and futures contracts are clearly highlighted. The role of the clearinghouse and the related issues of margining and marking to market are covered in detail. Futures contracts which permit multiple grades to be delivered are explained with suitable illustrations and the systems of multiplicative and additive price adjustments are highlighted. Delivery related issues are covered in adequate detail, both from a cash as well as delivery settlement standpoint. The difference between the concepts of 'Trading Volume' and 'Open Interest' is clearly brought out. The chapter rounds off with a discussion of the economic role of derivatives and the reasons for their growing popularity.Chapter 2: Valuation.The chapter begins by elucidating the Cash and Carry and Reverse Cash and Carry strategies used to derive the no-arbitrage futures price. Unlike most textbooks, the principles of short selling which are central to the Reverse Cash and Carry strategy, are presented in detail. The no-arbitrage arguments are then extended to assets making payouts, and physical assets. The concepts of Investment and Convenience assets are highlighted, and the principle of quasi-arbitrage is presented.The chapter then goes on to look at the issue of Net Carry, and illustrates the concepts of Backwardation and Contango markets. The chapter rounds off with a discussion of Normal Contango, Normal Backwardation, and the unbiased expectations theories, and extends the Capital Asset Pricing Model to futures contracts.Chapter 3: Hedging & Speculation.The use of futures contracts as potential hedging tools for both longs and shorts is clearly highlighted. The mechanics of hedging with futures is compared and contrasted with hedging strategies using options contracts. The concept of a 'Perfect Hedge' is defined, and the necessary conditions required to obtain such a position are outlined. The concept of the 'Basis' is defined, and the issues pertaining to 'Basis Risk' are highlighted. The chapter also clearly illustrates the strategies of 'Rolling a Hedge Forward' and 'Tailing a Hedge'.The focus then shifts to speculation. The use of futures contracts as tools for speculation is highlighted, and the mechanics of speculating with futures is compared with speculative strategies using options.Chapter 4: Orders & Exchanges.The chapter opens with a discussion of limit orders and market orders. The concept of a limit order book is explained, with a detailed illustration highlighting how the priority rules are applied, and how order matching takes place. The potential uses of marketable limit orders, stop orders, stop-limit orders, and market-if-touched orders are presented. The specification of validity conditions for orders is discussed.The chapter then goes on to discuss the open-outcry system of trading and its relative merits and demerits vis-a-vis electronic trading systems.Chapter 5: The Underlying Financial Assets: Key Concepts.The chapter commences with a discussion of equity shares and related corporate actions such as stock dividends, splits and reverse splits, and pre-emptive rights. It also discusses how single stock futures contracts are adjusted for such corporate actions. The focus then shifts to stock market indices. The computational principles behind price weighted, value weighted, and equally weighted indices are highlighted. The construction of tracking portfolios to mimic these index types is also discussed. Debt securities are the next issue that is studied. The principles of bond valuation, and the related concepts of day count conventions, and accrued interest, are expounded in detail. The concept of duration is presented. The discussion rounds off with a discussion of T-bills, Eurodollars, and Federal Funds. The last issue that is briefly discussed in this chapter is foreign exchanged.
