Derivative contracts: underlying subject matter: futures and options examples
Examples of determining the USM of a future or option
A company buys a number of exchange-traded sugar futures, and holds them to maturity, but opts to cash settle rather than take delivery of any sugar. The USM matter of the futures is sugar.
A company enters into a forward contract to buy US$500,000 for delivery in six months’ time, at a rate of US$1.6/£. At the delivery date, the company is therefore obliged to pay £312,500. Because of cashflow problems, it is agreed that the company can issue loan notes to the appropriate value instead of paying cash. The counterparty agrees to accept loan notes with a nominal value of £400,000 - it is agreed that these have a market value of £312,500.
The sole USM of the contract is currency (US dollars) - this is the property whose price and delivery date are agreed when the contract is made. The fact that the company hands over loan notes to settle the contract does not make the loan notes an USM. This would be the case even if it was written into the forward contract that payment would be by means of an issue of loan notes. It is still the price of the US dollars that is determined when the contract is made. The nominal amount of loan notes needed to satisfy that purchase price will vary according to prevailing interest rates and the company’s creditworthiness at the delivery date.
A company enters into a forward contract to buy an option. Under the forward contract, it agrees to pay a specified premium on a specified future date. The option in question is a call option over currency. The USM of the forward contract is therefore also currency.