derivatives ch 1
consider a stock that pays no dividend and it worth $60, you can borrow or lend money for a year at 5%. what should the 1 year forward price of the stock be? If the forward price is $67? if the forward price is $58?
$60: 60*.05=3 + 60 = $63 67: 4 58: 5
A clearing house
(which acts intermediary between the two parties) responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery - mitigates counter-party risk
What is the difference between otc market and exchange traded market
- otc is a telephone and computer network of financial institutions, fund managers, and corporate treasures where two participants can enter into any mutually acceptable contact - exchange traded is a market organized by an organization by an exchange where the contracts that can be traded have been defined by the exchange
Spot price of an asset is $100. A trader buys 100 put options a strike price of $100 with option fee of $6. - when will the option be exericised? What will be the net profit to trader if the option is exercised when the asset price is $93?
- when price is less than $100, if price is $100 or greater trader will loses entire $600 fee - payoff per option 100-93=$7 net profit per option 7-6=1 net profit on 100 option 1*100=100
Spot price of an asset is $22. A trader buys 100 call options a strike price of $25 with option premium/fee of $2. When will the option be exercised? What will be the net profit to trader if the option is exercised when the asset price is $30?
- when the price is about $25, if price is $25 or lower trader loses entire $200 fee - Payoff per option= $30-$25 = $5 Net Profit per option = $5-$2 = $3 (as option fee = $2) Net Profit on 100 options = 100 * $3 = $300
Protecting a portfolio against a market meltdown:
: A money manager whose portfolio has reaped huge gains can protect these gains by buying put options.
what is a financial derivative
A financial derivative is a financial instrument whose value is derived from an underlying asset, such as a stock, commodity, currency, or interest rate. Derivatives allow for risk management and speculation, as their value is linked to the performance of the underlying asset. Some common types of derivatives include options, futures, and swaps. They are often used by individuals, corporations, and financial institutions to hedge against price movements or to speculate on future market conditions. However, they can also be complex and carry high levels of risk, making them a controversial aspect of finance.
what is a derivative
A financial product that derives its value from the value of underlying assets such as stocks, bonds, or mortgages
hedging output price risk - gold
A gold-mining company can fix the selling price of gold by selling gold futures
Hedging Interest Rate Risk - pension fund
A pension fund manager who is worried that her bond portfolio losing value in rising interest rates can use Eurodollar futures to protect her portfolio
otc contracts
Are privately negotiated and traded directly between two parties without going through any intermediary. - offer flexibility - subject to counter party risk - forwards contracts, swaps, exotic options, and other exotic derivatives - much larger than exchange
price discovery and market efficiency
Derivatives provide valuable information about the spot price and the volatility (risk) of the underlying asset Existence of arbitrage opportunities between spot and derivative markets enhances market efficiency
how are derivatives traded
Exchange-Traded Derivatives: These are derivatives that are traded on organized exchanges, such as stock exchanges or commodity exchanges. Examples include stock options and futures contracts. These derivatives are standardized, and the terms and conditions of the contract are set by the exchange. Exchange-traded derivatives provide transparency and a level of standardization, making them a popular choice for many investors. Over-The-Counter (OTC) Derivatives: These are derivatives that are traded directly between two parties, without the use of an exchange. OTC derivatives are often customized to meet the specific needs of the parties involved, and as a result, they are not as standardized as exchange-traded derivatives. OTC derivatives can be less transparent and carry a higher level of counterparty risk, as there is no central clearinghouse to ensure the proper functioning of the trade.
operational advantage of derivative risks
Lower transaction cost Greater liquidity than the spot markets Increase leveraging (or gearing) Ease to sell short Changing the nature of liability / asset
notional value doesn't equal worth of a contract
Notional value (aka principal value) of a contract It is the total value of underlying assets at the spot price
Avoiding market restrictions
One may avoid short selling restrictions that an exchange might impose by taking a sell position in the options or the futures markets.
different applications for derivatives
Risk Management: Derivatives can be used to manage or hedge against risks associated with price movements in the underlying asset. For example, a company that relies on a particular commodity can use commodity futures to hedge against price fluctuations. Speculation: Derivatives can also be used for speculative purposes, allowing investors to profit from price movements in the underlying asset. Portfolio Diversification: By adding derivatives to a portfolio, investors can diversify their investments and potentially increase returns while reducing risk. Price Discovery: Derivatives can be used to help determine the fair value of an underlying asset, as prices in derivative markets can provide information about market expectations for the underlying asset. Improving Liquidity: By creating a market for derivatives, it can increase the liquidity of the underlying asset, making it easier to buy and sell the asset. Arbitrage: Derivatives can also be used to take advantage of price differences in related markets, known as arbitrage, which can help to ensure that prices stay efficient and aligned with underlying fundamentals.
exchange traded contracts
Standardized contracts that are defined by the exchange. The exchange establishes: The terms of contract-contract size, time period etc. A clearing house (which acts intermediary between the two parties) responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery - mitigates counter-party risk Margin requirements Daily settlement procedures Trading practices, etc Overall: Less flexibility (in terms of conditions of contract) but has no counter-party risk.
different assets that can be hedged
Stocks: Hedging stock investments can help mitigate the risk associated with market movements. Commodities: Commodities such as oil, gold, or agricultural products can be hedged using futures contracts to protect against price fluctuations. Foreign currency: Companies and investors can hedge against currency risk by using currency derivatives, such as currency forwards, options, or swaps. Interest rates: Interest rate derivatives can be used to hedge against changes in interest rates, for example by using interest rate swaps. Real estate: Real estate developers can hedge against changes in property prices by using derivatives such as real estate swaps or options.
Plain Vanilla Interest Rate Swap
Suppose two companies wish to borrow money. One company, say ABC, prefers fixed rate borrowing but has a comparative advantage in floating rate market. Other company, say XYZ, prefers floating rate but has a comparative advantage in fixed rate market. This is where swap comes in. ABC can borrow floating rate and XYZ can borrow fixed rate, and they can agree to swap cash flows (interest payments) in future. - borrow in the market of their competitive advantage
short position
The party that has agreed to sell
Gold $1000 (spot price) The quoted one-year futures price of gold = $1100. The one-year interest rate = 5% per annum. No income or storage-cost for gold Is there an arbitrage opportunity?
Today: Borrow $1000 and buy gold in spot market Enter into 1-year futures in which you sell gold in future Later: Sell gold at $1100 (forward contract price) Return 1000*1.05 = $1050 to lender 1100-1000=$50 is your risk-less profit !!
commodity derivatives
Variation in prices of commodities - corn, wheat, coffee, etc....copper, gold, silver, etc....crude oil, natural gas, etc
Explain carefully the difference between hedging, speculation, and arbitrage. hedging
a trader is hedging when she has an exposure to the price of an asset and takes a position in a derivate to offset the future
hedging using options
adding in how much shares can be sold at a set price by buying put options - provide insurance - protect investors against adverse price movements in the future while allowing them to benefit from favorable price movements - upfront fee
why engage in a future commitment?
allows both parties to eliminate price risk
Hedging Currency Risk - cereal
american manufacturer importing machines from Germany for which payment is due in 3 months can remove price risk from the dollar-euro exchanges rate by buying currency forward contract.
futures contract
an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price - normally traded on an exchange CBOE, CME
forward contract
an agreement to buy or sell an asset at a certain future time for a certain price OTC
spot contract
an agreement to buy or sell an asset immediately
When first issued, a stock provides funds for a company. Is the same true of an exchange-traded stock option?
an exchange traded stock option provides no funds for the company. it's a security sold by one investor to another
speculators
bet on the future direction of market variable to go up or down acquiring risk rather than hedging against it
swaps
binding agreements b/w two companies to exchange CFs in the futures - not available to retail investors ex. two friends agree to swap seats on a airplane
options trading
both otc and exhanges
speculation using futures
can have a long futures contract betting on a price movement or purchase in the spot market and hope the price increases loss and gain is very large
speculation and option
can purchase shares or a call option loss limited to the amount paid for options
hedging input costs
cereal manufactures fighting price by corn fluctuations
Pros and cons of forwards
flexibility to negotiate terms of the contract but carries counter party (or credit) risk
foreign exchange derivative
fluctuations in exchange rates hedge against price of a currency
call option
gives the holder the right to buy the underlying asset by a certain date at a specified price
put option
gives the holder the right to sell the underlying asset by a certain date for a specified price
Hedging using forward contracts
goal is to reduce risk. no guarantee that the outcome with hedging will be better than the outcome w/o hedging - meant to neutralize risk by fixing the price that the hedger will pay or receive for the underlying asset
why use a forward contract
hedge foreign currency risk or future price changes
what is the difference between entering into a long forward contract when the forward price is $50 and taking a long position in a call option with a strike price $50
in the first case the trader is obligated to buy the asset for $50 (trader doesn't have a choice). in the second case the trader has an option to buy the asset for $50 (trader doesn't have to exercise the option)
arbitrage
involves taking a position in two or more different markets to lock in a profit
arbitrageurs
locking in a riskless profit by simultaneously entering into transactions in two or more markets profit from price inefficiency in the two markets
pros/cons futuers
loss of flexibility but has lower counter party risk
what is the responsibility of a clearing house in future contracts
makes the traders deposit funds to buy and sell their products at the amount agreed
engagement
not a contract
admission acceptance letter from an university
obligation to school optional to student american style
futures contracts commodities
pork, cattle, sugar, wool, lumber, copper, gold, tin, stock indicies, currencies, treasury bonds
strike price
price i can later buy at (exercising price)
equity derivatives
price risk in individual stocks or stock indices hedging against price of share
return policy at Macys (90 days)
put option american
option premium or fee
received upfront for the sellers compensation for that risk
what is the difference between options and forwards/futures
the holder has the right to do something and doesn't have to exercise that right
long position
the party that has agreed to buy
speculation
the trader has no exposure to offset. she is betting on the future movements in the price of an asset
otc markets
traders working for banks, fund managers, and corporate treasures contact each other directly
credit derivatives
transfers of credit risk someone owes money and someone defaults - buys credit risk
hedging
use derivatives to reduce the risk that they face from potential future movements in a market variable
interest rate derivatives
variation in interest rates 10 yr bond - worry about inc int rates - buy derivative contract that pays off
what are the bid and offer quotes of a market marker in the otc market
when a market maker quotes a bid or offer the bid is the price at which the market maker is prepared to buy the offer is the price where the market maker is prepared to sell
what is the difference between a long forward position and a short forward position
when a trader enters into a long forward contract she is agreeing to buy the underlying asset for a certain price at a certain time in the future. when a trader enters into a short forward contract she is agreeing to sell the underlying asset for a certain price at a certain time in the future