Money and Banking Chapter 9: Derivatives: Futures, Options, and Swaps

Two types of calls and puts

-American options: can be exercised on any date from the time they are written to the expiration date -European options: can be exercised only on the day they expire

Characteristics of Forwards and Futures

-No payments are made when contract is agreed to -The seller/short position benefits from declines in the price of the underlying asset -The buyer/long position benefits from increases in the price of the underlying asset -The two parties each make an agreement with a clearing corporation --->clearing corporation operates like a large insurance company and is the counter party to both sides of the transaction (they guarantee that the parties will meet their obligations by requiring them to make deposit--called posting margin in a margin account) --->this lowers the risk buyers and sellers face --->the clearing corporation has the ability to monitor traders and the incentive to limit their risk taking

If the price of a specific bond is higher in one market than in another:

-The arbitrageur can buy at the low price and sell at the high price -This increases demand in one market and supply in another -The increase in demand raises price in that market -The increase in supply lowers price in the other market -This continues until prices are equal in both markets

Derivatives are different from outright purchases because:

1. Derivatives provide an easy way for investors to profit from price declines 2. In a derivatives transaction, one person's loss is always another person's gain

An option has two parts:

1. Intrinsic Value-value of the option if it is exercised immediately 2. Time value of the option-the fee paid for the option's potential benefits

Derivative

A financial instrument whose value depends on, is derived from, the value of some other financial instrument, called the underlying asset -While derivatives can be used to speculate, or gamble on future price movements, they allow investors to manage and reduce risk

Futures Contract

A forward contract that has been standardized and sold through an organized exchange -The contract specifies that the seller (short position) will deliver some quantity of a commodity or financial instrument to the buyer (long position) on a specific date, called the settlement or delivery date for a predetermined price

Options are...

Agreements between two parties ->seller is an option writer ->buyer is an option holder

Downside of derivatives

Allow individuals and firms to conceal the true nature of certain financial transactions

Forward Contract

An agreement between a buyer and a seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date -Customized, therefore hard to resell

On the settlement or delivery date, the price of the futures contract must _________ the price of the underlying asset the seller is obligated to deliver

Equal -if not, then it would be possible to make a risk-free profit by engaging in offsetting cash and futures transactions

Sellers of futures are betting that prices will...

Fall

Put Option

Gives the holder the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date

Option Price =

Intrinsic value + time value of the option

Clearing Corporation

Operates like a large insurance company and is the counter party to both sides of a futures transaction ->guarantee that the parties will meet their obligations by requiring them to make a deposit with the corporation (called posting margin in a margin account) ->posts daily gains and losses on the contract to the margin account of the parties involved (called marking to market) ->if someone's margin account falls below the minimum, the clearing corporation will sell the contracts, ending the person's participation in the market

Buyers of futures are betting that prices will...

Rise

Who sells (writes) a put option?

Someone who: -wants to bet that the market price of the underlying asset will not fall -a broker who is always willing to buy the underlying asset and is paid to take the risk

Who sells (writes) a call option?

Someone who: -wants to bet that the market price of the underlying asset will not rise -a broker who is always willing the sell the underlying asset and is paid to take the risk

Who buys a call option?

Someone who: -wants to buy an asset in the future and insure the price paid will not rise -wants to bet that the price of the underlying asset will rise

Who buys a put option?

Someone who: -wants to sell an asset in the future and insure the price paid will not fall -wants to bet that the price of the underlying asset will fall

Arbitrage

The practice of simultaneously buying and selling financial instruments in order to benefit from temporary price differences

Call Option

The right to buy, "call away", a given quantity of an underlying asset at a predetermined price, called the strike price, on or before a specific date

The purpose of derivatives is to....

Transfer risk from one person or firm to another

For someone who wants to purchase an asset in the future, a _______________ ensures that the cost of buying the asset will not rise

call option

By shifting risk to those willing and able to bear it, derivatives ______________ the risk-carrying capacity of the economy as a whole

increase

If the price of the stock exactly equals the strike price....

option is "at the money"

If the strike price exceeds the market price of the stock.....

option is "out of the money"

When the price of the stock is above the strike price of the call option....

option is profitable and "in the money"

For someone who plans to sell the asset in the future, a _________________ ensures that the price at which the asset can be sold will not go down

put option