EC 370 Lesson 8

Margin

a deposit placed by the buyer and seller of future contract with the clearing corporation

Swaps

a financial contract obligating one party to exchange one set of payments for a second set of payments made by a counterparty

European Options

only allow the option holder to exercise the option on the expiration date

Time Value

the value exercising an option in the future

Purpose of a derivative:

transfer risk from one person to another

Intrinsic Value

value of exercising an option right now, the difference between the strike price and the market price (or 0 if at the money or out of the money)

Time value is equal to what at expiration?

zero

For underlying assets that are perishable, the following are the main determinants of the futures price:

- Expected Market Price - Risk Premium

When the underlying asset can be stored and isn't perishable then the futures price is determined based upon:

- Spot Price - Interest Costs - Storage Costs

An underlying asset could be:

- financial instruments like stocks and bonds - a commodity like wheat and orange juice - tied to meteorological events like rainfall and snowfall

3 ways credit default swaps contributed to the financial crisis:

- fostered uncertainty - interconnectedness - easier to assume and conceal risk

Futures Contracts:

- no payments are made initially when eh contract is made - the seller benefits from declines int eh price of the asset - the buyer benefits from increases in the price of the asset

Why on earth would anyone sell an option?!?!?!?!

- speculation - insured against possible losses - supplying the underlying assets

Before expiration, the time value depends on:

- time left - volatility of the underlying asset's price

Clearing Corporation

A middleman to futures contracts. They are the counterpart to both sides of the transaction and they make sure the transactions are carried out smoothly and both sides fulfill their obligations

Option Price =

Time Value + Intrinsic Value

Derivative

a financial instrument whose value is derived from the value of some other financial instrument, which is called the underlying asset

Futures Contract

a forward contract that has been standardized and sold through an organized exchange

Interest-Rate Swap

agreements between two counterparties to exchange periodic interest-rate payments over some future period, based upon an agreed-upon amount of principal

American Options

allow the option holder to exercise the option any day prior to the expiration date

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

Put Option

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

Futures Contracts help the seller....

hedge risk

Credit-Default Swaps

the buyer makes payments to the seller and in exchange the seller pays the buyer if the underlying loan or security defaults

Long Position

the buyer, long here refers to being obligated to buy something in the future

Settlement or Delivery Date

the date the sale is specified for

Arbitrage

the practice of simultaneously buying and selling financial instruments to benefit from temporary price differences; eliminates a rissoles profit opportunity

Call Option

the right to buy a given quantity of an underlying asset at a predetermined price called the strike (exercise) price on or before a fixed date

Short Position

the seller, short refers to being obligated to deliver something whether or not they own it