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Introduction

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Introduction

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    1. 1.1 Introduction What are Derivatives? Derivatives are zero net supply bilateral contracts deriving their values from some underlying asset, reference rate, or index.

    2. 1.2

    3. 1.3 Ways Derivatives are Used To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another

    4. 1.4 Forward Contracts Obligates one party to buy (the long position) and the other party to sell (the short position) an asset or commodity in the future for an agreed-upon price. Physical delivery contract Cash-settled contract Trade only in an over-the-counter (OTC) market communication among traders is over the phone Examples: buy 5,000 oz. of gold @ US$400/oz. in one year sell 1,000,000 @ 1.5000 US$/ in six months earn a 4% rate of interest on a US$ deposit for a 3-month period starting in six months

    5. 1.5 How a Forward Contract Works The contract is a private agreement between two counterparties Normally, the price in the contract is chosen so that the contracts initial market value is zero => no money changes hands when first negotiated & the contract is settled at maturity Think about a forward contract as the decision to delay the sale or purchase of an asset three months, for example, from today.

    6. 1.6 Futures Contracts Like a forward: Obligates one party to buy (the long position) and the other party to sell (the short position) an asset or commodity in the future for an agreed-upon price. Physical delivery contract Cash-settled contract Unlike a forward: Trade on a futures exchange and are subject to daily settlement Evolved out of forwards and possess many of the same characteristics

    7. 1.7 Exchanges Trading Futures Chicago Board of Trade Chicago Mercantile Exchange LIFFE (London) Eurex (Europe) BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more (see list at end of book)

    8. 1.8 Options An option gives its owner the right to purchase or sell an asset on or before some date in the future. Call versus Put options American and European Options Physical delivery versus cash-settled options

    9. 1.9 Exchanges Trading Options Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange Pacific Exchange LIFFE (London) Eurex (Europe) and many more (see list at end of book)

    10. 1.10 Main Differences between Options and Futures: Hedging Strategies

    11. 1.11 OTC vs. Exchange-Traded Derivatives: Contract Characteristics Exchange-Traded Terms specified by listing agents (i.e. exchange) The main non-standard item in most exchange-traded derivatives is the price, which is determined in the market place Pure open outcry (CME) Physical delivery mkt (CBOE) Electronic dealer market (AMEX) Electronic limited order book (Sydney Futures Exch.) OTC Specific terms defined exclusively by the two counterparties General terms set forth in pro forma documentation called master agreements Can be customized through annexes to master agreements

    12. 1.12 OTC vs. Exchange-Traded Derivatives: Market Characteristics Exchange-Traded Organized market with specific and detailed trading rules Exchange defines the rules of the game and enforces them Highly transparent Quotes and prices are available very rapidly by numerous services OTC Deals are negotiated in opaque market Dealer market where brokers and dealers make two-way markets Sometimes brokered Often lacks transparency, esp. for customized and new transaction prices Plain vanilla products are more standardized

    13. 1.13 Types of Traders Hedgers mainly interested in protecting themselves against adverse price changes want to avoid risk Speculators hope to make money in the markets by betting on the direction of prices accept risk Arbitrageurs arbitrage involves locking into riskless profit by simultaneously entering into transactions in two or more markets

    14. 1.14 Hedging Examples A US company will pay 10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract An investor owns 1,000 Microsoft shares currently worth $73 per share. A two-month put with a strike price of $63 costs $2.50. The investor decides to hedge by buying 10 contracts

    15. 1.15 Speculation Example An investor with $4,000 to invest feels that Amazon.coms stock price will increase over the next 2 months. The current stock price is $40 and the price of a 2-month call option with a strike of 45 is $2 What are the alternative strategies?

    16. 1.16 Arbitrage Example A stock price is quoted as 100 in London and $172 in New York The current exchange rate is 1.7500 What is the arbitrage opportunity?

    17. 1.17 1. Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$390 The quoted 1-year futures price of gold is US$425 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?

    18. 1.18 2. Gold: Another Arbitrage Opportunity? Suppose that: The spot price of gold is US$390 The quoted 1-year futures price of gold is US$390 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity?

    19. 1.19 The Futures Price of Gold If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) risk-free rate of interest. In our examples, S=390, T=1, and r=0.05 so that F = 390(1+0.05) = 409.50

    20. 1.20 Derivative Resources on the Web Exchange information and contract specifications are available for all major exchanges Real-time pricing and volume data Educational tools Futures Exchange or Govt Agency Internet Site New York Mercantile Exchange http://www.nymex.com Kansas City Board of Trade http://www.kcbt.com Chicago Mercantile Exchange http://www.cme.com Chicago Board of Trade http://www.cbot.com Chicago Board Options Exchange http://www.cboe.com Minneapolis Grain Exchange http://www.mgex.com New York Cotton Exchange http://www.nyce.com Coffee, Sugar & Cocoa Exchange http://www.csce.com CFTC http://www.cftc.gov

    21. 1.21 Forward, Futures, and Swaps The first section of the course will cover forward, futures and swaps. Relevant Chapters in Textbook (4th edition) Mechanics of Futures and Forward Markets (Ch. 2) The Determination of Forward and Futures Prices (Ch. 3) Hedging Strategies using Futures (Ch. 4) Interest-Rate Futures (Parts of Ch. 5) Swaps (Ch. 6)

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