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Introduction to Financial Derivatives

Introduction to Financial Derivatives. Lecture #2 Jinho Bae March11, 2008. Terminologies. Suppose that on March 10, 2008, Chul-Soo and Young-Hee agree to buy and sell $100,000 for 96,530,000 won in September 2008. (965.3 won=1$) (1) Underlying asset

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Introduction to Financial Derivatives

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  1. Introduction to Financial Derivatives Lecture #2 Jinho Bae March11, 2008

  2. Terminologies Suppose that on March 10, 2008, Chul-Soo and Young-Hee agree to buy and sell $100,000 for 96,530,000 won in September 2008. (965.3 won=1$) (1) Underlying asset • An asset upon which a futures contract is based. • US $ is the underlying asset for the futures contract above.

  3. Classifications of futures contract by underlying assets • Commodity futures: futures contract whose underlying asset is a commodity such as • crude oil • crop (corn, wheat, coffee) • mineral (iron ore) • gold • Financial futures: futures contract whose underlying asset is a financial asset such as • foreign currency: US $, JPY, Euro • Stock indices: KOSPI 200, S&P 500 • interest rates: 3-Yr Korea Treasury Bond, 5-Yr KTB Visit KRX/Information Center: http://fm.krx.co.kr/index.html

  4. (2) Delivery month (or contract month) • The month in which an asset is delivered to terminate a futures contract • For the futures contract earlier, September 2008 is the delivery month. • For each underlying asset, there are a few given number of contract months. • For US $ futures, 6 contract months are traded. • Currently, March, April, May, June, September, and December 2008 US $ futures are traded on the exchange. • Visit KRX/Information Center: http://fm.krx.co.kr/index.html

  5. (3) Delivery date (or settlement date) • The date during the delivery month when delivery can be made. • The exchange must specify the date. • For US $ futures, the second day following the last trading day. (4) Last trading day • The last day during the delivery month when a contract is traded. • For US $ futures, the third Monday of the contract month.

  6. (5) Futures price • The price for which the underlying asset is exchanged • The price for the futures contract earlier is 965.3 won per dollar. • Futures prices are not fixed but can vary depending on the forces of market demand and supply • Prices on US $ futures are available at http://fm.krx.co.kr/index.html KRX/Information Center/Statistics/Past Traded Futures Series

  7. (6) Long position • A position in an asset which benefits from an increase in the asset price • A long position in a futures contract indicates purchase of the contract • Chul-Soo takes the long position in the futures contract earlier • We can also say Chul-Soo longs a futures contract.

  8. A person with a long position in a futures contract must fulfill her obligation in one of two ways • Sell it before it expires You do NOT have to wait until the expiration day of the futures contract. or • Accept delivery of the underlying asset at the futures price agreed upon when the futures contract was purchased

  9. An example Gil-Dong agrees to buy one August 2008 gold futures contract (equivalent to 1Kg) on March 11, 2008 for 10M won. Two ways in which the investor can close out the contract. • Hold the contract until its expiration. In August, the investor pays 10M won and get 1Kg of gold

  10. Liquidate it by selling before it expires • For example, suppose that the investor sells the Aug. 2008 gold contract on July 11. • Suppose that the Aug. 2008 gold futures contract on July 11 is 11M won. • Therefore, the investor would receive her profit of 1M won.

  11. Short position • A position in an asset which benefits from a decrease in the asset price • A short position in a futures contract indicates sale of the contract • Young-Hee takes the short position in the futures contract at the beginning • We can also say that Young-Hee shorts a futures contract.

  12. (7) Types of settlement • Physical delivery • On delivery date, the underlying asset is delivered from the investor with a short position to the investor with a long position • On Aug. 31, the seller delivers 1Kg of gold to the buyer and the buyer pays 10M won to the seller

  13. Cash settlement • The buyer and seller pay or get the won amount of the difference between the futures price at which the futures position began and the spot price on the last day. • Cash settlement usually occurs for financial futures.

  14. An example of cash settlement Chul-Soo agrees to buy $100,000 for 10M won in September 2008 (1,000won=1$). • The last trading day for the contract is Sep. 16. • Suppose that the spot exchange rate is 1100 won/dollar on the last trading day. • The seller of the contract pays 10000*100=1M won to the buyer of the contract.

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