Intro to Derivatives

Intro to Derivatives

1. Derivatives: financial instrument whose value is derived from an underlying asset's value.

   • examples of underlying assets: equity (stocks/indices), fixed income, interest rates, commodities, foreign currencies.
   • examples of derivatives: forwards/futures, options, credit derivatives
   • forwards contracts
     • agreement to buy or sell defined quantity (of real or financial asset) at an agreed date at a price that is agreed upon today.
       • buying/selling underlying asset, at MATURITY date at FORWARD/DELIVERY price
       • BUYER: LONG position and SELLER: short position
       • no money changes hands at contract inception date unlike options
       • unlike options binding for both buyer and seller
     • COMPARING forwards and futures
       • FORWARDS
         • OTC, customisable contract terms, no performance guarantee, subject to counter party default risks, held until maturity typically, settled with physical delivery or cash
           • customise contract size, delivery date, + options all negotiable
       • FUTURES
         • exchange traded, standardised terms, margin requirements, often closed out prior to maturity, typically settled with cash
           • requirements include marking-to-market, initial margin (collateral), margin calls
         • useful if party expects payment in foreign currency in future and wishes to guard against unfavorable movement of the exchange rate in the interim/period before payment is received
       • LONG position
         • you make profit if the spot price at maturity is LARGER than futures price initially entered
           • ST > F = P
         • ST < F = L
       • SHORT position
         • you make profit if the spot price at maturity is LESS than the futures price initially entered
           • ST < F = P
         • ST > F = L
   • mainly used for HEDGING: eliminating or managing risk
   • options
     • an option gives its owner the RIGHT (not the obligation) to buy or sell a real or financial asset on or before a future date at a price agreed upon today
       • buying underlying asset on or before the maturity/expiration date for a STRIKE or exercise price
       • the counter-party of the owner is the WRITER (who is the person who sold the option)
     • CALL options
       • gives owner the right to BUY an asset at strike price on or before maturity date
         • payoff to holder at expiration: max (ST - X,0) = ST - X if ST > X and 0 if ST </= X
     • PUT options
       • gives owner right to SELL asset at strike price on or before maturity date
         • payoff at expiration: max (X - ST,0) = 0 if ST >/= X and X - ST if ST < X
     • BUYER (holder): has a LONG position in contract
     • SELLER (writer) holds SHORT position in contract
     • AMERICAN option allows holder to exercise on any date UP TO and INCLUDING expiration date
     • EUROPEAN option allows holder to exercise only ON expiration date
     • PREMIUM: price of options contract
     • TERMINOLOGY
       • in-the-money
         • payoff would be POSITIVE if immediately exercised
       • at-the-money
         • the exercise price equals current stock price (X=So)
       • out-of-the-money
         • exercise price is higher for a call/lower for a put than current stock price. (CALL: X>So) (PUT: X<So)
       • hedge: reduce risk from adverse market changes e.g. stock index put option
       • speculate: place bet on direction in which investors think market likely to move
       • NOTATION
         • ST (stock price at expiration T)
         • X i(exercise price)