Derivatives: Introduction

Front 1

Three different perspectives of derivatives:

Back 1

1. Users:
-corporations
-investment managers
-investors
2. Intermediaries:
-Dealers: Market-makers-> Buy & re-sell
-Brokers: matchmakers between buyers and sellers ->earn commissions
3. Observers
-regulators
-researchers

Front 2

OTC

Back 2

-A computer and telephone-linked network of dealers at financial institutions, corporations, and fund managers
-Contracts are negotiated
E.g: forward contracts -> usually conducted with good credit corporations.
-Credit risk of the counter party

Major issues for the OTC contracts:
-Credit check
-Collateral

Front 3

Types of Traders

Back 3

1. Hedgers - Lock in price to reduce/eliminate risk. Offset-exposure

2. Speculators - Bet on the future direction of the market.

3. Arbitrageurs - Take advantage of price differences across markets.

-Forward contracts for hedging: neutralize risk

-Option contracts: provide insurance; still benefit from favorable price movements.

Front 4

A forward contract specifies:

Back 4

-The features and quantity of the asset to be delivered.
-The deliver logistics, such as time, date, and place
-The price the buyer will pay at the time of deliver called Delivery Price

Front 5

Payoff on a Forward Contract:
Long and Short positions

Back 5

Long Forward = Spot price at expiration - Forward price =S(T) - K

Short Forward = Forward price - Sport price at expiration =K - S(T)

Front 6

Features of option

Back 6

1. Premium = price of the option: call option price decreases as strike price increases
2. Put option price increases as strike price increases
3. As time to maturity increases, both option prices increase
4. 1 option = 100 shares

Front 7

Why short-sell?

Back 7

1. Speculation - bearish
2. Financing
3. Hedging - offsetting position

Front 8

Credit risk in short-selling

Back 8

Cash or securities which are subject to a discount known as "haircut".

Front 9

Payoff of shortselling stock for 90 days

Back 9

Payoff = +S(o) -S(90) -D