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Introduction to Derivatives Chapter 23 & 24

Introduction to Derivatives Chapter 23 & 24. The Nature of Derivatives. A derivative is an instrument whose value depends on the values of other more basic underlying variables. Examples of Derivatives. Forwards Futures Contracts (or Futures) Options Swaps. Ways Derivatives are Used.

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Introduction to Derivatives Chapter 23 & 24

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  1. Introduction to DerivativesChapter 23 & 24

  2. The Nature of Derivatives • A derivative is an instrument whose value depends on the values of other more basic underlying variables

  3. Examples of Derivatives • Forwards • Futures Contracts (or Futures) • Options • Swaps

  4. Ways Derivatives are Used • To hedge risks • To reflect 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

  5. Exchanges Trading Futures • Chicago Board of Trade • Chicago Mercantile Exchange • BM&F (Sao Paulo, Brazil) • LIFFE (London) • TIFFE (Tokyo) • and many more

  6. Exchanges Trading Options • Chicago Board Options Exchange • American Stock Exchange • Philadelphia Stock Exchange • Pacific Stock Exchange • European Options Exchange • Australian Options Market • and many more

  7. Futures Contracts • A futures contract is an agreement to BUY or SELL an asset at a certain time in the future for a certain price • contrast this with a spot contract where there is an agreement to buy or sell the asset immediately (or within a very short period of time)

  8. Futures Price • The futures prices for a particular contract is the price at which you agree to buy or sell • It is determined by supply and demand on the floor of the exchange in the same way as a spot price

  9. Examples of Futures Contracts • Agreement to: • buy 100 oz. of gold @ US$400/oz. in December (COMEX) • sell £62,500 @ 1.5000 US$/£ in March (CME) • sell 1,000 bbl. of oil @ US$20/bbl. in April (NYMEX)

  10. Terminology • The party that has agreed to: • BUY has what is termed a LONG position • SELL has what is termed a SHORT position

  11. Example • January: an investor enters into a long futures contract on COMEX to buy 100 oz of gold @ $400 in April • April: the price of gold $415 per oz What is the investor’s profit?

  12. A CALL is an option to BUY a certain asset by a certain date for a certain price A PUT is an option to SELL a certain asset by a certain date for a certain price Options

  13. A FUTURES contract gives the holder the OBLIGATION to buy or sell at a certain price An OPTION gives the holder the RIGHT to buy or sell at a certain price Futures vs Options

  14. Over-the-Counter MarketsForwards and Swaps • Contracts are agreed to on the phone (not on the floor of the exchange) • Contracts are between two financial institutions or between a financial institution and a corporate client) • Strike price and maturity of option do not have to correspond to those specified by exchange

  15. Types of Traders • Hedgers • Speculators • Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

  16. Hedging Examples • A US company will pay £1 million for imports from Britain and decides to hedge using a long position in 16 futures contracts • An investor owns 500 IBM shares currently worth $102 per share. A put with a strike price of $100 costs $4. The investor decides to hedge by buying 5 contracts (Protective Put)

  17. Speculation Example • An investor with $7,800 to invest feels that Exxon’s stock price will increase over the next 3 months. The current stock price is $78 and the price of 3-month options with a strike of 80 is $3 • What are the alternative strategies?

  18. The Futures Price of Gold If the spot price of gold is S & the futures price 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. Example: S=390, T=1, and r=0.05 so that F = 390(1+0.05) = 409.50

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