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Financial Derivatives

Financial Derivatives. Chapter 13 Week 2. Definition. A derivative is a financial instrument whose value depends on (or derives from) the value of another instrument (the underlying). Example: the value of a stock option depends on the value of the underlying stock.

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Financial Derivatives

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  1. Financial Derivatives Chapter 13 Week 2 Maclachlan, Money & Banking Spring 2006

  2. Definition A derivative is a financial instrument whose value depends on (or derives from) the value of another instrument (the underlying). Example: the value of a stock option depends on the value of the underlying stock. Maclachlan, Money & Banking Spring 2006

  3. Three Basic Types of Derivatives • Futures/Forwards • Options • Swaps Derivatives can be created through combining the basic types, e.g., swaptions, futures options. Maclachlan, Money & Banking Spring 2006

  4. Forward Contracts • Began as a way for farmers to hedge risk. • Suppose price of wheat could be $10 a bushel or $20 a bushel, depending on the weather. • How could farmer hedge? • Currency and interest rate forward contracts. Maclachlan, Money & Banking Spring 2006

  5. Futures Contracts • Standardized. • Exchange traded and insured. • Marked to market, margin requirements. • Highly liquid. • Open outcry http://www.nymex.com/media/sounds1.wav Maclachlan, Money & Banking Spring 2006

  6. http://www.nymex.com/lsco_pre_agree.aspx Maclachlan, Money & Banking Spring 2006

  7. Forward Contracts Customized Arranged by bankers. Subject to counterparty risk Illiquid Futures Standardized Exchange traded Insured, margin requirements Liquid Marked to market Comparison Maclachlan, Money & Banking Spring 2006

  8. Hillary Clinton’s 1979 Investment in Cattle Futures "It's a mockery of the profession to say you took a thousand dollars and made a hundred thousand," says Joe Gressel, a 19-year veteran of the Merc's trading pits. "Around here," he adds, in a sentiment echoed by some of his colleagues, "we're flabbergasted that she's bamboozled the people of New York state." Maclachlan, Money & Banking Spring 2006

  9. Options • Right but not the obligation to buy (sell) an underlying instrument at a prespecified price. • Call vs. put. • Strike (or exercise) price. • Price of underlying vs. price of option. • Hockey stick diagrams. Maclachlan, Money & Banking Spring 2006

  10. Swaps Swaps originated in the early 1980’s to hedge interest rate risk. The notional principal outstanding of swaps and other over-the-counter (OTC) derivatives, stood at $197 trillion at the end of December 2003. Maclachlan, Money & Banking Spring 2006

  11. Swaps • Allows a floating rate borrower to get a fixed rate obligation. • Longshore Construction can only get a loan from the bank at a floating rate. • Sallie Mae can issue long-term bonds to investors at a fixed rate. • How can they both benefit through trade? Maclachlan, Money & Banking Spring 2006

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