05 Derivatives Flashcards
Derivative - Definition
A derivative is a security that derives its value from the value or return of another asset or security (the so called underlying)
Derivative markets
- Marked by high leverage -> risky
- Provide price information
- Allow for management of risk -> hedging
- Reduce transaction costs
Exchange Traded Derivatives
- Standardized
- Backed by a clearinghouse
- Options and futures
Over-the-counter derivatives
- Unregulated
- No clearinghouse (-> default risk)
- Custom instruments created and traded between two counterparties
- Options, forwards, and swaps
Forward Commitment
Legally binding promise to perform some action in the future
Can be written on equities, indices, bonds, physical assets or interest rates
- Forward Contracts
- Future Contracts
- Swaps
Forward Commitment - Forward Contracts
One party agrees to buy, and the counterparty to sell, a physical asset or a security at a specific price on a specific point in time in the future
Forward Commitment - Future Contracts
A forward contract that is standardized and exchange traded, regulated, backed by a clearinghouse and requires daily settlement of gains and losses
Forward Commitment - Swaps
A series of forward contracts, mainly on interest rates, different currencies, or equity returns
Contingent Claims
- A claim to payoff that depends on a particular event
- Options are contingent claims that depend on a stock price at some future date
- In contrast to forwards, futures and swaps, where payments are made in both cases, upward and downward movements, contingent claims only require a payment if a certain threshold price is broken
- It takes two options to build a forward or a future
Concept of Arbitrage
- Arbitrage is a very important concept in valuing/pricing derivative securities
- If a return greater than the risk-free rate can be earned by holding a portfolio of assets that produces a certain riskless return, an arbitrage opportunity arises
- Arbitrage opportunity: A situation where a return greater than the risk-free rate can be generated without incurring any risk (riskless return)
- Arbitrage is based on the law of one price
Arbitrage - Law Of Price
Arbitrage is based on the law of one price
- Two securities or portfolios that have identical cash flows in the future, regardless of future events, should have the same price
- Example: If securities A and B have identical future payoffs, and A is priced lower than B, buy A and sell B short
No-Arbitrage Principle
- There should not be a riskless profit to be gained by a combination of the analyzed contract with positions in other assets
- If there were any arbitrage opportunity, market participants would exploit them and therewith bring the market back to an equilibrium without arbitrage opportunities
- No-arbitrage pricing is crucial to the determination of the value of all derivative instruments
No Arbitrage Principle - Assumptions
- No transaction costs
- Short sales are possible without restrictions
- Borrowing and lending without restrictions at risk-free rate
Forwards - Definition
A bilateral contract that obligates one party to buy and the other party to sell a specific quantity of an asset at a set price on a specific point in time in the future
- Forwards exist on physical assets and on financial assets
Why do parties enter a forward contract?
- Speculate on the future price (betting)
- Hedge the risk they already have and eliminate uncertainty about the future price
Forwards - Long and Short Position
- The party that agrees to buy the asset has a long position (called the long)
- The party that agrees to sell the asset has a short position (called the short)
- Both parties are exposed to default risk (i.e. probability that the counterparty will not perform as promised)
- Normally, no cash is paid to enter into the contract at its inception
- At any time, one party will have a negative contract value (“owe money”) and the other side a positive contract value of an equal amount
- Example: Party A agrees to buy a $1.000 face value, 90-day treasury bill from party B in 30 days from now at a price of $990
Settlement Options of a Forward Contract
- Delivery
- Cash Settlement
- Termination
Settlement Options of a Forward Contract - Delivery
The asset is delivered at the settlement date to the specified price
Settlement Options of a Forward Contract - Cash Settlement
- The party that has the position with the negative value is obligated to pay this amount to the other party
- The long (short) receives a payment if the price of the asset is above (below) the agreed upon price
- Ignoring transaction costs, the method yields the same results as asset delivery
Settlement Options of a Forward Contract - Termination
A party can exit the contract prior to expiration by entering into an opposite forward contract (with the same or a third party) with an expiration date equal to the time remaining on the original contract
Equity Forward
- Forward contract where the underlying asset is a single stock or a portfolio of stocks, e.g. an index
- The stock seller can lock in the selling price of the shares
Bond Forward
- Forward contracts on bonds are quite similar to bonds
- In contrast to equities, bonds do have a maturity -> Forward contract must settle before the bond matures
- Risk free bonds are often quoted as a percentage discount from face value
- Because of the possibility of default and embedded options special provisions must be included
Forward Rate Agreement
- Forward rate agreement can be viewed as a forward contract to borrow/lend money at a certain rate at some future date
-
In practice, settled in cash and no actual loan is made at settlement date
-> The creditworthiness of the parties to the contract need not to be considered in the forward interest rate, and a riskless rate as the LIBOR can be specified as floating market rate in the contract - The long position is the party that would borrow money (positive value when specified rate < market rate)
- The short position is the party that would lend money (positive value when specified rate > market rate)
Currency Forward
- One party agrees to exchange a certain amount of one currency for a certain amount of another currency at a future date
- In practice, an exchange rate will be specified at which one party can buy a fixed amount of the currency underlying the contract
- Currency forward can be delivered or settled in cash