1. Introductory Derivatives - Forwards and futures

Question 1

What is a Derivative?

Answer 1

A derivative is a financial instrument whose value is determined by the price of an underlying asset.

Question 2

Why Use Derivatives?

Answer 2

1. To manage risk. Derivatives may be purchased to reduce risk, which is known as hedging. For example, airlines can hedge against the price of oil by entering into derivatives on oil prices.
2. To speculate. Rather than reducing risk, speculation is making a bet. If an investor believes the price of a stock will decrease in six months, the investor may enter into a derivative that pays off if this happens.
3. To reduce transaction costs. Derivatives can sometimes be used to achieve the same economic outcome that one would get from trading stocks and bonds without actually buying or selling them. This can lower transactions costs.
4. To minimize taxes/avoid regulatory issues. Derivatives may be used to defer taxes or eliminate the risk of owning an asset while keeping the privileges the asset may offer: for example, by eliminating the risk of owning a stock while still owning the stock and keeping voting rights.

Question 3

Who Uses Derivatives?

Answer 3

1. End-users: People who enter into a derivative contract for the reasons above, such as corporations, investment managers, and investors.
2. Market-makers: Intermediaries who aim to make a profit by selling and buying derivatives to and from end-users.
3. Economic observers: Market observers, including regulators who analyze and regulate the activities of end-users and market-makers.

Question 4

Bid Price

Answer 4

The price at which market-makers buy from investors

Question 5

Ask Price

Answer 5

The price at which market-makers sells to investors

Question 6

Bid-Ask Spread

Answer 6

Bid-Ask Spread = Ask Price – Bid Price

Question 7

Process of Short-Selling

Answer 7

1. Borrow shares of stock now. You find someone to lend you the shares of stock, and promise to return them at a later time.
2. Immediately sell the borrowed stock. You will receive funds from this sale.
3. Buy the shares back. At a future time, buy the number of shares needed and return them to the lender, called covering or closing the short position.

Question 8

Short-Sale Proceeds

Answer 8

The lender will want to hold on to the proceeds or let a designated third party hold on to them as collateral.

The proceeds belong to the short-seller, however, and they will be returned to the short-seller when the short-seller successfully returns the borrowed shares back to the lender.

Question 9

Haircut

Answer 9

The additional collateral be set aside to compensate for the risk to the lender.

The haircut belongs to the short-seller, but it will usually be held by the lender or a designated third party. As with the short-sale proceeds, the haircut will be returned to the short-seller when the short-seller successfully returns the stock to the lender.

Question 10

Short Rebate

Answer 10

Interest earned by the short-seller on the collateral in the stock market.

Question 11

Repo Rate

Answer 11

Interest earned by the short-seller on the collateral in the bond market.

Question 12

Lease Rate

Answer 12

The dividends paid to the lender by the short-seller.

Question 13

Payofff

Answer 13

The amount that one party would have if he or she completely cashed out at any given time.It does not consider cash flows on other dates.

Question 14

Profit

Answer 14

Accumulated value of cash flows at the risk-free rate

Question 15

Forward Contract

Answer 15

An agreement between two parties, a buyer and a seller, to exchange an asset on a specified date and at a specified price.

Note that in a standard forward contract, no money is initially exchanged. Money is only exchanged at expiration. On the expiration date of the contract, the buyer is obligated to buy the underlying asset at the forward price, and the seller is obligated to sell at the forward price.

Question 16

Four Ways of Buying a Stock