6.4 Options and Derivatives Flashcards
Long Collerup
A long position is one that benefits from a RISE in the assets value.
Short Position
When the benefit is the assets decline.
Typically, the entity borrows the asset.
- Sells the asset at the high price
- Buys and replaces the asset at the lower price when it falls.
Derivative Instrument
Definition
Transaction in which parties Gain or Loss is derived from an Economic Event. eg price of a given stock, foreign exchange rate, price of a certain commodity.
One party enters to Speculate (incur risk), other to Hedge (avoid risk)
They are a type of Financial Instrument (along with cash, a/r, N/R, Bonds, preferred shares, common shares, etc) Not claims on Business Assets like Equity Securities.
Hedging
Using Offsetting committments to avoid the impact of adverse price movements.
Cash Flow Hedge
Definition
A hedge to avoid Risks to Future Cash Flows
Short POSITION
A person who is going BUY an asset in in a SHORT POSITION..
They hope the price will fall. Benefits from a FALL.
To protect, enter into an instrument whose VALUE RISES if the Asset’s Value Rises
A WHOLESALER hopes corn will drop when crops ready. To Protect,
buys a LONG HEDGE.
Fair Value Hedge
Definition
Natural Hedge
Definition
Hedges the exposure to changes in Fair Value of an ASSET or LIABILITY
Natural Hedge relies on NORMAL OPERATIONS to mitigate risk.
Not sophisticated financial products. eg FINANCING of long-lived equipment with same period as expected life of equipment.
Options
Definition/Notes
- most Common form of Derivatives
- Person who BUYS, has the right to DEMAND counterparty perform some Action on or before specified date.
- Exercise of option is at discretion of option holder (BUYER). Seller has NO CHOICE.
- Options have EXPIRATION DATES
- –European Option: Can ONLY be exercised on EXPIRATION DATE
- –American Option: On or Before expiration date
Covered versus Uncovered Options
Covered: Writer (Seller) owns the underlying
Uncovered: is Speculative. Seller does not own the underlying. Has to acquire at UNKNOWN PRICE to satisfy obligation of option contract
Options Exercise Price (def) Option Price (def)
Exercise Price (Strike Price) : Price AT WHICH owner of option can buy or sell ASSET underlying the option contract
Option Price (Option Premium): Amount buyer pays to ACQUIRE OPTION
Options are classified by underlying assets
types
Stock Option: Traded Stock
Index Option: underlying asset is a Market INDEX
LEAPS (Long-Term Equity Anticipation Securities)
- long term Stock or Index with expiration up to 3 years away.
Foreign Currency Options: Holder has right to BUY foreign currency at a specific Exchange Rate.
Call Options
Def and notes
Holder as right to purchase (right to Call) underlying at fixed price.
If underlying is above Exercise>In the money. Can buy underlying cheaper than market price.
If underlying is less than exercise, Out of the money. Not worth exercising.
At the money is exercise = market
Intrinsic Value of Call Option
Def
Price of underlying less exercise price. Can’t be less than zero. B.
Seller (Writer) of Call Option
Notes
In a Short Position
Hopes price of underlying remains below exercise
Seller/Buyer have opposite positions
Call Option BUYER
Formula for Gain(loss)
Units of Underlying x
Excess market over exercise - Option Price
