ch.10 Flashcards
Derivative
financial contact between 2 ppl whose value derived from/dependant on, value of another asset
Underlying asset/security
financial asset (stock, bond, currency, interest ratye, futures contract, equity index) or can be a real asset or commodity (crude oil, gold, wheat)
2 types of derivatives
- Options
2. Forwards
Options
contract between buyer and seller
§ Buyer of option has RIGHT , not obligation to buy/sell underlying asset in future at price agree today
Seller of option is OBLIGATED to complete transaction
§ Option gives owner right to buy-Call option
§ Right to sell- Put option
forwards
contracts between buyer/seller
§ Both OBLIGATED to trade underlying asset in future at price agreed on today
§ Neither party has given other any right, both MUST participate
Forwards features
○ No upfront money req
○ Both parties may make a “performance bond” “ good faith deposit”
Options features
○ Buyer makes pmt when contract drawn up- Premium
○ Premium gives buyer right to buy/sell asset at preset price before expires
exchg traded vs OTC derivatives– flexibility/standardization
○ In OTC market, terms/conditions can be customzed for OTC.
○ Exchange traded derivatives, contracts are standardized, cannot customize
excchag traded vs otc der.- privacyb
○ OTC derivative transaction, neither public nor others know about transaction
Exchanges: all transactions recorded and known to public
exchg traded vs OTC derivatives- Liquidity/offsetting
Otc derivatives cannot be easily terminated or trf to other parties in secondary market
Exchange traded derivatives- can be terminated easily b/c standardizzed and public
exchng traded vs OTC derivatives- Defaukt risk
○ Downside b/c OTC private
default risk
risk one person in contract cannot meet obligation
○ b/c of this risk, dealers do not deal w/ customers that are not credit worthy
Canadian Derivatives Clearing Corp (CDCC)
responsible for clearing Montreal exchange futures, and option trades and ICE clear Canada clears ICE futures Canada trades
exchg traded vs OTC derivatives- Regulation
○ OTC contracts are private and exchange traded contracts public
○ OTC generally unregulated
exchg traded - regulated
types of underlying assets
Commodities
financial assets
Commodities
• Commonly used by producers, merchandisers, processors of commodities to protect against fluctuating commodity prices (soy beans, crude oil, copper, gold)
Financials
Equities
Interest rates
currencies
users of derivatives
○ Individual Investors
○ Institutional investors
○ Businesses/Corporations
Derivatives dealers
use derivatives to speculate on price/value of underlying asset or to protect value of anticipated/existing position
Individual investors
Able to trade exchange traded derivatives only
active investors in exchnage traded options markets and futures market
Speculative strategies only in have high degree of risk tolerance, b/c potential large loss
Institutional Investors
- Incl mutual fund managers, hedge fund managers, pension fund managers, insurance companies, etc
- Use derivatives to speculate and risk management
other uses for derivatives
- market entry/exit
- yield enhancement
- arbitrage
Hedging
attempt to eliminate/reduce risk of holding asset for future sale/anticiaptinf future purchase of asset
market entry/exit
quickly exiting/entering market in conventional way- buying/selling stocks- is expensive
Yield enhancement
investment strategy used to boost returns on underlying investment portfolio
Arbitrage
same asset/commodity traded in different prices in 2 separate markets
What are options
• Option is contract between 2 parties , buyer (long position/holder), and Seller (short position/writer)
- Buyer has right , but not obligated
- Seller OBLIGATED to sell
- Gives holder right to buy, Writer obligation to sell= Call option
- Gives holder right to sell, writer obligation to pay = put option
Strike price (exercise price)
price at which underlying asset can be purchased/sold in future
Option premium
to obtain right to buy/sell underlying asset, option buyers must pay sellers a fee
expiration date
expires at specific/ pre established dates
○ Options listd with relativeley short terms (8mths or less)
Trading unit
describes size or amount of underlying asset represented by one option contract
Premium of option always listed on per unit basis
§ To calculate total premium: premium quote X options trading unit
American style options
can be exercised at any time up to and incl expiration date
European style options
option can be exercised only on expiration date
LEAPS (Long term equity AnticiPation Securities
long term option contracts, offer same risks and reward as regular options
Rights:
privilege granted to existing shareholder to acquire additional shares directly from issuing company
• No cost for shareholders to acquire rights
Exercise price of right= subscription or offering price
Record date
to determine list of shareholder that will receive the rights
○ c/s already in record books on record date receive rights
Ex rights
anyone buying shares at this time does not get the rights
Cum rights
-anyone who buys the stock entitled to receive rights if they hold sock until at least record date
Between day of announcement/record date and ex-rights date= Cum rights
Rights holder 4 options
○ Exercie some/all rights and acquire shares
○ Sell some/all rights
○ Buy more rights to trade, exercise later
○ Do nothing, rights expire– no benefit
trading price of a right
intrinsic value + Time value
Intrinsic value of right during ex- right
- 2 business days before record date, shares trade ex rights
- Intrinsic value of right during ex- right = S - X / n○ s= market price of stock
○ x= exercise/sub price of rights
○ n= number of rights needed to buy 1 share
- Intrinsic value of right during ex- right = S - X / n○ s= market price of stock
Intrinsic value of rights during cum right period
• Intrinsic value of rights during cum right period=
s-x / n + i
Regular delivery
Canadian trading requires rights transaction be settled by 3rd business day after transaction
Warrant
security that gives holder the right to buy shares in company from issuer at set price for set period of time
- • BUT warrants issued by company itslef (options issued by other investors)
Intrinsic value
amount by which market price of underlying C/S exceeds exercise price of the warrant
Time value
amount by which the market price of warrant exceeds intrinsic value
