Chapter 2 - Intro to forwards and options Flashcards
Recall the process of a stock trade
We typically conisder 3 steps:
1) Buyer and seller agree on a price
2) Buyer transfer cash
3) Seller transfer the shares
Why do we care about the process of a stock trade?
Forward contracts work this way, but the transfer of cash and shares doesnt necessarily happen at the same time and right after buyer and seller have located each other and agreed on a price.
Define a forward contract
Set terms today, at which you buy or sell asset at a later point in time.
what does a forward contract entail?
Specify quantity and the exact type of the asset or commodity that the seller must deliver.
Specify delivery logitistics.
Specifies the price that the buyer will pay at the time of delivery (t=T)
Obligates the seller to sell, and the buyer to buy, regardless of outcome.
What is the settlement date for forward contracts called
settlement is called expiration date for the contract
how much premium for forward contracts?
No premium
elaborate on the size of a futures contract
futures contracts are listed with a size multiplier in USD or other currency.
for instance: $250 x index
This means that the size of the position, the notional value, is given by the multiplication.
what’s a mini contract
one fifth in size relative to the regular futures contract
elaborate on the quote prices in regards to futures contracts as they are listed
quote is the price at settlement. It is therefore not likely the same as the spot price. the spot price is today’s price.
elaborate on the two sides of a forward contract
long and short.
The one who buys the asset is the long position. The one who sells the asset is the short position.
generally, what is a long position?
A long position is one that makes money whenver the price of the underlying moves up.
A short position makes money when the price of the underlying moves down.
what is the payoff to a contract?
The value of the position at expiration.
Payoff long forward contract = spot price at expiration - forward price
what is payoff of a short forward position?
Payoff = forward price - spot price at expiration
what is important to understand when consdiering the comparison between outright purchase and forward contract?
At expiration of the forward, we’d own the asset regardless. Both methods give us the asset at the end.
the difference is that when considering payoff, the forward contract includes the initial investment while the outright purchase does not. We say that the financing is different.
elaborate on the benefit of purchasing forward vs outright in terms of final profits
Outright:
Pay spot, hold, get asset.
Forward:
earn interest, pay forward later, get asset.
Since both ways gives the asset at final time, the total cash flow must be the same. Otherwise, there would be an arbitrage opportunity.
As a result, the forward price reflect interest you would earn by waiting to pay.
elaborate more deeply on the two ways to acquire the asset
the book makes a point in considering teh funding.
1)
invest 1000 in zero coupon bonds, along with the forward contract.
2)
Borrow to buy the asset outright.
With 1), we end up with only the index.
With 2), we also end up with only the index.
The differnece is that once of them are funded and the other is not.
what is a profit diagram
subrtacts from the payoff the future value of the investment in the position
what is cash settlement?
forward contract settles with paying cash rather than actual delivery of asset
what are options?
Insurance
