Derivatives (AssetClasses2) Flashcards
What are Derivatives?
Derivatives are financial instruments (financial contracts), that provide pay offs that depend on the values of other financial instruments
main derivative contracts used by the public and non- financial corporations are bond, index, currency and commodity futures and
options, but there are many other types of derivatives
What are OPTIONS?
An option contract gives the holder the right, but not the obligation, to buy or sell an underlying asset at a** specified price (strike price or exercise price)** before or at the expiration date.
You are NOT buying the stock itself—you’re buying the right to buy or sell it later at a fixed price.
You pay them $5,000 (premium) today to reserve the right to buy the house (stock) for $300,000 anytime in the next six months (expiration date).
This $5,000 is not refundable—if you don’t buy the house, you lose it.
If the house price goes up to $400,000, you still get to buy it for $300,000, making a $100,000 profit
If the house price stays at $300,000 or drops below, you don’t have to buy it, but you lose your $5,000 reservation fee. (you have the call option)
What is premium in OPTIONS?
the cost of the option
the price the buyer pays to the seller (writer) of the option
What happens if the option expires without being exercised?
the buyer looses the premium
buyer pays 5,000 to reserve a house and then never buys it
If the option is exercised, we can have 2 types:
If the option is exercised, the buyer either buys (call option) or sells (put option) the asset at the agreed price.
A Call Option = A coupon that lets you buy a stock at a set price later.
A Put Option = A coupon that lets you sell a stock at a set price later.
Long call formula
How do we calculate how much profit or loss we get from buying a call option?
A Long Call means you bought a call option, hoping the stock price will go up.
r = (P - X) - p
r = Return (profit or loss from the option) 100,000
P = Market price of the stock at expiration 400,000
X = Exercise price (strike price) – the price at which you have the right to buy the stock (el precio que reservas el stock) so 300,00 in house case
p = Premium (the cost you paid for the option) (lo que tienes que pagar para que te den el contrat, reserva) 5,000 in house case
Put Option
A Put Option gives the holder the right to sell an asset at a specified price (strike price) and expiration date. The Put is exercised only if the market price is below the strike at expiration. A buyer of a put benefits from lower prices.
For example, if the strike price (X) is $50, and the market price (P) drops to $40, you can still sell it for $50 by exercising your put option.
Formula for return on a Put Option
r = (X-P) - p
r = Return (profit or loss from the option)
X = Strike price (the price at which you have the right to sell the stock)
P = Market price of the stock at expiration
p = Premium (the cost you paid for the option)
What is the Black-Scholes Model?
most widely used option pricing model
The pricing depends on several key variables: the strike price, the risk-free rate, the volatility of the
stock and the time to expiration.
Traders use options in different ways depending on market expectations:
What does it mean to be bullish? what do bullish people do with puts and calls?
Bullish : Expecting prices of stocks to go up
BUY CALLS (your option will gain value, you say you buy for 300,000 and when you do it is actually worth 400,000 so you gain). It allows you to buy below the market price.
SELL PUTS (you collect the premium, they will probably not sell the stock to you as the value is higher than what you set before)
Traders use options in different ways depending on market expectations:
What does it mean to be bearish? what do bearish people do with puts and calls?
Bearish: Expect prices will go down
SELL CALLS: you are selling someone else the right to buy a stock from you at a predetermined price. You keep the premium.
BUY PUTS: you can sell above market price
What is a Futures contract?
legal agreement to buy or sell a commodity or asset (for physical delivery or, if cash-settled, its value) at a specified delivery or maturity day at a specified maturity date.
Unlike options, which give you the choice to buy or sell, a futures contract is an obligation.
Futures
What does it mean to Go Long or Go Short?
Go Short: you agree to buy the asset in the future
Go Long: you agree to sell the asset in the future
What are the 3 main differences between options and futures?
- Options require premium, futures do not require upfront cost
- Options are an option to buy or sell, futures are an obligation to buy (go short) or sell (go long)
- With options you don’t get the premium back. In futures, if you pay anything upfront, it will be discounted when you buy
