Lecture 9 Flashcards
Derivative
Plain vanilla definition
a term to describe any tradable asset, or financial instrument, in the financial world that is the simplest, most standard version of that asset. It can be applied to specific categories of financial instruments such as options or bonds, but can also be applied to trading strategies or modes of thinking in economics.
Plain vanilla derivatives examples
Call optinon definition
A call option is an agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period.
It may help you to remember that a call option gives you the right to call in, or buy, an asset. You profit on a call when the underlying asset increases in price.
Swaps definiton
A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable, that is, based on a a benchmark interest rate, floating currency exchange rate or index price.
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter contracts between businesses or financial institutions.
Exotic derivatives definition
Underlying definition
In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the (former) derivative depend on the value of this underlying. There must be an independent way to observe this value to avoid conflicts of interest.
Uses of Derivatives
- Hedging: Reduce/eliminate the risk of an existing position.
- Speculation: Take a risky position (a risky “bet”).
Future contracts introduction
Notations:
Physically-settled contracts definition
involve actual delivery at maturity. i.e., the seller delivers the underlying asset (e.g., stock, commodity) to
the buyer at the pre-agreed (forward) price, as discussed so far.
Cash-settled forward contract definition
the two parties settle their gains and losses at maturity through cash.
Pricing forward contracts
it means finding the “fair” forward price. Taking the current spot price S as given, the “fair” forward price can
be determined by no-arbitrage.
No-arbitrage principle
Two securities or portfolios of securities with the same cash flows must have the same value.
⇒ This will pin down F.
Forwards on Non-Dividend-Paying Stocks — no-arbitrage forward price is
Forwards on Dividend-Paying Stocks — the no-arbitrage forward price is
where I is the PV (at the riskless rate) of the dividends to be received until maturity.
Forwards on Commodities — no-arbitrage forward price becomes
where C is the PV (at the riskless rate) of the cost of storage until maturity.
The marked-to-market value of your position is
Futures contract
