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values of other financial instruments or on some measure of the

state of the economy or of nature. The instrument or measure

on whose value the derivative depends is called the

“underlying”.

a derivative.

1

Forward Contracts

which is an agreement to buy or to sell an asset at a specified

time at a specified price.

sell is a short position. The agreed upon price is the delivery

price. The consumation of the agreement is an execution.

analysis is important for developing pricing methods for other

derivatives.

2

Analysis of Forward Contracts

Using standard notation, let K be the delivery price or “strike price”, at

time T , and let Xt be the value of the underlying.

payoff

6 payoff

6

@

@

@

@

@

@

@

- @ -

0 0 @

K XT K

@ XT

@

@

@

@

@

@

long position short position @

@

of XT and of time to settlement.

F0 = X0 erT − K,

where r is the (annual) riskfree rate of growth, and T is the time (in years).

3

Derivatives: Basics

contract that involve

– asset

∗ investment

∗ consumable

∗ income producing

positions, intermediate party, etc.)

4

Derivatives: Basics

or obligation)

a specified time)

of the underlying

5

Types of Derivatives

These variations on the basic forward contract are all interesting. Only a

few of them are actually available.

Some variations are much easier to analyze than others. The simple ones

are interesting for classroom analyses and they may provide useful

approximations for derivatives that are actually available.

(realistically).

For all of them there is a ready market (always) through a third party, and

short sales are possible.

That kind of derivative is a right; not an obligation.

Therefore, a long position is a right and a short position (in the derivative)

is an obligation. The right “expires” at the settlement date.

6

Derivatives That Have Markets

• Stock options

• Index options

• Commodity futures

• Rate futures

7

Uses

investment companies for leverage, hedging, and income.

companies for hedging and speculative income.

speculative income, by investment companies for income, and

by producers and traders for hedging.

income, by investment companies for income and for hedgins,

and by traders for hedging.

8

Types of Common Derivatives

The variations depend on the nature of the underlying.

“call” and the sell side is a “put”.

– Settlement (exercise) is by delivery.

– Exercise can be any time prior to expiration date (“American style”).

“call” and the sell side is a “put”.

– Settlement is by cash.

– Exercise can only be at expiration date.

– Settlement is by delivery.

– Exercise can only be at expiration date.

9

U.S. Stock Options

security exchanges: Amex, CBOE, NYSE, Pacific Exchange,

and Philadelphia Exchange.

All (almost all) options are initiated with and through the

Options Clearing Corporation, owned by the exchanges and

headquartered on LaSalle St.

Futures Trading Commission (the analogue of the SEC). The

SEC also regulates options through its regulatory oversight of

the exchanges.

10

Analysis of Stock Options

forward contracts is that stock options are rights, not

obligations. The payoff therefore cannot be negative.

obtain a stock option.

The profit is the difference between the payoff and the price

paid.

that (real-world) stock options can be exercised at any time

(during trading hours) prior to expiration. We will, however,

often consider a modification, the “European option”, which

can only be exercised at a specified time. (There are some

European options that are actually traded, but they are

generally for large amounts, and they are rarely traded by

individuals.)

11

Analysis of Stock Options

The two sides of a forward contract result in the two types of stock options.

profit

6 profit

6

@

@

@

@

@

@

@

K - @ K -

0 0 @

@

X X

12

Market Models for Derivative Pricing

a riskless asset with price at time t of βt,

and a risky asset with price at time t of Xt.

strategies involving these two assets.

differential equation

dβt = rβtdt,

where r is the instantaneous riskfree interest rate.

equation

dXt = µXtdt + σXtdWt.

13

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