Professional Documents
Culture Documents
Chapter 1
Chapter 1
Introduction
2
Outline
Introduction
Forward Contracts
Futures Contracts
Options
Swaps
3
Introduction
4
Objectives
This segment
Introduces the major classes of derivative securities
Forwards
Futures
Options
Swaps
Discusses their broad characteristics and points of distinction.
Discusses their uses at a general level.
The objective is introductory: to lay the foundations for the
detailed analysis of derivative securities.
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Derivatives
6
Basic Distinctions - I
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Basic Distinctions – II
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Derivatives are BIG Business ...
BIS estimates of market size (in trillions of USD):
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... and a Rapidly Growing One
BIS estimates of market size (in trillions of USD):
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Risk-Management Roles - I
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Risk-Management Roles - II
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Outline for Remaining Discussion
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Forward Contracts
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Forward Contracts
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Forwards: Characteristics
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The Role of Forwards: Hedging
Forwards enable buyers and sellers to lock-in a price for a future market
transaction.
Thus, they address a basic economic need: hedging.
Demand for such hedging arises everywhere. Examples:
Currency forwards: lock-in an exchange rate for a future transaction to
eliminate exchange-rate risk.
Interest-rate forwards (a.k.a. forward-rate agreements): lock-in an
interest rate today for a future borrowing/investment to eliminate
interest-rate risk.
Commodity forwards: lock-in a price for a future sale or purchase of
commodity to eliminate commodity price risk.
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BUT...
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An Example
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Forward Contracts: Payoffs
Forward to buy XYZ stock at F = 100 at date T.
Let ST denote the price of XYZ on date T.
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Forwards are "Linear" Derivatives
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The Forward Price
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The Forward Price and the Delivery Price
At inception of the contract, the delivery price is set equal to the forward
price.
Thus, at inception, the forward price and delivery price are the same.
As time moves on, the forward price will typically change, but the delivery
price in a contract, of course, remains fixed.
So while a forward contract necessarily has zero value at inception, the value
of the contract could become positive or negative as time moves on.
That is, the locked-in delivery price may look favorable or unfavorable
compared to the forward price on a fresh contract with the same
maturity.
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The Forward Price
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Futures Contracts
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Futures Contracts
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Forwards vs. Futures
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Options
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Basic Definitions
An option is a financial security that gives the holder the right to buy or sell
a specified quantity of a specified asset at a specified price on or before a
specified date.
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Broad Categories of Options
Exchange-traded options:
Stocks (American).
Futures (American).
Indices (European & American)
Currencies (European and American)
OTC options:
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Options as Financial Insurance
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Put Options as Insurance: Example
Cisco stock is currently at $24.75. An investor plans to sell Cisco stock she
holds in a month's time, and is concerned that the price could fall over that
period.
Buying a one-month put option on Cisco with a strike of K will provide her
with insurance against the price falling below K.
For example, suppose she buys a one-month put with a strike of K =
22.50.
If the price falls below $22.50, the put can be exercised and the
stock sold for $22.50.
If the price increases beyond $22.50, the put can be allowed to
lapse and the stock sold at the higher price.
In general, puts provide potential sellers of the underlying with insurance
against declines in the underlying's price.
The higher the strike (or the longer the maturity), the greater the
amount of insurance provided by the put.
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Call Options as Insurance: Example
The lower the strike (or the longer the maturity), the greater the amount
of insurance provided by the call.
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The Provider of this Insurance
The writer of the option provides this insurance to the holder: The writer is
obligated to take part in the trade if the holder should so decide.
In exchange, writer receives a fee called the option price or the option
premium.
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Swaps
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What are Swaps?
https://www.youtube.com/watch?v=v_Fe-nSJZpc
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Categories of Swaps
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What do Swaps Achieve?
Swaps are among the most versatile of financial instruments with new
uses being discovered (invented?) almost every day.
One of the sources of swap utility comes from the fact that swaps
enable converting exposure to one market to exposure to another
market.
Example 1 Consider a 3-year equity swap in which
One counterparty pays the returns on the S&P 500 on a given
notional principal P.
The other counterparty pays a fixed rate of interest r on the
same principal P.
The first counterparty in this swap is exchanging equity-market returns
for interest-rate returns over this three-year horizon. The second
counter party is doing the opposite exchange.
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What do Swaps Achieve?
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What do Swaps Achieve?
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Linking Different Markets
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Linking Different Markets
Similarly:
Interest-rate swaps provide a link between different interest-rate
markets, for example, the fixed-rate at which floating-rate
exposure can be converted to fixed-rate exposure.
Currency swaps provide a link between interest-rate markets
indifferent currencies, for example, the EUR fixed rate at which
USD floating-rate exposure can be converted to EUR fixed-rate
exposure.
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Derivatives and Risk-Management:
Some Comments
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Derivatives and Risk-Management
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A Simple Example
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Comparing the Alternatives
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The Alternatives Compared
The table below presents the outcomes (in US$) under the three alternatives
in two scenarios:
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The Alternatives Compared
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The Best Alternative?
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Appendix: Interest-Rate Conventions
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Interest-Rate Convention
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Moving Between Conventions
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Two Specific Conventions
We discuss each below and also how to go from one convention to the
other.
Remark The main body of the text uses mainly continuous-
compounding. The money-market convention is introduced in the
Exercises section in Chapter 3, and is used in several other chapters in
the book.
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Continuous–Compounding
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Money-Market Convention
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Money-Market Convention
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Moving Between Conventions
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Moving Between Conventions
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Moving Between Conventions
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