Week 1 Flashcards
Derivative Definition
A financial instrument that has a value determined by the price of something else (the underlying)
Uses of Derivatives
- Risk management
- Speculation
- Reduce transaction costs
- Regulatory arbitrage
Over-the-Counter (OTC) Market
Large traders trade many financial claims directly with a dealer by bypassing organized exchanges.
Not as easy to observe or measure and is generally less regulated
Value of OTC trading > value traded on exchanges
Forward Contracts
A binding agreement (obligation) to buy/sell an underlying asset in the future, at a price set today.
Specifies:
- Features and quantity of asset to be delivered
- Delivery logistics
- The price the buyer will pay at the time of delivery
Payoff Forward Contract
Long and Short
Long forward = spot price at exp. - forward price
Short forward = forward price - spot price at exp.
Types of Settlement (Forward Contract)
Cash settlement: less costly and more practical
Physical delivery: often avoided due to significant costs
Call Option Definition
A non-binding agreement (right but not obligation) to buy an asset in the future, at a price set today
Preserves the upside potential
Payoff/Profit of a Purchased Call
Payoff = max[0, spot price at exp. - strike price] Profit = payoff - FV(option premium)
Types of Call Options
European-style: can be exercised only at expiration
American-style: can be exercised at any time before expiration
Bermudan-style: can be exercised during specified periods
Put Option Definition
A put option gives the owner the right but not the obligation to sell the underlying at a predetermined price during a predetermined time period.
The seller of a put option is obligated to buy if asked.
Payoff/Profit of a Purchased (Long) Call
Payoff = max[0, spot price at exp. - strike price] Profit = payoff - FV(option premium)
Payoff/Profit of a Written (Short) Put
Payoff = -max[0, strike price - spot price at exp.] Profit = payoff + FV(option premium)
When do call & put options before more profitable?
A call option becomes more profitable when the underlying asset appreciates in value
A put option becomes more profitable when the underlying asset depreciated in value
What do the profit graphs look like for the different options?
(Forward, Call, Put)
Long forward - diagonal up
Short forward - diagonal down
Long call - straight(down) then up
Short call - straight(up) then down
Long put - up then straight(down)
Short put - down then straight(up)
