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Financial Derivatives

Payoffs are linked to previously issued securities.

Futures

A type of financial derivative.

Forward Contracts

Another type of financial derivative.

Stock

Not classified as a financial derivative.

Portfolio Hedging

Reduces interest rate risk.

Hedging

Done to limit exposure to risk.

Long Position Hedging

Achieved by taking a short position.

Short Position Hedging

Achieved by taking a long position.

Long Contract

Requires buying securities on a future date.

Long Contract

Involves buying securities in the future.

Going Long

Agrees to buy an asset at a future date.

Short Contract

Requires selling securities in the future.

Short Contract

Involves selling securities on a future date.

Portfolio Hedging with Futures

Removes the chance of loss.

Lack of Liquidity in Forward Market

Makes transactions difficult.

Disadvantage of Forward Contracts

Lack of liquidity and default risk.

Risk in Forward Contracts

Subject to lack of liquidity and default risk.

Forward Contracts Advantage

None of the above (D).

Limited Usefulness of Forward Contracts

Due to default risk and lack of liquidity.

Futures Trading

Regularly done on the Chicago Board of Trade.

Hedging in Futures Market

Eliminates gains and losses.

Interest Rate Risk Hedging

No change in income with perfect hedging.

Long Position in Futures

Involves buying bonds.

Short Position in Futures

Involves selling bonds.

Selling Short Futures Contract

Agrees to deliver face value securities.

Buying Long Futures Contract

Agrees to deliver face value securities.

Futures Contract Price at Expiration

Equals the underlying asset price.

Elimination of Riskless Profits

Achieved through arbitrage in futures market.

Interest-Rate Futures Contract Loss

Calculated based on price difference.

Interest-Rate Futures Contract Profit

Calculated based on price difference.

Interest-Rate Futures Contract Loss

Calculated based on price difference.

Interest Rates and Futures Contracts

Hope for rise or fall based on position.

Hedging Treasury Bonds with Futures

Requires purchasing specific contracts.

Hedging Treasury Securities with Futures

Involves selling specific contracts.

Micro Hedge

Interest-rate risk hedge for a specific asset.

Micro Hedge

Interest-rate risk hedge for a specific asset.

Macro Hedge

Interest-rate risk hedge for the overall portfolio.

Open Interest

Number of outstanding futures contracts.

Features of Futures Contracts

Not designed to increase liquidity.

Differences Between Futures and Forwards

Standardization and daily marking.

Advantages of Futures Contracts

Standardization and liquidity.

Hedging Exchange Rate Risk

Done by selling or buying foreign exchange futures.

Options

Contracts giving the right to buy or sell an underlying asset.

Strike Price

Price specified on an option for buying or selling the asset.

Option Seller Obligation

To buy or sell the underlying asset.

Option Buyer Right

To buy or sell the underlying asset.

Option Premium

Amount paid for an option.

American Option

Can be exercised at any time up to maturity.

European Option

Can only be exercised at maturity.

Stock Options

Options on individual stocks.

Futures Options

Options on futures contracts.

Call Option

Gives the right to buy the underlying security.

Put Option

Gives the right to sell the underlying security.

Option Exercise

Depends on market price compared to strike price.

Option Exercise

Depends on market price compared to strike price.

Option Exercise

Depends on market price compared to strike price.

Option Exercise

Depends on market price compared to strike price.

Options on Futures Contracts

Control interest rate risk while preserving gains.

Buying Options on Futures

Preserves the possibility of gains.

Disadvantage of Hedging with Futures

Removes the possibility of gains.

Hedging with Put Options

Protects against losses from rising interest rates.

Buying Options

Limits potential losses.

Option Premiums and Maturity

Increase with longer terms.

Call Options and Exercise Price

Increase with lower exercise prices.

Call Option Premium

Decreases with higher exercise prices.

Option Premiums and Volatility

Increase with higher asset volatility.

Interest Rate Swap

Tool for managing interest rate risk.

Currency Swap

Involves exchange of payments in different currencies.

Interest Rate Swap

Exchange of interest payments.

Foreign Exchange Swap

Used to avoid exchange rate risk.

Plain Vanilla Swap

Most common type of