FMI 8 Derivatives

Derivatives are financial contracts whose

value depends on something else

purpose of derivatives

hedging— reduce or eliminate risk

What is an option

the right (not obligation) to buy or sell an asset at a fixed price (the strike X) on or before a certain date

Do buyers pay premium for options

yes

With options, the buyer can ____ while the seller cannot

walk away from a bad outcome

long position

you profit if price increases

short position

you profit if price goes down

how do you hedge a long position?

short

Call option

right to buy at the strike. you want price to raise

Put option

right to sell at the strike you want price to fall

Forward contract

OTC agreement to a transaction at a future date

A forward contract is a ____

zero-sum game

selling a forward contract is _____

shorting

buying a forward contract is___

going long

Pros of a forward contract

very flexible

Cons of a forward contract

default risk

counterparty risk

hard to find a counterparty

Futures

standardized forward contracts on an exchange with defined quantity, quality, and maturity

being traded on an exchange raises ___

liquidity

standardization raises ___

liquidity

Do futures usually get delivered on maturity

no. Holders usually short it by selling and closing their position

at maturity, future price = ____

spot rate

How do futures solve default risk?

Exchange is a clearing house. If 1 side fails the other side is still executed. Uses buyer and seller margin accounts

marking-to-market: crediting/debiting buyer and seller margin accounts by making margin calls. Based on the profit indicated by spot rates on a daily basis. If buyer/seller fails to make margin calls, position closed.

stock index futures

hedge stock market risk

stock index is underlying asset

cash is delivered

downside risk

risk of prices going down

upside risk

risk of prices going up