Study Notes on Derivative Markets and Hedge Fund Strategies

Critical Concepts

• Over-The-Counter and Exchange Markets

• Systemic Risk

• Forward Contracts

• Futures Contracts

• Options

• Trader Types

• Hedge Fund Strategies

Definition of Derivative

• An instrument whose value derives from another variable (e.g., stocks, bonds, currencies).

• Examples: Futures, forwards, swaps, options.

• Key role in risk transfer.

Uses of Derivatives

• Hedging risks

• Speculation

• Locking in arbitrage profits

• Changing the nature of investment/liability.

Trading Derivatives

• Traded on exchanges (CME, CBOE) or OTC among banks and managers.

OTC Market Overview

• Unregulated before 2008; banks as market makers.

• Master agreements governed transactions.

• Introduction of CCPs for some transactions.

Systemic Risk and Regulations Post-2008

• Changes due to systemic risk from OTC transactions.

• Aim: Reduce risk, increase transparency.

• Standardized products must be traded on SEFs.

Forward Contracts

• Agreement to buy/sell an asset at a specific future date.

• Forward price determined at the contract's initiation.

• Characteristics: long/short positions, no initial cost.

• Payoff: Long position profit: $ST - K$; Short position profit: $K - ST$.

Futures Contracts

• Agreement to buy/sell an asset at a future date, standardized contracts.

• Guaranteed by clearinghouse; daily settlement.

Options

• Call option: Right to buy an asset at a strike price.

• Put option: Right to sell at a strike price.

• Types: American (exercisable anytime) vs. European (exercisable at maturity).

Trader Types

• Hedgers: Reduce risk.

• Speculators: Bet on future market directions.

• Arbitrageurs: Lock in profits via offsetting positions.

Hedge Funds

• Not publicly traded, fewer regulations.

• Employ complex strategies for hedging, speculation, and arbitrage.

Hedge Fund Strategies

• Examples include Long/Short, Convertible Arbitrage, and Global Macro.