Chapter 1
Web Extension 1B
An Overview of Derivatives
Topics in Web Extension
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Overview of derivatives
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Forward contracts
Futures contracts
Options
Swaps
Forward Contracts
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2 parties to contract, each with a basic position:
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Terms
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One party is “long” (buy). Obligates party to buy the
underlying asset at some fixed price at a specified date in
the future.
One party is “short” (sell). Obligates party to sell the
underlying asset at some fixed price at a specified date in
the future.
Forward price
Delivery date (expiration date)
Forward contracts are common for currencies.
Hedging Risk with Forward
Contracts
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US wine importer might plan on purchasing French
wine with euros in the fall. Could lock in the
currency exchange rate for the fall by taking a long
position in a euro currency forward contract.
US computer manufacturer might plan on selling
computers to German company in fall, with the
payment in euros. Could lock in exchange rate by
taking a short position in euro forward contract.
Both parties have reduced risk by locking in the
exchange rate.
Problems with Forward
Contracts
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Forward contracts are made directly between
two parties, so there is the possibility of
default (although banks often are one of the
parties in each transaction, in effect acting as
“middlemen”).
Forward contracts are often designed for a
specific need, so there is not a standardized
contract, which makes it difficult to have a
secondary market.
Futures contract solve these problems.
Futures Contracts
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Similar to forwards, except:
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Marking-to-market
Many more assets- agriculture, livestock,
metals, indexes, currencies, interest rates,
energy
Standardized contracts that trade on
exchanges, such as CBOT
Options
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Basic Positions
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Terms
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Call / Put
Long / Short (writer)
Exercise Price
Expiration Date (can let expire unexercised)
Assets- Stocks, indexes, currency, and futures
CBOE
Swaps
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Two parties agree to “swap” some
particular obligation (usually associated
with debt)
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Swap payments in one currency for
payments in another currency
Swap floating-rate payments for fixed-rate
payments