MODULE 6: LANGUAGE STRUCTURE OF FORWARD, FUTURES MARKET, AND OPTION MARKETS Derivatives - It is a financial instrument whose value depends on the value of some other underlying asset Its purpose is to transfer risk from one person or firm to another Advantages: > Reduces risks by allowing firms and individuals to enter into agreements that they otherwise wouldn’t be willing to accept > Can also be used as insurance > Provides an easy way for investors to make profits from price declines > In a derivative transaction, one’s person’s loss is another person’s gain > Increases the risk-carrying capacity of the economy as a whole > Improving allocation of resources and increases the level of output > It allows to conceal the true nature of certain financial transactions Interest-Rate Future Contracts - A contractual agreement between two investors that obligates one to make payment to the other depending on the movement in interest rates over the next year Categories of Derivatives 1. Forward/Forward Contract - It is an agreement between a buyer and a seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date - Simplest and easy to use - Private agreements between two parties thus difficult to sell due to the element of customization 2. Futures/Futures Contract - It is a forward contract that has been standardized and sold through an organized exchange - It states that the seller is to deliver some quantity of a commodity or financial instrument to the buyer at the settlement or delivery date for a predetermined price - Both buyer and seller needed to have an assurance that both parties will execute their obligations which can be done through a clearing corporation which monitors traders and the incentive to limit their risk taking 3. Options - an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option. Kinds of Options + Call option - It is the right to buy or call a given quantity of an underlying asset at a perdetermined price called exercise price on or before a specific date; holder of the call is not required to buy shares and its a must on the part of the seller + Put Option - It gives the holder the right but not obligated to sell the underlying asset at a predetermined price on or before a fixed date + American Options - can be exercised on any date from the time written until the day they expire + European options - can be exercised only on the day of expiration Option price = Intrinsic value + Time value of the option 4. Swaps - a swap is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. Types of Swaps + Interest-Rate Swaps - are agreement between two counterp arties to exchange periodic interest rate payments over some future period based on an agreed upon amount of principal called notional principal + Credit Default Swap - it is a credit derivative that allows lenders to insure themselves against the risks that the borrower will default Swap rate - rate to be paid by the fixed rate payer; benchmark rate plus a premium Swap spread - measures the risk; benchmark rate - swap rate Note: In the money = Price of stock > Strike price = profitable In the money = Price of stock = Strike price Out of money = Price of stock < Strike Price Risk Management Strategies 1. Hedging 2. Speculation Arbitrage - The practice of simultaneously buying and selling financial instruments in order to benefit from temporary price differences MODULE 7: FOREIGN EXCHANGE MARKET Exchange Rate - The price of one currency in terms of another Are determined by the interaction of supply and demand Importance > Affects the relative price of domestic and foreign goods Determinants: > Law of one price - If two countries produce identical good and transportation costs and trade barriers are very low, the price of the good should be the same no matter which country produces it > Theory of Purchasing Power Parity - It states that exchange rates between two currencies will adjust to reflect changes in price levels of the two countries (appreciation-depreciation relationship or depreciation-appreciation relationships) Reasons that Theory of Purchasing Power Parity are unreasonable basis: > Products cannot be identical > Does not take into account that many goods and services are not traded across borders Factors That Affect Exchange Rates on a Long Run > Relative Price levels > Tariffs and Quotas > Preferences of domestic goods vs foreign goods > Productivity Exchange Rates on a Short Run - A Supply and Demand Analysis > Domestic Interest Rate > Foreign Interest Rate > Expected domestic price level > Expected trade barriers > Expected import demand > Expected export demand > Expected productivity Types of Transactions: > Spot Transactions - involved in immediate exchange bank deposits > Forward transactions - involve the exchange of bank deposits at some specified future date Types of Rate: > Spot Exchange rate - exchange rate for the spot transaction > Forward exchange rate - exchange rate for the forward transaction Appreciation = increase of currency value; In the perspective of another country, other country’s goods is expensive while the said goods in its country origin is cheaper Depreciation = decrease of currency value; In perspective of another country, other country’s goods is cheaper and the said goods in the country origin perspective is expensive; Easier to sell goods on the part of the domestic manufacturers while it makes less competitive on domestic markets on the part of the foreign goods Foreign Exchange Market - The financial market where the exchange rates are determined Organized as over the counter market in which parties are stand ready to buy and sell deposits denominated in foreign currencies Real Exchange Rate - The rate at which domestic goods can be exchanged for foreign goods Determines whether currency is relatively cheap or not If below 1.0 = cheap If beyond 1.0 = expensive If equal to 1.0 = same purchasing power regardless of different currency (same value ng one currency to another concept) Formula: Domestic currency/Foreign Currency
