Exam FM:
Financial Economics Material
Rick Gorvett, FCAS, ASA, CERA, MAAA, ARM, FRM, PhD
Director, Actuarial Science Program
State Farm Companies Foundation Scholar in Act. Sci.
University of Illinois at Urbana-Champaign
Agenda - Topics
• Basic derivatives concepts
• Forward and futures contracts
• Option contracts
• Option combinations and positions
• Risk management and hedging
• Methods of buying an asset
• Swap contracts
Basic
Derivatives
Concepts
Basics of Derivatives
• Derivative: value depends upon, or derives
from, the value of something else
• Reasons for using derivatives
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Risk management
Reducing transactions costs
Taxes, regulations, accounting
Speculation
• Perspectives
– End users
– Market makers
– Economic observers
Transactions Costs
• Commissions
– Percentage and / or flat amount
– For buying assets: add to cost
– For selling assets: subtract from proceeds
• Bid-ask spread
– Bid = price broker bids to buy asset
• Investor sells at bid price
– Ask = price broker asks to sell asset
• Investor buys at ask price
• Round-trip cost
– Total cost associated with buying and then selling
Example of Round-Trip Cost
• You buy 1,000 shares of a stock, and
immediately turn around and sell them.
– Ask price = 76.25
– Bid price = 75.50
– Commission is $20, plus 1% of the proceeds of any
buy or sell transaction.
• Find the round-trip transaction cost
Short-Selling
• Process:
– Borrow asset and sell
– Buy back and return asset later
• Issues:
– Lease rate: payment required by lender from
borrower (e.g., dividends  reimburse lender)
– Haircut: additional margin required by lender
– Short rebate / repo rate: interest rate on haircut
• Cost of short-selling includes difference between this rate
and the market rate you would otherwise earn
Example of Short-Selling
• One-year short sale of 100 shares of stock
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Price per share at t = 0 is $70
Price per share at t = 1 is $65
Additional collateral (haircut) required is $1,000
Effective market interest rate is 5%
Rate (short rebate) credited to collateral is 3%
Dividend of $1.50 per share paid at t = 0.5
Commission of $40 per transaction (on both ends)
• Find the short-seller’s profit.
Q: Reasons for Using Derivatives
(From Exam FM Fin Econ Sample Questions)