Concepts
Derivative markets and instruments
Derivative Derivative : security that derives from value / return of another asset or security
Options and future contracts : exchange‐traded derivatives
Forwards and swaps : traded in OTC markets (dealer market with no central location), each contract with a counterparty → expose to default risk
Forward commitment / Forward commitment : legal binding promise to perform some action in the future (including forward, future, and swaps)
Contingent claim Contingent claim : Claim that depends on a particular event (including option)
Forward contracts Forward contract : obligate 1 party to buy, and another to sell, a specific asset at a specific price (forward price), on a specific date in the future
Party agree to buy the asset : has a long forward position (the long)
Party agree to sell / deliver the asset : has a short forward position (the short)
Deliverable forward contract : settle by the short delivering the underlying asset to the long
Cash‐settled forward contract (contracts for differences / non‐deliverable forwards) : 1 party pays cash to the other based on the difference between the forward price and market
price of the underlying asset
Future contracts Future contract : forward contract that is standardised and exchange‐traded
Clearinghouse : Each futures exchange has 1 clearinghouse. Clearinghouse acts as buyer to every seller, and seller to every buyer → guarantees traders honor their obliga ons
Buyer of a future contract : gone long or take a long position
Seller of a future contract : gone short or take a short position
Settlement price : average price of the trades during the last period of trading → ↓ opportunity for traders to manipulate the se lement price
Speculators : use future to gain exposure to changes in price of the underlying asset
Hedgers : use future to reduce the existing exposure to price change in the asset
Margin : amount of money that must be deposted by both the long and the short as a performance guarantee prior to entering the contract→ provide protec on to the clearinghouse
Margin balance in a future account is adjusted daily for any gains/losses in value of future position based in the new settlement price
Initial margin : amount must be deposited in future account before a trade may be made
Maintenance margin : minimum amount of margin must be maintained in a future account
If margin balance < mantenance margin → addi onal fund must be deposited to bring the margin balance up to the ini al margin
Price limits : limit on how much the settlement price could change compare to previous day's settlement price (regulated by the exchange). Exchange members are prohibited to trade
outside of the limits
Swaps Swaps : agreements to exchange a series of payments on periodic settlement dates over a certain time period. At each payment date, 2 payments are netted → only 1 net payment is
made by party with greater liability
E.g.:
‐ Plain vanilla interest rate swap : swap fixed‐rate interest payments on loan with floating‐rate interest payments on loan
‐ Basic swap : swap 1 set of floating‐rate interest payments for another floating‐rate interest payments
Options Options : give the owner the right, but not the obligation, to buy / sell an underlying asset at a given price. The seller of the option (the option writer) is obligated to perform, if the
buyer exercises the option
Call option : right to purchase the underlying asset at a specific price for a specific time period
Put option : right to sell the underlying asset at a specific price for a specific time period
Long call : buyer of a call option ‐ has the right to buy the underlying asset
Short call : writer of a call option ‐ has the obligation to sell the underlying asset
Long put : buyer of a put option ‐ has the right to sell the underlying asset
Short put : writer of a put option ‐ has the obligation to buy the underlying asset
American option : exercise anytime up to and including the contract's expiration date
European option : exercise only at the contract's expiration date
Credit derivatives Credit derivative : contract that provide bondholder with protection against a downgrade or defaut by the borrower.
E.g.:
1. Credit default swap : insurance contract against default
2. Credit spread option : a call option based in a bond's yield spread relative to a benchmark
Benefits and Criticism of Benefits of derivatives :
derivatives ‐ Provide price information
‐ Allow risk to be managed and shifted among market participants
‐ Reduce transaction costs
Criticisims of derivatives :
‐ Too risky
Arbitrage Arbitrage opportunities arise when assets are mispriced. Trading by arbitrageurs will continue until they affect supply and demand enough to bring asset prices to efficient levels
1. Law on one price : 2 securities / portfolios with identical future CF, regardless of future events → same price
2. Portfolio with certain future payoffs → no risk in inves ng.
‐ Portfolio's certain return > risk free rate → Borrow @ risk free, invest in the por olio → keep excess por olio return a er paying risk‐free interest on the loan
‐ Portfolio's certain return < Risk free rate → Sell the por olio, invest @ Risk‐free rate → Earn more than the cost to buy back the por olio @ future date
Derivative markets and instruments
Derivative Derivative : security that derives from value / return of another asset or security
Options and future contracts : exchange‐traded derivatives
Forwards and swaps : traded in OTC markets (dealer market with no central location), each contract with a counterparty → expose to default risk
Forward commitment / Forward commitment : legal binding promise to perform some action in the future (including forward, future, and swaps)
Contingent claim Contingent claim : Claim that depends on a particular event (including option)
Forward contracts Forward contract : obligate 1 party to buy, and another to sell, a specific asset at a specific price (forward price), on a specific date in the future
Party agree to buy the asset : has a long forward position (the long)
Party agree to sell / deliver the asset : has a short forward position (the short)
Deliverable forward contract : settle by the short delivering the underlying asset to the long
Cash‐settled forward contract (contracts for differences / non‐deliverable forwards) : 1 party pays cash to the other based on the difference between the forward price and market
price of the underlying asset
Future contracts Future contract : forward contract that is standardised and exchange‐traded
Clearinghouse : Each futures exchange has 1 clearinghouse. Clearinghouse acts as buyer to every seller, and seller to every buyer → guarantees traders honor their obliga ons
Buyer of a future contract : gone long or take a long position
Seller of a future contract : gone short or take a short position
Settlement price : average price of the trades during the last period of trading → ↓ opportunity for traders to manipulate the se lement price
Speculators : use future to gain exposure to changes in price of the underlying asset
Hedgers : use future to reduce the existing exposure to price change in the asset
Margin : amount of money that must be deposted by both the long and the short as a performance guarantee prior to entering the contract→ provide protec on to the clearinghouse
Margin balance in a future account is adjusted daily for any gains/losses in value of future position based in the new settlement price
Initial margin : amount must be deposited in future account before a trade may be made
Maintenance margin : minimum amount of margin must be maintained in a future account
If margin balance < mantenance margin → addi onal fund must be deposited to bring the margin balance up to the ini al margin
Price limits : limit on how much the settlement price could change compare to previous day's settlement price (regulated by the exchange). Exchange members are prohibited to trade
outside of the limits
Swaps Swaps : agreements to exchange a series of payments on periodic settlement dates over a certain time period. At each payment date, 2 payments are netted → only 1 net payment is
made by party with greater liability
E.g.:
‐ Plain vanilla interest rate swap : swap fixed‐rate interest payments on loan with floating‐rate interest payments on loan
‐ Basic swap : swap 1 set of floating‐rate interest payments for another floating‐rate interest payments
Options Options : give the owner the right, but not the obligation, to buy / sell an underlying asset at a given price. The seller of the option (the option writer) is obligated to perform, if the
buyer exercises the option
Call option : right to purchase the underlying asset at a specific price for a specific time period
Put option : right to sell the underlying asset at a specific price for a specific time period
Long call : buyer of a call option ‐ has the right to buy the underlying asset
Short call : writer of a call option ‐ has the obligation to sell the underlying asset
Long put : buyer of a put option ‐ has the right to sell the underlying asset
Short put : writer of a put option ‐ has the obligation to buy the underlying asset
American option : exercise anytime up to and including the contract's expiration date
European option : exercise only at the contract's expiration date
Credit derivatives Credit derivative : contract that provide bondholder with protection against a downgrade or defaut by the borrower.
E.g.:
1. Credit default swap : insurance contract against default
2. Credit spread option : a call option based in a bond's yield spread relative to a benchmark
Benefits and Criticism of Benefits of derivatives :
derivatives ‐ Provide price information
‐ Allow risk to be managed and shifted among market participants
‐ Reduce transaction costs
Criticisims of derivatives :
‐ Too risky
Arbitrage Arbitrage opportunities arise when assets are mispriced. Trading by arbitrageurs will continue until they affect supply and demand enough to bring asset prices to efficient levels
1. Law on one price : 2 securities / portfolios with identical future CF, regardless of future events → same price
2. Portfolio with certain future payoffs → no risk in inves ng.
‐ Portfolio's certain return > risk free rate → Borrow @ risk free, invest in the por olio → keep excess por olio return a er paying risk‐free interest on the loan
‐ Portfolio's certain return < Risk free rate → Sell the por olio, invest @ Risk‐free rate → Earn more than the cost to buy back the por olio @ future date
