Financial instruments
Lecture 1 – chapter 1
A derivative is an instrument whose value depends on the values of
other basic underlying variables. A derivative can be constructed on
anything that has a price.
Futures contract:
It is an agreement to buy or sell an asset at a certain time in the future for
a certain price.
- The party that has agreed to buy has a long position.
- The party that has agreed to sell has a short position.
Forward contract:
Same as future contracts, except they trade in the over-the-counter
market.
Call option:
Option to buy a certain asset by a certain date for a strike price.
1. Buyer of a Call Option (long position):
An investor expects a stock, currently trading at $50, to rise in price. They
buy a call option.
Strike price: $55
Premium (cost): $2 per share
Contract size: 100 shares
Expiration: 1 month
1. Stock price rises to $60:
o The buyer exercises the option, buying the stock at $55 (strike
price) and selling it at $60 (market price).
o Profit = ($60 - $55) - $2 (premium) = $3 per share.
o Total profit = $3 × 100 = $300.
2. Stock price stays below $55:
o The buyer does not exercise the option since it’s cheaper to
buy the stock in the market.
o Loss = Premium paid = $200.
,2. Seller of a Call Option (short position):
An investor sells a call option on the same stock, expecting it to stay
below $55.
Strike price: $55
Premium received: $2 per share
Contract size: 100 shares
1. Stock price stays below $55:
o The option expires worthless, as the buyer has no incentive to
exercise it.
o The seller keeps the premium = $200 as profit.
2. Stock price rises to $60:
o The buyer exercises the option, forcing the seller to sell the
stock at $55 when it’s worth $60.
o Loss = ($60 - $55) × 100 = $500.
o After keeping the $200 premium, the seller’s net loss = $500 -
$200 = $300.
Buyer of a Call: Pays a premium and profits if the stock price rises
above the strike price.
Seller of a Call: Receives a premium but risks losses if the stock
price rises above the strike price.
Put option:
Option to sell a certain asset by a certain date for a strike price.
1. Buyer of a Put Option (long position):
An investor expects a stock, currently at $50, to decrease in price. They
buy a put option.
Strike price: $45
Premium (cost): $2 per share
Contract size: 100 shares
Expiration: 1 month
1. If the stock price drops to $40, the buyer exercises the option,
selling the stock for $45 when it’s worth $40.
o Profit = $45 - $40 - $2 = $3 per share.
o Total profit = $3 × 100 = $300.
, 2. If the stock price stays above $45, the option expires worthless, and
the buyer loses the $200 premium.
2. Seller of a Put Option (short position):
An investor sells a put option on the same stock, expecting it to stay
above $45.
Strike price: $45
Premium received: $2 per share
Contract size: 100 shares
1. If the stock price stays above $45, the option expires worthless. The
seller keeps the $200 premium as profit.
2. If the stock price falls to $40, the buyer exercises the option, and
the seller buys the stock at $45.
o Loss = ($45 - $40) × 100 = $500.
o After keeping the $200 premium, the seller’s net loss is $500 -
$200 = $300.
Buyer profits if the stock price falls below the strike price.
Seller profits if the stock price stays above the strike price but risks
losses if it falls.
An American option can be exercised at any time during its life. In
contrast, a European option can be exercised only at maturity.
The difference between a futures/forward contract and options is that with
futures/forwards, the holder has an obligation to buy or sell. But with an
option, the holder has the right to buy or sell.
Hedge funds are private funds that pool capital from accredited
investors to use flexible, high-risk strategies aimed at high returns. They
can take on more risk by using leverage short selling and adopting more
flexible investment strategies.
There are 3 reasons to use derivatives:
1. Hedging: used to manage or reduce risk by for example using
futures
2. Speculation: traders use them to bet on the future direction of asset
prices
Lecture 1 – chapter 1
A derivative is an instrument whose value depends on the values of
other basic underlying variables. A derivative can be constructed on
anything that has a price.
Futures contract:
It is an agreement to buy or sell an asset at a certain time in the future for
a certain price.
- The party that has agreed to buy has a long position.
- The party that has agreed to sell has a short position.
Forward contract:
Same as future contracts, except they trade in the over-the-counter
market.
Call option:
Option to buy a certain asset by a certain date for a strike price.
1. Buyer of a Call Option (long position):
An investor expects a stock, currently trading at $50, to rise in price. They
buy a call option.
Strike price: $55
Premium (cost): $2 per share
Contract size: 100 shares
Expiration: 1 month
1. Stock price rises to $60:
o The buyer exercises the option, buying the stock at $55 (strike
price) and selling it at $60 (market price).
o Profit = ($60 - $55) - $2 (premium) = $3 per share.
o Total profit = $3 × 100 = $300.
2. Stock price stays below $55:
o The buyer does not exercise the option since it’s cheaper to
buy the stock in the market.
o Loss = Premium paid = $200.
,2. Seller of a Call Option (short position):
An investor sells a call option on the same stock, expecting it to stay
below $55.
Strike price: $55
Premium received: $2 per share
Contract size: 100 shares
1. Stock price stays below $55:
o The option expires worthless, as the buyer has no incentive to
exercise it.
o The seller keeps the premium = $200 as profit.
2. Stock price rises to $60:
o The buyer exercises the option, forcing the seller to sell the
stock at $55 when it’s worth $60.
o Loss = ($60 - $55) × 100 = $500.
o After keeping the $200 premium, the seller’s net loss = $500 -
$200 = $300.
Buyer of a Call: Pays a premium and profits if the stock price rises
above the strike price.
Seller of a Call: Receives a premium but risks losses if the stock
price rises above the strike price.
Put option:
Option to sell a certain asset by a certain date for a strike price.
1. Buyer of a Put Option (long position):
An investor expects a stock, currently at $50, to decrease in price. They
buy a put option.
Strike price: $45
Premium (cost): $2 per share
Contract size: 100 shares
Expiration: 1 month
1. If the stock price drops to $40, the buyer exercises the option,
selling the stock for $45 when it’s worth $40.
o Profit = $45 - $40 - $2 = $3 per share.
o Total profit = $3 × 100 = $300.
, 2. If the stock price stays above $45, the option expires worthless, and
the buyer loses the $200 premium.
2. Seller of a Put Option (short position):
An investor sells a put option on the same stock, expecting it to stay
above $45.
Strike price: $45
Premium received: $2 per share
Contract size: 100 shares
1. If the stock price stays above $45, the option expires worthless. The
seller keeps the $200 premium as profit.
2. If the stock price falls to $40, the buyer exercises the option, and
the seller buys the stock at $45.
o Loss = ($45 - $40) × 100 = $500.
o After keeping the $200 premium, the seller’s net loss is $500 -
$200 = $300.
Buyer profits if the stock price falls below the strike price.
Seller profits if the stock price stays above the strike price but risks
losses if it falls.
An American option can be exercised at any time during its life. In
contrast, a European option can be exercised only at maturity.
The difference between a futures/forward contract and options is that with
futures/forwards, the holder has an obligation to buy or sell. But with an
option, the holder has the right to buy or sell.
Hedge funds are private funds that pool capital from accredited
investors to use flexible, high-risk strategies aimed at high returns. They
can take on more risk by using leverage short selling and adopting more
flexible investment strategies.
There are 3 reasons to use derivatives:
1. Hedging: used to manage or reduce risk by for example using
futures
2. Speculation: traders use them to bet on the future direction of asset
prices
