chapter 1 web extension 1a an overview of derivatives

Chapter 1Web Extension 1A

An Overview of Derivatives

Topics in Web Extension

Overview of derivatives Forward contracts Futures contracts Options Swaps

Forward Contracts 2 parties to contract, each with a basic

position: 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.

Terms Forward price Delivery date (expiration date)

Forward contracts are common for currencies.

Hedging Risk with Forward Contracts 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 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

Similar to forwards, except: Marking-to-market Many more assets- agriculture,

livestock, metals, indexes, currencies, interest rates, energy

Standardized contracts that trade on exchanges, such as CBOT

Options Basic Positions

Call / Put Long / Short (writer)

Terms Exercise Price Expiration Date (can let expire unexercised) Assets- Stocks, indexes, currency, and

futures CBOE

Swaps

Two parties agree to “swap” some particular obligation (usually associated with debt) Swap payments in one currency for

payments in another currency Swap floating-rate payments for

fixed-rate payments