Basics
Payoff
Market Mechanics
What drives the gains from trade?
Reading: Ch. 2
What is a Derivative?
Definition: A derivative is a financial instrument (contracts) whose value is based on the value of other underlying assets
Type of
Contract
Underlying
Assets
Forward/
Future
Investment
Asset
Options
Commodity
Swap
•
•
•
•
Stock Price
Interest Rate
Exchange Rate
…..
•
•
•
•
Energy: gas, Oil
Corn
Weather derivatives
….
Road Map
Payoff
Type of
Contract
Underlying
Assets
Forward
/ Future
Investment
Asset
Options
Commodity
Strategy
Swap
Pricing
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Plans for Forwards/Futures
Basics
Hedging Strategies (Ch.3)
Payoff and mechanics of Forward and Futures (Ch.2)
What drives the gains from trade?
Presentation 1: OTC vs. Centralized market
How to hedge properly as a firm/trader?
Presentation 2 : the use of derivatives
Pricing
Interest rates basics (Ch. 4)
Arbitrage pricing (Ch. 5)
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How Big Is the Derivative Market?
Source: Bank of International Settlements (www.bis.org)
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Forward Contracts
Definition: a binding agreement (obligation) to buy/sell an underlying asset at a predetermined date in the future, at a price set today
A forward contract specifies
The features and quantity of the asset to be delivered
The “expiration date”
The price the buyer will pay at the time of delivery: “the forward price”
Agreement
0
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Settlement/Delivery
T
time
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Features of Forward Contracts
Features of Forward Contracts
Customized
Non-standard and traded over the counter (not on exchanges) No money changes hands until maturity
Non-trivial counterparty risk
Futures contracts are the same as forwards in principle except for some institutional and pricing differences.
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Notation
S0: Spot price at time 0
ST: Spot price at time T
F0: Forward/Futures price at time 0
T: Time until delivery date (in years)
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Payoff on Forward Contracts
The payoff on a forward contract is its value at expiration.
Payoff on a long position
= Spot price at expiration – Forward price
= ST – F0
Payoff on a short position
= Forward price – Spot price at expiration
= F 0– S T
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Payoff on Forward Contracts
The payoff on a forward contract is its value at expiration.
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Agrees to buy the asset at time T
Payoff on a long position
= Spot price at expiration – Forward price
= ST – F0
(Pay F0 and get something worth ST)
Agrees to sell the asset at time T
Payoff on a short position
= Forward price – Spot price at expiration
= F 0 – ST
(Get F0 for something worth ST)
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At expiration
Payoff Diagrams
Long Position: Payoff
= Spot – Original Futures Price
= ST – F0 (at expiration)
ST
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Short Position: Payoff
= Original Futures Price - Spot
= F0 – ST (at expiration)
ST
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Cash Settlement
An alternative settlement procedure
Instead of requiring delivery of the asset, two parties make a net cash payment, which yields the same cash flow as if delivery had occurred
Why?
A physical transaction likely have transaction costs
Example: The stock index ST=$1040 ; F0 =$1020
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Net payment $20 from the short position to the long
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Example: Gold-diggers
A gold-mining firm enters a short forward contract, agreeing to sell gold at a price of $850/oz. in 1 year
What is the payoff on this short forward position?
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ST
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Questions
Why entering this contract?
Who might want to take the long position of this contract?
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Why entering this contract?