Transcript Lecture 02

The Uses of Derivatives
• Uses
– Risk management. Derivatives are a tool for
companies and other users to reduce risks.
– Speculation. Derivatives can serve as
investment vehicles.
– Reduce transaction costs. Sometimes
derivatives provide a lower cost way to
undertake a particular financial transaction.
– Regulatory arbitrage. It is sometimes possible
to circumvent regulatory restrictions, taxes, and
accounting rules by trading derivatives.
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2-1
Perspectives on Derivatives
• End users
– Corporations
– Investment
managers
– Investors
• Intermediaries
• Economic
– Market-makers
Observers
– Traders

Regulators

Researchers
Observers
End
user
Intermediary
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End
user
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Perspectives on Derivatives
(cont’d)
• End users:
They enter into derivatives contracts for the
reasons listed in P.14.
• Market-makers:
 They will buy derivatives from customers who wish to
sell, and sell derivatives to customers who wish to buy.
 They make money by charging a spread (buy at low
price and sell at higher price.
• Economic observers:
They look at the use of derivatives, the activities of
the market-makers, the organization of the
markets and the logic of the pricing models and
try to make sense of everything.
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Financial Engineering and
Security Design
• The construction of a financial product from
other products.
• New securities can be designed by using
existing securities.
• Financial engineering principles
–
–
–
–
Facilitate hedging of existing positions
Allow for creation of customized products
Enable understanding of complex positions
Render regulation less effective
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2-4
Transaction Costs and the BidAsk Spread
• Buying and selling a financial asset
– Brokers: commissions.
– Market-makers: earn bid-ask (offer) spread
• ask (offer) price: price that you buy the stock from
market makers.
• bid price: price that you sell the stock to market
makers.
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2-5
Transaction Costs and the BidAsk Spread (cont’d)
• Example 1.1: Buy and sell 100 shares of
XYZ
– XYZ: bid = $49.75, offer = $50, commission =
$15
– Buy: (100 x $50) + $15 = $5,015
– Sell: (100 x $49.75) – $15 = $4,960
– Round-trip transaction cost: $5015 – $4,960 =
$55
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Ways to buy or sell
• Market order
To trade a specific quantity of the asset
immediately at the best price that is
currently available.
Advantage:
The trade is executed as soon as possible.
Disadvantage:
You might have been able to get a better
price had you been more patient.
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2-7
Ways to buy or sell (cont’d)
• Limit order
To trade a specific quantity of the asset at a
specified or better price.
Advantage:
Can trade at a better price.
Disadvantage:
The possibility that the order is never filled.
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2-8
Ways to buy or sell (cont’d)
• Stop-loss order
The stop-loss order becomes a market order
to sell once the price of an asset hits the
prescribed value.
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2-9
Short-Selling
• When price of an asset is expected to fall
– First: borrow and sell an asset (get $$)
– Then: buy back and return the asset (pay $)
– If price fell in the mean time: Profit $ = $$ – $
– The lender must be compensated for dividends received
(lease-rate)
• Example: short-sell IBM stock for 90 days
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2-10
Short-Selling (cont’d)
• Why short-sell?
– Speculation
– Financing
– Hedging
• Credit risk in short-selling
– Collateral and “haircut”
• Interest received from lender on collateral
– Demand on the collateral drives down the interest rate
– Demand on cash drives up the interest rate
– Repo rate in bond markets
– Short rebate in the stock market
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2-11
Chapter 3
An Introduction
to Forwards
and Options
International Edition
Introduction
• Basic derivatives contracts
– Forward contracts
– Call options
– Put Options
• Types of positions
– Long position
– Short position
• Graphical representation
– Payoff diagrams
– Profit diagrams
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2-13
Forward Contracts
• Definition: a binding agreement (obligation) to buy/sell
an underlying asset in the future, at a price set today.
• Futures contracts are the same as forwards in principle
except for some institutional and pricing differences.
• A forward contract specifies
– The features and quantity of the asset to be delivered.
– The delivery logistics, such as time, date, and place.
– The price the buyer will pay at the time of delivery.
Today
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Expiration
date
2-14
Reading Price Quotes
Daily low
Settlement price
Daily high
Daily change
The open price
Open interest
Expiration month
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2-15
Reading Price Quotes (cont’d)
• Open Interest
Number of contracts outstanding. (Since each trade of a
contract has both a buyer and seller, a buyer-seller
pair counts as one contract).
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