Derivatives

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Derivatives- I

Mapping to Curriculum
• Reading 60: Derivative Markets and Instruments • Reading 61: Forward Markets and Contracts

• Reading 62: Future Markets and Contracts

Expect around 6 questions in the exam from today’s lecture

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Key Concepts
• Difference Between OTC And Exchange Traded Contracts • Payoffs of Futures and Forwards • FRA‘s • Margins • Types of Futures

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Introduction
What are the fundamental assets trading in the market?

1. 2. 3. 4.

Stocks Bonds Commodities Currency

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What Is A Derivative?

D

D – Derivative

A

A – Underlying, a fundamental asset For example, a Stock, Bond, Currency, Commodity

The value of D changes as A moves

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Derivatives Payoff

Non-Linear Payout Linear Payout Y-axis → Profit/Loss on (D)

X-axis → Value of Underlying (A)

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Types Of Derivatives

Derivatives

Linear (Have Linear Payoffs)

Non-Linear (Have Non-Linear Payoffs)

Forwards/Future s (D)

Options (D)

Swaps, Exotics (D2)

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Definition
• Derivative: It is a financial instrument whose value is derived (hence the name derivative) from the value on an underlying asset – Underlying asset: It can be stocks, indices, bonds, commodities, currency, rates, etc.

• Main types of derivatives (explained later): – Forwards and Futures – Swaps – Options – Exotics

Exchange traded: • Traditionally open-outcry system • Switching to electronic trading • Contracts are standardized • Example: - Europe: Liffe: http://www.liffe.com - US: Chicago Board of Trade http://www.cbot.com

• Trading Types: – Exchange traded – Over the Counter

Over the counter (OTC):
• A computer- and telephone-linked network of dealers • Contracts can be non-standard

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Difference Between OTC And Exchange Traded Contracts
Over the Counter (OTC)
Instruments are Customized Counter-party can be another company Mark-to-Market is not done. Cash is only exchanged at contract expiry. Low Liquidity High Counter-party risk

Exchange Traded
Instruments are Standardized The exchange is the counterparty Mark-to-Market Everyday (profit/loss is calculated and settled on a day to day basis) High Liquidity No counter-party risk

A dealer market with no central trading location
Unregulated Market No active secondary market

Backed by a clearinghouse
Regulated Market Active Secondary Market

Instruments: Swaps, Exotics

Instruments: Futures, Options

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Forward contract - Example
You need a laptop, one year from now. The current price of a laptop is $1000.

You have 3 options, to fulfill your requirement: 1. Buy it now at $1000, and use it after a year 2. Buy it a year from now at the market price prevailing one year from now (unknown price). 3. Enter into an agreement with the vendor so as to purchase the laptop a year from now at a price of $1000.

In each of the three scenarios, what would be your profit/loss if the price of the laptop after one year is: 1. $500 2. $1000 3. $1500

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Forward contract - Example
• Taking the Third Scenario, If you locked a fixed price of $1000 for a laptop after one year, your profit and loss would look like:

Agreed upon Price of Laptop (X=strike)
1000
1000 1000

Price of Laptop (S=spot)
500
1000 1500

Profit and Loss from the Buyer’s Perspective (S-X)
-500
0 500

• The Profit and Loss from the vendor’s point of...
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