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FIN 5DER (2)


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La Trobe University
Lily Nyugen

Study Notes: Derivative Securities INTRODUCTION TO DERIVATIVE MARKETS A “derivative” is a financial instrument whose value depends upon the value of another asset. It derives its value, thus the term DERIVATIVES. “Another asset” is called UNDERLYING ASSET. Where are derivatives traded? 1. Exchanged Traded Markets 2. Over-the-counter (OTC) Markets - Organized markets; normally - Markets where transactions take based on computer trading so place normally on telephone parties don’t know each other trading & parties know each other - Have standard terms and - Have non-standard terms and conditions set by the market conditions; can be set by the trading parties - No credit risk as the - Some credit risk as counterparties counterparties are required to set may not be able to fulfill conditions up margin account with the exchange. - Example: Chicago Board Options Exchange, Sydney Futures Market Types of Derivatives: A derivative is broadly divided into 2 categories. 1. A forward commitment: Two parties agree to engage in a transaction at a later date at a price agreed upon at the start of the contract. Example: Forward contract, Futures contract, Swap. 2. A contingent claim: It is a claim made by one of the parties which depends upon a specific event. Example: Options Study Notes: Derivative Securities Forward contract: OTC & Forward commitment - Contract between two parties, a buyer and a seller, to buy or sell an underlying asset at a FUTURE DATE at a FORWARD PRICE. “A enter into a forward contract with B on 1/1/2012 to buy 100 ounces of gold at $5.0 per ounce on 1/7/2012. And the market price of gold on 1/1/2012 is $4.5 per ounce.” Here: - A: buyer of underlying asset (gold) = long position/ long - B: seller of underlying asset (gold) = short position/ short - 1/1/2012: (today) when the contract is established between parties A and B - 1/7/2012 (after 6 months): Future date/ contract maturity date/ delivery date/ settlement date/ expiration date - $4.5 per ounce = Spot price: market price of the underlying asset today. - $5.0 per ounce = Forward price/ delivery price: fixed price that is agreed by buyer to pay to the seller on the future date for the underlying asset. - The buyer expects the price of the underlying asset to increase; whereas the seller expects the price to decrease. - But, at the time that contract is entered into, the delivery price is chosen so that the value of forward contract to both parties is zero. i.e. initial value of forward contract is 0. This means that it costs nothing to take either a long or short position. No initial payment to enter into a forward contract. - Terminal value: value of the contract at maturity. - Forward contracts can be on equities, bonds, interest rates, currencies. Study Notes: Derivative Securities Futures contract: Market exchange & forward commitment - Agreement between two parties; to buy or sell an underlying asset at a FUTURE DATE at a price agreed upon at the start of the contract. Difference between Forward contract and Futures contract: Forward contract Futures contract Forward commitment & OTC market Forward commitment & Exchange traded market Has non- standard terms and conditions Has standard terms and conditions made customized to the parties’ needs by the exchange market Subject to default risk Less/No default risk Settlement occurs once at the end of the Daily settlement/ marking to market, contract i.e. delivery date margin accounts of the parties are settled daily according to market price changes of the underlying asset The delivery date is agreed at the start of The exact delivery date is not usually the contract specified. The contract is referred by its delivery month and short position has the right to choose the time Delivery is normally made is forward A vast number of futures contracts are contracts not made as the holder of the contract enters into an offsetting contract with the same delivery month as the original contract. Parties don’t need to pay to initiate a Parties need to pay or maintain a margin forward contract in the exchange to initiate the contract Study Notes: Derivative Securities Swaps: OTC & forward commitment - It is an agreement between two partie
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