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FIN5DER Chapter Notes -Chicago Board Options Exchange, Forward Contract, Forward Price


Department
FIN
Course Code
FIN5DER
Professor
Lily Nyugen

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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
based on computer trading so
parties don’t know each other
- Have standard terms and
conditions set by the market
- No credit risk as the
counterparties are required to set
up margin account with the
exchange.
- Example: Chicago Board Options
Exchange, Sydney Futures Market
- Markets where transactions take
place normally on telephone
trading & parties know each other
- Have non-standard terms and
conditions; can be set by the
trading parties
- Some credit risk as counterparties
may not be able to fulfill conditions
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

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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.
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