Engines of the Economy or Instruments of Mass Destruction?. The magic of Financial Derivatives. Klaus Volpert Villanova University March 22, 2000. I can think of no other area that has the potential of creating greater havoc on a global basis if something goes wrong.
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The magic of
March 22, 2000
Dr. Henry Kaufman, May 1992
Derivatives are the dynamite for financial crises and the fuse-wire for international transmission at the same time.
Alfred Steinherr, author of
Derivatives: The Wild Beast of Finance (1998)
At time of expiry what is our payoff? ParityAnswer: if S is the IBM share price at time T, and If S>120, payoff = S - (S - 120) = 120 If S<120, payoff = S +(120 - S) = 120So this portfolio is risk-free! Its fair market price should be the same as for the benchmark treasury bond - which is $120 discounted to the present time. So 100 + P - C = 120 exp(-r*T) = 117So, P - C = 17
Buy a call with strike 120, buy a put with strike 80 (a Paritystrangle). Then a payoff-minus-cost diagram would look like
In addition sell a call and a put with strike 100 (known as a butterfly). payoff-minus-cost diagram :Engineering of derivatives:
So, while the underlying stock price has gone up 10 %, the value of the option has gone up 250%!This is called leveraging.By buying options instead of assets, you can magnify your risk / your potential payoff almost without limit.