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Derivatives

Derivatives. Topic #4. Futures Contracts. An agreement to buy or sell an asset at a certain time in the future for a certain price Long and Short positions Futures price This eliminates the risk for both participants Exchanges: CBOT (1848) Chicago Mercantile Exchange (1874)

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Derivatives

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  1. Derivatives Topic #4

  2. Futures Contracts • An agreement to buy or sell an asset at a certain time in the future for a certain price • Long and Short positions • Futures price • This eliminates the risk for both participants • Exchanges: • CBOT (1848) • Chicago Mercantile Exchange (1874) • London Financial Futures and Options Exchange • Eurex • Over the counter

  3. Profits from Futures Contracts Long Position Short Position Profit Profit 0 0 K ST K ST

  4. Contract Specifications • The underlying asset • Commodity: exact specification of the quality and the available alternatives • Financial: exact specification, usually without any flexibility • Contract size - depends on the likely user • Delivery arrangements • Location • Packaging

  5. Contract Specifications • Delivery months • Commodity: usually allows some flexibility • Financial: usually is very specific • Price quotes • Price movement limits • Designed to stabilize the prices • Position limits • Futures and Spot Prices

  6. Forward Contracts • Just like Futures, but not traded on an exchange

  7. Options Contracts • Call (Put) options - the right, but not the obligation, to buy (sell) an asset • Exercise (strike) price • Expiration date (maturity) • European vs. American option • Each contract is for 100 shares • Participants: • Buyers of calls or puts • Sellers of calls or puts (i.e. writing an option)

  8. Options Markets • Put and Call Brokers and Dealers Association • Case by case basis • First over-the-counter market • CBOE and many other exchanges • Recent over-the-counter markets • Large transactions • Contracts tailored to specific needs

  9. Other Derivatives • Interest-rate caps • If the interest rate on a floating rate loan exceeds the cap, the seller of the cap provides the difference • Convertible bonds • At expiration the bonds can be converted into stock • Weather derivatives • Real Estate Price Indices

  10. Hedging • If you need to make a future foreign currency payment • If you are going to receive a future foreign currency payment • In general: if you need to deliver or get some asset or commodity in the future • Hedging using options • Futures fix the future price, while options provide insurance at some upfront cost

  11. Speculating • Expose yourself to price movements • Spot vs. Futures transactions • Spot vs. Options transactions • Arbitrage • Lock-in a riskless profit • Hard to come by • Absence of arbitrage enhances market efficiency

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