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Questions and Answers
What is a financial derivative?
A financial derivative is a financial contract between two institutions whose value is determined by the value of another asset called the underlying asset.
Which of the following are main types of derivatives studied in the course? (Select all that apply)
What is a forward contract?
A forward contract is an agreement between two institutions which forces the first to buy a given asset from the second at a pre-determined date and price.
The first institution in a forward contract has a ______ position.
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What are the two ways a forward contract can be settled?
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What does the strike price in a forward contract denote?
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How is the strike price determined according to the document?
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What is a short sale?
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Study Notes
Introduction to Derivatives
- Derivatives are financial contracts between institutions based on the value of an underlying asset.
- The most common types of derivatives are forwards & futures, and options.
Forward Contracts
- A forward contract is an agreement to buy or sell an underlying asset at a predetermined date and price.
- The party agreeing to buy has a long position.
- The party agreeing to sell has a short position.
- Key terms of a forward contract include the strike price and the maturity date.
Underlying Asset Classes
- Common asset classes include: equities (stocks, financial indices, ETFs), fixed income (T-Bills, corporate bonds), commodities (natural gas, commodities, metals), and foreign currencies (FX).
Forward Contract Example
- Institution A agrees to buy 5,000 bushels of corn from institution B on December 31, 2018, for $25,000.
- The strike price is $25,000.
- The maturity date is December 31, 2018.
- The underlying asset is corn.
- Institution A holds the long position, institution B holds the short position.
Forward Contract Settlement
- Settlement can occur through either a physical delivery of the underlying asset at maturity, or a financial payment.
- Financial settlement is more common as banks typically do not have the expertise to store commodities.
Forward Contract Payoff
- The payoff for a long position is the difference between the underlying asset price (ST) and the strike price (K).
- Payoff for a long position is: ST - K.
- The payoff for a short position is the negative of a long position's payoff.
Determining The Strike Price
- The strike price is determined based on various market factors and arbitrage opportunities.
- Concepts of arbitrage and short sales are essential for understanding the determination of a fair strike price.
Short Sale
- Short selling involves selling an asset that the seller does not own.
- The asset must be borrowed from a third party.
- At the maturity date, the asset must be returned to the third party, typically by buying it back in the market.
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Description
Explore the fundamentals of derivatives with a focus on forward contracts. Understand key concepts such as long and short positions, strike prices, and underlying asset classes. This quiz will help reinforce your knowledge of financial contracts and their applications.
