Derivatives PDF

## DERIVATIVES ### WHAT ARE DERIVATIVES? 1. **Definition:** * Financial instruments * Derive value from: * Underlying asset * Index * Rate 2. **Purpose:** * Used for hedging risk. * Used for speculating price movements. * Leveraging...

## DERIVATIVES ### WHAT ARE DERIVATIVES? 1. **Definition:** * Financial instruments * Derive value from: * Underlying asset * Index * Rate 2. **Purpose:** * Used for hedging risk. * Used for speculating price movements. * Leveraging positions: Using borrowed funds to increase the size of investment. 3. **Common Underlying Assets:** * Stocks * Bonds * Commodities * Interest rates * Currencies * Indices ### TYPES OF DERIVATIVES 1. **Forward:** * **Description:** Customized contracts to buy/sell an asset * **Features:** * Specified price * Future date * Privately traded (over-the-counter) * Customized * Subject to counterparty risk (one party may default - not pay for the contract) 2. **Future:** * **Description:** * Standardized contracts * Traded on exchanges * To buy/sell an asset * Set price * Specific future date * **Features:** * Highly regulated * Marked-to-market daily * Clearing houses (in between buyers and sellers) * Reduce counterparty risk 3. **Options:** * **Call Option:** The chance to buy an asset @ a predetermined price before a certain date * **Put Option:** Right to sell an asset at a predetermined price before a certain date * **Features:** * Traded on exchanges & over-the-counter * Offers flexibility * Premium cost (price paid for the option) 4. **Swaps:** * **Description:** * Contracts * Exchange cash flows * Between 2 parties * Based on different financial instruments * **Types:** * **Interest rate swap:** Exchange of fixed interest rates for floating rates and vice versa * **Currency:** Exchanging principal and interest in different currencies * **Commodity:** Exchange cash flows related to commodity prices. * **Features:** * Offer over the counter * To manage: * Interest rates * Currency * Commodity exposure ### USES OF DERIVATIVES 1. **Hedging:** A way to protect your money from losses by making a second investment that: * Balances out the risk * If the main investment loses value, hedge reduces loss * Reduces risk by taking a position in a derivative to offset potential losses in an asset. * **Example:** Farmer uses Futures to lock in a selling price for crops * This protects against price drops 2. **Speculation:** Making a bet on what you think will happen with prices * Buying stocks/commodities because you believe its price will go up soon * Risky because if prices go down, you lose, unlike hedging. * Purely trying to make a profit based on price changes. * **Example:** Investor buys call options (right to buy stock) on a stock, expecting its price to rise. 3. **Arbitrage:** Exploiting price differences between markets to earn risk-free profit * **Example:** Buying a derivative in one market and selling it in another where the price is higher. ### KEY CONCEPTS IN DERIVATIVES 1. **Strike Price:** The price at which the holder of an option can buy/sell the underlying asset 2. **Premium:** Cost of buying an option; paid upfront 3. **Expiration Date:** Date which derivatives contracts expire 4. **In-the-money (ITM):** Option has value right now * **For: Call options if strike price < current market price** * **Put options if strike price > current market price.** 5. **Out-of-the-money (OTM):** Option has NO value right now * **OTM for: Call options if strike > current** * **Put options if strike < current** 6. **Leverage:** Using a small amount of money to command large positions. * Derivatives allow high leverage * Amplifies potential gains and losses ### VALUATION OF DERIVATIVES 1. **Forwards/Futures:** Valued: * Figure out the difference in the current market price and the agreed price in the contract * Consider how time/interest rates affect this difference 2. **Options:** Valued using models like: Black-Scholes * Considers factors like: * Underlying asset price. * Strike price * Time to expiration * Volatility * Interest rates 3. **Intrinsic Value:** Difference between current price of underlying asset and strike price (if ITM) 4. **Time Value:** Additional value due to time remaining until expiration * Factors in potential future volatility 5. **Swaps:** Valued by: Calculating the net present value of expected future cash flows exchanged between parties. ### RISK IN DERIVATIVES 1. **Market Risk:** Changes in underlying assets price can lead to losses 2. **Credit (Counterparty) Risk:** * Risk one party might default. * Relevant for over-the-counter derivatives, especially as contracts are made directly between 2 parties/not traded on an exchange 3. **Liquidity Risk:** Difficulty buying/selling an asset without changing the market price 4. **Leverage Risk:** Losing more money than originally invested * Derivatives can amplify gains and losses; this can lead to significant losses. ### KEY TERMS 1. **Underlying Asset:** The asset from which a derivative gets its value 2. **Counterparty:** The other party in a derivative contract. * Responsible for fulfilling the terms of the contract 3. **Clearing house:** An in-between entity that facilitates the settlements of over-the-counter derivatives to reduce default risk. ### EXAMPLES OF DERIVATIVES IN USE 1. **Interest Rate Swaps:** * Company with floating rate loan may swap it for a fixed rate to avoid volatility. 2. **Currency Option:** * Locking in exchange rate for a big deal or overseas transactions to prevent costly money. * Goes down on concession votes if the exchange rate goes down. 3. **Commodity Futures:** * Airline uses have contracts to lock in fuel prices to manage operational costs.