Chapter 1 Web Extension 1B

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Chapter 1Web Extension 1B

• An Overview of Derivatives

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Topics in Web Extension

• Overview of derivatives
• Forward contracts
• Futures contracts
• Options
• Swaps

3
Forward Contracts

• 2 parties to contract, each with a basic
  position
• One party is long (buy). Obligates party to
  buy the underlying asset at some fixed price at a
  specified date in the future.
• One party is short (sell). Obligates party to
  sell the underlying asset at some fixed price at
  a specified date in the future.
• Terms
• Forward price
• Delivery date (expiration date)
• Forward contracts are common for currencies.

4
Hedging Risk with Forward Contracts

• US wine importer might plan on purchasing French
  wine with euros in the fall. Could lock in the
  currency exchange rate for the fall by taking a
  long position in a euro currency forward
  contract.
• US computer manufacturer might plan on selling
  computers to German company in fall, with the
  payment in euros. Could lock in exchange rate by
  taking a short position in euro forward contract.
• Both parties have reduced risk by locking in the
  exchange rate.

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Problems with Forward Contracts

• Forward contracts are made directly between two
  parties, so there is the possibility of default
  (although banks often are one of the parties in
  each transaction, in effect acting as
  middlemen).
• Forward contracts are often designed for a
  specific need, so there is not a standardized
  contract, which makes it difficult to have a
  secondary market.
• Futures contract solve these problems.

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Futures Contracts

• Similar to forwards, except
• Marking-to-market
• Many more assets- agriculture, livestock, metals,
  indexes, currencies, interest rates, energy
• Standardized contracts that trade on exchanges,
  such as CBOT

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Options

• Basic Positions
• Call / Put
• Long / Short (writer)
• Terms
• Exercise Price
• Expiration Date (can let expire unexercised)
• Assets- Stocks, indexes, currency, and futures
• CBOE

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Swaps

• Two parties agree to swap some particular
  obligation (usually associated with debt)
• Swap payments in one currency for payments in
  another currency
• Swap floating-rate payments for fixed-rate
  payments