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Financial Derivatives

Chapter 1: Introduction to derivatives: Derivatives are financial instruments whose returns are derived from those of other financial instruments with the aim of hedging financial risks. That is, their performance depends on how other financial instruments perform. Derivatives serve a valuable purpose in providing a means of managing financial risk. **All derivatives are priced based on arbitrage theory. The derivative is priced in a way that makes no room for arbitrage. Arbitrage is to make riskless profit, but investment is associated always with risk. Financial Instrument: a contract between two parties that gives a claim for one party to future cash flows, its an asset & liability at the same time and has a market price. An asset is an item of ownership having positive monetary value. A liability is an item of ownership having negative monetary value. A security is a tradable instrument representing a claim on a group of assets. A contract is an enforceable legal agreement. Business risk vs. Financial risk: Business risks are risks are related to the underlying nature of the business and deal with such matters as the uncertainty of future sales or the cost of inputs. On the other hand Financial risks are risks deals with uncertainties such as interest rates, exchange rates, stock prices, and commodity prices. Derivatives can be based on real assets, which are physical assets and include agricultural commodities, metals, and sources of energy. And they can be also based on financial assets which are stocks, bonds/loans, and currencies. Cash markets or spot markets the markets for assets, purchases and sales require that the underlying asset be delivered either immediately or shortly thereafter. Payment usually is made immediately, although credit arrangements are sometimes used. The sale is made, the payment is remitted, and the good or security is delivered. On the other hand, Derivative markets are markets for contractual instruments whose performance is determined by the way in which another instrument or asset performs and the good or security is to be delivered at a later date. Derivative Instruments: 1. Forwards: Forward: a forward is a deal between two parties to buy or sell an underlying asset sometime in the future at a price agreed upon today. This is an OTC type of deals and is binding for both parties. Forward contract can be customized. OTC -Over The Counter- means that they have no physical facilities for trading; there is no building or formal corporate body organized as the market, an over-the-counter market consisting of direct communications among major financial institutions.
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Financial Derivatives
Any OTC agreement has credit risk- The risk of borrower's failure to meet a contractual obligation **Forward price of a Forward contract for currencies exchange is based on interest rate differential between two currencies. In other words, forward rate must equate the interest rate differential between two currencies so that there would be NO room for arbitrage. ISDA: International Swap & Derivatives agreement: sort of regulation on OTC agreements between banks.

2. Future Contract: Future contract: is similar to forward contract-is also a contract between two partiesa buyer and a sellerto buy or sell something at a future date at a price agreed upon today-, But futures are exchange traded which means that its guaranteed against the risk that either party might default, is subject to a daily settlement procedure, standardized (specific quantities& dates), have listing requirements, all commodities have future contracts In the daily settlement, investors who incur losses pay the losses every day to investors who make profits. Futures prices fluctuate from day to day, and contract buyers and sellers attempt both to profit from these price changes and to lower the risk of transacting in the underlying goods. 3. Swap: A swap is a deal between two parties to exchange a series of future cash flows linked to an underlying asset or a benchmark, exclusively over-the-counter. Interest rate swaps make up more than half of the over-the-counter derivatives market. LIBOR: London Interbank Offered Rate: is the average interest rate that leading banks in London charge when lending to other banks. Floating Interest Rate; An interest rate that is allowed to move up and down with the rest of the market or along with an index, A floating interest rate can also be referred to as a variable interest rate because it can vary over the duration of the debt obligation. This contrasts with a fixed interest rate, in which the interest rate of a debt obligation stays constant for the duration of the agreement. Fixed-For-Floating Swap: An advantageous arrangement between two parties (counterparties), in which one party pays a fixed rate, while the other pays a floating rate. Through an interest rate swap, each party can swap its interest rate with the other to obtain its preferred interest rate

Financial Derivatives
4. Options: An option is a contract between two parties holder (buyer) & writer (seller) that gives the holder, the right but not the obligation to buy call or sell put an underlying asset sometime in the future at a price called exercise price agreed upon today and for that right the holder pays a premium. An option to buy something is referred to as a call; an option to sell something is called a put. *Options are the only derivative tools that are exchange traded and OTC. Important concepts in derivative markets: o Risk Preference: Risk aversion vs. risk neutrality: risk neutral, meaning that investors are indifferent to the risk, on the other hand, risk averse is a description of an investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk. Although most individuals are indeed risk averse, it may surprise you to find that in the world of derivative markets, we can actually pretend that most people are risk neutral.
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Short Selling:

A typical transaction in the stock market involves one party buying stock from another party. It is possible, however, that the party selling the stock does not actually own the stock. That party could borrow the stock from a broker. That person is said to be selling short or, sometimes, shorting. He is doing so in the anticipation of the price falling, at which time the short seller would then buy back the stock at a lower price, capturing a profit and repaying the shares to the broker. A short seller views the stock as being worth less than the market price. Establishing a short position creates a liability. The short seller is obligated to someday buy back the stock and return it to the broker. Short selling, however, can be quite beneficial in that the risk of short positions can be useful in offsetting the risk of long positions. Downward markets Upward markets go short go long

o Repurchase agreement: A repurchase agreement (known as repos) is a legal contract between a seller and a buyer; the seller agrees to sell currently a specified asset to the buyeras well as buy it back (usually) at a specified time in the future at an agreed future price. The seller is effectively borrowing money from the buyer at an implied interest rate. o Return and Risk Return: a measure of an investments performance and represents an increase in investors wealth. Dollar return measures investment performance as total dollar profit or loss. Percentage return It represents the percentage increase in the investors wealth that results from making the investment.
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Financial Derivatives
Risk: the uncertainty of future outcomes. The return investors expect is composed of the risk-free rate and a risk premium. Risk-return trade-off arises because all investors seek to maximize expected return subject to a minimum level of risk.

An efficient market is one in which the price of an asset equals its true economic value, which is called the theoretical fair value. Spot and derivative markets are normally quite efficient. ****Arbitrage and the Law of One Price Arbitrage: is a process where the arbitrageur attempts to make riskless profits in the cases where the asset is priced differently in two markets. *****The following example is extremely important, is there an arbitrage opportunity or not??:

Theres an arbitrage opportunity 1st: weve to know which stock is overpriced and which one is underpriced, S1 is overpriced and S2 is under priced

Financial Derivatives
****Markets ruled by the law of one price have the following four characteristics: o Investors always prefer more wealth to less. o Given two investment opportunities, investors will always prefer one that performs at least as well as the other in all states and better in at least one state. o If two investment opportunities offer equivalent outcomes, they must have equivalent prices. o An investment opportunity that produces the same return in all states is risk-free and must earn the risk-free rate. ***The Role of Derivative Markets: Derivative markets provide a means of managing risk, discovering prices, reducing costs, improving liquidity, selling short, and making the market more efficient. 1. Risk Management: Because derivative prices are related to the prices of the underlying spot market goods, they can be used to reduce or increase the risk of owning the spot items. Derivative market participants seeking to reduce their risk are called hedgers. Hedgers use derivatives to get rid of risk that their business imposes on them. Derivative market participants seeking to increase their risk are called speculators. Speculators use derivative to assume risk voluntarily in the hope of realizing returns, setting risk to an acceptable level through the use of derivative. On the other side of hedging is speculation. Unless a hedger can find another hedger with opposite needs, the hedgers risk must be assumed by a speculator. Derivative markets provide an alternative and efficient means of speculating. 2. Price Discovery: o Forward and futures markets are an important source of information about prices, Futures markets, in particular, are considered a primary means for determining the spot price of an asset. o Advertisement of future items allows it to be used in pricing spot items. o Future prices indicate what market participants expect the future spot price to be o Derivative provide very valuable information about the volatility of the underlying asset

3. Operational Advantages a. Transaction costs are lower than spot market b. Liquidity is higher than spot market c. Ease of short selling as compared to the spot market 4. Market efficiency Arbitrageurs are constantly on the search of inefficiencies and their exploitation of these inefficiencies eliminates them and benefits the economy. The ease and low cost of transacting in these markets
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Financial Derivatives
facilitate the arbitrage trading and rapid price adjustments that quickly eradicate these profit opportunities. Criticisms of Derivative Markets: Zero Sum Game 1. Zero sum game: Unlike financial markets, derivative markets neither create nor destroy wealth they merely provide a means to transfer risk. 2. Speculation: Derivative markets allow the transfer of risk from those wanting to remove or decrease it to those wanting to assume or increase it. These markets require the presence of speculators willing to assume risk to in order to accommodate the hedgers wishing to reduce it. 3. Comparison to gambling 4. Counter argument o Derivatives -unlike the stock market- neither create nor destroy wealth. It merely transfers risk o Gambling only benefits participants and few other indirectly. Derivatives benefits the economy and provides better opportunities in managing risk. Misuses of Derivatives: o High leverage: huge gains and losses from small price changes o Inappropriate use

Financial Derivatives
Chapter 2: CALL OPTIONS A call option is an option to buy an asset at a fixed pricethe exercise price. A call in which the stock price exceeds the exercise price is said to be in-the-money. If the stock price is less than the exercise price, the call option is said to be out-of-the-money. Out-of-the-money calls should never be exercised. Put Options: A put option is an option to sell an asset, such as a stock.

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