08.A1 Lecture Slides Ch.14 - Derivatives [x2].pptx

08.A1 Lecture Slides Ch.14 - Derivatives [x2].pptx - The...

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Francesco Marchionne The Nature of Derivatives A derivative is an instrument whose value depends on the values of other more basic underlying variables 1 Complex Risky 1. What are these financial instruments? 2. Why should an investor buy them?
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Francesco Marchionne Derivatives instruments and market Contracts Forward Contracts Futures Contracts Options Swaps Credit Derivatives Underlyings Interest rate contracts Foreign exchange contracts Equity-linked contracts Commodity contracts Credit default swaps 2 Forwards Exchange-listed market Over the counter market Derivatives Futures Options Swaps Options
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Why and How Derivatives are Used Francesco Marchionne Reasons: To hedge risks (offset a long with a short position or viceversa) To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another 3
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Francesco Marchionne Hedging Engage in a financial transaction that reduces or eliminates risk Long position = bought an asset Short position = sold an asset (future delivery) Basic hedging principle Hedging risk involves engaging in a financial transaction that: offsets a long position … by taking an additional short position offsets a short position … by taking an additional long position 4
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Francesco Marchionne Forward Contracts Agreement to buy or sell an asset at a certain time in the future for a certain price . There is no daily settlement . At the end of the life of the contract one party buys the asset for the agreed price from the other party. Elements of (Interest-Rate Forward) Contracts Specification of the actual debt instrument to deliver at a future date Amount of the debt instrument to be delivered Price (interest rate) on the debt instrument when it is delivered Date on which delivery will takes place 5
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Francesco Marchionne How a Forward Contract Works? Over-the-counter (OTC) contract between 2 companies No money changes hands when first negotiated The contract is settled at maturity The initial value of the contract is zero The forward price is the delivery price applicable to the contract if negotiated today The forward price may be different for contracts of different maturities 6
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Francesco Marchionne Interest-Rate Forward Markets Long position = agree to buy securities at future date Hedges by locking interest rate (if funds coming in future) Short position = agree to sell securities at future date Hedges by reducing price (interest rate risk if holding bonds) Pros Flexible: as flexible as the parties involved would like Cons Lack of liquidity: hard to find counterparty Subject to default risk: requires information to screen good from bad risk 7
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Francesco Marchionne Long Forward Position Profit Price of Underlying at Maturity Short Forward Position Profit Price of Underlying at Maturity Profit from Forward Contracts 8
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