Chapter 1

Chapter 1 - Derivatives, Introduction Types 1. Forward...

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Derivatives, Introduction Types 1. Forward contracts A forward contract is a contract that is an agreement to buy or sell some commodity sometime in the future. The terms of the contract are specific to the individual. This is not to be confused with the cash or spot markets which are contracts for immediate delivery. These contracts appear in markets that there is some degree of trust or knowledge between the parties and established relationships make the possibility of default less likely. Almost all forward contracts are delivered which means that the parties at the contract date exchange cash for the commodity. 2. Futures Contracts Futures contract are like forward contract but are standardized and are traded on organized exchanges whether electronic or on a physical exchange. 3. Options contracts Options contracts are contracts that give the holder the right to purchase or sell a specific amount of underlying commodity at a specific price for a specific period of time. For this right the holder pays to the creator (writer) of the option a premium. If the option is a right to buy it is called a call option and if it is the right to sell it is called a put option. The price at which the underlying asset can be sold (put option) or bought (call option) is known as the strike or exercise price. For stock options the underlying asset is 100 shares of stock. There are two styles of options, American and European. An American option can be exercised at anytime up to the expiration of the option while a European option can only be exercise at the time if expiration. There are 4 basic options strategies: 1. Buy a call 2. Sell (write) a call 3. Buy a put 4. Sell (write) a put Types of traders 1. Hedgers The intention of hedgers is to reduce risk by taking the opposite position in the derivative market as they have in the cash market 2. Speculators Take on additional risk to make additional profit 3. Arbitrageurs Riskless profit Futures contracts Futures contracts are a refinement of the forward contract concept. In these contracts a
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This note was uploaded on 11/23/2009 for the course FIN 5180 taught by Professor Rader during the Fall '09 term at Temple.

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Chapter 1 - Derivatives, Introduction Types 1. Forward...

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