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Lecture1_Introduction

Lecture1_Introduction - NBA 6730 Derivative Securities...

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1 NBA 6730: Derivative Securities Lecture 1: Introduction 08/26/2010 George Gao NBA6730-Derivative Securities I 2 Agenda This lecture introduces forward contracts, futures, and options. We first use some examples to understand the meaning of hedging and the differences between forwards and futures. We then introduce the no arbitrage principle. Define derivatives: obligations vs. rights Understand futures contracts: margin requirement and marking to market No-arbitrage pricing philosophy
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2 NBA6730-Derivative Securities I 3 (1) What are Derivatives? A derivative is a contract that derives its value from one or more underlying variables such as asset prices, reference rates, or indices. Example 1: forward/futures contracts A forward/futures contract is an agreement between two parties to buy (sell) something at a pre-specified price on a pre-specified date. The party agreeing to buy the good in the future is said to buy a forward/futures, and has a long position The party agreeing to sell the good in the future is said to sell a forward/futures contract, and has a short position Zero-sum game: net number of outstanding contracts = zero NBA6730-Derivative Securities I 4 (1) What are Derivatives? Example 1 (cont.): hedge by a forward contract Jim will harvest 10,000-bushel corn in three months. The current price $4/bushel is fair to him, but this price cannot be guaranteed after three months. Case 1: sell a forward contract of 10,000 bushels @ $4/bushel in three months Case 2: do nothing today and just wait for three months Price increases to $4.5/bushel Price decreases to $3.5/bushel Hedge is to neutralize the risk (uncertainty) as far as possible Case 1: no uncertainty of future cash flow since Jim already locks in the price through a forward contract Case 2: future cash flow is volatile
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3 NBA6730-Derivative Securities I 5 (1) What are Derivatives? Example 2: options A call (put) option gives you the right , but not the obligation , to buy (sell) something at a pre-specified price on a pre-specified date. The party that receives the right to buy/sell at a later date buys the option and has a long position The party that gives the right to buy/sell at a later date writes (sells) the option and has a short position Buy a call, buy a put, sell a call, sell a put (don’t confuse them!)
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