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lecture02

# lecture02 - Derivatives basics Trading strategies using...

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Derivatives - basics Trading strategies using options Lecture 2 - Options payoffs and strategies BUSI 588, Fall 2011 Diego Garc´ ıa Kenan-Flagler Business School UNC at Chapel Hill August 29th, 2011 c Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 2 - Options payoffs and strategies 1 / 27 Derivatives - basics Trading strategies using options Outline and handouts 1 Derivatives - basics Definitions Payoff tables and payoff diagrams 2 Trading strategies using options Rinconete Trading strategies Meeting clients’ needs Handouts today: Class slides. Case 2 solutions. Other random things: Class representatives? Comments/suggestions on webpage. c Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 2 - Options payoffs and strategies 2 / 27

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Derivatives - basics Trading strategies using options An aside on compounding There are many different interest rate conventions in Finance: Annual compounding (i.e. yield curve). Semi-annual compounding. Daily compounding (i.e. credit cards). Continuously compounding. The book likes the continuously compounding convention. I (and the WSJ) like the annual compounding. Key: read e - rT as 1 (1+ r ) T . c Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 2 - Options payoffs and strategies 3 / 27 Derivatives - basics Trading strategies using options From simple annual rates to continuously compounded Continuously compounded interest rate r c . For each \$1 invested you get \$ e r c t in t years. Annual (simple) interest rate r . For each \$1 invested you get \$ (1 + r ) t in t years. To go from one to the other: 1 + r = e r c Examples 1 r = 5% is the same as r c = 4 . 879%. 2 r c = 5% is the same as r = 5 . 127%. c Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 2 - Options payoffs and strategies 4 / 27
Derivatives - basics Trading strategies using options Derivatives Definition A derivative security is a legal contract between two counterparties; which specifies a set of payments (payoffs) to be received or paid by each counterparty; where the payments depend upon (are a function of) some other asset’s future price(s), the underlying asset . Sample derivative instruments: futures and forward contracts, options (calls and puts), exotics (lookback, binary, chooser), swaps (collection of forwards), warrants, corporate bonds (callable and convertible), oil wells, gold mines, eletricity mills, marriage, life. Underlying assets can be: stocks, indexes, exchange rates, aluminum, weather, pork bellies, . . . . c Diego Garc´ ıa, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 2 - Options payoffs and strategies 5 / 27 Derivatives - basics Trading strategies using options Derivatives markets Most derivative contracts are traded over-the-counter (OTC). But there are also active exchanges (CBOE, CME). Focus on this course on forward and future contracts, plain-vanilla call and put options. But be aware (more on Advanced Derivatives): Largest segment is interest rate derivatives (swaps).

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