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Unformatted text preview: 十十 Asset Valuation: Derivative Investments 1.A: Introduction a: Define derivative instrument, arbitrage opportunity, forward contract, futures contract, option (both a put and a call), option on futures, and swap. A financial derivative is a financial instrument whose payoffs depend on another financial instrument or asset. For example, an option on a share of stock depends on the value of the underlying price of the share. This book discusses four types of derivatives: forwards, futures, options, and swaps. An arbitrage opportunity is the chance to make a riskless profit with no investment. In arbitrage, you observe two identical assets with different prices. A forward contract is a contract negotiated in the present that gives the contract holder both the right and full legal obligation to conduct a transaction at a specific future time involving a specific quantity and type of asset at a predetermined price. A futures contract is a forward contract that has been highly standardized and closely specified. As with a forward contract, a futures contract calls for the exchange of some good at a future date for cash, with the payment for the good to occur at the future delivery date. An options contract gives its owner the right, but not the legal obligation, to conduct a transaction involving an underlying asset at a predetermined future date and at a predetermined price (called the exercise or strike price). Options, however, only give the long position the right to decide whether or not the trade will eventually take place. A swap is an agreement between two or more parties to exchange sets of cash flows over a period in the future. The parties that agree to the swap are known as counterparties. The cash flows that the counterparties make are generally tied to the value of debt instruments or the value of foreign currencies. Therefore, the two basic kinds of swaps are interest rate swaps and currency swaps. b: Discuss the no-arbitrage principle. Since any observed pricing errors will be instantaneously corrected by the first person to observe them, any quoted price must be free of all known errors. This is the basis behind the text’s no-arbitrage principle , which states that any rational price for a financial instrument must exclude arbitrage opportunities. The no-arbitrage opportunity assumption is the basic requirement for rational prices in the financial markets. This means that markets and prices are efficient. That is, all relevant information is impounded in the asset’s price. c: Distinguish between a futures contract and a forward contract. • Forwards are private contracts and do not trade on an organized exchange. Futures contracts trade on organized exchanges....
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- Fall '08
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