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lecture3 (1) - Lecture 3: Forward Contracts Steven Skiena...

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Lecture 3: Forward Contracts Steven Skiena Department of Computer Science State University of New York Stony Brook, NY 11794–4400 http://www.cs.sunysb.edu/ skiena
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Derivatives Derivatives are financial instruments whose value derives from the values of other, more basic variables. Options give the owner the right, but not the obligation, to buy or sell a security at a specified price on (or perhaps before) a specified date. The Chicago Board of Exchange (www.cboe.com) trades options on over 1200 stocks and stock indices. Futures contracts gives one the right and obligation to buy or sell a commodity at a given price at a given time.
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Forward Contracts Forward contracts give the owner the right and obligation, to buy or sell a given security at a specified price on a specified date. The long position on the contract agrees to buy the security on the date. They are betting the the price will go up. The short position on the contract agrees to sell the security on the date. They are betting the the price will go down. Forward contracts can be worth less than zero. If I have the long position on an expiring forward contract for $100 and the price is $90, this will cost me $10.
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Enforcing Contracts That futures/forward contracts can go negative implies that mechanisms must be in place to ensure ultimate delivery. Both the legal system and the Mafia have effective enforce- ment mechanisms, but they only work if the party can pay. Futures markets have developed mechanisms to ensure payment, typically settling gain/loss on a daily basis for cash.
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Margin Requirements and Leverage A particularly important mechanism to enforce financial contracts are
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lecture3 (1) - Lecture 3: Forward Contracts Steven Skiena...

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