17_Derivatives

17_Derivatives - Derivative Markets and Instruments: -...

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Derivative Markets and Instruments: - Derivative contracts can be classified into two general categories: o Forward Commitments Forward contracts take place in large and private markets consisting of banks, investment banking firms, governments and corporations. These contracts call for a purchase and sale of an underlying asset at a later date. Futures is similar to forwards. However, it is not a private and customized transaction. It is a public and standardized transaction that takes place on a futures exchange. In a forward contract, the risk of default is a concern. In a futures contract, the futures exchange guarantees to each party that if the other party fails to pay, the exchange will pay. The futures exchange implements this performance guarantee through a clearing house which requires a daily settlement. Another important distinction between futures and forwards is that forward contracts are generally designed to be held until expiration. Swap is a variation of a forward contract that is essentially equivalent to a series of forward contracts. Specifically, a swap is an agreement between two parties to exchange a series of future cash flows. Typically, at least one of the two series of cash flows is determined by a later outcome. In other words, one party agrees to pay the other a series of cash flows whose value will be determined by the unknown future course of some underlying factors, such as an interest rate, exchange rate, stock price, or commodity price. o Contingent Claims - Exchange traded derivatives are standardized and backed by a clearinghouse - Purposes of Derivative Markets: o Price Discovery o Risk Management o Improve market efficiency of the underlying assets o Serve as a form of insurance - There are two arbitrage arguments that are particularly useful in the study and use of derivatives: o Law of one price o If two securities with uncertain returns can be combined in a portfolio that will have a certain payoff. Forward Markets and Contracts - Delivery and Settlement o Delivery o Cash Settlement: Cash settled forward contracts are sometimes called NDFs or nondeliverable forwards. - Types of Forward Contracts
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o Equity Forwards: An equity forward is a contract calling for the purchase of an individual stock, a stock portfolio, or a stock index at a later date. Equity forward contracts typically have payoffs based only on the price of the equity, value of the portfolio or level of the index. They do not ordinarily pay off dividends paid by the component stocks. An exception, however, is that some equity forwards on stock indices are based on total return indices. o Bonds and Interest Rate Forwards: Bond may pay a coupon which resembles a dividend. But unlike a stock, a bond matures, and a forward contract on the bond must expire prior to the bond’s maturity date. A forward contract written on a bond must contain a provision to recognize how default is defined, what it means for the bond to default and how default would affect the parties to the contract. FRAs are contract in which
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This note was uploaded on 02/25/2012 for the course BIO 2400 taught by Professor Mclean during the Fall '09 term at Texas State.

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17_Derivatives - Derivative Markets and Instruments: -...

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