Underlying types of futures o stock index contract

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Underlying Types of futures: o Stock index contract- weighted average of the prices of a basket of stocks Price tracks the price of the underlying basket of stocks quite closely because of a type of trading known as index arbitrage OPTIONS: A right to purchase or to sell the underlying assets Types of options: o Put option: buying the right to sell the underlying at the exercise or strike price (contract price) o Call option: right to purchase the underlying at the exercise price o American option: can exercise the option at any time through the maturity date
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o European option: buyer may exercise the option only on maturity date Enter an option contract because the seller is compensated with an upfront payment- the premium o Seller must be compensated because the purchaser can only win Price determined by supply and demand Market makers- trade on their own accounts, like locals in futures market Options on futures- options to purchase and sell futures contracts rather than to purchase and sell the underlying asset itself SWAPS: Fastest growing derivative security Interest rate swap- exchange of one type of interest payment for another Companies swap to lower borrowing costs Can hedge risk by becoming a floating rate payer on a swap agreement Swaps are promises, here is how they work o NOT an auction market organized through exchange o Rather, it is a deal or the over the counter market o Dealers who make the market are large banks and securities firms o Rather than trading directly, people work through swap dealers o Bid asked spread is determined by competition amount swap dealers Still bear replacement risk As market markers swap dealers provide liquidity Types: o Interest rate swaps o Currency swaps- countries will borrow in their own currencies and then swap with a foreign company because it is cheaper for someone to borrow money in their home currency than for a foreigner o Commodity swaps o Equity swaps o Credit default swaps SWAPS ARE THE MOST IMPORTANT TYPE OF OTC DERIVATIVES, How exchange traded and OTC derivatives differ Liquidity- o ET are more liquid than OTC. Less easy and more expensive to change one’s position in OTC instruments Flexibility- o ET derivatives are less flexible than OTC. ET contracts are standardized- result= basis risk Cost- o Cost is lower for ET derivatives, they’re a commodity that is arms-length and competitive Maturity- o OTC’s have much longer maturity dates Regulation- o OTC is essentially unregulated Replacement risk- o Essentially none in ET derivatives o This is an issue in OTC market
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ET’s are more liquid, less expensive, and involve less replacement risk. Because standardized they’re NOT better for hedgers. BETTER FOR MARKET MAKERS OTC provides better hedges but they’re more expensive, less liquid, and subject to replacement risk- hedgers that have known and unchanging risk LIBOR = FLOATING RATE
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