How do dealers hedge their risk? Key Characteristics : • Flexibility & Customization • Privacy • Lower Liquidity • Higher Credit Risk
4 – Types of Derivatives Forward commitments Obligation a. Forward contracts b. Futures c. Swaps Contingent claims Contingent on an event a. Options b. Credit derivatives c. Asset-backed securities Hybrids a. E.g. callable bonds, convertible bonds etc.
Forward Commitments a. Forward contracts Key Terminologies / Concepts : • Spot Price • Forward Price • Pay-off / Value of Contract
Settlement of Forward Contracts :
Pay-off from Forward Contracts:
Marking to Market
The account is referred to as Margin Account : • Initial margin? • Maintenance margin? • Margin call?
Provisions Limiting Price Changes : Definition of Open Interest :
Futures Price Eventually Converges to Spot Price :
Plain Vanilla Swap :
Converting a floating-rate loan to a fixed-rate loan:
Swaps vs. Actual Loans : • Other Differences : Lower credit risk than loan because notional principal is not exchanged There are also interest rate swaps in which one party pays based on one reference rate while the other party uses another reference rate
Value of Swap at Initiation = 0
Call option vs. Put option:
Exercise Price ? Option Premium ?
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- Spring '20
- Derivative, Convertible bond