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FMI week 9 Derivative Markets - Coggle Diagram
FMI week 9 Derivative Markets
Derivatives overview
a financial contract between two parties which has a payoff
determined by the price of underlying assets
Benefits
Allow risk to be shared among market participants
increase liquidity
transmit information
interest rate derivatives
are large in size and mostly dealt with OTC
Forward and Future contracts
Forward contract
a
binding agreement
to buy or sell a
specific quantity
of some asset at
predetermined price and date.
Zero cost
OTC market
Physical delivery
by the short side to specific date and location or
Cash settlement
to send cheque with payoff amount.
Pros
Tailored
to precisely meet the need
Uncertainty
of future price is
hedged
by both parties
Cons
profitability is not certain
both parties subject to
credit risk,
when price move adversely
highly customised, difficult to
offset a position
Future Contract
Collateral with
marking to market
for credit risks
Standardised
requires
collateral(margin)
must be maintained at acceptable level
gains and losses are paid daily via ASX clearing house, if not margin call will be made
risks
Margin risks:
margin requirement may cause cash shortage, force investor liquidate.
Basis risk: ??
Options
options give the buyer
the right, not obligation
to buy/sell financial instrument at a
predetermined price
on or before a
specific date.
Only long side can get to
decide
when/whether to exercise, put side has to
accept
and gets reversed payoff.
European options
can be exercised only on expiration date T.
America options
can be exercised any time up to T.
futures vs options
futures: both parties face same amount of risk, fair chance to win/lose.
options: give buyer downside price protection and upside potentials.
futures are free, options have
positive premiums
Bonds with options
permit issuers/buyers the
right, not obligation
to change the bond before maturity.
Callable bonds
gives the
issuer
the right to buy the bond from the buyer at fixed strike price before bond maturity.
helps issuers hedge against
declining interest rate
, buy back and replace with low cost debt
Call interest premium
: difference in interest rate between callable and non-callable bonds. higher to compensate investors.
Puttable bonds
permits
buyer
the right to sell the bond back to issuer at fixed strike price before bond maturity.
helps buyer hedge
increasing interest rates
, sell bond and reinvest in higher return project.
The put interest discount:
difference between puttable and nonputtable bonds. lower due to benefit of investor protection.
Convertible bond
permits the buyer to
convert it
into equity at pre-specified conversion rate on permitted date.
most valuable when share market prices are rising and bond prices are declining.
for issuers:
obtain better financial conditions, diminish liabilities. offer lower interest rate.
for buyers
: defensive security
tend to be used by smaller firms with high growth rate and more financial leveraged.
Swap contract
two parties agree to exchange payment obligations on two underlying financial liabilities that are
equal in notional principle amount
but
differ in payment patterns.
interest rate swap
Generic swap:
a swap of a series of
fixed interest rate
payments for
floating interest rate
payments.
two parties swap their interest payment obligations
the principle amount is never actually transferred between counter parties.
Basis swap
: a swap of
two different reference rate
interest payments
reasons for interest rate swaps
Lower cost of funds
access gained to otherwise inaccessible debt market
Hedge interest rate risk exposures
profit margins locked in on economic transactions
equity swap contract:
swaps floating interest rate to performance of a stock or market index. using Marking to market to reduce credit risks.