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B294 - Unit 6 - Derivatives and risk management - Coggle Diagram
B294 - Unit 6 - Derivatives and risk management
Session 1
Contracts
Forward
Creates legal obligations to fulfil
One party promises deliver specified asset at a specified future date
Second party must accept delivery and make payment on specified date
Payment is agreed when contract is made
Typically organised by financial intermediary
Matches buyers and sellers
Flexible Ts and Cs
No collateral given
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Payoff function
Seller = short position
Assumes market price will be lower than agreed
May not have goods at agreed date
Can purchase at a spot price when due
High risk exposure
Buyer = long position
Assumes market price will be higher than agreed
One party is always making a direct gain at the expense of the second
Understanding fair future pricing
Arbitrage
Involves two or more offsetting transactions
Guarentees positive profit
e.g. buy a car in MK for £12,000 and immediately sell in London for £15,000
Requires strong demand for good
Financed by bank loan
Paid off immediately
Short-selling
Borrow an asset from another client
Sell in hopes value goes down
Repurchase at later date for lower price
Return to original holder at new value
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Calculation
Assumptions made
No arbitrage opportunities
Ignores transaction costs
Businesses can easily borrow money
F0,T = S0 × (1 + rf)T
Futures
Traded on financial exchanges
Protection to ensure companies do not default on agreements
Standardised Ts and Cs
No negotiation
Less flexible
Asset is specified to higher level
Delivery locations usually preset
Contract size is fixed
Less risky
Companies must post collateral as a deposit
Given to broker when contract initiated
Sits in a margin account
Called inital margin
If balance in account increases above margin, it can be withdrawn
If balance falls below maintenance margin
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Exchange trade results in high liquidity
Delivery of asset at later date for payment
Several derivatives
Used for
Speculation
Bet on future value for gain (or loss)
Hedging
Basic commodties
Financial assets
Non-tangible / unconventional
Session 2
Option contracts
Flexible
Transactions only undertaken with benefit
Traded OTC or on exchanges
Value and market price always positive
Cost to enter
Option premium
Must be deducted from any profits
Right to conduct a trade at a future agreed date at a predetermined price
No obligation
Date is called expiration date
Strike or exercise price
Two basic options
Call
Right to buy
Wins when prices go up past strike price
Put
Right to sell
Wins when prices go down below strike price
Black-Scholes model
Options for arbitrage lead to market corrected pricing
Programmed into calculators
Assumptions made
Trading is smooth and continuous
No friction
Investors borrow and lend at risk free rate
Constant over time
Not the case
Market crash = high interest rates
Stock prices effectively change continuously
Session 3
Hedge risk and speculate
Hedges
Long position
Forward contract
Purchase of raw materials
Secures price
Delivery at later date
Short position
Forward contract
Used to hedge currency risk
Payment received can be sent to forward party
Attempts to mitigate risk
Put protection
Right to sell stock
At strike price
Commands higher insurance premium
Upfront cost
Can still sell on market if asset increases
Dangers of speculation
Can be used alternatively to gamble on stock market
Get rich quick
Get poor quicker
Losses potentially unlimited