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The Uses of Derivatives • Uses – Risk management. Derivatives are a tool for companies and other users to reduce risks. – Speculation. Derivatives can serve as investment vehicles. – Reduce transaction costs. Sometimes derivatives provide a lower cost way to undertake a particular financial transaction. – Regulatory arbitrage. It is sometimes possible to circumvent regulatory restrictions, taxes, and accounting rules by trading derivatives. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-1 Perspectives on Derivatives • End users – Corporations – Investment managers – Investors • Intermediaries • Economic – Market-makers Observers – Traders Regulators Researchers Observers End user Intermediary © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. End user 2-2 Perspectives on Derivatives (cont’d) • End users: They enter into derivatives contracts for the reasons listed in P.14. • Market-makers: They will buy derivatives from customers who wish to sell, and sell derivatives to customers who wish to buy. They make money by charging a spread (buy at low price and sell at higher price. • Economic observers: They look at the use of derivatives, the activities of the market-makers, the organization of the markets and the logic of the pricing models and try to make sense of everything. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-3 Financial Engineering and Security Design • The construction of a financial product from other products. • New securities can be designed by using existing securities. • Financial engineering principles – – – – Facilitate hedging of existing positions Allow for creation of customized products Enable understanding of complex positions Render regulation less effective © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-4 Transaction Costs and the BidAsk Spread • Buying and selling a financial asset – Brokers: commissions. – Market-makers: earn bid-ask (offer) spread • ask (offer) price: price that you buy the stock from market makers. • bid price: price that you sell the stock to market makers. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-5 Transaction Costs and the BidAsk Spread (cont’d) • Example 1.1: Buy and sell 100 shares of XYZ – XYZ: bid = $49.75, offer = $50, commission = $15 – Buy: (100 x $50) + $15 = $5,015 – Sell: (100 x $49.75) – $15 = $4,960 – Round-trip transaction cost: $5015 – $4,960 = $55 © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-6 Ways to buy or sell • Market order To trade a specific quantity of the asset immediately at the best price that is currently available. Advantage: The trade is executed as soon as possible. Disadvantage: You might have been able to get a better price had you been more patient. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-7 Ways to buy or sell (cont’d) • Limit order To trade a specific quantity of the asset at a specified or better price. Advantage: Can trade at a better price. Disadvantage: The possibility that the order is never filled. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-8 Ways to buy or sell (cont’d) • Stop-loss order The stop-loss order becomes a market order to sell once the price of an asset hits the prescribed value. © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-9 Short-Selling • When price of an asset is expected to fall – First: borrow and sell an asset (get $$) – Then: buy back and return the asset (pay $) – If price fell in the mean time: Profit $ = $$ – $ – The lender must be compensated for dividends received (lease-rate) • Example: short-sell IBM stock for 90 days © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-10 Short-Selling (cont’d) • Why short-sell? – Speculation – Financing – Hedging • Credit risk in short-selling – Collateral and “haircut” • Interest received from lender on collateral – Demand on the collateral drives down the interest rate – Demand on cash drives up the interest rate – Repo rate in bond markets – Short rebate in the stock market © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-11 Chapter 3 An Introduction to Forwards and Options International Edition Introduction • Basic derivatives contracts – Forward contracts – Call options – Put Options • Types of positions – Long position – Short position • Graphical representation – Payoff diagrams – Profit diagrams © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-13 Forward Contracts • Definition: a binding agreement (obligation) to buy/sell an underlying asset in the future, at a price set today. • Futures contracts are the same as forwards in principle except for some institutional and pricing differences. • A forward contract specifies – The features and quantity of the asset to be delivered. – The delivery logistics, such as time, date, and place. – The price the buyer will pay at the time of delivery. Today © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. Expiration date 2-14 Reading Price Quotes Daily low Settlement price Daily high Daily change The open price Open interest Expiration month © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-15 Reading Price Quotes (cont’d) • Open Interest Number of contracts outstanding. (Since each trade of a contract has both a buyer and seller, a buyer-seller pair counts as one contract). © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-16 © 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. 2-17