Study session 17 of Schweser Notes
Derivative - derives its value from the value or return of another asset or security
Can be exchange traded - standardized and backed by a clearinghouse
Forwards and swaps have no central location, created ad hoc. This is OTC. Largely unregulated.
Some options trade in OTC market, esp bonds.
Forward commitment - promise to perform some action in future
Options differ from forwards in that they depend on hitting some threshold exercise price. You need two options to replicate a future or forward.
Forward contract - one party buys and one party sells at a future date at a given price. Lock in today's price.
Futures are well regulated forwards. Futures trade actively in a secondary market.
Swap - a series of forward contracts. E.g. floating/fixed swap, currency swap, etc.
Call option - call holder can call in a bond, and seller of call has obligation to deliver if exercised.
Put option - put holder can sell bond, and put seller has obligation to buy if exercised.
Benefits of derivatives - provide price information, allow risk management, and reduce transaction costs.
Law of One Price - two securities with identical cash flows (regardless of future events) should have the same price. Buy the underpriced asset and sell short the other.
Other arbitrage opportunity is when you combine two assets to earn more than the risk free rate. Borrow at the risk free and buy the portfolio of the two assets. Payoff will cover the loan.
Derivative - derives its value from the value or return of another asset or security
Can be exchange traded - standardized and backed by a clearinghouse
Forwards and swaps have no central location, created ad hoc. This is OTC. Largely unregulated.
Some options trade in OTC market, esp bonds.
Forward commitment - promise to perform some action in future
Options differ from forwards in that they depend on hitting some threshold exercise price. You need two options to replicate a future or forward.
Forward contract - one party buys and one party sells at a future date at a given price. Lock in today's price.
Futures are well regulated forwards. Futures trade actively in a secondary market.
Swap - a series of forward contracts. E.g. floating/fixed swap, currency swap, etc.
Call option - call holder can call in a bond, and seller of call has obligation to deliver if exercised.
Put option - put holder can sell bond, and put seller has obligation to buy if exercised.
Benefits of derivatives - provide price information, allow risk management, and reduce transaction costs.
Law of One Price - two securities with identical cash flows (regardless of future events) should have the same price. Buy the underpriced asset and sell short the other.
Other arbitrage opportunity is when you combine two assets to earn more than the risk free rate. Borrow at the risk free and buy the portfolio of the two assets. Payoff will cover the loan.
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