Forward Commitiments vs. Contingent Claims
Both the long forward and the call option payoffs increase as ST rises. In the case of a forward, this linear relationship is equal to [ST – F0(T)], with the payoff equal to profit because no cash is exchanged at inception. For the buyer of a call option with an exercise price of F0(T), Π = max[0, ST – F0(T)] – c0. Setting the…
Options
The option buyer pays a call option premium, c0, at time t = 0 to the option seller and has the right to purchase the underlying, ST , at an exercise price of X at time t = T. The exercise payoff (ST – X) is positive if ST > X and zero if ST ≤ X. The call option value at maturity, cT , The call option buyer’s profit equals the payoff minus the call premium, c0 This asymmetric payoff profile is…
Swaps
A swap is a firm commitment under which two counterparties exchange a series of cash flows in the future. One set of cash flows is typically variable, or floating, and determined by a market reference rate that resets each period. The other cash flow stream is usually fixed or may vary based on a different…
Futures
Futures contracts are forward contracts with standardised sizes, dates, and underlyings that trade on futures exchanges. Futures markets offer both greater liquidity and protection against loss by default by combining contract uniformity with an organised market with rules, regulations, and a central clearing facility. The futures contract buyer creates a long exposure to the underlying by…
Forwards, Futures, and Swaps
Forwards, futures, and swaps are the most common derivative contracts which represent a firm commitment. This firm commitment is an obligation of both counterparties to perform under the terms of the derivative contract. Key common features of this type of derivative include the following:
Derivative Markets
Over-the-Counter (OTC) Derivative Markets OTC markets can be formal organisations, such as NASDAQ, or informal networks of parties that buy from and sell to one another, as in the US fixed-income markets. OTC derivative markets involve contracts entered between derivatives end users and dealers, or financial intermediaries, such as commercial banks or investment banks. OTC dealers,…
Derivative Underlyings
Equities Equity derivatives usually reference an individual stock, a group of stocks, or a stock index. Fixed-Income Instruments Bonds are a widely used underlying, and related derivatives include options, forwards, futures, and swaps. Government issuers, such as the US Treasury or Japanese Ministry of Finance, usually have many bond issues outstanding. An interest rate is…
Derivative Features
Definition and Features of a Derivative A derivative is a financial instrument that derives its value from the performance of an underlying asset. The asset in a derivative is called the underlying. The underlying may not be an individual asset but rather a group of standardised assets or variables, such as interest rates or a…