Options, Futures and Other Derivatives: Global Edition

Product Information

Derivatives are majorly used to hedge or to speculate. The following are specific examples of the uses of derivatives. Hedgers use derivatives to reduce or remove risk exposure. We have already discussed how hedging works above. Consider the following example where foreign exchange risk is hedged using options.

The agreed-upon price is called the forward price. The price at which the dealer wants to buy is called the bid price, while the price the dealer wants to sell is called the ask price. The risk manager can hedge against the foreign exchange risk by buying the call option with a strike price of USD 1.1120. If in six months the exchange rate is more than USD 1.1120, the risk manager will exercise the option, getting the 10 million euros using the exchange rate of USD 1.1120. If now, the risk manager’s company is due to receive 10 million euros in six months, at a USD 1.112O exchange rate. How can the risk manager this position against the foreign exchange rate? Closing out a deal prior to maturity, e.g., in an American option that can be exercised before maturity, can at times be difficult. Even more likely, bid-ask spreads could be so large as to represent a substantial cost. Operational Risk Long exposure in a futures contract means the holder of the position is obliged to buy the underlying instrument at the contract price at expiry. The holder will make a profit if the price of the instrument goes up.

What Is a Derivative?

In options, such as a European call option, the potential loss is capped at the premium paid, while gains can be unlimited if the underlying asset’s price moves favorably. Alternatively, the risk manager could buy the European put option to sell 10 million euros at an exchange rate of USD 1.1120. If in six months the exchange is less than USD 1.1120, the risk manager exercises the option by selling the received for USD 1.1120. On the other hand, if the exchange is greater than USD 1.1120, the option is not exercised, and the risk manager acquires a favorable exchange rate. Speculators Margins: Daily settlements may not provide a buffer strong enough to avoid future losses. For this reason, each party is required to post collateral that can be seized in the event of default. The initial margin must be posted when initiating the contract. If the equity in the account falls below the maintenance margin, the relevant party must provide additional funds to cover the initial margin. The years 1997-2017 saw the exchange-traded market and the OTC markets growing by a factor of 6 and 7.4, respectively. Options, Futures, and Forwards Options

NEW! Available DerivaGem 3.00 software—including to Excel applications, the Options Calculator and the Applications Builder, and a Monte Carlo simulation worksheet: Non-linear derivatives, such as options, have an asymmetrical payoff profile. This characteristic means that the holder of the option can have limited loss (the premium paid for the option) with the potential for unlimited gain. In the case of a European call option, if the price of the underlying asset goes above the strike price, the holder can exercise the option and make a profit. If the price stays below the strike price, the holder’s loss is limited to the premium paid. This is a distinguishing feature of non-linear derivatives. A forward contract is a non-standardized contract – traded in an over-the-counter market –between two parties that specifies the price and the quantity of an asset to be delivered in the future. That it’s non-standardized implies it cannot be traded on an exchange. Instead, they are traded in the OTC market. One party takes a long position and agrees to buy the underlying asset at a specified price on the specified date, while the other party takes a short position and agrees to sell the asset on that same date at that same price. If the underlying makes a move, the value of the derivative moves with a nearly identical margin. In fact, there is a 1:1 relationship between the derivative and the underlying – explaining why linear derivatives are said to be “delta-one” products. However, the delta itself need not always be equal to 1. Examples of linear derivatives include futures and forwards.Non-linear derivatives have a constant rate of change in value with respect to changes in the underlying asset. Bridges the gap between theory and practice—a best-selling college text, and considered “the bible” by practitioners, it provides the latest information in the industry, including: Options not only hedge against risk but also provide additional protection against adverse price movements. In other words, they protect against negative risk while preserving upward payoffs. This program provides a better teaching and learning experience—for you and your students. Here's how: Define derivatives, describe the features and uses of derivatives, and compare linear and non-linear derivatives.

o The Applications Builder consists of a number of Excel functions from which users can build their own applications. It includes a number of sample applications and enables students to explore the properties of options and numerical procedures more easily. It also allows more interesting assignments to be designed. Which of the following characteristics is a defining feature of non-linear derivatives (such as a European call option) in comparison to linear derivatives (such as a forward contract)? Non-linear derivatives have an asymmetrical payoff profile, allowing for limited loss with unlimited potential gain.Options have been embedded in capital Investment opportunities to give room for expanding or doing away with the project depending on the turn of events. A is incorrect because non-linear derivatives do not always have positive values. For example, an option can be worthless if it is out-of-the-money at expiration. Options are derivatives that offer the investor the right (but not the obligation) to buy or sell an asset in the future at a fixed price. Options can be found on exchanges and in the over-the-counter market. There are two types of options: call and put options. An option contract involves two parties: the party with a long position and a short position in the option. A risk manager in company X (located in the U.S.) knows that his company is due to pay 10 million euros in 6 months, at the exchange rate of USD 1.1120 per euro. How can the risk manager hedge again foreign exchange risk using a call option?

For the put options, the party in a long position has the right but not the obligation to sell an asset from a short position at a specified price called the strike price or exercise price within a given period. Option Payoffs Call Option Payoff

Investors trade in contracts that have been identified in the exchange. Traditionally trading was done using the outcry system (Investors met at the exchange floor and used signals to indicate their proposed trades.) Currently, trading is done electronically through a computer. Advantages of OTC Markets over Exchanges A call option gives the holder the right but not the obligation to buy the underlying asset at the strike price before the expiration date. On the other hand, a put option gives the holder the right but not the obligation to sell the underlying asset at the strike price before the expiration date. Forwards Contracts Hedging is the use of derivatives like futures and options to reduce or eliminate financial exposure. Before delving further into hedging, it is imperative to understand the following points: Companies use derivatives to manage various risks: interest rate risk, foreign exchange risk, and commodity price changes to risk. Consider the forward contract on CAD- EUR exchange rate. The spot bid and ask prices per one euro are CAD 1.1080 and CAD 1.1083, respectively. The 6-month bid and ask prices are CAD 1.1120 and CAD 1.1125, respectively.