Derivatives

CHAPTER 1Derivative Securities

Aims

• To explain forward and futures contracts, their similarities and differences.
• To examine the basic concepts behind call and put options and how their payoffs at maturity can provide ‘insurance’.
• To show how interest rate swaps can be used to alter the cash flow profile of uncertain payments or receipts, and hence reduce the risk attached to such cash flows.
• To analyse how derivative securities are used in speculation, hedging and arbitrage.
• To explain short-selling.

There are three main types of derivative securities, namely futures, options and swaps. Derivative securities are assets whose price depends on the price of some other (underlying) asset. Hence the derivatives price is derived from the price of this underlying asset.

For example, lets assume a futures contract on AT&T stocks is traded on the Chicago Mercantile Exchange (CME). The underlying asset in the futures contract is the stock of AT&T itself, which is traded on a different exchange, namely the New York Stock Exchange (NYSE). The price of the stock on the NYSE is for immediate delivery of the stock, and is known as the spot or cash market price. In contrast, today's futures price (on AT&T stock) quoted in Chicago is a price quote for delivery of AT&T stock (in Chicago) at a specific date in the future. However, we can show that the AT&T futures price (in Chicago) is (largely) determined by the stock price of AT&T (quoted on the NYSE). If AT&T's stock price changes on the ...