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Derivative market Financial derivative is a contractual agreement, whose profits or loss depends on the price of assets underlying in a contract. Financial derivative product: Forward contract Future contract Option contract SWAP www.assignmentbasket.com
Importance of financial derivative market Risk management: Hedging risk Transfer of risk Keeping risk at an acceptable level Price discovery: Investors expectation of future price Forward or future price contains valuable information Option market provide valuable information about volatility and risk of assets Operational advantage: Larger transaction cost Greater liquidity Short selling www.assignmentbasket.com
Development of forward contract In 1840 farmers in Chicago a huge loss reasons being lowest price ,storage facilities and insufficient buyers. In 1848 a group of businessman met together and formed Chicago board of trade, which objectives are: Standardizing the quantities Maintaining quality of grain Enables farmers to sell products well around of time and thereby locking the price In 1898, Foundation of Chicago Mercantile exchange(CME) In 1920 established clearing house as an integer of CBOT. Clearing house facilitating the development of future market and nature of future contracts. www.assignmentbasket.com
Forward Contract Forward contract is an agreement between two parties in order to buy and sell a particular asset at a prefixed price on a certain date in the future. Feature of FC: Forward contract is an agreement Forward contract is an agreement between two parties Forward contract is an agreement to buy and sell Trading a particular asset Price is prefixed Date is prefixed FC is a product of OTC market FC is non-standardized product FC can be made for any amount of quantity www.assignmentbasket.com
Investment asset ( stocks, bonds, gold) Types of FC: Foreign currency Investment asset ( stocks, bonds, gold) Consumption assets ( oil, jute rice) www.assignmentbasket.com
Forward contract Vs Future contract Nature OTC Standardized Trading conducted Direct conducted over phone, Fax, mail etc. in person Automation through broker Buy/sell Principle and Agent Non member deal Participants Mostly financial institutions and Friends and relatives Investors, Speculators, Banks, Financial institutions Commission No Yes Credit risk Exchanged Clearing Margin Not required Required Settlement On maturity date Through clearing house Liquidity Cash settlement On delivery Regulated training www.assignmentbasket.com
Problem-1 (Forward contract): A one year long forward contract on a non-dividend paying stock is entered into when the stock price is Tk. 40 and the risk free interest rate is 10% p.a. with continuous compounding. What are the forward price and the initial value of the forward contract? Six month later, the price of the stock is Tk. 45 and the risk free interest rate is still 10%. What are the forward price and the initial value of the forward contract? www.assignmentbasket.com
What is the forward price? What arbitrage opportunity is there? Problem-2 (Forward contract): Assume that a 10-month forward contract on a stock with a price of Tk. 60. The risk free interest rate is 7% p.a. with continuous compounding. It is assumed that dividends of 0.90 per share are expected after 5 months and 8 months. What is the forward price? What arbitrage opportunity is there? www.assignmentbasket.com
Types of Future contact Commodity future contract Financial Future contract - Interest rate future contract - Currency future contract - Stock index future contract www.assignmentbasket.com
Problem-3(Future Contract): XYZ enter into future contract to buy 300 units @ Tk. 70 each at the end of the 3 months. XYZ corporation is required to deposit 10% of contractual agreement price as margin. Maintenance margin is Tk. 1000. Show margin a/c if market price is as follows: Dec-1 Tk. 72 2 Tk. 71 3 Tk. 69 4 Tk. 67 5 Tk. 64 6 Tk. 69 www.assignmentbasket.com
Calculate the future price of silver for delivery in nine months. Problem-4(future contract): The current price of silver $ 1000 and the risk free rate is 7% per annum for all maturities. The storage cost are $12 per ounce per year, with the payment being made at the end of the year. Calculate the future price of silver for delivery in nine months. What should arbitrage do if future of goods be $1050 or $ 1080? www.assignmentbasket.com
Options Option on stock were first traded on an organized exchange in 1973. since then there has been a dramatic growth in options markets. Option are now traded on many exchanges throughout the world. Huge volumes of options are also traded OTC by banks and other financial institutions. Characteristics of Option market: Option market may be OTC market or organized market Very old Deals with the right not obligation Option market acts as insurance www.assignmentbasket.com
Products of option market: Call option Put option SWAPs option Option on stock index Option on currency Option on future www.assignmentbasket.com
Option is a contract that provides right to option buyer develops obligation for option seller facilitates for buying and selling and a particular underlying to the contract at prefixed price/strike price on the certain date in the future or during the contractual period. Parties of the Option: Option writer or seller Option buyer Option buyer paid the premium to the option seller and option seller given the right to the option buyer. www.assignmentbasket.com
The underlying asserts in option market include: Stocks Option on assets: The underlying asserts in option market include: Stocks Foreign currencies Debt securities Commodities Future contracts www.assignmentbasket.com
Calls and puts can be one of the two types: Types of option: Call option: A call option grants its purchaser called the option holder, the right to purchase a specified number of units of some underlying asset from the option seller. The option seller is called the option writer or sometimes the option grantor. Put option: A put option grants its purchaser called the option holder, the right to sell a specified number of units of some underlying asset. Calls and puts can be one of the two types: A European option: is an option that can only be exercised only on the expiration date itself. A American option: in an option that can be exercised at any time from the moment it is created until the time it expires. www.assignmentbasket.com
Option premium: Factors that influence for determining option premium: Strike price: The price which is prefixed by the buyer and seller on the day of contract. Strike price depends on Spot price Interest rate Inflation rate demand and supply Option premium: Factors that influence for determining option premium: Total risk risk free interest rate Market price profitability Strike price In option premium a model was develop that called Black and School model. www.assignmentbasket.com
When to exercise option? Call option: strike price(K) < market price(S) Put option: strike price(K) > market price(S) www.assignmentbasket.com
Problem-5 (Call option): Jerry house paid a premium of $ 4 per share for one 6-month call option contract (total of $ 400 for 100 shares) of the Mahony Corporation. At the time of the purchase, Mahony stock was selling for $ 56 per share and the exercise price of the call option was $ 55. Determine Jerry’s profit or loss if the price of Mahony’s stock is $ 54 when the option is exercised. What is Jerry’s profit or loss if the price of mahony’s stock is $62 when the option is exercised? www.assignmentbasket.com
Determine jerrey’s profit or loss if he had purchased the $2 put. Protective put: when an investor purchase a long position in common stock, losses will incur if the price of the stock falls. One way to obtain protection from this loss is to purchase a protective put. A put where the exercise price and current price are equal. Problem-6 Jerry is considering purchase 100 shares of Beximco’s stock at a current price of $ 50 per share. However, jerry is afraid that the price of stock could fall in two months after buys it. A current 3 month at the money put option for Beximco is selling 42 premium per share. What profit or loss will jerry make if he purchases Beximco for $50 per share and the price of Beximco’s stock falls in one month to $40 per share without a protective put. Determine jerrey’s profit or loss if he had purchased the $2 put. www.assignmentbasket.com
Straddle: is the combination of call and put option on the same stock for the same duration and exercise price is simultaneously purchase of both call and put option on the same stock with the same exercise and duration. www.assignmentbasket.com
Spread: is the simultaneous purchase of call option as well as put option on the same stock purchase of call option and sell of call option on the same stock purchase of put option and sale of put option on the same stock With the different exercise price same expiration date different cost of call/of put. www.assignmentbasket.com
SWAP A SWAP is an agreement between two parties in order to exchange a series of cash flow between them in future with a view to convert floating rate obligation into fixed obligation Convert obligation in one currency in to an another currency convert floating price into fixed price And finally hedge risk that arises from volatility of interest rate Volatility in exchange rate Volatility in commodity price www.assignmentbasket.com
Development of SWAP market SWAP market has been experience a phenomenal growth. Reason being: volatility of interest rate Volatility in exchange rate Volatility in commodity price First, currency SWAP market was developed, engineering in London in 1973 1981, Swap market started expanding. First interest rate SWAP was done/transaction 1984, standardize document were develops for SWAP 1985, Foundation of international SWAP dealer association and published SWAP code. 1986, commodity SWAP was introduced and engineered in USA. www.assignmentbasket.com
Kinds of SWAP Interest rate SWAP: The SWAP which converted floating rate obligation into fixed obligation Currency SWAP: The SWAP which Converted obligation in one currency in to an another currency Commodity SWAP: The SWAP which converted floating price into fixed price www.assignmentbasket.com
To reduce cost of capital To manage risk To exploit economics of scale Why uses of SWAP? To reduce cost of capital To manage risk To exploit economics of scale To arbitrage world capital market To enter into new financial market Matching fixed rate asset and liabilities Potential to benefit from anticipated fall in rate. www.assignmentbasket.com
Govt. agency and Municipal Corp. a, b, d User of SWAP Why they use Government b, c Govt. agency and Municipal Corp. a, b, d Expert credit agency a, b, c Supra Nationals b, d, g Financial institutions a, b, c, d, e Corporation a - g www.assignmentbasket.com