DERIVATIVES

What are derivatives?  Financial instruments whose price depends on the movement of another price (MK, p.100) The value of the contract is derived from another asset. ↓ the underlying asset:commodities, currencies, securities  Futures & forwards, options, swaps

COMMODITIES (animal, vegetable, mineral?)  Wheat  Coffee  Palm oil  Nickel  Sugar  Maize  Milk  Bauxite  Iron ore  Wool  Grain  Rubber  Wine  Copper  Beef  Tea  Zinc  Gold  Lead  oil  Phosphates  Fowl  Tin  Timber

COMMODITIES (animal, vegetable, mineral)  Wheat  Coffee  Palm oil  Nickel  Sugar  Maize  Milk  Bauxite  Iron ore  Wool  Grain  Rubber  Wine  Copper  Beef  Tea  Zinc  Gold  Lead  Oil  Phosphates  Fowl  Tin  Timber

Commodities can be traded... ...for immediate delivery at their current prices on spot markets ... for future deliveries at prices fixed at the time of the deal on futures markets

A case of a silversmith Source: A silversmith must secure a certain amount of silver in six months time for earrings and bracelets that have already been advertised in an upcoming catalog with specific prices. But what if the price of silver goes up over the next six months? Because the prices of the earrings and bracelets are already set, the extra cost of the silver can't be passed on to the retail buyer, meaning it would be passed on to the silversmith. The silversmith needs to hedge, or minimize her risk against a possible price increase in silver. How?

Source: The silversmith would enter the futures market and purchase a silver contract for settlement in six months time (let's say June) at a price of $5 per ounce.futures market At the end of the six months, the price of silver in the cash market is actually $6 per ounce, so the silversmith benefits from the futures contract and escapes the higher price. Had the price of silver declined in the cash market, the silversmith would, in the end, have been better off without the futures contract. At the same time, however, because the silver market is very volatile, the silver maker was still sheltering himself from risk by entering into the futures contract.

A case of a silversmith (fill in) A silversmith must secure a certain amount of silver in six months time for earrings and bracelets that have already been advertised in an upcoming catalog with specific prices. But what if the price of silver ………….over the next six months? Because the prices of the earrings and bracelets are already ………., the extra cost of the silver can't be passed on to the ……….. buyer, meaning it would be passed on to the silversmith. The silversmith needs to ………….., or minimize her ………….. against a possible price ………….. in silver. How?

The silversmith would enter the ………………..market and purchase a silver contract for settlement in six months time (let's say June) ……………a price of $5 per ounce.market At the end of the six months, the price of silver in the cash market is actually $6 per ounce, so the silversmith benefits from the futures …………… and escapes the higher price. Had the price of silver …………….in the cash market, the silversmith would, in the end, have been better off without the futures contract. At the same time, however, because the silver market is very ………………., the silver maker was still sheltering himself from risk by entering into the …………………contract.

The idea behind an option is present in many everyday situations: Say, for example, that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.cash

Now, consider two theoretical situations that might arise: Source: 1.It's discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).

Source: 2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.