1. Derivatives: Instruments whose values are derived from the prices of underlying assets DerivativesUnderlying Assets Forward contractsStocks Futures contractsStock indexes OptionsTreasury bonds CallsCurrencies PutsCommodities Swaps Wheat, Pork Bellies Gold, Silver Electricity, snowfall

2. Denizens of derivatives markets Arbitrageurs: Buy low – Sell HIGH … all at once – –If you can buy one thing at a low price and sell it or its equivalent at high price, do so until the prices are driven to equality  Can’t lose propositions Hedgers: enter contracts whose winnings offset losses you would otherwise suffer Speculators: place bets on expected price changes of underlying assets – –Leverage your bets

3. Forward and Futures Contracts Contract to buy (long position) or sell (short position) some amount of an underlying asset (stock,…) at a specified forward/future price on a specified delivery date. Forward contracts: customized Futures contracts: standard amounts and standard delivery (expiration) dates – –Clearing corporations … back futures contracts Margin account Initial margin Mark-to-market

4. Pricing Forward/Futures Contracts P ↔ P P Futures ↔ P Forward – P down to P –Arbitrage makes it so: if you could sell a bundle of a stock at a future price of $100 K and cover yourself by buying the same bundle forward at a price of $99 K … you and others would sell so much of the futures contract that you would drive P Futures down to P Forward P ↔ P P Futures ↔ P Spot P and sell it at PP/P Seller of futures contract could put funds out to interest (R) or buy the bundle now at P Spot and sell it at P Futures, locking in gross return of P Future /P Spot. P/P For Parity: (1+R) = P Future /P Spot or P= (1+R) P P Future = (1+R) P Spot. – –The daily price of a futures contract is linked to the price of the underlying asset.

5. Options: Calls and Puts You buy an option … you pay the seller a premium up front Call option: the right to a standard bundle of an underlying asset (stock, bond, …) at a specified on (or before) a standard Call option: the right to buy a standard bundle of an underlying asset (stock, bond, …) at a specified strike price on (or before) a standard expiration date. right to sell a standard bundle of an underlying asset (stock, bond, …) at a specified on (or before) a standard Put option: right to sell a standard bundle of an underlying asset (stock, bond, …) at a specified strike price on (or before) a standard expiration date. – –If an option is “in the money,” you’d exercise it. – –If it is “out of the money,” you’d let it expire.

6. Pricing Options Option Price = Intrinsic Value + Option Premium Intrinsic value: the extent to which an option is in the money or out of the money when it’s bought. Option premium: An option is worth more the greater the chance it will be in the money big time – –the longer it has to run – –the more volatile the price of the underlying asset