Chapter 1

Web Extension 1B
An Overview of Derivatives

Topics in Web Extension

Overview of derivatives

Forward contracts
Futures contracts
Options
Swaps

Forward Contracts

2 parties to contract, each with a basic position:

Terms

One party is long (buy). Obligates party to buy the

underlying asset at some fixed price at a specified date in
the future.
One party is short (sell). Obligates party to sell the
underlying asset at some fixed price at a specified date in
the future.
Forward price
Delivery date (expiration date)

Forward contracts are common for currencies.

Hedging Risk with Forward

Contracts

US wine importer might plan on purchasing French

wine with euros in the fall. Could lock in the
currency exchange rate for the fall by taking a long
position in a euro currency forward contract.
US computer manufacturer might plan on selling
computers to German company in fall, with the
payment in euros. Could lock in exchange rate by
taking a short position in euro forward contract.
Both parties have reduced risk by locking in the
exchange rate.

Problems with Forward

Contracts

Forward contracts are made directly between

two parties, so there is the possibility of
default (although banks often are one of the
parties in each transaction, in effect acting as
middlemen).
Forward contracts are often designed for a
specific need, so there is not a standardized
contract, which makes it difficult to have a
secondary market.
Futures contract solve these problems.

Futures Contracts

Similar to forwards, except:

Marking-to-market
Many more assets- agriculture, livestock,
metals, indexes, currencies, interest rates,
energy
Standardized contracts that trade on
exchanges, such as CBOT

Options

Basic Positions

Terms

Call / Put
Long / Short (writer)

Exercise Price
Expiration Date (can let expire unexercised)
Assets- Stocks, indexes, currency, and futures

CBOE

Swaps

Two parties agree to swap some

particular obligation (usually associated
with debt)

Swap payments in one currency for

payments in another currency
Swap floating-rate payments for fixed-rate
payments