Stock and derivative intruments

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Capital and Finance Markets Stock and Derivative Instruments Marta Cristina Amorim Miranda – Erasmus Program UWM Stock and Derivative Instruments – Capital and Finance Market ndex Introduction 2 1. Derivative Instrum 3 1. 1. Definition 4 2 p 1. 2. Pros & cons of derivative financial instruments 2. Futures and Forwards 2. 1 Futures 2. 1 . 1. Concept value of currencles or commodities. In the 1 980s, financial futures began to dominate trading. Some investment bankers began to turn hedging into a profitable business in its own right, developing progressively complex ways of hedging.

Swaps nd options have become the next most common form of derivative trading after the original futures. Options were invented because people liked the security ofk nowing they could buy or sell at a certain Price, but wanted the chance to profit if the market Price suited them better at the time of delivery. Swaps are, as the name suggests, an exchange of something. They are generally done on interest rates or currencies. For example a firm may want to swap a floating interest rate for fixed interest rate to minimize uncertainty.

There are derivatives on almost all types of asset which are raded – the main four being bonds (which vary in Price according to interest rates), currencies, shares and What can broadly be described as goods (metals, energy sources, agricultural produce etc. ). New ones are even beng developed on catastrophes, such as earthquakes, and even on the creditworthiness of investors. n th•s paper Will discuss the main derivatives: futures, forwards, swaps and options, as well as highl’ght their stren hs and weaknesses. 0F 12 instrument (or smply ‘derivative’) is a financial instrument which derives its value from the value of some other financial instrument or ariable. Its fair value changes with the changes of the hedged item (i. e. changes of interest rate, security Price, commodity Price, currency rate, stock exchange indices value). Derivatives have two components: the underlying variable, also called underlying asset or ‘underlying’ (the payoffs depend on its Price change), and the notional component, as a certain amount of assets or liabilities whose value derives from underlying variable.

Usually, derivatives are contracts to buy or sell the underlying asset at a future time, with the Price, quantity and other specifications defined today. Contracts can be binding for both parties or for one party only, with the other party reserving the option to exercise or not- If the underlying asset is not traded, for example if the underlying is an index, some kind of cash settlement has to take place.

From the accounting point of view, a derivative is a financial instrument which meets all the following conditions: LI whose value changes in response to the change In the speclfied underlying; that requires no initial net investment or the initial investment should be less than the investment needed to acquire a primary financial instrument that has a similar response to changes in market onditions; and 30F 12 Derivatives are traded in organized exchanges as well as over the counter (OTC).

It can be used to mitigate the risk of economic loss arising from changes in the value ofthe underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves In the direction they expect, bearing extra risk by speculations. Examples of derivatives include forwards, futures, options, swaps, and many others. 1. 2. 1 pros • Derivative financial instruments give investors the opportunlty to cover in full or n part, all or some of the asset categories in their portfolio when the assets which make it up are liable to experience a substantial adverse trend. • They offer the opportunity to speculate on a significant gain in the short term thanks to gearing. • Derivative financial instruments energize portfolio management. 1. 2. 2. cons • Derivative financial instruments quoted on the markets are generally standardized to allow an e t.

Thus the underlving AGE 4 2 the rules of the game and closely track market trends. 2. 1 . Futures 2. 1 . 1 Concept: “A futures contract is a negotiable contract, on an rganized market in which one party (buyer) undertakes to buy another (seller), at an agreed Price, an asset in quantity and quality standard in a given date and a pre-determined place… ” (Pinho e Soares, 2008) A futures contract is a promise of a future purchase. 2. 1. 2. Products traded on futures market Agricultural Products (wheat, corn, rice, sugar, coffee, cotton,.. ) Metals (copper, gold, platinum, silver,.. LI Petroleum, Interest Rates and Foregn exchange. 2. 1 -3. Features n It is a derivative financial product, then its value depends on the value of the asset that underlies it; LI A future is an implied obligation to purchase; It is a standardized contract and it is traded on an organized market , meaning that since futures contracts are traded on organized markets, they are normalized, ie, are traded for certain maturities, for a certain amount per contract, quali d and fixed place of s 2 by a clearing house, so the players do not know the counterparty to the contract.

Thus, the clearing house acts as buyer and seller to the buyer to act as the seller. 2. 2. Forwards 2. 2. 1 . Concept: forward contract is a contract that specifies the delivery, of the seller to the buyer of an asset at a future date at a s pecified Price. One example can be the contract of buying and selling a house: The buyer agrees to buy the house for a certain Price, and establish the delivery of the house to a specified future date.

At the moment the seller delivers to the house to the buyer, the buyer pays the seller the agreed amount. When someone buys any property that is not available for immediate delivery, and accords with the seller that he undertakes to deliver the good at a future date at a Price, and the buyer agrees to receive and pay the good at that future date, we have a fixed term contract or forward contract, even if sometimes that contract is only informally. . 2. 2. Similarities and diferences of fonwards and futures It is convenient make a distinction between the future market and fonnard market: Like futures, forward co 6 2 ivatives; contract of futures have a high level of liquidity, What doesn’t happen with forward contract that due to specificity of the terms established between the parties. The transaction ofthe good occurs in the future, despite the terms of the transaction are set at the time the contract is made; LI Stakeholders establish contracts directly; n In forward contracts, the date of delivery of the goods is specified, while in utures contract is only set in the month and year in which the delivery occurs (the seller ofthe asset can choose the day ofthe month in which he makes the delivery); LI In a forward contract, the buyer and seller only settle accounts with each other in the day of the delivery; in futures contract, gains and losses are calculated daily; Positions held in futures contracts can be settled at any time, by taking opposite positions on the same contract. On the contrary, in the case of fonnard contracts, their extinction is only made by delivery of the underlying asset. 2. 3. pros and Cons of Futures and Forwards pros Forward contracts can be adapted to Cons 2 made by taking into account the specific needs of each part What makes it difficult for them to abandon the contract. 6 3. Swaps 3. 1 .

Concept: A swap is a bilateral contract in which two parties agree to exchange between themselves cash flows (interests or capital) during a predetermined penod. It anses, therefore, a situation similar to that of a simultaneous loan and an investment of funds, in amounts and durations equivalent, but with diferent conditions in terms of currencies and / or interest rates. 3. 2. Types of Swaps: There are several types of swaps but the ost common are: LI Interest Rate Swaps (aim of modifying exposure to interest rates) D Currency Swaps (aim to generate cash in a currency other than that which is available without creating an open position (without exchange risk). ) 3. 3.

Purpose and utility of a swap operation Reducing the cost of financing or enhancing the profitability of investments (the discovery of this possibility was possibly the starting point for the product development). CJ Risk management of interest rate and foreign currency exposure (the considerable size and liquidity of the swaps market enjoys nowadays, in international terms, is essentially ased on the enormous possibilities of this product in the management ofthe risks mentioned above. ) Swaps provide access to a Iower cost, or even 8 2 cost, or even obtaining conditions otherwise inaccessible through the use of comparative advantage of the other party. The credit risk is limited. 3. 4. pros and Cons of Swaps Allows hedge currency risks of transactions in short and long positions. Fixed maturity date. The contracts are irreversible. remium is the option Price and reflects What the market is prepared to pay for the exercise right it represents. Options can be traded in a secondary market. 4. 2. Examples Example of a Call Option: Considering the case of a call option which, for the next three months, allows the purchase of share “x” at a Price of 50 euros, and assuming that the current share Price is 45 euros and that the option costs 1. 50 euros. The buyer, who has paid 1. 50 euros for this option, hopes that share “x” Will have risen sufficiently in three months, so that it is more worthwhile exercising the option (i. e. paying 50 euros to obtain one share) than buying the share on the stock exchange. In this case, the total cost Will be 51. 0 euros (strike Price of 50 euros plus the option Price of 1. 0 euros). If the share is worth 55 euros three months later, the investor Will make a gain of 3. 50 euros (55 euros -51. 50 euros) by exercising his option reselling the share directly on the stock exchange. Prices above cost (51. 50 euros) Will make an increasingly higher gain for the option. The value of a call option increases, therefore, with the probability that the market Price Will exceed the strike Price; this is all the more likely as the option has a long Ife and the share is considerably volatile. However, if share “x” is worth less than 50 euros, the investor Will not exerc he Will incur a Ioss 0 12

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