Hello!Chapter#1

Introduction to Derivatives

Salma Alsuwailem

Summary!✘ What is a Derivative?A derivative is a financial instrument whose value is determined by the price of something else.

The "something else" in the above definition is the underlying asset of the derivative, which for this exam is most often a stock.

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To manage risk.Derivatives may be purchased to reduce risk, which is known as hedging.

To speculate If an investor believes the price of a stock will decrease in six months, the investor may enter into a derivative that pays off if this happens.

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To minimize taxes/avoid regulatory issues.Derivatives may be used to defer taxes or eliminate the risk of owning an asset while keeping the privileges the asset may offer.

Why Use Derivatives?

To reduce transaction costs.Derivatives can sometimes be used to achieve the same economic outcome that one would get from trading stocks and bonds without actually buying or selling them. This can lower transactions costs.

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Who Uses Derivatives?

End-users(buyers and sellers)

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Market-makers Intermediaries who aim to make a profit by selling and buying derivatives to and from end-users.

Economic observers Market observers, including regulators who analyze and regulate the activities of end-users and market-makers.

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Underlying Assets✘ Stocks (COMMON STOCK)✘ indices✘ commodities✘ and currencies

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Buying and Selling Assets

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Market-maker✘ A stock exchange is an auction where stocks are bought and

sold.

✘ A market-maker has a special arrangement with an exchange, or exchanges, to facilitate the buying and selling of an exchange's assets, thus "making a market."

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Let's now examine the profits that market-makers

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CommissionThere are two types of commission fees:

A flat amount

A percentage

Bid-Ask PricesAt any point in time, there are two prices for any stock: (i) the bid price, and (ii) the ask price. The price at which market-makers buy from investors is called the bid price, and the price at which they sell is called the ask price.The bid-ask spread is the difference between the bid and ask prices.

Bid-Ask Spread = Ask Price – Bid Price

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Bid Ask

Market-Maker Buys Low Sells High

Investor Sells Low Buys High

The following table summarizes this concept:

Thecostassociatedwithopeningandclosingafinancialpositionisknownasthe round-triptransactioncost. Itisthedifferencebetweenwhatyoupayandwhatyoureceivefromasaleusingthesamesetofbidandaskprices.

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examples✘ Determine which of the following statements is NOT a typical reason for why

derivative securities are used to manage financial risk.

(A) Derivatives are used as a means of hedging.

(B) Derivatives are used to reduce the likelihood of bankruptcy.

(C) Derivatives are used to reduce transaction costs.

(D) Derivatives are used to satisfy regulatory, tax, and accounting constraints.

(E) Derivatives are used as a form of insurance.

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✘ For one share of Morrel & Son, Inc. you are given:The bid price is $105.82.

The ask price is $106.92.

The broker’s commission is $10 per trade.

Edmond Dantes purchases 100 shares of the stock, regrets his decision, and then immediately sells the shares back before any change in the bid-ask spread.

Calculate Edmond's round-trip transaction cost.

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✘ For one share of MILO, you are given:The bid price is $792.22.

The bid-ask spread is $1.10.

The broker’s commission is 0.2%.

Yossarian purchases 22 shares of the stock and immediately sells them.

Calculate Yossarian’s round-trip transaction cost.

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✘ For a stock, the bid-ask spread is $0.4. The current bid price is $100.

You buy 10 shares and sell the stock after 1 day,

when the ask price becomes $100.

Ignoring brokerage fee, interest and commissions, calculate the 1-day profit.

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Short-Selling Assets

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Long vs. Short✘ A long position and a short position describe how an

investor benefits from a price increase or decrease in an asset:

If you have a long position in an asset, then you benefit from a price increase in that asset.If you have a short position in an asset, then you benefit from a price decrease in that asset.

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What is Short-Selling?✘ Process of short-selling:Borrow shares of stock now. You find someone to lend you the shares of stock,and promise to return them at a later time.

Immediately sell the borrowed stock. You will receive funds from this sale.

Buy the shares back. At a future time, buy the number of shares needed and return them to the lender, called covering or closing the short position.

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Speculating. An investor can profit from a price decrease

Financing. Short-selling is a way to borrow money (especially common in bond markets).

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Why investors short-sell?

Hedging. An investor can offset the risk of owning a stock. If an investor has a long position in the stock and then short-sells, the risk of the long position is eliminated.

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✘ For one share of Energy Reinsurance Inc. (EYRE), the following bid and ask prices are given:

Bertha Mason enters into a short-sale on December 31, 2015, for 5 shares and keeps the net proceeds from the short-sale. She then closes her short position on March 31, 2016.

The broker’s commission is $10 per transaction, and the annual effective interest rate is 1%.

Calculate Bertha's profit or loss on the short-sale on March 31, 2016.

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Dec. 31, 2015 Mar. 31, 2016

Bid 105.50 113.90

Ask 106.00 114.70

examples

✘ For one share of Stock GOT, the following bid and ask prices are given:

Arya short-sells 50 shares of Stock GOT on Dec. 31, 2014 and keeps the net proceeds from the short-sale. She covers her short position on Dec. 31, 2016.

The broker's commission per transaction is 0.5%. The continuously compounded risk-free interest rate is 2%.

Calculate Arya's profit on Dec. 31, 2016.

A Loss of 200

B Loss of 250

C Loss of 300

D Loss of 400

E Loss of 500 20 Salma Alsuwailem

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THANKS!Any questions?