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Derivatives Notes

Law Notes > Banking Law Notes

This is an extract of our Derivatives document, which we sell as part of our Banking Law Notes collection written by the top tier of King's College London students.

The following is a more accessble plain text extract of the PDF sample above, taken from our Banking Law Notes. Due to the challenges of extracting text from PDFs, it will have odd formatting:

Types of derivative contracts
● Definition of derivatives: A financial asset whose value is driven by the value of some other (financial) asset(s).
● Types of derivatives:
○ Forwards;
○ Futures;
○ Swaps; and
○ Options.
Forwards and Futures:
● Forward contract = Unconditional promise to buy or sell some underlying asset at a specified price (the "forward price") on a specified date (the "settlement" or the
"maturity date").
○ This can cover financial assets and tangible assets.
○ Usually used in foreign exchange markets, where the underlying asset will be in a different currency.
● Futures contract = Similar to a forward, except the underlying asset is not actually transferred but (cash-)settled by offset and parties' positions are marked to market on a daily basis.
○ The result form the offset = Either the buyer or the seller has to pay
(depending on who wins the "bet").
○ Mutual compensation for marginal changes (i.e. margin calls).
○ Exchange-traded.
Swaps:
● A swap is an unconditional promise between two counterparties to exchange cash flows and is calculated on a different basis form the other.
○ Interest rate swap: Based on nominal amount, fixed interest payments are exchanged for floating interest payments.
○ Currency swap: Payments in one currency are exchanged for payments in a different currency.
○ Equity swap (Contract for difference) Cashflows based on share price movements (up or down) are exchanged for a fixed "premium".
○ Credit default swap: In exchange for a fee, one counterparty compensates the other for any losses on credit contracts with a third party.
Options:
● A right (but not an obligation) to purchase or sell an underlying financial asset at a specified price, on or by a specified date.
○ Call option = Right to buy.
○ Put option = Right to sell. ○ American Call or Put = May be exercised up to and on the expiration date.
○ European Call or Put = May be exercised only on the expiration date.
○ Warrant = Usually a call sold by the iss50uer itself, and, upon exercising it, the company will issue a new share.
● Most calls and puts are traded amongst parties who do not actually own any of the underlying assets.
● Specifications:
○ Underlying security (price at time t = st)
○ Strike price (K) = The price that must be paid by the option holder for exercising the option
○ Expiration date (T)
○ At the money option, strike price (K) = market price of the security at time t
○ "In the money" call = K < st; "out of the money" call = K > st
○ "In the money" put = K > st; "out of the money" put = K < st
○ Intrinsic value = st - K
○ Value (i.e. price) of the call or put option at time t = ct or pt respectively
■ Note that the value of the option is linked to the value of the underlying security, but they are not the same.
Put-call parity and option pricing
● 1-year European call with K = 50 and c0 = 10
● 1-year European put with K = 50 and c0 = 10
Share price T

Buying a call

Buying a put

0 -10

40 25

-10

15 50

-10

-10

75 15

-10

100 40

-10

125 65

-10

150 90

-10

175 115

-10

● How are these values calculated?
○ Costs incurred in buying and exercising a call option = Value of the call option
+ Strike price; Benefits accrued in exercising a call option = Value of the underlying security; Buying a call therefore = ST - c0 - K.

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