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Lecture 1- Derivative's
Terms in this set (18)
What is bullish vs bearish?
1. bullish: believe the price of one or + securities will rise.
2. bearish: believe the price will go down and eradicate amount of wealth
Call Option definition
1. Financial contract gives the option not the obligation to buy security within specified price and time.
2. profits when the underlying asset increases in price.
Put Option definition
1. contract gives the right not the obligation to sell or short sell specific amount of a security at a pre-determined price called strike price.
2. Put option increase in value as underlying asset decreases price as volatility increases and interest rate decreases.
3. Lose value when underlying asset increases price and volatility of underlying asset price decreases and interest rate increases and time to expiration nears.
You have bought a call option on AF with strike price of 8 euro.
Are you bearish or bullish? (would make $ If AF price increase or decrease)
Are you bullish or bearish on volatility?
1. Bullish because make money if price increases since is an option.
2. Larger volatility its good as increases maximum profit no maximum loss. Increase price volatility means call option will be worth it.
Sold a call option on AF with strike price of 9 euro. Are you bullish or bearish on AF (would make money if AF price increases or decreases). Are you bullish or bearish in the vol. on AF?
If price of AF goes up, call option worth more. If vol goes up, call option AF is worth more. If sold the call option means bearish because if the price of AF goes up and sell: will lost. Loss money when close the position. Here is short selling.
short selling definition
is the selling of a stock that the seller doesn't own. ... Sooner or later you must "close" the short by buying back the same number of shares (called "covering") and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference.
You have the same maturity:
- bought a call strike 8 on AF
- sold a call option strike 9 on AF
Combine two positions, are you bullish or bearish on AF price? and on volatility?
Combine the two positions: have opposite exposure to the price of AF and vol. The position depends where AF price is. Cannot answer now. Overall: always bullish on the price of AF but exposure of vol depends on: some are large vol. exposure in markets and other short in vol. exposure.
forward contract definition
is a customized contract between two parties to buy or sell an asset at a specified price on a future date.
Cash and Carry Arbitrage with no dividends
1. selling forward at maturity: carry until maturity.
Reverse cash and carry
1. sell short the asset
2. invest the proceeds at rf
3. enter a long forward contract
Arbitrage opportunities with bid-ask spreads
if there is an apparent arbitrage opportunity based on mid prices, it disappears when considering bid-ask spreads. Mid prices is between big and ask.
What is bid and ask prices?
Ask price: what the price maker will sell: someone is always available to sell and buy at the spot market. The ask pricerefers to the lowest price a seller will accept for a security.
Mid price: average between bid and ask.
Bid price: refers to the highest price a buyer will pay for a security.
No-Arbitrage Channel rule
1. There is a no arbitrage change if the market forward price does not differ enough from the fair price= arbitrage is not feasible but when derivates enough= arbitrage becomes feasible even after transaction costs.
2. How large is the mispricing from spot as ask relative to mid. What matters is not the distance of forward from equilibrium but relative to liquidity of market. (spot may be more liquid, no possible the arbitrage as if too large the difference between forward bid, ask and mid).
No arbitrage channel: even if a full arbitrage is unfeasible
1. knowing no arbitrage relationships enables the forward buyer to save money: replicating the long forward is cheaper.
2. no arbitrage relationships may be important in practice even with directional positions or for trading
3. specular opportunities may arise for a seller under opposite market conditions.
A repurchase agreement (repo)
Deal in which a counterpart buys a bond spot and sells it forward at a specified price (investment repo) or vice versa sells spot and buys forward (financing repo).
If there are no dividends/ coupons between the two dates: it is extremely easy to derive the interest rate obtained or paid through the repo.
ex: no dividend paying stock X: buy spot X at 100 + sell 1-year forward X at 102= 1-year risk free investment at 2%. Arbitrage the bank will do.
First: make an investment repo combined by buying cash and selling forward at the forward price of the market. Buy cash and sell forward and is an investment repo because CF structure is investing today and get tomorrow. At the same time finance yourself at risk free rate and if implied repo larger risk free then enjoy the difference: the treasury guy: investing, borrow and get the gain in a 6 months horizon: check recording! Example the forward market lower than equilibrium: which larger if market trades below equilibrium: risk free will be larger. Here risk free larger, borrow at the implied repo and invest in risk free hence have a financing repo, which means sell today and buy forward, and invest in risk free.
The implied repo rate: rule
1. the cheapest bond: highest implied repo rate.
2. Given the maturity of the forward t, the larger the difference between S and Fmkt and the greater is the implied repo rate.
ex: given t and F, if S is low: cheap then have a greater implied repo rate.
Forward price with one or more dividends rule
The larger dividend, the lower the forward price. Earlier dividend comes: lower the forward price.
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