Introduction to Financial Derivation - Banking - Lecture Slides, Slides of Banking and Finance

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Topic 7

Introduction to Financial

Topic 7, page 1

ECO 350 • Money and Banking

Introduction to Financial

1. Overview

A.

Derivatives

: Financial instruments with payoffs linked to

pre-existing assets, risk reduction tools.

Topic 7, page 2

1. Overview

A.

Derivatives

: Financial instruments with payoffs linked to

pre-existing assets, risk reduction tools. B.

Four types

i.^

Forward contracts ii. Futuresiii. Options

Topic 7, page 4

ECO 350 • Money and Banking

iii.

Options iv. Swaps

C.

Types of prices

i.^

Spot price

1. Overview

A.

Derivatives

: Financial instruments with payoffs linked to

pre-existing assets, risk reduction tools. B.

Four types

i.^

Forward contracts ii. Futuresiii. Options

Topic 7, page 5

ECO 350 • Money and Banking

iii.

Options iv. Swaps

C.

Types of prices

i.^

Spot price

: Price of asset delivered immediately

ii. Forward price

1. Overview (cont’d)

D.

Hedging:

Engaging in a financial transaction that reduces

or eliminates risk

i.^

Micro hedge

: hedging the risk for a particular asset

ii. Macro hedge

: hedging the risk for the entire

portfolio iii. Not profit-maximizing

Topic 7, page 7

ECO 350 • Money and Banking

1. Overview (cont’d)

D.

Hedging:

Engaging in a financial transaction that reduces

or eliminates risk

i.^

Micro hedge

: hedging the risk for a particular asset

ii. Macro hedge

: hedging the risk for the entire

portfolio iii. Not profit-maximizing

Topic 7, page 8

ECO 350 • Money and Banking

1. Overview (cont’d)

D.

Hedging:

Engaging in a financial transaction that reduces

or eliminates risk

i.^

Micro hedge

: hedging the risk for a particular asset

ii. Macro hedge

: hedging the risk for the entire

portfolio iii. Not profit-maximizing

Topic 7, page 10

ECO 350 • Money and Banking

E.

Basic principle of hedging: offset a long position by takingan additional short position, or offset a short position bytaking an additional long position.

i.^

Long position:

bought an asset

ii. Short position:

1. Overview (cont’d)

F.

Speculation

: Bet on outcomes in the economy, to

maximize expected returns.

Topic 7, page 11

1. Overview (cont’d)

F.

Speculation

: Bet on outcomes in the economy, to

maximize expected returns.

i.^

Assumes risk of hedgers: provides counterparties ii. Helps set prices for derivativesiii. Provides useful information

Topic 7, page 13

ECO 350 • Money and Banking

iv. Hedge Funds

1. Overview (cont’d)

F.

Speculation

: Bet on outcomes in the economy, to

maximize expected returns.

i.^

Assumes risk of hedgers: provides counterparties ii. Helps set prices for derivativesiii. Provides useful information

Topic 7, page 14

ECO 350 • Money and Banking

iv. Hedge Funds

: Mutual funds for speculators

G. Arbitrage

2. Forward Contract (cont’d)

[Example] The First National Bank agrees to sell to the RockSolid Insurance Company, one year from today, $5 millionface value of the 6s of 2023 Treasury bonds at a price of $5million.•

Specification of the actual asset that will be delivered at afuture date: T-Bonds with a 6% coupon rate that maturein 2023;

Topic 7, page 16

ECO 350 • Money and Banking

in 2023;

2. Forward Contract (cont’d)

B.

Payoff structure

i.^

PF

= forward price for asset X

ii.

PS

= spot price for asset X at the time when the forward contract

expires

Topic 7, page 17

2. Forward Contract (cont’d)

B.

Payoff structure

i.^

PF

= forward price for asset X

ii.

PS

= spot price for asset X at the time when the forward contract

expires

iii. Profit =

P

SALE

P

PURCHASE

iv.

If you sign a forward contract to

buy

asset X at price

P

:

Topic 7, page 19

ECO 350 • Money and Banking

iv.

If you sign a forward contract to

buy

asset X at price

P

: F

-^

Profit =

?

2. Forward Contract (cont’d)

B.

Payoff structure

i.^

PF

= forward price for asset X

ii.

PS

= spot price for asset X at the time when the forward contract

expires

iii. Profit =

P

SALE

P

PURCHASE

iv.

If you sign a forward contract to

buy

asset X at price

P

:

Topic 7, page 20

ECO 350 • Money and Banking

iv.

If you sign a forward contract to

buy

asset X at price

P

: F

-^

Profit =

P

- S P

F