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FINALS HANDOUTS

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Valerie Balais
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14 views6 pages

FINALS HANDOUTS

Uploaded by

Valerie Balais
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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BASIC BUSINESS FINANCE

Handouts
Prepared by: Valerie D. Balais

WEEK 15-17: DERIVATIVES


Derivatives are financial contracts whose value is derived from the performance of an
underlying asset or benchmark. Common underlying assets include stocks, bonds, commodities,
currencies, interest rates, and indices.
Uses of Derivatives
1. Risk management. Derivatives are a key tool for mitigating risks related to price volatility,
currency fluctuations, or changes in interest rates.
2. Speculation. Companies and investors use derivatives to bet on the future movement of prices,
potentially generating significant profits.
3. Arbitrage Opportunities. Derivatives allow traders to exploit price differences in
4. Improving financial efficiency. Derivatives an provide exposure to assets without requiring
full investment, improving liquidity and capital allocation.

Advantages of Derivatives
Risk Mitigation. Reduces exposure to unfavorable price movements.
Leverage. Allows control of large market positions with smaller capital outlays.
Market access. facilitates participation in markets otherwise difficult to enter directly.
Flexibility. Customizable to meet specific business need (e.g., forwards and swaps).

Challenges and Risk in Derivatives


Market Risk. volatility in the underlying asset can lead to losses.
Credit Risk. Counterparty default in derivatives can cause financial instability.
Complexity. Derivatives require specialized knowledge and carry significant operational and
legal risks.
Systemic risk. Excessive use of derivatives has been linked to financial crises.
Option is a financial instrument known as a derivatives contract between a buyer & seller. Option
gives the buyer the right, but not the obligation, to buy (or sell) a certain asset at a specific price
at any time during the life of the contract.
Options Contract:
 Is an agreement that gives the owners option to purchase (puts option) or sell (calls
option) an asset.
Two (2) types of Options Contract:
1. Puts Option; and
2. Calls Option

Puts Option:
Puts give the buyer the right, but not the obligation, to sell the underlying asset at the strike price
specified in the contract. The writer (seller) of the put option is obligated to buy the asset if the
put buyer exercises their option. Investors buy puts when they believe the price of the underlying
asset will decrease and sell puts if they believe it will increase.

Calls Option:
Calls give the buyer the right, but not the obligation, to buy the underlying asset at the strike
price specified in the option contract. Investors buy calls when they believe the price of the
underlying asset will increase and sell calls if they believe it will decrease.

Key Features of Puts and Calls:


 Strike Price
-The price at which the option holder can buy or sell the underlying asset.
 Expiration Date
-The date on which the option expires, after which it is no longer valid.
 Premium
-The price paid by the buyer of the option to the seller.

Uses of Puts and Calls:


 Hedging
-To reduce potential losses on an existing investment.
 Speculation
-To profit from expected price movements in the underlying asset.
 Income Generation
-Option sellers can earn a premium by selling options.
 Leverage
-Options allow you to control a large amount of underlying assets (like stocks) with a relatively
small investment, known as the premium.
 Risk Management
-Options can be used to hedge against potential losses in your portfolio or to speculate on price
movements without taking on the full risk of buying or selling the underlying asset.
 Flexibility
-Options provide more flexibility than simply buying or selling stocks.

Options: Puts and Calls - Advantages & Disadvantages


Options are financial instruments that give the holder the right, but not the obligation, to buy
(call) or sell (put) an underlying asset at a specific price (strike price) on or before a certain date
(expiration date).

Calls
Advantages
Potential for high profits
-If the underlying asset price rises, the call option can generate significant returns.
Limited Risk
-The maximum loss is the premium paid for the option.

Disadvantages
Time Decay
-The value of a call option decreases over time as it approaches its expiration date.
Limited Upside Potential
-The maximum profit is capped at the difference between the strike price and the market price of
the underlying asset at expiration.

Puts
Advantages
Protection against Losses
-If the underlying asset price falls, the put option can offset the loss.
Limited Risk
-The maximum loss is the premium paid for the option.

Disadvantages
Time Decay
-The value of a put option decreases over time as it approaches its expiration date.
Limited Upside Potential
-The maximum profit is capped at the premium paid for the option.
General Concepts
An option usually contains the following elements:
1. Option holder/buyer - is given the right to buy or sell an asset
2. Option writer/seller - issues option contract, has an obligation to
sell or buy the asset if the option is exercised by option's holder.
3. Strike/Exercise Price - price at which the asset can be traded under a
option contracts
4. Limited time frame Expiration date - the date at which an unexercised option
becomes invalid
5. Price
Premium - purchase price of an option
Future contracts are standardized agreements to buy or sell an asset at a predetermined price on
a future date. Traded on regulated exchanges, ensuring transparency and reducing counterparty
risks. Used for hedging, speculation, and arbitrage

Key Characteristics
1. Standardization. Contracts specify the quantity, quality, and delivery terms of the underlying
asset.
2. Underlying Assets. Commodities such as gold, crude oil, agricultural products (e.g., wheat,
corn).
3. Leverage. Traders only need to deposit a fraction of the contract’s value (margin), amplifying
potential gains and losses.
4. Mark-to-Market. Profits and losses are settled daily based on market price changes.
5. Settlement. Physical delivery: Actual delivery of the asset (e.g., barrels of oil, bushels of
wheat).
Cash settlement: Payment of the difference between contract price and market price.

Uses of Futures Contracts


1. Hedging: Protects businesses from adverse price movements.
Examples:
Farmers hedge crop prices.
Airlines hedge fuel costs.
2. Speculation. Traders aim to profit from price fluctuations.
No intention of taking delivery of the asset.
3. Arbitrage. Exploiting price differences between futures and spot markets.

Benefits of Futures Contracts


Risk Management: Provides price certainty.
Price Discovery: Helps determine market expectations for future prices.
Liquidity: High trading volumes ensure easy entry and exit.
Leverage: Offers significant market exposure with limited capital.
A swap contract is a financial agreement between two parties to exchange cash flows or
liabilities over a specified period. Swaps are commonly used in finance to manage risk, hedge
against market fluctuations, or speculate on changes in market conditions. The two most
common types of swaps are interest rate swaps and currency swaps.

Types of Swap Contracts


1. Interest Rate Swap: Two parties agree to exchange interest payments—one pays a fixed rate,
and the other pays a floating rate based on a reference rate like LIBOR or SOFR.
2. Currency Swap: Two parties exchange principal and interest payments in different currencies.
Often used to hedge currency risk in international trade.
3. Hybrid Swaps (Exotic Products) allow their holders to swap financial flows associated with
different debt instruments that are also denominated in different currencies.

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