Financial Derivatives I

Financial derivatives are assets whose value is derived from the value of another asset. (maybe easier to understand: Financial derivatives are assets whose value "depends on" the value of another asset).

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http://fisher.osu.edu/fin/faculty/stulz/publishedpapers/milkeninstitute_pubpaper.pdf

A relatively easy to follow introduction to derivatives by renowned finance professor Rene Stulz.

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Black-Scholes - Wikipedia, the free encyclopedia

The Black-Scholes or Black-Scholes-Merton model is a mathematical model of a financial market containing certain derivative investment instruments. From the model, one can deduce the Black-Scholes formula, which gives a theoretical estimate of the price of European-style options.

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Derivative Payoff Diagrams - Educreations

Payoff diagrams are critical to understanding derivatives.

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http://www.barbicanconsulting.co.uk/derivatives

A fairly extensive list of financial derivatives and some of the accompanying payoffs and and risk profiles.

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Option payoff diagrams

I look at payoff diagrams for options

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A brief Introduction to Financial Derivatives

A high level introduction to financial derivatives. This will be the first of about 10 videos on derivatives for my finance classes.

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NumaWeb : DERIVATIVES : Option Calculator

This is probably the option price calculator we will use in class as it is easy to use and you can see how the price of the option changes with input changes.

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Payoff to Call Options at Expiration (using a Milk Coupon as the example)

A look at how much a call option is worth at expiration. Includes payoff diagrams. Introduction to financial derivatives

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Forwards and Futures Introduction

The starting point for any examination of Financial Derivatives are a few relatively simple building blocks.  Understand them well and your trip though the world of financial derivatives will be much easier.

Forward Contracts:  An agreement between two parties for the delivery of some asset at some time for some price (note how vague this is!)

Example: I agree to buy 10 gallons of gas on July 4 for \$5.00 a gallon.  (I am long the contract).  You (as the "Counterparty" agree to sell me 10 gallons of gas on July 4 for \$5.00 a gallon.
1. Each Contract is unique (at least in theory) and hence nonnegotiable, nontransferable, and cannot be traded
2. The biggest benefit is that these contracts can be totally customized to the unique circumstances of the counter parties.
3. A drawback is that they are very illiquid.
4.  Usually limited to parties that have good credit ratings because of the high risk of default inherent in the contract.
5. The payoff of a long forward position (i.e. you are taking ownership of the asset) is equal to underlying asset price - price agreed upon in the contract. (suppose the price of gas is \$6 a gallon.  Your payoff would be 6-5=\$1 per gallon.)
6. The payoff to a short forward position (i.e. you are selling the asset) is equal to the price agreed upon in the contract - the underlying asset price.     (suppose the price of gas is \$6 a gallon.  Your payoff would be 5-6= \$-1 per gallon.)

Futures Contracts--in many ways these are standardized forward contracts that can be traded.

1. These contracts can be traded and are much more liquid than forward contracts - very active market
2. The payoff looks the same as forward contracts
3. Standardized for quality, quantity
4. Payoff if long: spot price at exercise - original futures price
5. Payoff if short: original futures-spot price at exercise
6. If the price of the product goes up then the payoff of the long position goes up and vice versa.
7. every contract is made with a middleman called a clearinghouse
8. marked-to-market daily
9. Contracts can be cash settled or with physical delivery

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