Advantage of derivatives?
Ability to modify the risk-return characteristics of existing securities in a cost-effective way.
How derivatives restructure a portfolio synthetically
- Combine derivatives with the underlying position to replicate the cash flows of another traded instrument
- Combine derivatives with the original portfolio to create payoff structure that would otherwise be unavailable
Forwards with symmetrical terminal payoffs
Don’t require initial payments but you are obligated to pay even if the transaction is unfavourable at the future date.
Difference between forwards and options
Forwards are symmetrical
- are obligated to pay agreed price
- don’t pay upfront
Options are asymmetrical
- are not obligated, can choose not to exercise option
- need you to pay upfront
Put-call parity
Put-call parity conditions outline the linkages between 5 securities: stock, T-bills, forward contracts, call options and put options.
- one of these will be redundant because it can be replicated
Arbitrage investing
Because we can create synthetic replicas of existing securities, when the synthetic and actual instruments sell for different prices there is an arbitrage opportunity.
Futures vs Forwards contract
Futures:
- central markets
- more liquidity
- standardised
- less credit risk ( you post initial margin and trades are backed)
- settlement price (marking to market)
Forwards
- contracts are OTC (therefore negotiable)
- not liquid
- subject to credit risk
- no payments till expiration
3 Prominent derivative applications for managing equity positions
- Shorting forwards/futures
- Buying protective puts
- Buying equity collars
Broadly diversified
Beta = 1
Risk free assets
Have a beta of 0
