Financial Derivatives

Short futures hedges when company owns the asset; Long futures hedges when compan knows it will have to purchase the asset.

Hedging with a slightly different asset.

Contango: Futures price higher than expected future spot price; Backwardation when price is lower than expected future spot price.

An option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a refeerence price.

The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction.

The buyer of a call option has the right, but not the obligation to buy an agreed quantitiy of a particular underlying from the seller of the option at a certain time, the expiration, for a certain price, the strike.

The buyer of a put option, has the right, but not the obligarion, to sell the asset at the strike price by the future date.

American options may be excercised at any time up to and including the contracts's expiration date. European options can be exercised only on the contract's expiration date.

Intrinsic value: Amount by which the option is in the money; Time value: premium a rational investor would pay over the current intrinsic value, based on ist potential to increase in value before expiring.

The options clearing corporation.

Warrants confer the same rights as equity options, often also traded in 2nd markets.

Issued by the underlying company, New shares are issued (dilutive), Maturity sometimes years.

Warrants that issued as a private contract between the employer and employee.

A type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price.

Dividends paid during the life of an option contract reduces the stock value. (Announcement reduces call value, increases put value)

A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates.

Combination of options with the same strikes but with different expiry dates.

Combination of options with different strikes and differnet expiry dates.

Binomial trees and the black-scholes formula

They tell us what the market believes forward-looking future volatility will be like on a stock or underlying until the option's maturity.

Most popular index of expected market volatility.

Hedging refers to all trading activity that reduces risks/minimises unwanted exposures, or neutralises portfolio risks.

Delta refers to the change in value of options when the underlying moves. Delta is the first derivative of the options price with respect to the underlying S.

Delta is a quick way of determining, ata given S how options values change with small movements in S over the next short period of time.

The sensitivity of option values to the passage of time. Longer dated options are worth more. Time decay. First derivative with respect to time.

Rho measures the sensitivity of options valuations to change in interest rates.

Rate of change of the value of an option with respect to the changes in the volatility of the underlying asset. Volatility does not stay constant.

They profit as long as they stay well delta hedged. Make money if they sell options with Implied Volatility higher than volatility realises over the life of the option.

The rate of change of delta with respect to the underlying. It is the second derivative with respect to S.