Exchange-traded or Over-the-counter (OTC) optionsExchange-traded- are those derivatives instruments that are traded via specialized exchanges or other exchanges (Chicago Board Options Exchange, EUREX, Korea Exchange);Exchange-traded options include: stock options, bond options and other interest rate options, stock market index options or, simply, index options and options on futures contracts, callable bull/bear contract. Over-the-counter- are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. 3.Another important classes of options are: Employee stock options, which are awarded by a company to their employees as a form of incentive compensation; Real estate options are often used to assemble large parcels of land; Prepayment options are usually included in mortgage loans; European option – an option that may only be exercised on expiration. American option – an option that may be exercised on any trading day on or before expiry. Bermudan option – an option that may be exercised only on specified dates on or before expiration. Barrier option – any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised. Exotic option – any of a broad category of options that may include complex financial structures. Vanilla option – any option that is not exotic; The following strategies exist: 1. Protective put -when investing in some stocks at the same time the Put option is bought, so it gives the right to sell the stock at a given price. It is an insurance for the case of stock price decline; 2. Covered calls- in which a trader buys a stock (or holds a previously-purchased long stock position), and sells a call. If the stock price rises above the exercise price, the call will be exercised and the trader will get a fixed profit. If the stock price falls, the call will not be exercised, and any loss incurred to the trader will be partially offset by the premium received from selling the call. Overall, the payoffs match the payoffs from selling a put. 3. A straddle is established by buying both a call and a put on a stock, each with the same exercise price, X, and the same expiration date, T. Straddles are useful strategies for investors who believe a stock will move a lot in price but are uncertain about the direction of the move. Strips and straps are variations of straddles. A strip is two puts and one call on a security with the same exercise price and maturity date. A strap is two calls and one put. 4. A Spread is a combination of two or more call options (or two or more puts) on the same stock with differing exercise prices or times to maturity. Some options are bought, whereas others are sold, or written. A money spread involves the purchase of one option and the simultaneous sale of another with a different exercise price. A time spread refers to the sale and purchase of options with differing expiration dates. 105. Swaps: concept, types, strategies for using Swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange, IntercontinentalExchange and Frankfurt-based Eurex AG. Types of SWAPs: 1.Interest rate swap- is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. 2. Currency swap- involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage. 3. Credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into default (fails to pay). CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure. 4. Other types. As the swaps are not standardized and usually traded on OTC the variety of Swaps is great because the counterparties can agree about different terms and make an appropriate contract according to these terms). - A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. -An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap. - An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs. -A Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the same time would like to conserve cash for operational purposes. -A Deferred rate swap is particularly attractive to those users of funds that need funds immediately but do not consider the current rates of interest very attractive and feel that the rates may fall in future. -An Accreting swap is used by banks which have agreed to lend increasing sums over time to its customers so that they may fund projects. -A Forward swap is an agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a forward start swap, delayed start swap, and a deferred start swap 106. Futures: concept, types, strategies for using A futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The futures contract is an obligation, the terms specified in the contract are to be fulfilled with both parties. Types of futures contracts:(according to the underlying assets in which they are based) 1.Foreign exchange futures - is used to hedge against the currency exchange rates fluctuations. Are usually used by the companies involved in international trading or relations; 2.Stock-index futures -are settled by a cash amount equal to the value of the stock index in question on the contract maturity date times a multiplier that scales the size of the contract- is used to hedge the systematic risk; 3.Interest rate futures - may be written on the prices of debt securities (as in the case of Treasury-bond futures contracts) or on interest rates directly (as in the case of Eurodollar contracts); 4.Commodity futures – the contracts about physical assets (energy, metals, agriculture). Are traded on New York Mercantile Exchange (NYMEX), Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME), London, metal exchange (LME),etc. The stretegies: 1.Hedging. A hedger uses futures contract to protect against price movement in interested underlying asset. 2.Speculating. A speculator uses a futures contract to profit from movements in futures prices. If speculators believe prices will increase, they will take a long position for expected profits. Conversely, they exploit expected price declines by taking a short position.
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