Financial Markets and Products
Markets and products
Know the mechanics and economics of forwards, futures, options, swaps, and the institutions that trade them. A forward is OTC and customizable, with counterparty credit risk; a futures contract is exchange-traded, standardized, marked to market daily, and backed by a clearinghouse. The forward price is S0e^((r-q)T) for a dividend yield q, or S0e^(rT) with storage and convenience adjustments for commodities. Futures and forwards converge to spot at maturity; before maturity their values can differ.
Options: a call gives the right to buy at strike K; a put gives the right to sell. American options can be exercised early, European cannot. Put-call parity for European options on a non-dividend stock is C + K*e^(-rT) = P + S0. A violation implies arbitrage. Trap: parity does not hold exactly for American options or dividend-paying stocks without adjustment.
Swaps are portfolios of forwards; in a plain vanilla interest rate swap, the fixed-rate payer pays fixed and receives floating. Credit risk rises when the swap is in the money.
Worked example: S0=100, K=100, r=5%, T=1, C=8. Then P = C + K*e^(-rT) - S0 = 8 + 95.12 - 100 = 3.12. If the market put is 2.50, buy the put and the stock, sell the call, and lend the present value of K to lock in arbitrage.
Traps: confusing long and short payoff direction; ignoring daily settlement cash flows for futures; and treating OTC derivatives as free of liquidity risk.