● Derivatives are issued on equities, fixed-income securities, interest rates, currencies, commodities, credit, and a variety of such diverse underlyings as weather, electricity, and disaster claims.
● Derivatives facilitate the transfer of risk, enable the creation of strategies and payoffs not otherwise possible with spot assets, provide information about the spot market, offer lower transaction costs, reduce the amount of capital required, are easier than the underlyings to go short, and improve the efficiency of spot markets.
● Derivatives are sometimes criticized for being a form of legalized gambling and for leading to destabilizing speculation, although these points can generally be refuted.
● Derivatives are typically priced by forming a hedge involving the underlying asset and a derivative such that the combination must pay the risk-free rate and do so for only one derivative price.
● Derivatives pricing relies heavily on the principle of storage, meaning the ability to hold or store the underlying asset. Storage can incur costs but can also generate cash, such as dividends and interest.
● Arbitrage is the condition that two equivalent assets or derivatives or combinations of assets and derivatives sell for different prices, leading to an opportunity to buy at the low price and sell at the high price, thereby earning a risk-free profit without committing any capital.
● The combined actions of arbitrageurs bring about a convergence of prices. Hence, arbitrage leads to the law of one price: Transactions that produce equivalent results must sell for equivalent prices.
PROBLEMS
1. A derivative is best described as a financial instrument that derives its performance by:
A. passing through the returns of the underlying.
B. replicating the performance of the underlying.
C. transforming the performance of the underlying.
2. Compared with exchange-traded derivatives, over-the-counter derivatives would most likely be described as:
A. standardized.
B. less transparent.
C. more transparent.
3. Exchange-traded derivatives are:
A. largely unregulated.
B. traded through an informal network.
C. guaranteed by a clearinghouse against default.
4. Which of the following derivatives is classified as a contingent claim?
A. Futures contracts
B. Interest rate swaps
C. Credit default swaps
5. In contrast to contingent claims, forward commitments provide the:
A. right to buy or sell the underlying asset in the future.
B. obligation to buy or sell the underlying asset in the future.
C. promise to provide credit protection in the event of default.
6. Which of the following derivatives provide payoffs that are non-linearly related to the payoffs of the underlying?
A. Options
B. Forwards
C. Interest rate swaps
7. An interest rate swap is a derivative contract in which:
A. two parties agree to exchange a series of cash flows.
B. the credit seller provides protection to the credit buyer.
C. the buyer has the right to purchase the underlying from the seller.
8. Forward commitments subject to default are:
A. forwards and futures.
B. futures and interest rate swaps.
C. interest rate swaps and forwards.
9. Which of the following derivatives is least likely to have a value of zero at initiation of the contract?
A. Futures
B. Options
C. Forwards
10. A credit derivative is a derivative contract in which the:
A. clearinghouse provides a credit guarantee to both the buyer and the seller.
B. seller provides protection to the buyer against the credit risk of a third party.
C. the buyer and seller provide a performance bond at initiation of the contract.
11. Compared with the underlying spot market, derivative markets are more likely to have:
A. greater liquidity.
B. higher transaction costs.
C. higher capital requirements.
12. Which of the following characteristics is least likely to be a benefit associated with using derivatives?
A. More effective management of risk
B. Payoffs similar to those associated with the underlying
C. Greater opportunities to go short compared with the spot market
13. Which of the following is most likely to be a destabilizing consequence of speculation using derivatives?
A. Increased defaults by speculators and creditors
B. Market price swings resulting from arbitrage activities
C. The creation of trading strategies that result in asymmetric performance
14. The law of one price is best described as:
A. the true fundamental value of an asset.
B. earning a risk-free profit without committing any capital.
C. two assets that will produce the same cash flows in the future must sell for equivalent prices.
15. Arbitrage opportunities exist when:
A. two identical assets or derivatives sell for different prices.
B. combinations of the underlying asset and a derivative earn the risk-free rate.
C. arbitrageurs simultaneously buy takeover targets and sell takeover acquirers.
CHAPTER 2
BASICS OF DERIVATIVE PRICING AND VALUATION
LEARNING OUTCOMES
After completing this chapter, you will be able to do the following:
● explain how the concepts of arbitrage, replication, and risk neutrality are used in pricing derivatives;
● distinguish between value and price of forward and futures contracts;
● explain how the value and price of a forward contract are determined at expiration, during the life of the contract, and at initiation;
● describe monetary and nonmonetary benefits and costs associated with holding the underlying asset and explain how they affect the value and price of a forward contract;
● define a forward rate agreement and describe its uses;
● explain why forward and futures prices differ;
● explain how swap contracts are similar to but different from a series of forward contracts;
● distinguish between the value and price of swaps;
● explain how the value of a European option is determined at expiration;
● explain the exercise value, time value, and moneyness of an option;
● identify the factors that determine the value of an option and explain how each factor affects the value of an option;
● explain put–call parity for European options;
● explain put–call–forward parity for European