Types of options A call is an option to buy A put is an option to sell A European option can be exercised only at the end of its life An American option can be exercised at any time
Nature of Swaps A swap is an agreement to exchange cash flows at specified future times according to certain specified rules Options, Futures, and Other Derivatives, 5th edition 2002 by John C. Hull
Consumption vs Investment Assets Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold, silver) Consumption assets are assets held primarily for consumption(Examples: copper, oil)
The nature of derivatives a derivative is an instrument whose value depends on the values of other more basic underlying variables Options, Futures, and Other Derivatives, 5th edition C 2002 by John C. Hull
Three Alternative strategies Take a position in the option and the underlying Take a position in 2 or more options of the same type(a spread Combination: Take a position in a mixture of calls puts(A combination)
Standard approach to Estimating Volatility Define on as the volatility per day between day n-1 and day n, as estimated at end of day Define S: as the value of market variable at end of day i
Derivatives Dependent on a single Underlying Variable Consider a variable, 0, (not necessarily the price of a traded security) that follows the process d e S Imagine two derivative s dependent on e with prices f, and f2. Suppose
Valuation of Swaps The standard approach is to assume that forward rates will be realized This works for plain vanilla interest rate and plain vanilla currency swaps, but does not necessarily work for non- standard swaps
