Number of OTC transactions less, but average size much larger, dominated by FI’s, banks, fund managers, corporations.

Banks can act as market makers with bid offer or parties contact each other directly. A derivative is an
instrument whose value depends on or is derived from the value of another asset. CBOT in 1848, CBOE 1973. OTC traded on swap execution facilities. CCP. All trades reported to central repository. Market value = units of claims x
price of claims (all claims that could be traded). Notional value = units of claims x number of underlying assets x price of underlying assets. Quality risk can exist with commodities. Mutual funds disclose investment policies,
make share redeemable, limited leverage

Futures contract specifies asset, contract size, where delivery is made, when delivery is made. Variation in quality of commodity. Different qualities adjusts the price. Contract size needs to be right, if too large hard to hedge
small exposures, speculate small positions, if too small trading too expensive because of transaction costs. Price adjusted to delivery location chosen by party, higher for delivery locations relatively far from main sources of
commodity. Specifies precise period during month when delivery can be made. Futures converses to spot, if greater cash and carry, if less, reverse cash and carry. Minimum margin levels determined by variability of price of
underlying asset and revised when necessary. Variability ^ margin ^. Margin account for hedger less than speculator as deemed less risk of default. Clearing house is intermediary in futures transactions. Guarantees performance
of parties. Members contribute to default fund. Clearing margin is margin kept by clearing member and house, no maintenance. Keeps track of all transactions to calculate daily net position of members. OTC now has collateral
and Central Clearing Partty. Can have different collateral arrangements which are negotiated. CCP becomes counterparty to both parties and takes on credt risk of both parties which is managed by initial and variation margin.
Large amount of day traders can lead to trading volume > open interest. Stock indices cash settled. Cornering the market is when take huge long position and exercise control over supply of underlying so that near delivery,
futures exceeds supply and sellers forced to sell increasing prices. Hedging gain/loss recognised when closed out, speculating gain/loss recognised as accrued. Futures gain/loss relaised day by day, forward recognised at end.
Futures always USD per currency. Forwards are USD per pound, euro, aud, NZD or currency per US. Futures regulated nationally by ASIC ASX. Speculators required as add liquidity to market.

Companies hedge to minimise risks from variables such as interest rates, exchange rates, commodity prices that they have no expertise in predicting hence can focus on main activites. Arguments against: shareholders can hedge
risks themselves. (flaws with this include shareholders not having same information as management, ignores commission and transaction costs which are cheaper per dollar for large transactions, and can be impossible for
shareholders due to size of futures contracts). Instead shareholders diversify so immune to risks facrd by corporation. If hedging not norm in country, doesn’t make sense to do it. Competitive pressures from within industry
couldl mean prices reflect material costs, interest / exchange rates etc. No hedge means constant profit margin while hedge means profit margin fluctuates. Hedging can cause increase or decrease in profits relative to no hedge
position. Can be hard to explain if leads to worse outcome (thus hedging strategy should be fully set out by board/execs and outlined to shareholders). Hedging not perfect because asset beinig hedged not same as underlying
futures asset, don’t know exact date of buy/sell asset, contract closed out prior to maturity. Basis = spot – futures. Strengthening is increase of basis. Basis risk is the uncertainty associated with the basis at end of hedged
position. If basis strengthens, short position improves as gets higher price for asset after taking into account futures gain. Cross hedging basis formula accounts for basis due to difference between two assets. Choose contract
that has futures prices most closely correlated with price of asset. Choose delivery month as close to but later than expiration of hedge as futures prices quite erratic during delivery month and run risk of taking delivery which is
time consuming and costly. Hedge ratio is ratio of size of futures position to size of exposure. Hedger should choose hedge position that minimises variance of value of hedged position. Hedge ratio is slope of lin reg of change in
spot and futures prices. Hedge effectiveness is the proportion of variance that is eliminated by hedging (p^2). Theoretically when tailing the hedge (which takes into account daily settlement), should adjust hedged position.
Percentage increase of stock index equals percentage increase in portfolio of underlying stocks less dividends (only tracks capital gain). Beta is slope of lin reg of return on asset and market return. Hedge equity portfolio is stocks
picked well and uncertain about market but confident will earn above market, thus hedge removes risk from market moves and leaves hedger exposed only to performance of portfolio relative to market. Another reason is want
short term protection and selling rebuying has high transaction costs. Liquidity problems can occur from hedging as prices decline can lead to outflows before inflows from the hedge (timing mismatch).

Investment asset held solely for investment purposes by significant number of investors. Consumption asset held primarily for consumption and not usually investment. COC model assumptions for some (key) market
participants. No transaction costs, same tax rate on net trading profits, borrow and lend at same risk free rate, take advantage of arbitrage. If short sale not possible for investment asset, fine as definition of investment is enough
people hold it for investment thus if forward price too low, attractive to sell asset and long forward. Value of forward contract zero at inception. Futures gain is realised almost immediately while forward gain realised at
maturity / when closed out. When no uncertainty about future interest rates, futures = forwards. When interest rates unpredictable, if spot price strongly positively correlated futures > forwards as invest gain at higher rate and
finance loss at lower rate, if negatively correlated forwards > futures short invest gain at higher rate finance loss at lower rate high supply of futures, low demand price decrease. If low maturity can assume same. Other factors
affecting prices include taxes, transaction costs, margin accounts. Value of q for forward price of stock index should be average annualised dividend yield during life of contract. To an investor, the foreign currency provides an
income equal to the interest rate x value of the currency per year i.e. income paying asset. For consumption assets cannot short sell and companies holding these assets reluctant to sell and buy futures as can’t use futures in
manufacturing process / consume futures. Ownership of asset provides benefits not obtained by hoding futures. Convenience yield is benefits from holding asset. Represents markets expectation concerning future availability of
commodity. Relationship between futures and spot prices is cost of carry. If c>y, benefits from holding asset (convenience yield less storage costs) less than risk free rate hence should deliver as early as possible and priced on the
fact that delivery takes place at beginning. If c<y, futures price calculated on assumption that should deliver as late as possible. Expected spot price is market average opnion of spot price. If hedgers short, speculators long,
futures price less than expected as speculators compensated for risk they take and hedgers will to lose money on average as reduce risk. Futures price unbiased estimate of expected future stock price when return from
underlying uncorrelated with stock market. Normal backwardation when futures less than expected, contango opposite.

Plain vanilla is fixed for floating. One party usually pys other party the settlement amount. Principal not actually exchanged in interest rate. If notional was exchanged, effects cash flows but has no financial value. Used to
transform assets and liabilities. FI enters two offsetting transactions and makes a profit. Parties don’t know other party when bank inbetween. If company defaults, FI has to honour agreement with other party thus profit
compensate them for risk of company defaulting on payment. FI act as market maker hence enter swap with no counter party. Present bid offer and swap rate is average. Market maker hedge risk with FRA’s, futures, bonds to
minise interest rate risk. If the fixed rate of new swap is swap rate, then value of zero. A swap is mutually beneficial when the desired interest rate type differs from the interest rate type in which comparative advantage is
enjoyed. Comparative advantage argument criticised because: fixed rates 5 years, floating are 6 months, lender can adjust floating every 6 months, if credit rating changes can increase decrease rate (can’t in fixed). Spreads in
rates depend on likelihood of defaulting. Fix spread > float as credit probability of default likely to increase quicker for worse credit rating and fix has longer term. In reality of swap, float only converted to determined fixed (for
lower credit rated company) if can keep borrowing at rate, however their float could change and hence fixed changes. For higher credit rating, earn advantage but face credit risk of FI not experienced if borrowed directly. Worth
zero when started. In currency swap, principal exchanged at beginning and end. Principal amounts chosen to be approximately equivalent using exchange rate at initiation. Convert interest rate, currency based on your
prediction of future (if rates/currency go up/down). Comparative advantages (fix-fix) more genuine in currency swap due to tax advantages in different countries. When FI experiences exchange risk in currency swap, can buy the
currency it has to pay in forward market to lock in rate. FI typically bears exchange risk as in best position to hedge this. If party defaults, FI liable to lose whole of its pos value of swap. If party with pos value defaults, likely to
rearrange affairs to still receive positive value. Potential losses much less for swap than loan on same principal as value of swap only small fraction of value of loan. Loss on currency swap greater than on interest rate as principal
in two different currencies exchanged at end so liable to have greater value at tiem of default. Credit risk arises from probability that party defaults and market risk is possibility of interest / exchange rate make value negative.
Swap buyer pays fixed receives floating. Derivatives not usually valued using treasury yield curves. Introduced CCP, margin, collateral to limit credit exposure of banks. Parties of FRA agree to make payment which compensates
one party for higher borrowing costs or lower return from lending. If rk > rm, the borrower borrows at rm and makes a compensating payment to the lender. If rm > rk, the borrower borrows at rm and receives a compensating
payment from the lender. Floating rate borrowers “buy” FRA’s to hedge against rising interest rates. Floating rate investors “sell” FRA’s to hedge against falling interest rates.

US expiration date is Saturday following third Friday of month (last trading day of options for month). Trade in Jan, Apr, Jul, Oct | Feb, May, Aug, Nov | Mar, Jun, Sept, Dec cycles. If less than expiration date, current, current + 1,
next two in cycle. If past expiration date, next month, next + 1, next 2 in cycle. When one option reaches expiration, next begins trading. LEAPS (long term equity anticipation securities) trade up to 39 months ahead. Strike price
diff $2.5 if 5<ST<25, $5 25<ST<200, $10 ST>200. Splits dividends can lead to non standard prices. When new expiration date introduced, 2/3 closest to spot price become strike price, if out of range, add. Option class is all
options of call or put on stock. Options series is option class with same expiration and strike. Intrinsic value of option is max(st – K, 0) or rev for puts if exercised now. ITM American option value >= intrinsic value because can
exercise immediately. American option has time value where worth to wait rather than exercise. Weekly expire start Thursday, expire next Friday. Quarterly expire last business day. ET not adjusted for cash dividend (unless
extreme circumstance and exchange chooses). Position limits max number held on 1 side. Exercise limit is max can be exercised in 5 bus days. Market maker quote bid-offer. Exchange sets limits on bid-offer spread. Add liquidity
to market and make profit from bid-offer. Don’t know if party talking to is buying or selling. If neither party offset position, open interest increases, if one offset one doesn’t remain unchanged, if both offset decrease by 1.
Hidden cost in trading is bid-offer spread and is difference between price paid and fair price (average of bid-offer). Naked option is option not combined with offsetting position in underlying. Initial and Maintenance greater of
(100% of sale proceeds (premium) + 20% underlying spot price – amount OTM) and (100% sale proceeds + 10% share price(call) or strike price(put)). Different rules for other trading strategies. Options Clearing Corporation
essentially same as CCP for futures. When option is exercised, open interest decreases by 1. May not exercise ITM option if transaction costs too high. Warrants are options issued by financial institutions or nonfinancial
corporations. Common use is attach call warrants to bond issue to make attractive (company con lower interest rates and investor can benefit from growth of company). Employee stock option call option issued to employee,
ATM when issued. Convertible bond can convert to equity using predetermined exchange ratio. Predetermined number of options issued for these but when option exercised, number of shares increases. Normal ET options have
no set amount but no change in share number. Forward contracts neutralise price risk by fixing price, options protect from adverse while benefit from favourable. However hedging with forward can lead to much worse position
than no hedge. Option premium (upfront payment) makes less attractive for hedging. In US, ET traded stock options are American style. Holder of American style has all same rights as European + more, arb from short euro long
amer. Maturity > 9 months to be bought on margin.

Call option more valuable is stock price increase and strike price decrease, put increase when stock decrease and strike icnrease. American put and call = or more valuable when time increases as more opportunity to exercise
early. European tend to increase but not always case as if T too large, cant exercise within lifetime. Both increase with volatility as increase chance of more value but limited downside risk when stock decrease. If interest
increases, expected return on stock tends to increase and pv of future cash flows from option decrease so call increase value, put decrease value (pay K for call so pay less, receive K for put so receive less). Dividends reduce
stock price. There are market participants such as large investment banks and ready to take arbitrage opps, no transaction costs, all profits subject to same tax, borrowing and lending at same rate. Call never worth more than
stock so upper bound S0. American put receive max K no matter what so cant be more than K, cant be more than present K for European. Never exercise American call on non dividend early. If withhold from exercising early, can
earn interest on the strike price and still keep insurance if stock price drops below K. Due to time value of money, later strike price is paid, the better. Should sell call instead and will be able to sell for at least intrinsic + TV. Can be
optimal to exercise American nondiv put early. Should always be exercised early if sufficiently deep ITM. For example if S0= 0, make K and can never make more, and money now better than money in the future. Early exercise
more attractive as So decreases, r increases and volatility decreases. Since should sometimes exercise American put early, always worth more than European put. Since American put worth more than intrinsic value, European
put sometimes worth less than intrinsic value. If dividends, could exercise American call early before ex dividend date.

Writing covered call is long stock and short call. Long stock covers / protects investor from payoff on short call that is necessary if sharp rise in stock price. Long put and long stock is protective put. Spreads take position in two or
more options of same type. Bull spread long low strike, short high strike, same expiration date. Bull call requires investment as low strike more expensive. Limits upside and downside risk. Can have both calls out of money (most
aggressive), one in one out, both in the money. Gets more conservative more ITM. Bull put gets initial cash flow. Bull spread want increase. Bear spread want decrease. Buy high strike, sell low strike. Bear call inflow, bear put
outflow. Limit upside potential and downside risk. Box spread is combination of bull call and bear put. K1 and K2 match for bull and bear. Value of box spred always (k2-k1)e-rt. Box spread arbitrage only works with European
options (difference in pricing between American and European puts). Butterfly is long k1,k3 and short 2 k2. K2 usually around ATM. Strategy for not large stock price move. Requires investment. Calender spread have same strike
different expiration. Short lower maturity, long higher maturity same for put/call. Greatest payoff ATM. Neutral calender spread has relatively ATM, bullish ITM, bearish OTM. Combination has both puts and calls on same stock.
Straddle is long European call and put same strike / expiration. Loss if at strike price, profit if large move. Appropriate for large move but don’t know what direction. Strip is long 1 call, 2 puts, strap is long 2 calls, 1 put. Big
movement and one side more likely than other. Strangle is long European call and put with different strikes. Betting large move, uncertain direction, have to move further for profit yet less downside risk. Further away the strike,
less downside risk and larger move required for profit.

We don’t use probabilities of up/down movement in stock as not valuing option in absolute terms. Valuing in terms of price of underlying, probabilities of future up or down already included in stock price. Risk neutral valuation
assumes investors are risk neutral. Means investors do not expect increased return for increased risk. Features are expected return on stock is risk free rate and discount rate used for expected payoffs is risk free rate. When we
assume world is risk neutral, get right price for derivatives in all worlds, not just risk neutral one. Can be used regardless of assumptions made about evolution of stock price. It costs nothing to take a long or short position in
futures hence in risk neutral world, futures price has expected growth rate of 0.

BSM assumes return on stock in short period of time is normally distributed with returns in two non overlapping periods being independent. BSM assumes Stock price at any time is lognormally distributed hence natural log of
stock price is normally distributed. Stock price is smooth. Log Stock price follows geometric Brownian motion (random walk around upward drift) with continuously compounded expected return u and standard deviation of that
o. Continuously compounded return is normally distributed. Volatility is the standard deviation of the continuously compounded return in one year. Assumptions of BSM are stock price correspondes to log normal model with u
and o constant. There are no transaction costs or taxes. All securities are perfectily divisible. There are no dividends on the stock during the life of the option. There are no riskless arbitrage opportunities. Security trading is
continuous. Investors can borrow and lend at same risk free rate. Short term risk free rate is constant. Can’t value American put directly with BSM. Can value American call as same as European Call. N(d2) is probability that call
option will be exercised in risk-neutral world. BSM doesn’t involve u as in risk neutral world so risk preferences have no effect. Valuing a forward contract risk neturally: value at maturity = St- K. St = Soe^rt (risk neutral) therefore
value = Soe^rt – K. Discount at risk free, value = So – ke^rt which is formula. Deduct PV(D) from S0. Blacks approximation for American call on div paying: calculate European option that matures at same time as American option
and European option maturing before last ex-dividend date that occurs during the life of the option. American option is higher of the two values. The calculations include the dividends during the life of the option. When valuing
dividend yeidl / currency options, sub in Soe^-qt / Soe^-rft everywhere where there is So and in d1 formula, sub in r – q or r-rf for r. In general American calls on high interest currencies and puts on low interest currencies
exercised early (high interest expected to depreciate and low interest expected to appreciate). Calls with high div and puts with low div exercised early. Concepts underlying: option and stock have same underlying source of
uncertainty (St), can form portfolio of stock and option which eliminates source of uncertainty, portfolio instantaneously riskless and must instantaneously earn risk free rate, leads to BSM diff equation. European call. Binomial
assumes one period riskless hedge, BSM assumes instantaneous riskless hedge. Each instantaneous time t, for riskless stock/option portfolio. St continuous stochastic process. C perfectly positively correlated with St
instantaneously. Requires continuous rebalance. BSM only perfect hedge in reality if stock follows assumed GBM and can rebalance continuously. Each small interval is normal dist, accumalting up for whole process gives log
normal dist. Risk neutral: assume expected return is risk free, calculate expected payoff, discount at risk free. Garman Kohlhagn 1983 if foreign currency BSM, Black 1973 is dividend yield BSM. Implied volatility of option is
volatility for which BSM price equals market price. VIX index is implied volatility of short term, near the money options on market index (S&P 500 in US, S&P/ASX200 in Aus).

Delta positive for long calls, negative for long puts. Gamma always positive for long options. Theta always negative for long options. Veta always positive for long position. Rho positive for long call and negative for long put.
Portfolios often delta hedged. Gamma hedging protects against large changes in stock price between hedge rebalancing. When hedging option position, total cost should always be near BSM price as that is the assumption of
BSM. Delta hedge rebalanced frequently as only neutral for short period of time. Variation when delta hedging between PV(cost) and BSM price due to rebalancing frequency, vol constant and no transaction costs. Delta hedging
attempts to keep value of portfolio unchanged. Delta hedging keeps equivalent opposite position in option synthetically. PV(expected cost) comes from average difference between when stock is purchased and sold. Doesn’t
make sense to hedge theta as no uncertainty with the passage of time. If gamma small, delta changes slowly and rebalancing only needs to occur relatively infrequently. Risky to lead portfolio unhedged if gamma is high .need a
position in an instrument not linearly dependent on underlying for gamma neutrality. Gamma neutrality acts as correction for hedging error. Have previously assumed constant vol but vol changes value. If only one traded
option, can only keep gamma or vega neutral, determining factor is rebalancing frequency and volatility of volatility. In reality hard to keep all greeks zero when managing portfolio on one underlying as difficult to find non liner
derivatives that can be traded at volume required at competitive prices to keep gamma and vega zero. Gamma and vega high ATM. Theta most negative ATM, tends to -rKe^-rt