Derivatives

Options

ELEVATORS MAY GO DOWtf AS WELL AS UP

Derivatives are financial products whose value depends on - or is derived from - another financial product, such as a stock, a stock market index, or interest rate payments. They can be used to manage the risks associated with securities, to protect against fluctuations in value, or to speculate. The main kinds of derivatives are options and swaps.

Options are like futures (see Unit 34) except that they give the right - give the possibility, but not the obligation - to buy or sell an asset in the future (e.g. 1,000 General Electric stocks on

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31 March). If you buy a call option it gives you ' ' —

the right to buy an asset for a specific price,

either at any time before the option ends or on a specific future date. However, if you buy a put option, it gives you the right to sell an asset at a specific price within a specified period or on a specific future date. Investors can buy put options to hedge against falls in the price of stocks.

In-the-money and out-of-the-money

Selling or writing options contracts involves the obligation either to deliver or to buy assets, if the buyer exercises the option - chooses to make the trade. For this the seller (writer) receives a fee called a premium from the buyer. But writers of options do not expect them to be exercised. For example, if you expect the price of a stock to rise from 100 to 120, you can buy a call option giving the right to buy the stock at 110. If the stock price does not rise to 110, you will not exercise the option, and the seller of the option will gain the premium. Your option will be out-of-the-money, as the stock is trading at below the strike price or exercise price of 110, the price stated in the option. If, on the other hand, the stock price rises above 110, you are in-the-money: you can exercise the option and you will gain the difference between the current market price and 110. If the market moves in an unexpected direction, the writers of options can lose enormous amounts of money.

Warrants and swaps

Some companies issue warrants which, like options, give the right, but not the obligation, to buy stocks in the future at a particular price, probably higher than the current market price. They are usually issued along with bonds, but they can generally be detached from the bonds and traded separately. Unlike call options, which last three, six or nine months, warrants have long maturities of up to ten years.

Swaps are arrangements between institutions to exchange interest rates or currencies (e.g. dollars for yen). For example, a company that has borrowed money by issuing floating- rate notes (see Unit 33) could protect itself from a rise in interest rates by arranging with a bank to swap its floating-rate payments for a fixed-rate payment, if the bank expected interest rates to fall.

Match the two parts of the sentences. Look at A opposite to help you.

1 The price of a derivative always depends on

2 Options can he used to hedge against

3 A call option gives its owner

4 A put option gives its owner

a future price changes, b the right to buy something, c the price of another financial product, d the right to sell something.

35.1

35.2

a buy a call option,

b sell a call option,

c buy a put option,

d sell a put option.

a buy a call option,

b sell a call option,

c buy a put option,

d sell a put option.

a be exercised,

b not be exercised.

a lose money,

b gain money.

a writers of options,

b buyers of options.

Choose the correct endings for the sentences. Some sentences have more than one possible ending. Look at A and B opposite to help you.

1 If you expect the price of a stock to rise, you can

2 If you expect the price of a stock to fall, you can

3 If an option is out-of-the-money it will

4 If an option is in-the-money the seller will

5 The bigger risk is taken by

35.3 Complete the definitions. Look at A, B and C opposite to help you.

.................. are like call

options, but with much longer time spans.

give the right to sell securities at a fixed price within a specified period.

.................. can be used

to speculate on interest rate movements.

35.4 Complete these sentences using words from A, B and C opposite.

1 If your put option is out-of-the-money, the seller will gain the...........................................................

2 You only exercise a call option if the market price is higher than the...................................................

3 If I expect a stock price to go up in the short term, I buy instead of

the stock.

4 If I expect a big company's stock price to go up in the long term, I sometimes buy their •

5 We needed euros and had a lot of dollars in the bank, so we did a with a German

company which needed dollars.

Ov&r +o upu

Buying and selling options and swaps is highly risky: one party in the deal is guaranteed to lose. Would you like to have a job which required you to buy and sell these products?

Date: 2015-02-28; view: 3454