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Chapter 15 notes 2012 08 05

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Chapter 15 notes 2012 08 05

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 15Introduction to other Financial DerivativesAugust 2012
  2. 2. Chapter summary and outlineThis chapter provides an overview of other common financialderivatives, such as knock-out products, contracts for differences(CFDs), extended settlement (ES) contracts.Chapter outline:• Knock-out products• Contracts for Differences (CFDs)• Extended Settlement (ES) contractsfinlogIQ 2
  3. 3. Knock-Out Products• Are instruments that combine an underlying asset, such as an equity security, a fixed income security, or other financial assets and an option – Optionality – pay off profile is “All or nothing” – Value of the option can become worthless should the price of the underlying instrument or some other pre-determined reference reach a certain level.• Diff between product with KO and without KO - holder of KO product will get no returns (or smaller returns) on the investment should the price of the underlying asset trade at or beyond the target price level• Embedded option includes: currencies, commodities, interest rates and equity productsfinlogIQ 3
  4. 4. Contracts for Differences (CFDs)• Over-the-counter (“OTC”) financial derivative product that is based on an agreement between two parties (the client and the provider) to settle the difference in the price of a reference instrument between the inception transaction and closing transaction.• In order to mitigate the credit risk from the broker’s perspective: – Client puts up collateral before he can trade the product• Traders can initiate long or short positions without actually owning the underlying reference instrument• Product has higher risk profile given their leveraged naturefinlogIQ 4
  5. 5. Contracts for Differences (CFDs) - 2• The chart below shows a typical CFD transaction referencing the stock of a company – Trader takes a long position in a stock by just providing a margin plus some financing and transaction fees to the broker in return for an economic interest in the stock.• CFD brokers would allow for this contract to be open indefinitely as long as the trader maintains adequate margin.• The trader may close the contract and then settle the price difference in cash at any time.finlogIQ 5
  6. 6. Extended Settlement Contracts• Is a contract between two parties, to buy or sell a specific quantity of a specific underlying security at a specific price for settlement at a specific future date• Commonly known as single stock futures if underlying is an equity security.• Pricing mechanism: Based on the spot futures parity equation• In other words it is like a typical futures contractfinlogIQ 6

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