Stocks, Bonds and Forwards

Stocks

• Issued by firms to finance operations
• Represent ownership of the firm
• Prices known today, but not the future
• May or may not pay dividends

Bonds

• Price known today
• Future payoffs known at fixed dates
• Otherwise, price movement is random
• Final payoff at maturity
• Intermediate payoffs : coupons
• Exposed to default/credit risk

Derivatives

• Sell for a price/value/premium today
• Future value derived from the value of the underlying securities
• Traded at exchanges - standardised contracts, no credit risk or over the counter (a network of dealers, institutions, can be non-standard)
• Some credit risk

Why derivatives?

• To hedge risk
• To speculate
• To attain “arbitrage” profit
• To exchange one type of payoff for another
• To circumvent regulations

Forward (Contract)

• An agreement to buy (long) or sell (short) a given underlying asset S at a predetermined future date T (maturity) at a predetermined price F (forward price)
• F is chosen so that the contract has zero value today
• Delivery takes place at T
• Payoff : S(T) - F or F - S(T)
• S(T) := spot market price at maturity

Swaps

• Agreement between 2 parties to exchange 2 series of payments
• E.g paying fixed interest rate patments