1. Exam FM: Financial Economics Material Rick Gorvett, FCAS, ASA, CERA, MAAA, ARM, FRM, PhD Director, Actuarial Science Program State Farm Companies Foundation Scholar in Act. Sci. University of Illinois at Urbana-Champaign

2. Agenda - Topics Basic derivatives concepts Forward and futures contracts Option contracts Option combinations and positions Risk management and hedging Methods of buying an asset Swap contracts

3. Basic Derivatives Concepts

4. Basics of Derivatives Derivative: value depends upon, or derives from, the value of something else Reasons for using derivatives –Risk management –Reducing transactions costs –Taxes, regulations, accounting –Speculation Perspectives –End users –Market makers –Economic observers

5. Transactions Costs Commissions –Percentage and / or flat amount –For buying assets: add to cost –For selling assets: subtract from proceeds Bid-ask spread –Bid = price broker bids to buy asset Investor sells at bid price –Ask = price broker asks to sell asset Investor buys at ask price Round-trip cost –Total cost associated with buying and then selling

6. Example of Round-Trip Cost You buy 1,000 shares of a stock, and immediately turn around and sell them. –Ask price = 76.25 –Bid price = 75.50 –Commission is $20, plus 1% of the proceeds of any buy or sell transaction. Find the round-trip transaction cost

7. Short-Selling Process: –Borrow asset and sell –Buy back and return asset later Issues: –Lease rate: payment required by lender from borrower (e.g., dividends  reimburse lender) –Haircut: additional margin required by lender –Short rebate / repo rate: interest rate on haircut Cost of short-selling includes difference between this rate and the market rate you would otherwise earn

8. Example of Short-Selling One-year short sale of 100 shares of stock –Price per share at t = 0 is $70 –Price per share at t = 1 is $65 –Additional collateral (haircut) required is $1,000 –Effective market interest rate is 5% –Rate (short rebate) credited to collateral is 3% –Dividend of $1.50 per share paid at t = 0.5 –Commission of $40 per transaction (on both ends) Find the short-seller’s profit.

9. Q: Reasons for Using Derivatives (From Exam FM Fin Econ Sample Questions)