1. Economics 434 Financial Markets Professor Burton University of Virginia Fall 2015 December 3, 2015

2. The Derivatives Market Exchange Traded Derivatives – Options – Futures Over the Counter Derivatives (not traded on exchanges) – Forwards – Swaps (including CDS, credit default swaps) December 3, 2015

3. Futures Contract What would a gold future look like, assume current (spot) price of Gold is 1100? It would provide a date and a quantity of Gold, lets assume 10 troy ounces (which would cost $ 11,100 in the spot market) February 2016 Gold would “require” the owner to buy gold at what at whatever price they paid for the future (times 10) December 3, 2015

4. Example Suppose Jan 16 Gold is trading at 1120 Then, no matter where gold is trading at the end of January, the owner must pay $ 11,200 and will receive 10 troy ounces in physical gold Expiration date is called a delivery date in the futures market December 3, 2015

5. How “Margin” Works “Margin” is a deposit that a futures buyer puts up to “guarantee” that they will actually buy the underlying commodity when the maturity (delivery) date occurs. If you buy one gold futures contract at a price of 1,120, then you have agreed to pay $ 11,200 for 10 troy oz of gold. What if the price of gold falls to 800 per oz. How do they know that you will honor the purchase? December 3, 2015

6. So, What Actually Happens When you buy the future, you make a small initial deposit, say $ 500 But if gold falls by more than $ 50/oz, your $ 500 just exactly covers the loss So, the exchange requests more “margin”, say another $ 500 And, so on, making you keep “marking” your position by providing additional cash if gold falls more December 3, 2015

7. What if gold goes up? You put up $ 500 initially Suppose gold goes from 1100 to 1200 and the future goes from 1120 to 1220. You now have a $ 1,000 profit The exchange will release $ 500 cash to you and hold onto $ 500 as a deposit to make sure you honor your purchase (after all gold might soon fall in price as well) December 3, 2015

8. So, what is happening It is directly analogous to the purchase of a house – You agree to a price and a settlement date – You put down a deposit to ensure that you will carry forward with the purchase on the settlement date In essence, buying a futures contract is equivalent to buying actual gold with a “delayed settlement” December 3, 2015

9. Review for Final Exam 75 to 80 percent of the final exam will come from material presented from the first day and through the last class before the 2 nd mid term examination 20 to 25 percent of the final exam will come from material presented after the 2 nd mid term December 3, 2015

10. Sections of the Course Bankruptcy Modern Finance Theory – State prices and the No-Arbitrage Assumption – Capital Asset Pricing Model Markowitz mean-variance theory Tobin and the risk free rate assumption Two main conclusions of CAPM – Interpretation Fixed Income – Default free securities Treasuries – ABS – Mortgages Cash Flow Analysis – Why does cash flow matter? – How does it differ from net income – How does it drive valuations Derivatives – Call Options – Gold Futures December 3, 2015

11. Final: 2 PM Friday, Dec 18th No calculators, no paper; just bring something to write on the exam with Three hours There will a spillover room – Physics 204 (A few days before the final will detail who should go to the Wilson Auditorium and who should go to Physics 204 December 3, 2015