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These instruments can be used for two very distinct management objectives:
Speculation use of derivative instruments to take a position in the expectation of a profit
Hedging use of derivative instruments to reduce the risks associated with the everyday management of corporate cash flow
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Major features that are standardized are: Contract size Method of stating exchange rates Maturity date Last trading day Collateral and maintenance margins Settlement Commissions Use of a clearinghouse as a counterparty
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A European option can be exercised only on its expiration date, not before.
The premium, or option price, is the cost of the option.
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Traders who believe that volatilities will fall significantly in the near-term will sell (write) options now, hoping to buy them back for a profit immediately volatilities fall, causing option premiums to fall.
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Currency option prices and values are focused on the forward rate
The forward rate is in turn based on the theory of Interest Rate Parity Interest rate changes in either currency will alter the forward rate, which in turn will alter the options premium or value A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises. This timing will allow the trader to purchase the option before its price increases.
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Mini-Case Questions: Warren Buffetts Love-Hate Relationship with Derivatives In his 2002 letter to shareholders, what does Warren Buffett seem to fear most about financial derivatives? In his 2007 letter to shareholders, what does Warren Buffett admit that he and Charlie had done? Do you think there is an underlying consistency in his viewpoint on the proper use of derivatives?
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Chapter 8
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Exhibit 8.8 Analysis of Call Option on British Pounds with a Strike Price = $1.70/
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Exhibit 8.9 The Intrinsic, Time, and Total Value Components of the 90-Day Call Option on British Pounds at Varying Spot Exchange Rates
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Exhibit 8.10 Decomposing Call Option Premiums: Intrinsic Value and Time Value
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Exhibit 8.12 Foreign Exchange Implied Volatility for Foreign Currency Options, January 30, 2008
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