(48) Derivative Markets and Instruments Flashcards
LOS 57. a: Define a derivative and distinguish between exchange-traded and over-the-counter derivatives.
Financial contract between 2 parties whose value depends on teh value of some other underlying asset. Allow the transfer of risk. Derivatives are a zero-sum game - they do not create wealth, they simply transfer it. Derivatives are used for hedging or speculation
I.e. - Buyer or seller agrees to buy or sell a specific asset at a specific price on a specific date
LOS 57. a: Define a derivative and distinguish between exchange-traded and over-the-counter derivatives.
Exchange-traded derivatives, notably futures and some options, are traded in centralized locations (exchanges) and are standardized, highly regulated, settled daily, have no counterparty risk and are free of default. A clearinghouse is the middle man between the buyer and seller.
Forward and swaps are custom contracts (over-the-counter derivatives) created by dealers or financial institutions. There is limited trading of these contracts in secondary markets and default (counterparty) risk must be considered.
LOS 57. b: Contrast forward commitments with contingent claims.
A forward commitment is an obligation entered into at one point in time that require both parties to engage in a transaction at a later point in time on terms agreed upon today. Forward contracts, futures contracts, and swaps are all forward commitments. The forward price agreed at expiration is agreed upon at the start of the contract. (Linear payoffs)
A contingent claim is an asset that has a future payoff only if some future event takes place (e.g., asset price is greater than a specified price). Options and credit derivatives are contingent claims. Seller has the obligation, while buyer has a right. (non linear payoffs).
Forward commitments can end in default by either party but that is not the case with contingent claims
LOS 57. c: Define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics.
Forward contracts obligate one party to buy, and another party to sell, a specific asset at a specific price at a specific time in the future. Not all underlying assets are delivered or deliverable. These are over-the-counter (OTC)
LOS 57. c: Define forward contracts, futures contracts, options (calls and puts), swaps (interest), and credit derivatives and compare their basic characteristics.
An OTC contract in which 2 parties agree to swap a series of cash flows whereby one party pays a variable rate and other party pays variable rate or fixed rate. Value of swap at inception is zero.
As the floating rate changes, the value of the swap changes.
Most common swap: fixed for floating (plain vanilla)
Corporations use swaps to convert its floating rate loan to a fixed rate loan by adding a swap
Interest rate swaps contracts are equivalent to a series of forward contracts on interest rates.
LOS 57. c: Define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics.
Futures contracts are much like forward contracts, but are exchange-traded, liquid, and require daily settlement (mark to market) of any gains or losses. Subject to daily price limits
Other characteristics: initial margin, maintenance margin, margin call, and closing out a position before delivery
Futures and spot prices converge on the final day
LOS 57. c: Define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics.
Buyer has the right and seller has the obligation. These are OTC or exchange traded but exchange traded are more common.
A call option gives the holder the right, but not the obligation, to buy an asset at a specific price by a pre specified date.
A put option gives the holder the right, but not the obligation, to sell an asset at a specific price by a pre specified date.
American style options - exercised anytime before expiration
European style options - can only be exercised on the expiration date.
LOS 57. c: Define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics.
Class of derivative contracts between two parties, a credit protection buyer and a credit protection seller, in which the latter provides protection to the former against a specific credit loss.
Main example is credit default swap (CDS): buyer makes a series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the default of the third party
LOS 48. d: Determine the value at expiration and profit from a long or a short position in a call or put option
Out of the money call option: Underlying value (ST) < than exercise price (X)
At the money: ST = X
In the money: ST > X
Payoff of call at expiration (CT): ST - X if ST > 0, otherwise its zero
Profit call buyer= CT - C0
Profit for call seller = - C0 + CT
Buyer (long position) will always have a zero payoff in all three positions and profit will be positive only when the position is “in the moey”
Seller (short position) will have zero payoff in all positions except when its in the money (payoff will be negative. Profit is only positive in OTM and ATM.
LOS 48. d: Determine the value at expiration and profit from a long or a short position in a call or put option
Out of the money put option: Underlying value (ST) < than exercise price (X)
At the money: ST = X
In the money: ST > X
Payoff of call at expiration (PT): X - ST if ST < 0, otherwise its zero
Profit for put buyer = PT - P0
Profit for put seller = - P0 + PT
LOS 57. e: Describe purposes of, and controversies related to, derivative markets.
Derivative markets are criticized for their risky nature, their speculation, and complexity. However, many market participants use derivatives to manage and reduce existing risk exposures.
Derivatives may provide an indication of the direction of the underlying. They also have lower transaction costs, provide leverage, and have greater liquidity.
Derivative securities play an important role in promoting efficient market prices and reducing transaction costs.
LOS 57. f: Explain arbitrage and the role it plays in determining prices and promoting market efficiency.
Riskless arbitrage refers to earning more than the risk-free rate of return with no risk, or receiving an immediate gain with no possible future liability.
Arbitrage can be expected to force the prices of two securities or portfolios of securities to be equal if they have the same future cash flows regardless of future events.
Arbitrage helps determine prices and improves market efficiency
What does long and short mean in derivatives markets?
Long means buyer - long takes delivery in futures contract
Short means seller - short must deliver to a specific location
Define initial margin, maintenance margin, and margin call
Initial margin: The amount that must be deposited in a clearinghouse account when entering into a futures contract
Maintenance Margin: The margin requirement on any day other than the first day of a transaction (The maintenance margin is always significantally lower than the initial margin
Margin call: A request for the short to deposit additional funds to bring their balance up to the initial margin
What is information discovery in the futures market?
Futures markets reveal the price that the holder of the asset can take to avoid uncertainty.
