(57) Derivative Markets and Instruments Flashcards
LOS 57. a: Define a derivative and distinguish between exchange-traded and over-the-counter derivatives.
A derivative’s value is derived from the value of another asset or an interest rate.
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, regulated, and are free of default
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 to buy or sell an asset or make a payment in the future. Forward contracts, futures contracts, and swaps are all forward commitments.
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.
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.
LOS 57. c: Define forward contracts, futures contracts, options (calls and puts), swaps (interest), and credit derivatives and compare their basic characteristics.
A swap is an agreement to buy or sell an underlying asset periodically over the life of the swap contract.
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 of any gains or losses.
LOS 57. c: Define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics.
A call option gives the holder the right, but not the obligation, to buy an asset at a specific price at some time in the future.
A put option gives the holder the right, but not the obligation, to sell an asset at a specific price at some time in the future.
LOS 57. c: Define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics.
A credit derivative is a contract that provides a payment if a specified credit event occurs.
LOS 57. d: Describe purposes of, and controversies related to, derivative markets.
Derivative markets are criticized for their risky nature. However, may market participants use derivatives to manage and reduce existing risk exposures.
Derivative securities play an important role in promoting efficient market prices and reducing transaction costs.
LOS 57. e: 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.
