A define a derivative, and distinguish between exchange-traded and over-the-counter derivatives Flashcards
define a derivative, and distinguish between exchange-traded and over-the-counter derivatives
“What are the defining characteristics of derivatives?” Define a derivative
Derivatives are financial instruments that derive their values from the performance of basic underlyings (equities, fixed income, currency, commodities)
Best characterization: Derivatives “transform the performance of the underlying before paying it out in the derivatives transaction (Distinguishes Derivatives from Mutual Funds, ETFs, or straight pass instruments)
- transfers underlying risk between parties
- payoff on the basis of a source of risk
- definite life span
- expire on a specified date
- created in the form of legal contracts
- Buyer holds derivative contract long
- Seller hold derivative contract short
- strategic
ETD’s
formal organizational structures (Market makers or dealers bring buyers and sellers together to facilitate transactions). –formal rule structures
-required to comply with all securities laws.
Exchange-Traded Derivative: Mutual Funds, ETF’s are straight pass-trough instruments: “mutual funds and exchange-traded funds simply pass through the returns of their underlying securities.
Formal: Buyers and sellers deal through market makers
Standardized derivs: Exchange specifies terms and conditions
Standard contracts provide liquidity as market makers match lots to trade
Standard contracts are cleared: Rather, execution is verified and identities recorded.
Settlement: More efficient (contracts settle over night) clearing house provides a credit guarantee via a participant margin or performance bond.
Transparent: Full Info, though less privacy
Standardized: Less flexibility
Exchange determines terms of contract except price terms
market makers do not charge a commission
OTC Exchanges
NASDAQ: Informal: Electronic
Customized: More flexibility, less regulation. Higher degree of privacy but less transparency.
Informal: Dealers are not obligated to buy or sell, as the motive is profit
OTC deriv dealers pass risk on to other parties by offsetting transactions.
ISDA banks oversee OTC as principal dealers in ‘dealer markets.’
Not always ‘less liquid’ as “Liquidity is always driven by trading interest, which can be strong or weak in both types of markets.”
