C.1 Introduction Flashcards
What is a derivative
A derivative is an instrument whose value depends on the values of the other more basic underlying variables
What is their purpose in the economy
Transferring risk
Types of derivatives
- Futures contracts
- Forwards contracts
- Swaps
- Options
Ways derivatives are used
- To hedge risks
- To speculate on the future of the market
- To lock in an arbitrage profit
- To change the nature of a liability
- To change the nature of an investment by avoiding the costs of selling one portfolio and buying another
What is a futures contract
An agreement to buy or sell an asset at a certain time in the future for a certain price
What is a spot contact
An agreement to buy/sell an asset immediately (or short time period) at the spot price
Exchanges trading futures
- CME Group
- Intercontinental Exchange
- Euronext
- Eurex
- BM&FBovespa
- National Stock Exchange of India
- China Financial futures Exchange
How is a futures price determined
The price you agree to buy/sell at a future time. It is determined by supply and demand similarly to spot price
Open outcry system
When traders physically met on the floor to make an exchange
Long position
The party that has agreed to buy
Short position
The party that has agreed to sell
What is the over-the-counter market
An important alternative to exchanges where trades are usually between financial institutions, corporate treasurers, and fund managers
Transaction in the over-the-counter market
Fewer transactions, but of a much larger scale than in the exchange-traded market
The Lehman Bankruptcy and OTC markets
Heavily invested in OTC derivatives and got into shit bc it took high risks that it was unable to roll over its short term funding. Not being able to afford these is what caused them to have to liquidate
Regulations for OTC market
Becoming more like exchange-traded market after Lehman disaster to reduce systematic risk
- Standard OTC products between F.I.s must be traded on swap execution facilities
- A central clearing party must be used as an intermediary for standard products when traded between F.I.s
- Trades must be reported to a central registry
How is systematic risk and OTC transactions related
A default by one large F.I. can lead to losses by other F.I.s
What is a forward contract
Traded in OTC market like futures, popular with currencies and interest rates
Forward price
Delivery price that would be applicable to the contract if it were negotiated today (the price that would make the contract worth zero). May be different for different maturities
What is a call option
An option to buy a certain asset by a certain date for a certain price
What is a put option
An option to sell a certain asset by a certain date at a certain price
What is the price for an option
The strike price
American vs European option
American can be exercised at any time during its life while a European can only be exercised at maturity
Options vs futures/forwards
A futures/forwards contract gives the holder the obligation to buy/sell at a certain price while an option gives the holder the right to buy or sell at a certain price
Rules for mutual funds
- Disclose investment policies
- Make shares in fund redeemable at any time
- Limit use of leverage
Hedge funds vs mutual funds
Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly
Hedge fund fee
2 + 20% (standard)
Reasons for trading derivatives
- Hedging
- Speculation
- Arbitrage
