CH 10 Derivatives Flashcards
derivatives
a financial contract between two parties, whose value is derived from or determined by the value of an underlying asset
two basic categories of derivatives
options
forwards
Options?
buyer has the right but not the obligation to sell or buy specified quantity of underlying asset in future price agreed upon today
Forwards?
both parties oblige to trade the underlying asset in future price agreed upon today
Call Option and Put Option
call- gives the owner right to buy underlying asset
put- gives the right to sell underlying asset
Common features of Derivatives
- contractual agreements between two parties : buyer and seller
- a price upon which the buyer and seller must agree; buyers try to buy them for as little as possible,
whereas sellers try to sell them for as much as possible.
-They have an expiration date. Both parties must fulfill their obligations or exercise their rights under the
contract on or before the expiration date. After that date, the contract is automatically terminated.
OTC Derivative features
- Flexibility- terms and conditions can be tailored for specific users
2.Privacy- neither the
general public nor others (including competitors) know about the transaction
3.Liquiditity and offsetting- cannot be easily terminated or transferred to other
parties in a secondary market, terminated only through negotiation - Default Risk- Credit risk is a major concern
- Regulation- transactions are generally unregulated, and permits unrestricted and explosive growth in financial innovation and
engineering
Exchange-Traded Derivative feature
- Standardization- specifies the contracts that are available to be traded and has standardized terms and other
specifications - Privacy- all transactions are recorded and known to the general public but do not
announce, nor do they necessarily know, the identities of the ultimate counterparties to every transaction - Liquidity and offsetting can be terminated
easily by taking an offsetting position in the contract
4.Default risk- not a significant concern with exchange-traded derivatives, Clearinghouses ensure that markets operate efficiently, guarantee the financial obligations of every party and
contract. - Regulation- extensively regulated by the exchanges themselves and by government agencies, brings about fairness, transparency, and an efficient secondary market.
Types of Underlying Assets (2)
- Commodities
-Grains and oilseeds (e.g., wheat, corn, soybeans, and canola)
• Livestock and meat (e.g., pork bellies, hogs, live cattle, and feeder cattle)
• Forest, fibre, and food (e.g., lumber, cotton, orange juice, sugar, cocoa, and coffee)
• Precious and industrial metals (e.g., gold, silver, platinum, copper, and aluminum)
• Energy products (e.g., crude oil, heating oil, gasoline, natural gas, and propane) - Financial Assets
- equities
- interest rates
- currencies
causes of growth in financial derivatives
- Increasingly volatile interest rates, exchange rates, and equity prices
- Financial deregulation and intensified competition among financial institutions
- Globalization of trade and the tremendous advances in information technology
- Extraordinary theoretical breakthroughs in financial engineering
Users of derivatives (4)
- Individual investors - active investors
- Institutional investors - mutual, hedge fund, pension fund managers & insurance companies
- Businesses and corporations
- Derivative dealers
Institutional investors common investment strategies using derivatives
- market entry and exit
- arbitrage
- yield enhancement
Syntax used to describe a specific option
{Number of Option Contracts} + {Underlying Asset} + {Expiration Month} + {Strike Price} + {Option Type}
