Ch 19 Derivatives Flashcards
What are derivatives
Securities whose price is dependent on the price of other assets or value of other variables
What is an important feature of derivatives
Contact between two parties, profits for one is loss for the other
What are two types of derivatives markets
Over the counter
Exchange Traded
What are over the counter markets
Central dealer making specialised deals for investors. Dealer matches parties to eachother in opposite positions. There is an element of credit risk as this isn’t supervised
What are exchange traded markets
This is where derivatives can be bought and sold.
Here contracts are standardised and parties deal with the clearing house who take a margin payment to reduce credit risk
Electronically or open outcry system
What is the person who sells a derivative called
A writer of the contract or Short party
What is the person who buys a derivative called
Long party
What are forwards and futures
Contracts that obligate both parties to trade a specified asset at a specified date for a specified price (strike price)
What is the difference between a future and a forward
Futures are traded on exchanges
Forwards exchanged over the counter
In a long forward position what is the pay off
St - k (share price at maturity - strike price)
What is the payoff to a short party of a forward
K-St
What is the difference in buying and selling and underlying asset vs future or forward
You don’t need to buy a real asset , the amount of money exchanged at outset of the transaction is zero with forward contracts and very small futures
What is speculation
When people purchased derivative contracts that could expose them to massive profits or losses for a small initial investment
What is a less risk strategy with futures
Hedging
What is hedging
Reduction in probability of losses as a result of adverse movements in the market
What is an option
Contract creating the option to trade an asset at a specified date for a specified amount
Explain details of an option
Able to let an option expire if unfavourable and will only lose premium payments
Difference between European and American options
European only exercised at maturity
American can be exercised at any time
What is a call option
Gives the holder the right to buy an asset
What is a put option
The right to sell the underlying asset at a future date for a specified strike price
What is a the call option formula
Market price - strike price - premium
Why is it riskier to short a call option
Because losses are infinite and profits maximise to premiums
What is a European put option
Offers the holder the right but not obligation to sell an asset at a future date for a given price
What are the uses of derivatives
Reduces or removes investment risk (hedging)
Increase investment risk in order to enhance returns (speculation)
Change notional composition of portfolio assets without investors having to buy or sell
How do futures and options provide people with leverage
Investor gains increased exposure to the market for the same or less investment than un leveraged investors
What are arbitrageurs
Take offsetting positions in two or more instruments in order to make a certain profit from mis pricing
Assets could be traded on different exchanges but same underlying asset
