Chapter 1 - Introduction to derivatives Flashcards
why do we care about derivatives?
The world of finance is concerned about more than just issuing debt and equity.
Derivatives are useful in many areas. For instance, we can use swaps to fix the cost of production inputs, options to compensate employees, futures to hedge against risk.
besides the direct use of derivatives, why do we care so much about learning them?
Derivatives provide a language and a set of tools that is extremely useful for valuation and measuring risk.
elaborate on what a derivative is
A derivative is a financial instrument that has a value, and this value is determined based on the value of something else.
There is emphasis on financial instrument. A buschel of corn is not a derivative, but a contract specfiying an agreement that regards the price of corn, is a derivative.
What determines whether a derivative is risk-reducing or not?
It is about how the derivative is used. The context determines.
If a farmer purchase a derivative that pays if price of corn is low, and loose if price of corn is high, it is a risk reducing instrument.
However, if someone not related to farming just buys a naked contract like that, it is a bet with risk.
elaborate on trading of financial assets
we refer to a 4 step procedure:
1) A seller and buyer must agree on a price
2) The trade must be “cleared”. This means, the obligations of each party must be fulfilled. for instance, in a stock trade, the seller must supply the shares, while the buyer must supply the cash.
3) The trade must be “settled”. This refers to the fact that both the buyer and seller must deliver the obligations in a required period of time.
4) Once the trade is complete, the trade is done and ownership is changed.
The clearing step is about recognizing whether the parties have the funds etc. In many cases, it is typical to post collateral. Posting collateral refer to bringing assets to a third party in order to ensure that obligations can be met.
The clearing step is basically a verification step where the parties become legally tied and obligations are made. the obligations need not be fulfilled, this happens at settlement.
It is crucial to understand these steps. There may be significant time between the clearing and settlement. Consider options, for instnace. Can be years.
In the meantime, the clearing house acts as insurance, abstractly representing a buyer for every seller, and a seller for every buyer.
Clearing houses are typically private entities, but are heavily regulated.
elaborate on novation
Novation is a term used to describe scenarios where a party takes the place of another party in a trade, like the clearing houses do to ensure smooth trading. This is especially important in derivatives trading, because payments happen at various points in time.
Elaborate on OTC
Over the counter. Trading directly with a dealer. bypassing organized exchanges.
there are many reasons for trading OTC. for instance, if you want to purchase a very big amount of shares, for much cash, there is significant savings in fees and you can negotiate a specific price that avoids liquidity issues etc.
OTC can also be used to trade a financial insturment that is custom and not currently traded.
There is also the opportunity to trade multiple claims at once.
OTC trades are typically facilitated by brokers.
name the usual suspects of metrics used for measuring market size and activity
1) Volume
2) Open interest
3) Market value
4) notional value
volume is the number of claims traded. for instnace, number of shares, or number of option contracts traded in a specific time frame.
Open interest is the number of active contracts, meaning the number of contracts where the counterparty have a future obligation to fulfill.
Market valueis the sum of market value of claims that COULD be traded.
Notional value refer to the total value of the underlying asset. It is typically an important metric for derivatives, because it refer to the value of the assets that are subject to the contracts. For instance, for options, the notional value refer to contracts100pricePerShare.
For regualr stock, notional value is basically the same as market value.
characteristics of the bond market
about hte same size as the stock market, but trades usually happens through dealers, not exchanges. Most bonds are also traded much more infrequently that most stocks.
what is typically considered as the “driver” for implementation and use of derivatives in a market?
price risk. Volatility. Derivatives are intended to be used for hedign against violent moves in price.
what can we say about a derivative, if its underlying asset has no risk involved?
No one would pay for the derivative.
elaborate on risk sharing
the concept of risk sharing is basically about diversifiable risk and non-diversifiable risk.
two important perspectives of derivatives…?
1) Who use them and why?
2) How do we interpret the activity that we see?
who use derivatives and why?
Reduce risk.
Speculation.
Reduced transaction cost: If the derivative represent multiple other transactions, this can be beneficial if the derivative is constructed so that it yield the same benefits etc.
Regulatory arbitrage. Taxes for instance. Can for instance defer taxes.
why is it well known and “accepted” that regulatory arbitrage using derivatives is happening?
It is very difficult (impossible?) to regulate trading based on motive.
elaborate on perspectives of derivates that we use in the book?
1) The end user perspective. End users have a goal, and use derivatives to meet it. The goal can be any of the reasons previously discussed (risk reduction, speculating, regulatory arbitrage, reduced transaction costs). It is important for the end-user perpsective that the derivatives has a job to do. End-user can be corporations, investors, anyone.
2) The market maker perpsective. Market makers buy from those who sell, and sell to those who want to buy. In order to make money, they need to charge a “spread”. They buy at low price and sell at high price.
One can use the analogy to a wholesaler. The inventory of the wholesaler doesnt reflect his own demands, but rather the demand of the customers. At the same time, he must buy the inventory cheaper than he sells it.
The market makers can be anyone, but are typically larger entities. THe definition is that they post a bid and ask simultaneusly.
Their motivation is making a profit, but by making the spread narrower, they are also supplying liquidity which is beneficial for the market as a whole.
Market makers are extremely interested in the mathematics and details about the contracts.
3) The economic observer. Often the view of the regulators. It is about trying to make sense of whats going on.
elaborate on bid-ask
The terms are logically backwards, because they do not relate to how the investor approach the trade. The bid and ask is in regards to the market maker.
The market maker use the bid as how much THEY are willing to give for a share. Thus, this is the price WE sell at.
At the opposite side, the “ask” is what the market maker asks for if WE are to buy a share.
The market makers sell high and buy low. This makes the spread.
The concept of market maker is important because when we trade, we are most likely not dealing directly with some opposite order from a regular investor, it is more likely that we are buying and selling from the market maker.
what happens with the shares if you buy them?
They are typically held in a central depository, in the name of your broker.
Such securities are said to be held in “street name”. we as regular investors are not listed as official owners, but are beneficial owners.
what is a stop loss order?
If you own stock, a stop loss order is a trigger option to sell if the share price (bid) is lower than some limit.
Stop loss orders are MARKET ORDERS. This means that we risk selling for less than the bid.
how can we look at short selling?
A way of borrowing money.
We borrow shares, but we sell them immediately. This gives us liquidity/cash/money.
We eventually have to repay it, making it a borrowing case.
Of course, it is worth mentioning the risk involved with this “loan” since we dont know the rate we end up paying (or gaining).
This means that there are most likely short sale variants we can use as risky loans.
elaborate on lease rate of an asset
dividends, typically.
Abstractly, it can be anything. For Wine, it can be the utility of seeing the wine in the cellar, so there will be placed a fee for borrowing that comes in addition to the rate you get from the difference in price.
