Chapter 3: Derivatives Flashcards
Explain the concept of deferred delivery
This is where you agree a price today at which you will buy and sell a asset at some time in the future. This replaces risk and adds certainty
What are the two main types of derivatives?
- Exchange traded standardised products
2. Off-exchange or Over-The-Counter (OTC) bespoke products
What is the difference between 'Exchange traded standardised products' and 'Off-exchange/OTC bespoke products'? In terms of: Terms Delivery dates Liquidity Counterparty Risk Costs Regulation
1) ETS
Terms: Standardised by the exchange for all products
Delivery Dates: Standard fixed dates
Liquidity: Generally good liquidity
Counterparty: None - due to clearing systems
Costs: Relatively Low initial costs
Regulation: Significant regulation and investor protection
2) OTC
Terms: Specified in the contract
Delivery Dates: Specified in the contract
Liquidity: May be limited
Counterparty: Default risks exists unless centrally cleared interest rate
Costs: Costs specifically agreed (may be high)
Regulation: Less regulated
Define Future and Forward
Future: An agreement to buy or sell a STANDARD quantity of a specified asset on a fixed future date at a price agreed today, that may be traded on the EXCHANGE (an ETS)
Forward: An agreement to buy or sell a specific quantity of a SPECIFIC quantity of a specified asset on a fixed future date at a price agreed today (an OTC)
What are the two parties involved in a future?
A buyer - who enters into an obligation to buy on a specified date
A seller - who is under an obligation to sell on a future date
Define the main elements of a future:
1) Standard quantity
2) Specified asset
3) Fixed futures date
1) Futures are traded in standardised indivisible parcels aka contracts
2) All future contracts are government by their contract specifications setting out the size of each contract, when delivery is, what exactly is to be delivered
3) The delivery takes place on a specified date(s) known as delivery day(s)
Also all futured have finite lifespans in which you can trade in
What are the three main categories of users of futures?
1) Hedgers - trying to reduce risk
2) Speculator - trying to gain profits by taking risk
3) Arbitrageur - seeking riskless profits by exploiting market inefficiencies
Define long futures position and what is its purpose?
It is a future that is PURCHASED to open a position.
It opens the investor to the risks and rewards of ownership of that underlying asset
Risk - limited but large
Rewards - unlimited
Define short futures position and what is its purpose?
It is a future that is SOLD to open a position.
It opens the investor to the OPPOSITE risks and rewards of ownership of the underlying asset
Risk - Unlimited
Rewards - Limited but large
What will a speculator do if they thing an asset’s price will:
a) Rise
b) Fall
a) They will seek to make a profit by buying the future at the currently low price and subsequently sell it back at a higher price
b) They will seek to make a profit by selling the future at the currently high price and subsequently buy it back at a lower price
Why do hedgers use futures and why are they motivated?
Use futures to reduce the risk of existing cash market positions.
Motivated by certainty, security and reduced risk.
What is the basic theory of hedging futures
Producing profits or losses to offset the losses or profits in the cash market
Define a long cash market position and a short hedge
Long cash market position: which profits of a company is largely the price of an asset
Short hedge: This protects against a price fall and involves selling futures to hedge a long cash market position
Define a long hedge
This protects against a price raise and involves buying futures to hedge against the cash market
Define: Tick size and Tick Value
Tick size: The smallest permitted quote movement on one contract
Tick value: The change in the value of one contract if there is one-tick change in the quote
