Chapter 6 Flashcards
What are derivatives
Financial instrument whose price is based on the price of something else, typically an underlying asset. This asset could be a financial instrument such as a bond, share, commodity e.g. oil, gold, silver.
What is hedging
It involves replacing uncertainty with certainty so that risk is reduced.
E.g. farmer agreeing a price fro harvest in advance so he doesn’t worry about market prices changing. They are using a derivative (forward contract) to hedge (reduce risk by replacing an uncertain price on a certain price).
What is speculation
Using derivatives to make money.
E.g. speculator could buy wheat, store it while its price increases then sell it at a higher price or increase profit. A speculator using a derivative contact could buy a grain at a future date at a pre-agreed price
What did the CBOT do?
Opened the worlds first derivative exchange in 1848. The exchange soon depleted future contracts that enable standardised qualities and quantities of grain to be traded for a fixed future price on a stated delivery date
What’s the difference between forward and future contracts?
Future contracts can be traded. They have subsequently been extended to a wide variety of underlying assets and are offered by an increasing number of derivatives exchange
What’s a future?
Legally binding agreement between a buyer and seller. buyer agrees to a pre-specified amount for the delivery of a quantity of an asset at a future date. seller agrees to deliver the asset at a future date in exchange for the pre specified amount of money
What are the two distinctive features future contracts have?
- they are exchange traded
- they are dealt on standardised terms
What does it mean by a future being exchange traded
Any one of the multitude of derivatives exchanges around the world can exchange it
What does it mean by a future being dealt on standardised terms
The exchange specifies the quality of the underlying asset, the quantity underlying each contract, the future date and the delivery location. Only the price is open to negotiation
Similarities between futures and forwards
- used to hedge - replacing uncertainty about prices at a later date, with certainty about those prices
- used for speculation- trying to make money by correctly anticipating a rise, or fall in price
What is an option
It’s a derivative that gives they buyer the right but not obligation to buy or sell a specified quantity of an underlying asset at a pre-agreed price, on or before a pre-specified future date or between specified dates. The seller, in exchange for the payment of a premium, grants the option to the buyer
What are the two classes of options
- call option
- put option
What is a call option
When the buyer has the right to buy the asset at the exercise price, if they choose to. The seller is obligated to deliver if the buyer exercises that option
What is a put option?
When the buyer has the right to sell the underlying asset at the exercise price. The seller of the put option is obliged to take delivery and pay the exercise price, if the buyer exercises that option
What is the premium in terms of an option?
Money paid by the buyer to the seller at the beginning of the options contract, if it’s non-refundable
