Chapter 6: Derivatives Flashcards
What is a derivative?
A derivative is a financial instrument where price is based on the price of something else, typically an underlying asset.
The underlying asset could be a financial instrument such as a bond, or a commodity like oil, gold, silver, corn or wheat.
Give three types of derivatives.
1) Forwards
2) Futures
3) Options
For what two main purposes are derivatives used?
1) Hedging
2) Speculation
What is a derivative?
A derivative is a financial instrument whose price is based on the price of something else, typically an underlying asset.
The underlying asset could be a financial instrument such as a bond, or a commodity like oil, gold, silver, corn or wheat.
What are forwards?
Forwards set the price at which a stated amount of an asset would be exchanged at a pre-specified future date.
What is hedging?
Participants in a forward use the derivative to ‘hedge’ (reduce) the risks they face by replacing an uncertain price with a certain price.
Speculation
Look at relevant section of the textbook.
What is a future?
A future is a legally binding agreement between a buyer and seller.
The buyer agrees to pay a pre-specified amount for the delivery of a particular pre-specified quantity of an asset at a pre-specified future date.
The seller agrees to deliver the asset at the future date, in exchange for the pre-specified amount of money.
Give the two distinct features of a future.
1) They are exchange traded - for example, on any one of a multitude of derivatives exchanges around the world such as the Chicago Mercantile Exchange (CME) or the London’s ICE Futures Exchange.
2) They are 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.
What is an option?
What is the premium?
An option is a derivative that gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at an agreed exercise price, on or before a pre-specified future date or between two dates.
In exchange for the payment of a premium, the seller grants the option to the buyer.
The premium is the money paid by the buyer to the seller at the beginning of the options contract; it is non-refundable.
What are the two classes of option?
1) Call option
2) Put option
What is a call option?
A call option is when the buyer has the right to buy the asset at the exercise price, if they choose to. The seller is obliged to deliver if the buyer exercises the option.
What is a put option?
A put option is 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 the option.
How does the buyer of a call option make profit/loss?
What is the maximum possible loss?
When a call option is purchased for speculative purposes, it is possible for the buyer to make a profit or incur a loss. In order to make a profit, the underlying asset on which the call option is based has to increase to a price above the exercise price plus the premium. The buyer of the option cannot lose more than the premium paid because the buyer has the choice of whether to exercise the option or not – if the exercise of the option is not worthwhile, the buyer will simply not exercise it.
