chapter 6 derivatives Flashcards
what is a derivative?
a financial instrument whose price is based on the price of something else, typically an underlying asset
what are the three forms that derivatives come in?
- forwards
- futures
- options
what are the two major purposes derivatives are used for?
hedging and speculation
what is hedging?
replacing uncertainty with certainty so that risk is reduced
what is an option?
a derivative that gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a pre-agreed exercise price, on or before a pre-specified future date or between two specified dates
what are the two classes of options?
call and put
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 the 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 the option
what is the premium?
the money paid by the buyer to the seller at the beginning of the options contract; it is not refundable
how can the buyer of a call option 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
what is the maximum loss that can be incurred from a call option?
the premium the buyer has paid
which one of the derivatives gives the buyer a choice as to whether to go ahead with the contract or not?
option contract
which of the derivatives is/are traded in standardised sizes on derivatives exchanges?
futures and option contracts
which one of the derivatives requires the buyer to pay a non-refundable premium?
option contract
a speculator wants to have the choice as to whether to buy an underlying asset or not, which one of the derivatives is most appropriate?
buying call options
