Chapter 6 - Derivatives Flashcards
Define a derivative? when was first derivative exchange?
Financial instrument whose price is based on the price of another underlying asset.
1848 Chicago Board of Trade
Why are derivatives used
Hedging - technique employed by portfolio managers to reduce the impact of price movement
Anticipating future cash flows - forecasting future inflows and outflows to access risk
Asset Allocation changes - changing to assets in a fund
Arbitrage - taking advantage of price differences between instruments for profit
What is a future? what are two features of futures?
financial contract that obligates the buyer to purchase, and the seller to sell at a predetermined price and date. two features:
- it is exchange traded
- dealt on standardised terms
what are the terms associated with futures?
long - term associated with the buyer of the future, the buyer is committed to buying the asset at that price
short - the seller is committed to delivering the asset in exchange for price
open - the initial trade, when the trade first enters
close - means settling or liquidating a position before the contract expires
covered - the seller has the underlying asset for physical delivery
naked - the seller does not have the physical asset
Define an option? how can it be traded
An option gives the buyer the right, not obligation, to buy or sell an asset at a specified price before a certain date.
it can be traded through an exchange on standardized terms, or it can be traded OTC if the option is outside standardized terms.
what are the two types of options?
Call Option - gives the buyer the right to PURCHASE an asset at a specific price before a certain date
Put Option - gives the buyer the right to SELL an asset at a specified price before the same date
What are the buyers referred to and what are the sellers referred to?
What is the price paid for an option known?
Buyers = holders Sellers = writers
The options premium
What does the terms mean in interest rate swaps
Fixed-rate - one party pays a fixed interest rate
Floating rate - other party pays a variable interest rate
Notional amount - the hypothetical amount used to calculate interest payments
variable rate - based on market reference, such as SOFR (secured overnight funding rate)
Why are options used?
Hedging - protecting losses on an asset
Speculation - Buying them in hope to profit
What are interest rate swaps?
Financial contracts where two parties exchange cash flows based on different interest rates
How are interest rate swaps traded
Primarily OTC, but there is a move towards standardized exchanges
What does credit default swap mean? what is its purpose?
Financial contracts that provide protection against the default of a borrower. It can be thought as a type of insurance
Purpose - enable an organization to protect itself against unwanted credit exposure
What are the two types of derivative markets
OTC - negotiated and traded privately between parties without use of an exchange. this would be for Interest rate swaps and forward rate agreements
ETD - Have standardized terms, acts as an intermediately to provide a guarantee that the trades will be settled.
What are examples of physical markets
Commodities
- agriculture markets
- metals
- energy
- power
- plastic
What are the main derivative markets?
ICE Futures Europe - based on interest rate and bonds, equity indices, individual equities
EUREX - German bonds futures and options, trades index products for EU markets
Interconnectional exchange (ICE) - operates the electronic global futures and OTC marketplace for trading energy commodity contracts
London Metal Exchange (LME) - Futures and options for a range of metals
