d describe purposes of, and controversies related to, derivative markets; Flashcards
Risk Allocation, Transfer, Management
Risk Allocation: “They allow trading the risk without trading the instrument itself” and ““derivatives provide an effective method of transferring risk from parties who do not want the risk to parties who do.”
“derivatives can improve the allocation of risk and facilitate more effective risk management for both companies and economies.”
Information discoverey
Predictive price value
“U.S. futures markets open before the U.S. stock market opens.”
“derivative markets require less capital, information can flow into the derivative markets before it gets into the spot market.”
(Institute 41)
Institute, CFA. CFA Institute Level I 2014 Volume 6 Derivatives and Alternative Investments. Wiley Global Finance, 2013-07-12. VitalBook file.
“futures markets convey another simple piece of infor- mation: What price would one accept to avoid uncertainty?” - “it should be the price that guarantees the risk-free rate minus whatever dividends would be paid on the stock”
“Derivatives—specifically, futures, forwards, and swaps—reveal the price that the holder of an asset could take and avoid the risk.”
Operational Advantages
Lower transaction costs
Great liquidity
less capital
lower future margin reqs and option premiums
Going short is easy
Market Efficiency
“competition, the relatively free flow of information, and ease of trading tend to bring prices back in line with fundamental values”
“When prices deviate from fundamental values, derivative markets offer less costly ways to exploit the mispricing.”
An Option reflects…
2 characteristics of the option: X, time to expiration
3 Characteristics of Underlying: Price, Volatility, expected CF’s
One general macro factor: Risk free rate
Implied volatility
“implied volatility, measures the risk of the underlying”
“It reflects the volatility that investors use to determine the market price of the option. Knowing the risk of the underlying asset is an extremely useful piece of information.”
summary
“less capital is required, transaction costs are lower, and short selling is easier. We also noted that as a result of these features, it is possible, indeed likely, that fundamental value will be reflected in the derivatives markets before it is restored in the underlying market.”
Criticisms and Misuses
Two principal arguments: Legalized gambling, destabilize the markets.
Destabilization and Systematic Risk
“Opponents of derivatives claim that the very benefits of derivatives (low cost, low capital requirements, ease of going short) result in an excessive amount of speculative trading that brings instability to the market.”
Highly leveraged speculators subject themselves and creditors to substantial risk, which may induce systematic risk.
Extreme complexity and high level of mathematical understanding.
Purposes
Purpose of Derivatives Markets
• Derivatives enhance market efficiency:
Provide price information
Allow risk to be managed and shifted among market participants
High Liquidity offers low transaction costs
Criticisms
- Their complexity can wreak havoc with inexperienced investors
- They encourage speculation - highly leveraged
- They promote excessive trading - highly leveraged
