Derivative Markets And Instruments Flashcards
Derivatives derive their values from the performance of these basic assets.
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Derivative
Financial instruments that derives their values from the performance of an underlying asset
ETF derivatives
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OTC derivatives
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Forward commitments
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Contingent claims
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Distinguish derivatives from mutual funds, ETF’s and other ‘pass-through’ instruments
Derivatives transform the performance of the underlying asset before paying it out in the derivatives transaction.
Transformation is implicit
Derivatives take their value and certain other characteristics from the underlying asset.
Derivatives take their performance from an underlying asset.
Mutual funds and ETF’s ‘pass through’
The returns of their underlying securities
Derivative strategy performance
Derived from the underlying and the specific features of derivatives
Derivatives are similar to insurance
Transfer risk from one party to another
Insurance
A financial contract that provides protection against loss.
Insurance provides protection against loss
The party bearing the risk purchases an insurance policy, which transfers the risk to the insurer for a specified period of time. Risk itself does not change, the party bearing it does.
Underlying
Aka ‘underlying asset’, stocks and bonds
The out option when combined with a position exposed to risk
Functions almost exactly like insurance
An insurance contract must specify the ‘underlying risks’
Property, health, life
An underlying value
Is the source of risk
Common derivatives underlyings
Equities
Fixed income securities
Currencies
Commodities
Interest rates
Credit
Energy
Weather
Other derivatives
Derivatives are created in what form?
Legal contracts
Legal contracts
Two parties - the buyer and seller
Derivatives buyer
Long, the holder
Derivatives seller
Short, the writer
General classes of derivatives
Forward commitments
Contingent claims
The ability to lock in an underlyings buy or sell price
Forward commitments
the two parties must transact in the future at an underlying previously locked in price
Forward commitment
Types of forward commitments
Forwards contracts
Futures contracts
Swaps
The right but not obligation to buy or sell the underlying at a predetermined price
Contingent claims
‘Contingent’ claims
Choice of trade v. Inaction depends on a particular random outcome
Primary contingent claim
Option
Derivatives serve to improve market the performance of the markets for the underlyings
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Derivatives characteristics
Higher degree of leverage relative to the value of the underlying
Lower transaction costs relative spot market transactions
More liquid than their underlyings
Risk transfer is simple, effective, and low cost
Easier to go short
A relatively high degree of leverage
Participants may invest only a small amount of their own capital relative to the value of the underlying
High leverage drawback
Small movements in the underlying can lead to large movements in gain or loss on a derivative
Going short derivatives
Benefiting from a decline in the value of the underlying
Spot markets
Where assets are traded for immediate delivery
Shareholders trade a derivative on the equity
To reduce or completely eliminate the market exposure
Holders of fixed income, to focus on credit risk or interest rate risk
Use derivatives to reduce or completely eliminate one risk to focus better on the other
Types of performance transformations facilitated by derivatives
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Derivatives facilitate performance transformations in order to…
Allow market participants to practice more effective risk management
A financial expert expects derivatives to result in
management of financial risk
Risk management has taken a prominent role in financial markets
Large losses from trading, lending, or operations reflect how poorly a company manages risk
Risk management does not guarantee that large losses will not occur
Unless the amount of risk taken is so small that the organization would be effectively constrained from pursuing its primary objectives (profit)
Risk management process
Define a willing level of risk
Measure the effectual level of risk
Adjust the effectual risk level to match the willing risk level
The best example of a derivative
A contract to purchase an equity share at a fixed price
Not a characteristic of a derivative
A low degree of leverage
Derivatives are not created in the spot market where
Underlyings trade
Derivatives as risk management tools
Better adjust the level of risk than trading underlyings
The overriding objective of derivatives
To manage risk
Where do equities trade?
Organized exchange traded equity markets
OTC markets
Exchange traded equity markets
Formal organizational structures that facilitate transactions between buyers and sellers together through market makers, or dealers
Market makers
Stand ready to buy at one price and sell at a higher price
Standardization of terms and an active market allow market makers to ‘scalp’
Ability to buy and sell almost simultaneously at different prices, locking in small, short term profits
Exchange traded derivative contracts are standardized
Terms and conditions are precisely specified by the exchange aka there is very limited ability to alter those terms
Standardized exchange traded derivatives markets make it easier to provide liquidity.
Market makers guarantee that derivatives can be bought and sold because contracts are well defined
Cornerstones of exchange traded derivatives markets
Market makers
Speculators
OTC derivatives are customized
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Historical difference between OTC and exchange
OTC - formally organized or refer to informal networks of parties who buy and sell with each other. Strictly electronic.
Exchange traded markets: brought buyers and sellers together in a physical location
Informal OTC network of buyers who buy and sell with each other
Corporate and gov bond markets in the US
A market maker is unable to scalp
Forced to hold exposed positions or layoff to speculators
Lay off the risk
Trading (selling) off the risk to speculators
Good speculators manage risk by watching their exposures, absorbing market information, observing the flow of orders to able to survive and profit or become uncomfortable speculator and…
…hedge risks
Standardization facilitates creation of clearing and settlement operations
Which establish a critical flow of money in trading derivatives
Clearing process
The exchange verifies transaction execution
The exchange records the participants identities
Settlement process
The exchange transfers money from one participant to the other or between the participant and exchange
A critical element of derivatives trading
The flow of money due to clearing and settlement
Derivative exchanges relative to securities exchanges in clearing and settlement
Derivatives clear and settle over night. Securities exchanges require two business days.
Exchange traded derivative markets provide a credit guarantee via clearinghouses because derivative contract engagements are zero sum
Clearinghouses pay the winner if the loser cannot by margin bond or performance bond
Margin bond or performance bond
A cash deposit that provides a credit guarantee
Exchange market benefits
Standardized
Highly liquid
Guaranteed credit
Transparent
Exchange market transparency and standardization trade offs
Transparency discloses full information on all transactions to exchanges and regulatory bodies at the cost of privacy
Standardization provides liquidity at the expense of flexibility
A critical element by which derivative exchanges are able to provide their services
Standardization
3.2 - OTC Feb 11
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