Derivatives - 1.1 Flashcards
What is a derivative? (definition)
A derivative is a financial instrument (a legal contract) which derives it value from an underlying (asset or interest rate).
2 positions are long and short.
What are Futures and it’s features?
Futures are Exchange Traded Derivatives Markets. Features:
- Clearing & Settlement process
- All contracts terms are standardized, except for price.
- More liquid
- More Transparent
- Credit Guarantee
What are Forwards and it’s features?
Forwards are traded in Over-the-Counter Derivatives Markets. Features:
- Informal network of market participants
- Dealer market
- Less Liquid
- Less transparent
- Customised
What are Forward Commitments? What are the types of forward commitments?
Contracts entered into at one point in time that require both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start. The parties establish the identity & quantity of the underlying, the manner in which the contract will be executed or settled when it expires, and the fixed price at which the underlying will be exchanged. This fixed price is called the forward price.
Types:
- Forward Contracts
- Futures
- Swaps
What is a Forward Contract?
is an OTC derivative contract in which two parties agree that one party, the buyer, will purchase the underlying asset from the other party, the seller, at a later date at a fixed price they agree upon when the contract is signed.
What is a Futures Contract?
is a standardized derivative contract created & traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.
What are swaps?
Swaps are OTC derivative contracts in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either a variable series determined by a different underlying asset or rate or a fixed series.
Types of Derivatives?
- Forward Commitments
- Contingent Claims
- Hybrids
- Derivatives Underlyings
What are Contingent Claims? What are the types of Contingent Claims?
The holder of a contingent claim has the right, but not an obligation, to make a final payment contingent on the performance of the underlying.
Types:
- Options
- Credit default swaps
- Asset-backed securities
What is an option? What are Credit Derivatives? What are Credit default swaps?
- An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.
- A credit derivative is a class of derivative contracts between two parties, a credit protection buyer and a credit protection seller, in which the seller provides protection to the buyer against a specific credit loss (contingent claim)
- A credit default swap is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the default of a third party.
What are Asset-Backed Securities?
is a derivative contract in which a portfolio of debt instruments is assembled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments made by the debt securities such that prepayments or credit losses are allocated to the most-junior tranches first and the most-senior tranches last.
What can be Derivatives Underlyings?
- Equities: Stock or Stock index
- Fixed-Income Instruments
- Interest rates
- Currencies
- Commodities
- Credit: Credit default swaps & credit default obligations
- Other: Like weather, electricity, etc.
What are Hybrids?
Hybrids are instruments which combine derivatives, fixed-income securities, currencies, equities and commodities.
Classic example - create an instrument with an option + a bond -> callable bonds or convertible bonds.
What are the Benefits of Derivatives? Criticism & Misuses of Derivatives?
- Risk allocation, Transfer & Management
- Information Discovery: Price discovery & Implied volatility
- Operational Advantages: Reduce transaction costs, Liquidity & Short is only possible in derivatives.
- Market efficiency: The quicker the mispricing is removed, the higher the market efficiency & derivatives improve speed.
Criticism & Misuses of Derivatives:
- Speculation & Gambling
- Destabilization & Systematic Risk
