Derivatives Flashcards
What is a derivative?
1) A derivative is a financial instrument whose price is based on the price of an underlying asset.
2) The underlying asset can be a financial instrument such as a bond or share, or a commodity like gold or wheat.
What is the purpose of derivatives?
1) Hedging, and
2) Speculation
What are the types of derivatives?
1) Forwards
2) Futures
3) Options
What is hedging?
1) Replacing uncertainty with certainty.
2) This reduces risk
3) an example is a farmer who agrees a price for his harvest can plan with certainty so that he doesn’t need to worry about market prices changing between sowing the seeds and harvest time.
What is speculation?
1) Using derivatives to make money.
2) Make money by correctly estimating the future price of something.
3) They use a derivative to speculate on future prices without having to physically buy the asset.
Give an example of how a derivative works
1) The speculator tells a farmer he will buy his wheat harvest for £100 in 3 months.
2) The farmer is happy because he has secured a certain price of £100.
3) The speculator thinks the market price in 3 months will be £110.
4) If he is right then he can pay the farmer £100 as promised but then make a £10 profit.
5) He can ask the farmer to sell in 3 months and the speculator makes a profit (or loss) if the price is higher than £100.
6) If the price is £90 then the farmer still gets his certain £100 and the speculator has to make up the £10 shortfall.
Why do people want to hedge?
To reduce their risk by ensuring a certain outcome in an unknown future.
What are the features of a future?
1) Futures can be traded on exchanges.
2) They use standardised terms - quality and quantity of the underlying product, the future date and the delivery location.
3) The price is unknown and open to negotiation.
Why do people want to buy futures?
1) Replace uncertainty about prices at a future date.
Why do people want to sell futures?
1) To speculate to make money.
2) The profit is available because customers are prepared to pay for someone to take on the risk.
If an old producer wants to hedge its revenues should it buy or sell futures contracts?
It will sell futures contracts. He wants to fix the price he will receive in future. The contract states what price he will receive when he sells in future.
A speculator wants to make money out of an anticipated fall in the oil price, should it buy or sell futures contracts?
He will want to sell futures contracts. This will give him the right to sell at the current prices which are higher than the future price he anticipates.
What is an option?
It is a derivative that gives the 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 agreed date or range of dates.
What are the two classes of options?
Call and Put.
What is a call option?
When the buyer has the right to buy an asset at the exercise price if they choose. The seller is obliged to deliver if the option is exercised.
