Derivatives Flashcards
Define derivative
A derivative is a financial instrument, derives its performance from the performance of an underlying asset
What is: underlying asset
Also called underlying
underlying asset - trades in the spot or cash market, its price is called cash or spot price
What are the two classes of derivatives?
forwards commitment & contingent claims
How can derivative be created?
as a standardized instrument on derivative exchanges, or as a customized instrument in the over the counter market
extange traded
standardized, highly regulated, transparent transactions, guaranteed against default - thanks to the clearinghouse
Over the counter
customized, flexible, more private, and less regulated than exchange-traded, greater risk of default
Forward contract
Over the counter derivative
2 parties agree that one party, the buyer, purchase an underlying asset from the other party, the seller, at a later date and at a fixed price they agreed upon on the day they signed the contract
Future contract
similar to forward contract, but future contract is a standardized derivatives contract created and traded on the futures exchange.
2 parties agree that one party, the buyer, will purchase an underlying asset from another party, the seller, at a later date and at a price agreed on by the two parties when the contract was initiated.
there are daily settling gains and losses and a credit guarantee by the future exchange through its clearinghouse
Call option
buy the underlying asset
Put option
sell the underlying asset
SWAP
over the counter derivavite
2 parties agree to exchange a series of cash flows, one party pays a variable series (that will be determined by an underlying asset or rate), and the other party pays either a fixes series, or a variable series (determined by a different underlying asset or rate).
Option
is a derivative contract
1 party the buyer - pay a sum of money to the other party - the seller or writer, and receive 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.
other name for seller in the option market is?
writter
Credit derivatives are
class of derivatives contract between two parties, the credit protection (buyer and seller),
where the second (latter), provide protection to the first (former) against a specific credit loss
credit default swap
widely used credit derivatives
contract between 2 parties, credit protection (buyer and seller)
where the buyer makes a series of payments to the seller and receives a promise of compensation for credit losses resulting from the default of a 3rd party
Derivative combination to other derivatives
derivatives can be combined with other derivatives or underlying assets to form hybrids
Asset backed securities
Derivative contract - where a portfolio of debt is created and claims are issued not he portfolio in forms of tranches - which have different priorities.
prepayment or credit losses are allocated to the most junior tranches first and the most senior tranche last.
Where are derivatives issued on?
Equities, fixed-income securities, credit, commodities, interest rate, currency, underlying weather, disaster claims, electricity
Derivatives and gambling
criticized for being a form of gambling
Transfer of risk with derivatives
Transfer of risk is facilitated,
creation go strategy and payoff
provide information about the spot market
offer lower transaction costs,
reduce the amount of capital required
easier to go short,
improve the efficiency of the sport market
Derivatives and priced forming
priced by forming a hedge involving the underlying asset and a derivative,
the combination must pay the risk free rate and do so for only one derivative price
Pricing - storage - derivatives
Pricing relies heavily on the principle of storage
storage can incur costs, but can also generate cash - like dividends and interest
Arbitage condition
2 parties equivalent assets or derivatives or combination of assets and derivatives sell for different prices,
opportunity to buy at a lower price and sell at the higher price,
earning a risk-free-rate profit without committing any capital
Combined action of arbitrageurs
Bring about a convergence of prices, arbitrage leads to the law of one price: Transactions that produce equivalent results must sell for equivalent prices
Law of one price
Transactions that produces equivalent results must sell for equivalent prices.
