Derivatives Markets Flashcards
Define a derivative
Derivatives are contracts whose value is derived from
the price of other asset(s) or another contract(s).
Explain the idea of a forward contract
Forwards contracts, roughly speaking, involve buying
something in the future rather than today, but with details
agreed today
Explain the difference between Fowards & Futures contracts
Agreement to buy or sell an asset on a specific date in the future.
-Futures contracts are traded on exchanges with standarised terms.
-Fowards are traded OTC
Explain swap contracts
A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments.
What is one well known use of interest rate swaps - often how they are defined?
Its said interest rate swaps are traded between one party having a competitive advanatge in fixed interest with another who had an advanatge in floating.
Party A: Agrees to pay a fixed 5% interest rate on a notional amount of $10 million.
Party B: Agrees to pay a floating interest rate of LIBOR + 1% on the same notional amount.
Why do banks use interest rate swaps
banks use them to hedge interest rate exposures from business conducted and the risks arising from them. Interest rate swaps produce a similar cash flow to normal bank lending - synthetic lending by banks. Banks typically lend for long terms receiving a fixed rate while funding itself short term with lower floating rates
Explain swaptions
Swaptions are options on swaps, i.e., the option to enter
into a swap at some point in future on pre-specified
terms
Where did derivative markets originate?
Modern derivatives markets are considered to have
begun in Chicago in the mid-1800s. For grain prices when harvest was greater than expected the prices were lower and vice versa creating problems for farmers and purchasers of grain. This prompted the idea of the “to arrive contract”
Explain the “to arrive contract” in terms of the history of derivative markets
The price of grain was agreed in advance for delivery to arrive at a specified date. This type of contract enabled both parties (farmer and purchaser) to reduce (hedge) their risks.
Explain the history of derivative markets when financial derivatives caught on.
Financial derivatives began to catch on in the 1970s and
have grown exponentially, chicago is the location of the biggest derivatives exchange with the chicago mercantile exchange and the chicago board options exchange.
Why is it hard to measure the size of derivative markets?
Not as easy as OTC markets because derivatives are private transactions so the data is not collected
What is ISDA?
ISDA (International, swaps and derivatives association) fosters safe and efficient derivatives markets to facilitate effective risk management for all users of derivative products
Why do investors use derivatives?
Efficient Portfolio Management: Quickly adjust portfolio exposures using derivatives with lower costs and higher liquidity than physical assets.
Asset Transitions: Use futures to gain temporary market exposure while building a physical portfolio, selling futures as assets are purchased.
Currency Hedging: Hedge foreign currency risks, especially for low-risk assets like bonds, using currency forwards.
Leveraged Investments: Create leveraged exposures (e.g., 2-3x an index) using swaps, without traditional financing costs
Explain the appeal of derivatives over a physcial ownership of an asset
More liquid and can be traded with lower costs for most asset classes. For shorter term positions or those requiring leverage derivatives have sigificantly lower cost where liquid and standard contracts are used. If derivatives are held for a long time or rolled over repeatedly the costs increase as its an expensive contract renewal. May be better to hold physical investment more long term particularly if turnover is low.
Explain asset transitions as a reason why investors use derivatives
Asset transitions – for example, a target equity market exposure could be created quickly using futures whilst a
physical equity portfolio is being built up in parallel by a manager. The futures are sold down as equities are purchased
Explain currency hedging programmes as a reason why investors use derivatives
Lock In exchange rate in the future
An overseas investor will want to generate returns in their local currency rather than gain unintended currency exposure. Currency forwards allow unintended currency exposures to be hedged
Explain Leveraged investment as a reason why investors use derivatives
Possible to create a leveraged exposure without entering
into financing agreements and hence with lower costs.
Explain leveraged investing
Leveraged investing is a technique that seeks higher investment profits by using borrowed money. These profits come from the difference between the investment returns on the borrowed capital and the cost of the associated interest.
Explain a margin call
A margin call is a demand from your brokerage firm to increase the amount of equity in your account.
What does a long position when holding an investment mean?
With a long-position investment, the investor purchases an asset and owns it with the expectation that the price is going to rise.
Explain a short position investment
Short selling occurs when an investor borrows a security, sells it on the open market, and expects to buy it back later for less money.
