Derivitaves Flashcards
What is a derivative
A derivative is a financial instrument whose value depends on, or derives from, the value of another asset:
What are the 4 types of derivatives
- Futures
- Forwards
- Swaps
- Options
What are some examples of underlying assets ?
- Stocks
- Currencies
- Interest Rates
- Commodities
- Debt intruments
- Electricity
- Insurance payouts
What are over-the-counter markets
markets where traders working for banks, fund managers and corporate treasures contact each other directly
How can derivatives be traded
They can be traded in the Over-the-counter markets
What are some key features of over the counter markets
- Tailor-made contracts
- Flexibility in negotiations
- Larger than the exchange-traded market
- Telephone and computer-linked network of dealers
- Subject to higher credit risk
What are forwards contracts
- An Agreement to buy or sell an asset at a certain future time for a certain price
- Traded in the OTC market
- Tailor-made instruments
- Available for long maturities
- The party that agrees to buy the underlying asset has what is termed a long position
- And the party that agrees to sell the underlying asset has what is termed a short position
- Binding agreement for both sides
What are payoffs from forwards contracts
Depends on:
F - Delivery price of the underlying assset specified at the forward contract
St - Spot price of the asset at the maturity of the contract
What is the spot price ??
The price the asset can be bought and sold immedietly
Payoff from a long position in a forward contract
Spot price - Delivery price
Payoff from a short position in a forward contract
Delivery price - Spot price
What are futures contracts
- Agreement to buy or sell an asset for a certain price at a specified future time
- Similar to forward contracts, but futures are traded on an exchange instead of OTC
- Available on a wide range of commodities and financial assets
- Standardised contracts
- Specifications need to be defined, what can be delivered, where it can be delivered and when it can de delivered
- These contracts are settled daily
Give an example of a futures contract
It is genuinly just a contract to buy or sell an asset at a certain price at a specified time
So an agreement to buy:
- 100Oz of gold for £1400 per oz in sept 2017
-10,000Bu of corn at £370 per Bu in June 2017
Agreement to sell:
Sell 500bbl of oil at £40 per bbl in april 2017
What are options contracts
- A call options gives the holder the right to buy the underlying asset on or by a certain date for a certain price
- A put option gives the holder the right to sell the underlying asset on or by a certain date for a certain price
- An American option can be exercised at any time up to the expiration date
- A European option can only be exercised on the expiration date
What does premium mean in terms of options contracts
The price at which options are bought and sold, an option gives the holder (the investor) a right and this has to be paid
What is the exercise or strike price
The price at which the right to buy (sell) the underlying asset of a call (put) option is set
What is the expiration date and maturity
The date in the contract by/on which the option can only be exercised
What are some differences between options and futures/forwards
- Forwards/futures is a commitment to buy or sell at a certain date and a certain price
- Where as an option gives the holder the right to buy or sell, so they dont have to, also on or by a certain date
-Options are traded on both OTC markets and in exchanges
What are the 3 different types of traders
- Hedgers
- Speculators
- Arbitrageors
What are Hedgers ?
Hedgers is the first, they use derivates to reduce risk that they face from potential future movements in a market variable
What are the 2 types of hedging
- Long hedge
- Short hedge
What is Long Hedging ??
If one is commited to buying assets on a future date she can fix the future price by taking a long position in futures on the asset, so essentially you are hedging against the possibility of a rise in price
What is short Hedging ?
If one is committed to selling assets on a future date they can fix the selling price by taking a short position in futures on the asset, so this is hedging against the possibility of a fall in price
What is the purpose of Hedging
The purpose of hedging is to reduce risk, there is no guarantee that the outcome with hedging will be better than the outcome without hedging
What is Speculation
This is the act of trading in an asset or conducting a financial transaction that has a significant risk of losing most or all of the initial outlay with the expectation of a substantial gain. Speculators are betting on future changes in the price of an asset, eithing increases or decreases.
What is Arbitrage
This is the simultaneous purchase and sale of an asset to profit from a difference in price - like exchange rates
