I_SS17_R60_Derivative Markets and Instruments Flashcards
Two general types of derivative contracts
forward commitments and contingent claims
Forward contract is agreement between two parties in which
buyer agrees to buy from seller the underlying at a future date at a price established at the start
Default risk for a forward contract
Each party is subject to the possibility of default
Forward contract may be settled through
delivery where buyer pays and receives asset or through equivalent cash settlement
Can generally assume that default risk of futures contract
is default-free
A swap is equivalent to
a series of forward contracts
Forward contract is a single payment but a swap
is a series of payments
Forward commitments are
firm and binding agreements to engage in a transaction at a future date
Contingent claims allow one party the
flexibility to not engage in a future transaction depending on market conditions
Contingent claims are derivatives in which payoffs occur if
a specific event happens. Generally refer to these types of derivatives as options
Chicago Board of Trade was established in
1848
Standardized options contracts were introduced in
1973 which essentially killed off the customized options market
Futures and options are
exchange-listed contracts
Standard option in US covers
100 shares of stock
BIS
Bank for International Settlements, http://www.bis.org/
Notional principal of a derivative measures
the amount of the underlying asset covered by a derivative contract
Derivative market value represents
economic worth of a derivative contract and represents amount of money that would change hands
Best estimate of the derivatives market is based on
market value rather than the notional principal of the underlying
Primary function of futures market is
price discovery
Current price of the underlying asset of a derivative is
the spot price or cash price
Proxy for the price of the underlying in the futures market
is the contract with the shortest time to expiration
Forwards, futures and swaps allowing hedging through
locking in a price for the future
Options protect against loss and also
allow participation in gains if prices move favorably
Most important purpose of derivatives market is
risk management
Risk management is the process of
identifying the desired level of risk, the actual level of risk and altering the latter to equal the former
Futures prices are not necessarily expectations of
future spot prices. They allow substitution of the futures price for the uncertainty of future spot prices of the asset. They permit the acceptance of a sure price and the avoidance of risk
Market value of a fixed rate loan is more volatile than
a floating rate loan
Derivatives are tools that enable
the practice of risk management
Efficient markets are fair and competitive and do not allow one party to
easily take money from another
Derivatives markets are characterized by relatively low
transaction costs
Insurance cannot be a viable product if its cost is
too high relative to the value of the insured asset
Derivatives provide a means of managing
risk
Arbitrage occurs when equivalent assets or combinations of assets
sell for two different prices
Law of one price
principle that no arbitrage opportunities should be available
There are no opportunities for
arbitrage profits
Prices are set to eliminate the opportunity
to profit at no risk with no commitment of one’s own funds
