Introduction to Derivatives Flashcards
derivative
a financial contract that derives its value from an underlying asset.
The underlying asset can be a stock, bond, commodity, or currency.
Derivatives are used to hedge risk, speculate on price movements, and manage portfolios.
types of derivatives
Forwards
Futures
Options
Swaps (exchange payments between two parties.)
Benefits of using Derivatives
Hedging risk (used to hedge against risk)
Speculating on price movements (used to speculate on price movements)
Managing portfolios (used to manage portfolios)
Liquidity (provide liquidity to markets)
Pricing (used to price assets)
Risks of using Derivatives
Leverage (control a large amount of an asset with a relatively small amount of money)
Complexity (very complex instruments)
Counterparty risk (other party to a derivative contract will default on their obligations)
Market volatility (prices can fluctuate rapidly)
Regulation
forward contract
a type of derivative contract that obligates two parties to trade an asset at a specified price on a specified date in the future.
often used to hedge against risk or to speculate on price movements
Futures contracts
a derivative contract that obligates two parties to trade an asset at a specified price on a specified date in the future.
Futures contracts are similar to forward contracts, but they are traded on an exchange.
more liquid than forward contracts, but are more standardized.
The price is determined by the supply and demand in the same way as the spot price
Electronic Trading
the buying and selling of financial instruments through electronic systems.
Electronic trading is different from traditional trading, which is done over the phone or in person.
benefits to electronic trading
Speed
Accuracy
Liquidity
Cost-effectiveness
Risks of electronic trading
Cybersecurity
Market manipulation.
System failures
Insider trading
Types of Electronic Trading
Order-driven trading (submit orders to a central electronic exchange)
Quote-driven trading: (provide quotes for the buying and selling of financial instruments)
Hybrid trading (combination of order-driven and quote-driven trading)
Important Terminology in Derivatives
Underlying asset ( the asset that the derivative is based on)
Notional value (amount of money that is being exchanged)
Strike price (price at which the underlying asset can be bought or sold)
Expiration date (when the derivative contract expires)
Premium (price that is paid for the derivative contract)
Long position (The party that has agreed to buy)
Short position (the party that has agreed to sell)
Advantages of OTC markets
Flexibility
Liquidity
Privacy
Disadvantages of OTC markets
Risk
Cost
Complexity
Ways to use Derivatives
To hedge risks
To speculate (take a view on the future direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without incurring the costs of selling one portfolio and buying another
Regulation of the OTC Market
The creation of the Financial Stability Oversight Council (FSOC): monitoring and identifying systemic risks
The requirement for central clearing of certain OTC derivatives: trades are cleared through a central counterparty (CCP)
The requirement for margining of certain OTC derivatives:deposit collateral with their counterparties
