Introduction to Derivatives

Question 1

What is a Derivative

Answer 1

A Derivative is an instrument whose values depends on the values of other more basic underlying variables.

Question 2

Examples of Derivatives?

Answer 2

Forward Contracts
Future Contracts
Swaps
Options

Question 3

What are Derivatives Markets

Answer 3

Exchange Traded

Over-the-counter (OTC)

Question 4

What is Exchange Traded

Answer 4

• This is a market where exchanges have used the open outcry system, but increasingly they are switching to electronic traded.
• Contracts are standard there is virtually no credit.

Question 5

What are Over-the counter (OTC)

Answer 5

• A computer and telephone linked network of dealers at financial institutions, corporations and fund managers.
• Contracts can be non-standard, and there is some small amount of credit risk.

Question 6

What are the ways in which derivatives are used?

Answer 6

• To hedge risks
• To speculate (take a view on the future direction of the marker)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment without incurring the cost of selling one portfolio and buying another

Question 7

What are Forward Contracts

Answer 7

• A forward contract is an agreement to buy or sell a certain asset in the future for a certain price (the delivery price)
• It can be contrasted with a spot contract which is an agreement to buy or sell immediately.
• It is traded in the OTC market

Question 8

What is a Forward Price?

Answer 8

• The forward price for a contract is the delivery price that would be applicable to the contract if it were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)
• The forward price may be different for contracts of different maturities.

Question 9

What is a long position?

Answer 9

The party that has agreed to buy

Question 10

What is a short position?

Answer 10

The party that has agreed to sell

Question 11

What are Future Contracts?

Answer 11

• An agreement to buy and sell an asset for a certain price at a certain time.
• Similar to a Forward Contract
• Whereas a forward contract is traded OTC, a futures contract is traded on exchange.

Question 12

Give examples of exchange trading options.

Answer 12

• Chicago Board Options Exchange
• American Stock Exchange
• Philadelphia Stock Exchange
• Pacific Stock Exchange
• European Stock Exchange
• Australian Options Market

Question 13

What is an Option?

Answer 13

-An option is a option to buy a certain asset by a certain date for a certain price (the strike price)
or
-An option can be sold for a certain asset by a certain date for a certain price (the strike price)

Question 14

Types of Traders

Answer 14

-Hedgers
-Speculators
-Arbitrageurs
Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to be speculators.

Question 15

Give an example of Hedging?

Answer 15

• A US company will pay £10 million for imports from Britain in 3 months and decide to hedge using a long position in a forward contract.
• An investor owns 1,000 Microsoft shares currently worth $73 per share. A two month put with a strike price of $65 costs $2.50. The investor decides to hedge by buying 10 contracts.