Introduction to Derivatives Flashcards
Determine which of the following statements regarding uses of derivatives is TRUE.
A
Derivatives are a tool for companies and other users to reduce risks.
B
Derivatives can provide a way to make bets that are highly leveraged and tailored to a specific view.
C
Derivatives sometimes provide a lower-cost way to undertake a particular financial transaction.
D
Derivatives are often used to achieve the economic sale of stock while still maintaining physical possession of the stock.
E All (A), (B), (C), and (D) are true.
E All (A), (B), (C), and (D) are true.
Determine which of the following statements is FALSE.
A
A market order is a buy or sell order to be executed immediately at the best price currently available.
B
A limit order is an order to buy a security at no more than a specific price, or to sell a security at no less than a specific price.
C
A stop-loss order specifies that the stock is sold if the price increases to the specified amount.
D
A limit order and a stop-loss order might never be filled if the price does not move past the cutoff point.
E
If a stop-loss order is executed, it is possible that the sale price could be less than the cutoff point.
C
A stop-loss order specifies that the stock is sold if the price increases to the specified amount.
A company uses derivatives to manage its financial risk.
Determine in which of the following scenarios the company is MOST LIKELY to use a derivative security.
A
To comply with generally accepted accounting principles.
B
To minimize its tax deductions.
C
To hedge against the increase of an asset the company already owns.
D
To guarantee that an asset it will be purchasing can be bought at higher price.
E
To adequately fund a guarantee it has sold to its customers.
E
To adequately fund a guarantee it has sold to its customers.
What is a Derivative?
A derivative is a financial instrument whose value is determined by the price of something else.
Why Use Derivatives?
To manage risk. Derivatives may be purchased to reduce risk, which is known as hedging. For example, airlines can hedge against the price of oil by entering into derivatives on oil prices.
To speculate. Rather than reducing risk, speculation is making a bet. If an investor believes the price of a stock will decrease in six months, the investor may enter into a derivative that pays off if this happens.
To reduce transaction costs. Derivatives can sometimes be used to achieve the same economic outcome that one would get from trading stocks and bonds without actually buying or selling them. This can lower transactions costs.
To minimize taxes/avoid regulatory issues. Derivatives may be used to defer taxes or eliminate the risk of owning an asset while keeping the privileges the asset may offer: for example, by eliminating the risk of owning a stock while still owning the stock and keeping voting rights.
Who Uses Derivatives?
End-users: People who enter into a derivative contract for the reasons above, such as corporations, investment managers, and investors.
Market-makers: Intermediaries who aim to make a profit by selling and buying derivatives to and from end-users.
Economic observers: Market observers, including regulators who analyze and regulate the activities of end-users and market-makers.
Types of underlying assets
STOCKS
INDICES
COMMODITIES
CURRENCIES
What is a stock exchange?
An auction where stocks are bought and sold. In the United States, the two largest stock exchanges are the New York Stock Exchange and the Nasdaq.
What is the role of a market-maker?
A market-maker has a special arrangement with an exchange, or exchanges, to facilitate the buying and selling of an exchange’s assets, thus “making a market.”
Bid-Ask Prices
Bid-Ask Spread = Ask Price – Bid Price
When a market-maker buys a stock from an investor, the market-maker bids the lower price. When a market-maker sells a stock to an investor, the market-maker asks for the higher price.
The ask price is always greater than the bid price
What is the round-trip transaction cost?
It is the difference between what you pay and what you receive from a sale using the same set of bid and ask prices.
Example: Investor point of view
(# of shares * ask price + commission) - (# of shares * bid price - commission)
What he pays - what he receives
What is a market order?
By placing a market order on a stock, you are instructing the market-maker to fulfill your order immediately at the best available price.
Advantage: you can immediately own or sell the stock
Disadvantage: if you instead wait for prices to change, you may be able to purchase the stock at a lower price, or, in the case of selling, sell at a higher price.
What is a limit order?
You are specifying a certain price at which to buy or sell.
What is a stop-loss order?
A stop-loss order is executed whenever the price of the asset falls to (or below) a certain price.
What is the economic profit?
revenue - explicit costs - implicit costs
implicit cost = (amount bought)* interest
