Introduction to derivatives Flashcards
What are the 4 steps to trade financial assets on a financial market?
- Buyer&Seller must find each other
- Trade is cleared through a clearinghouse
- Trade is settled
- Ownership records are updated
What does it mean for a trade to be cleared?
Both sides must specify their obligations (pay or handover an asset)
What is a clearinghouse?
Intermediary between the buyer&seller (matches them and keeps track of their obligation and payment)
What are the advantages of “over-the-counter” trading?
- Easier to trade LARGE quantities (avoiding fees)
- OTC may create custom financial assets (NOT available on financial markets)
- Can trade MANY financial assets in A SINGLE transaction
What are the four measures of market size and activity?
- Trading volume (market activity)
- Market value
- Notional value (market size of derivative)
- Open interest (market size of derivative)
Describe trading volume.
Number of units that change hands in a period.
Describe market value.
Value of a company on an exchange based on the price of its stocks. MV = #Stocks x $ per share
Describe notional value.
Value of a derivative relative to some underlying asset
NV = #options x #stock in 1 option x $ of stock
Describe open interest.
Number of contract for which there is a future obligation for one party to perform.
What are the purposes for derivatives?
- Risk management
- Speculation
- Reduced transaction costs
- Regulatory arbitrage (ex : delay taxes)
What is a market-maker ?
Dealer (stands ready to buy or sell). Buys low and sells high
What is the bid-ask spread?
Bid price: price at which the MM buys an asset
Ask price: price at which the MM sells an asset
Bid-ask spread = Ask price - bid price
What are the different kind of stock orders?
- Market order
- Limit order
- Stop-loss order
Describe a market order.
Buy or sell the stock immediately
Describe a limit order.
Specifies the maximum buying price or the minimum selling price. Fulfilled when the price is available.
Describe a stop-loss order.
Specifies that the stock is sold if the price decreases to the specified amount. The actual sales price may be less since the stock is sold at the market price.
What are the purposes of short selling?
- Speculation
- Financing
- Hedging
How does shot selling a stock work?
- Borrow stock
- Sell stock
- If the stock pays dividends, you must pay them to the lender
- Buy the stock back and return to lender.
The dividends received during the short sell process are taxable and tax-deductible for whom?
Taxable for the lender
Tax-deductible for the borrower
What is the lease rate?
Dividends rate the borrower pays.
Describe the haircut and the two possible interest rates on the haircut (repo rate and short rebate).
Haircut : $ put as collateral to assure the lender the borrower will buy back the shares.
If the asset borrowed is an obligation : interest on collateral is called the repo rate
If the asset borrowed is a stock : interest on collateral is called the short rebate
