Lesson 1: Introduction to Derivatives

Question 1

What is a derivative security?

Answer 1

A financial instrument whose value depends on another security

Question 2

What are the four steps to trade a financial asset?

Answer 2

1. Buyer and seller must find each other.
2. Trade is cleared, meaning both sides must specify their obligations, to pay or to hand over an asset.
3. Trade is settled.
4. Ownership records are updated.

Question 3

What are the advantages of over-the-counter trading (OTC)?

Answer 3

1. Easier to trade large quantity directly, avoiding exchange fee and market tumult.
2. OTC May create custom financial assets not available on financial markets.
3. Can trade many financial assets in a single transaction.

Question 4

What are 4 measures of market size and activity?

Answer 4

1. Trading volume
2. Market value
3. Notional value
4. Open interest

Question 5

What is Trading Volume?

Answer 5

The number of units that change hands in a period (a day or a year). Trading volume is a measure of market activity. For stocks a unit is one share; for options a unit is one option, but typically a stock option has 100 shares of stock underlying it.

Question 6

What is Market Value?

Answer 6

The value of a company on an exchange based on the price of its stock. More generally, market value is the price of an asset.

Question 7

What is Notional value?

Answer 7

The value of a derivative relative to some underlying asset. Notional value is a useful measure of the market size of derivatives.

Question 8

What is Open Interest?

Answer 8

The number of contracts for which there is a future obligation for one party to perform. It is a useful measure of the market size of derivatives.

Question 9

What purpose to derivatives serve?

Answer 9

1. Risk management
2. Speculation
3. Reduced transaction cost
4. Regulatory arbitrage

Question 10

What are the three perspectives of derivatives?

Answer 10

1. End user. This is the one who buys the derivative: the individual or the corporation.
2. Market-maker. This is the dealer, the one who sells the derivative.
3. Economic observer. This is the government regulator, or the economist who is understanding and analyzing the markets.

Question 11

What is hedging?

Answer 11

Eliminating risk by guaranteeing a buying or selling price.

Question 12

What is the definition of Bid Price?

Answer 12

The amount that the market-maker bids for an asset.

Question 13

What is the definition of Offer Price?

Answer 13

Offer Price or Ask Price is the price you can buy an asset for.

Question 14

What is the bid-ask spread?

Answer 14

The difference between the bid price and the ask or offer price.

Question 15

What is a market order?

Answer 15

An order to pay the market price (the ask price) to buy the stock immediately, or sells at the bid price immediately.

Question 16

What is a limit order?

Answer 16

An order that specifies the maximum buying price or the minimum selling price, and may not be fulfilled immediately if that price is not available.

Question 17

What is the definition of speculation?

Answer 17

The opposite of risk management. One may believe that the price of an asset will increase, and by using options, can make a bet on the price increase with little investment.