LM 1: Derivative Instrument & Derivative Market Features

Question 1

What is a derivative?

Answer 1

financial instrument that derives its performance from an underlying asset

Question 2

Which 2 parties are involved in a derivatives contract and which party has the long and short position, and which party sells and buys the security?

Answer 2

financial intermediary (seller/writer): sells the contract to buyer & has a short position

buyer: purchases contract from seller and has long position

Question 3

What is a derivative contract?

Answer 3

defines the rights & obligations of each party

Question 4

What are 2 classes of derivatives, describe them?

Answer 4

1. forward commitments (agreements to transact at later date, details specified in advance, eg. price)
2. contingent claims (allow owner of derivative to choose if they want to transact at a later date, eg the right to by/sell underlying but not the obligation)

Question 5

What are the 4 purposes of derivatives, describe them? CILR

Answer 5

1. create investment strategies that couldn’t exist without them (short position that wouldn’t allow you too short stock shares.)
2. increased leverage
3. low transaction costs
4. risk management (preferred tools to reduce certain risk eg. downside risk.)

Question 6

What are 6 possible different asset classes that can underly derivatives? EFCCCO

Answer 6

1. equities (eg. options, forwards, swaps)
2. fixed income instruments & interest rates
3. currencies
4. commodities
5. credit
6. other (weather eg. farmer hedging against drought or too much rain)

Question 7

What are soft commodities & hard commodities?

Answer 7

soft commodities = agricultural products, cattle corn

hard commodities = natural resources eg crude oils & metals

Question 8

Where are 2 places where derivatives are traded on?

Answer 8

1. organized exchanges
2. over-the counter markets

Question 9

What 3 things do market makers (aka dealers) do?

Answer 9

1. participates in the market at all times
2. buy securities from sellers and sell securities to buyers
3. providing liquidity

Question 10

What are speculators and why are they used?

Answer 10

speculators take on risk of holding position for a while when market makers can’t find buyers

Question 11

What is the difference between clearing and settlement?

Answer 11

clearing: verifies identities of counterparties and confirms trade execution

settlement: ensuring final payments and delivery terms are met

Question 12

What are CCP for OTC derivatives?

Answer 12

central counter party mandated to bear credit risk of each party to a contract, as well as provide clearing and settlement services.

Question 13

What are the 3 steps for CCP for OTC derivatives?

Answer 13

1. two parties (financial intermediaries) reach swap agreement through swap execution facility (SEF)
2. details of SEF transactions submitted to CCP
3. CCP replaces original contract between two parties, substitutes it with 2 new contracts. one contract between CCP and buyer and another contract between CCP and seller.

Question 14

What is the novation process?

Answer 14

CCP replaces original contract between two parties, substitutes it with 2 new contracts. one contract between CCP and buyer and another contract between CCP and seller.

Question 15

What do options use as their underlying asset?

Answer 15

individual securities or equity indexes

Question 16

What do swaps, forwards, and futures use as their underlying asset?

Answer 16

based on indexes

Question 17

What caused the rapid growth of OTC markets?

Answer 17

wanting contracts based on underlying assets of currencies, interest rates, and credit