LM 1: Derivative Instrument & Derivative Market Features Flashcards
What is a derivative?
financial instrument that derives its performance from an underlying asset
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?
financial intermediary (seller/writer): sells the contract to buyer & has a short position
buyer: purchases contract from seller and has long position
What is a derivative contract?
defines the rights & obligations of each party
What are 2 classes of derivatives, describe them?
- forward commitments (agreements to transact at later date, details specified in advance, eg. price)
- 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)
What are the 4 purposes of derivatives, describe them? CILR
- create investment strategies that couldn’t exist without them (short position that wouldn’t allow you too short stock shares.)
- increased leverage
- low transaction costs
- risk management (preferred tools to reduce certain risk eg. downside risk.)
What are 6 possible different asset classes that can underly derivatives? EFCCCO
- equities (eg. options, forwards, swaps)
- fixed income instruments & interest rates
- currencies
- commodities
- credit
- other (weather eg. farmer hedging against drought or too much rain)
What are soft commodities & hard commodities?
soft commodities = agricultural products, cattle corn
hard commodities = natural resources eg crude oils & metals
Where are 2 places where derivatives are traded on?
- organized exchanges
- over-the counter markets
What 3 things do market makers (aka dealers) do?
- participates in the market at all times
- buy securities from sellers and sell securities to buyers
- providing liquidity
What are speculators and why are they used?
speculators take on risk of holding position for a while when market makers can’t find buyers
What is the difference between clearing and settlement?
clearing: verifies identities of counterparties and confirms trade execution
settlement: ensuring final payments and delivery terms are met
What are CCP for OTC derivatives?
central counter party mandated to bear credit risk of each party to a contract, as well as provide clearing and settlement services.
What are the 3 steps for CCP for OTC derivatives?
- two parties (financial intermediaries) reach swap agreement through swap execution facility (SEF)
- details of SEF transactions submitted to CCP
- 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.
What is the novation process?
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.
What do options use as their underlying asset?
individual securities or equity indexes
What do swaps, forwards, and futures use as their underlying asset?
based on indexes
What caused the rapid growth of OTC markets?
wanting contracts based on underlying assets of currencies, interest rates, and credit
