Options And Derivativs Flashcards
What are Derivative Instruments? W
A financial instrument is a document that has monetary value or which establishes an obligation to pay. Examples of financial instruments are cash, foreign currencies, accounts receivable, loans, bonds, equity securities, and accounts payable. A derivative is a financial instrument
A derivative is a financial instrument that has the following characteristics:
Write the four characteristics
It is a financial instrument or a contract that requires either a small or no initial investment;
There is at least one notional amount (the face value of a financial instrument, which is used to make calculations based on that amount) or payment provision;
It can be settled net, which is a payment that reflects the net difference between the ending positions of the two parties; and
Its value changes in relation to a change in an underlying, which is a variable, such as an interest rate, exchange rate, credit rating, or commodity price, that is used to determine the settlement of a derivative instrument. The value of a derivative can even change in conjunction with the weather.
How Derivative Instruments are Used?
In essence, a derivative constitutes a bet that something will increase or decrease. As such, a derivative can be used in two ways. Either it is a tool for avoiding risk, or it is used to speculate. In the former case, derivatives are used to offset expected changes in the value of an asset or liability, so that the net effect is zero. In the latter case, an entity accepts risk in order to possibly earn above-average profits. Speculation using derivatives can be extremely risky, since a large adverse movement in an underlying could trigger a massive liability for the holder of a derivative.
Examples of Derivative Instruments
Call option. An agreement that gives the holder the right, but not the obligation, to buy shares, bonds, commodities, or other assets at a predetermined price within a predefined time period.
Put option. An agreement that gives the holder the right, but not the obligation, to sell shares, bonds, commodities, or other assets at a predetermined price within a predefined time period.
Forward. An agreement to buy or sell an asset at a predetermined price as of a future date. This is a highly customizable derivative, which is not traded on an exchange.
Futures. An agreement to buy or sell an asset at a predetermined price as of a future date. This is a standardized agreement, so that they can be more easily traded on a futures exchange.
Swap. An agreement to exchange one security for another, with the intent of altering the security terms to which each party individually is subjected.
Derivatives are one of the three main categories of financial instruments, the other two ?
the other two beingequity(i.e., stocks or shares) anddebt(i.e.,bondsandmortgages)
In finance, a derivative is a contract that derives its value from [continue]
the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the “underlying”.[1][2] Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.[3] Some of the more common derivatives include forwards, futures, options, swaps
Hedging
Hedging is the process of using offsetting commitments to minimize or avoid the impact of
adverse price movements.
Is derivatives and hedging the same? w
Both concepts are also different in nature. Hedging is a form of investment to protect another investment, while derivatives come in the form of contracts or agreements between two parties.
a long position
A person who would like to sell an asset in the future has a long position in the asset because (s)he benefits from a rise in value of the asset.
1) To protect against a decline in value, the owner can enter into a short hedge, i.e., obtain an instrument whose value will rise if the asset’s value falls.
2) EXAMPLE: A soybean farmer hopes that the price of soybeans will rise by the time her crop is ready to go to market. The farmer is thus long in soybeans. To protect against the possibility that the price will fall in the meantime, she can obtain a short hedge.
This arrangement is a cash-flow hedge because the intent of the transaction is to avoid risks attributable to future cash flows.
a short position
A person who would like to buy an asset in the future has a short position in the asset because (s)he benefits from a fall in value of the asset.
1) To protect against a rise in value, the party can enter into a long hedge, i.e., obtain an instrument whose value will rise if the asset’s value rises.
2) EXAMPLE: An agricultural wholesaler hopes that the price of soybeans will fall by the time farmers are bringing their harvests to the warehouse. The wholesaler is thus short in soybeans. To protect against the possibility that the price will rise in the
meantime, the wholesaler can obtain a long hedge.
3) A fair-value hedge is an instrument that hedges the exposure to changes in fair value of an asset or liability
A natural hedge
A natural hedge relies on normal operations to mitigate risk. It does not involve sophisticated financial products. For example, financing a purchase of long-lived equipment over the same period as the life of the equipment is a form of hedge.
