R 28.1 Derivatives and securities

Question 1

A derivative effectively derives its price from some other variable.

Answer 1

Derivatives can be used for financial risk management (i.e., hedging),
for speculation,
for diversification of exposures,
as added features to a bond (e.g., convertible, callable),
as employee compensation in the case of stock options,
within a capital project as an embedded option (e.g., real or abandonment options).

Question 2

Linear and non linear derivatives

Answer 2

Linear derivatives, such as forward and futures contracts, have a linear payoff that is directly related to the value of the underlying. zero-sum games where one party wins the same amount that the other party loses.
non-linear derivatives, such as options, involve the option purchaser (holder) having the right but not being obligated to buy or sell an underlying asset at a stated time in the future. Therefore, the payoff is non-linear in relation to the value of the underlying.

Question 3

open outcry system and an electronic trading system

Answer 3

open outcry system - traders indicating their trades through hand signals and shouting.

Electronic trading, which represents most of the trading done today, does not involve a physical exchange location, but rather involves matching buyers and sellers electronically via computers.

Algorithmic trading executes trades without human involvement.

Question 4

OTC market typically involves much larger trades than traditional exchanges.

Answer 4

The OTC market is several times the size of the traditional exchange market. For example, in 2017, the OTC market was over $530 trillion, while the exchange-traded market was over $80 trillion.

Advantages of OTC trading:
Terms are not set by any exchange, Few regulations, trade confidentiality
Disadvantages : credit risk