(R48) Derivative Markets and Instruments Flashcards
Define Derivative
- Financial contract between 2 parties whose value depends on the value of some other underlying asset. - Buyer or seller agrees to buy or sell a specific asset at a specific price on a specific date
Purpose of derivatives
- Transfers wealth, does not create it (derivatives are a zero sum game) - Used for hedging and speculation
Exchange-traded derivatives
- Standardized contracts for futures and options - no counterparty risk because of clearing house - Transparency - Highly regulated
Two types of exchange traded derivatives
Futures and options
Over-the-Counter (OTC) derivatives
- Dealer market - Customizable contracts for forwards and swaps - Low regulation - Privacy
Two types of OTC derivatives
Forwards and swaps
Forward Commitment
Obligation entered into at one point in time that require both parties to engage in a transaction at future date on terms agreed upon today. No money is required to change hands at inception. (OTC Contract)
Forward Price
The fixed price or rate at which the transaction scheduled to occur at the expiration of a forward contract will take place. This price is agreed on at the initiation date of the contract. Notation is Fo
What does long and short mean in derivatives markets?
- Long means buyer - long takes delivery in futures contract - Short means seller - short must deliver to a specific location
What is the difference between future spot price and forward price? Does long or short profit if spot price is greater than forward price?
- Future spot price (ST): The price of an asset at a future date
- Forward price (Fo): The future price agreed upon today
If (ST) > (Fo) then the long (buyer) profits
Futures Commitment
- Futures contracts are much like forward contracts, but are exchange-traded, liquid, and require daily settlement (mark to market) of any gains or losses. Subject to daily price limits and require a margin.
- Futures and spot prices converge on final day
- Value at contract initiation is always equal to zero
Define swaps
An OTC contract in which 2 parties agree to swap a series of cash flows whereby one party pays a variable rate and other party pays variable rate or fixed rate. Value of swap at inception is zero. Type of commitment
Non-deliverable forwards
Cash-settled forward contracts, used predominately with respect to foreign exchange forwards.
Option
A financial instrument that gives one party the right, but not the obligation, to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time. (Also known as contingent claim)
Three types of commitments
- Forward commitment
- Futures commitment
- Swap
Two types of contingent claims
- Options
- Credit Derivatives
American style vs. european style options
- American: can be exercised anytime before expiration
- European: can only be exercised on the expiration date
Options
A financial instrument that gives one party the right, but not the obligation, to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time. (Type of contingent claim)
Credit Derivatives
A contract in which one party has the right to claim a payment from another party in the event that a specific credit event occurs over the life of the contract.
Credit default swap (CDS)
A type of credit derivative in which one party, the credit protection buyer who is seeking credit protection against a third party, makes a series of regularly scheduled payments to the other party, the credit protection seller. The seller makes no payments until a credit event occurs.
Call Option
An option that gives the holder the right to buy an underlying asset from another party at a fixed price over a specific period of time
Put Option
An option that gives the holder the right to sell an underlying asset to another party at a fixed price over a specific period of time.
Calculate the value of a call at expiration (payoff) and profit from the buyers perspective
Value of call (payoff): CT = Max (0, ST-X)
Profit: π = Max (0, ST-X) - C0)
ST: Spot price at a future date
X: strike price
C0: original price paid for the call
Calculate the value of a call at expiration (payoff) and profit from the sellers perspective
Value of call (payoff): CT = -Max (0, ST-X)
Profit: π = -Max (0, ST-X) + C0)
ST: Spot price at a future date
X: strike price
C0: original price paid for the call
For calls:
- In the Money
- Out of the Money
- At the Money
In the money: ST > X
At the money: ST = X
Out of the money: ST < X
ST: Spot price at a future date
X: strike price
Calculate the value of a put at expiration (payoff) and profit from the buyers perspective
Value of put (payoff):PT = Max (0, X-ST)
Profit: π = Max (0, X-ST) - P0
ST: Spot price at a future date
X: strike price
P0: original price paid for the put
Calculate the value of a put at expiration (payoff) and profit from the sellers perspective
Value of put (payoff): PT = -Max (0, X-ST)
Profit: π = -Max (0, X-ST) + P0
ST: Spot price at a future date
X: strike price
P0: original price paid for the put
For puts:
- In the Money
- Out of the Money
- At the Money
In the money: X > ST
At the money: X = ST
Out of the money: X < ST
ST: Spot price at a future date
X: strike price
Underlying
An asset that trades in a market in which buyers and sellers meet, decide on a price, and the seller then delivers the asset to the buyer and receives payment. The underlying is the asset or other derivative on which a particular derivative is based.
Arbitrage Pricing
- The simulataneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio, in order to obtain a risk less profit on the price differential.
- Arbitrage can be expected to force the prices of two securities or portfolios of securities to be equal if they have the same future cash flows regardless of future events.
Non-deliverable forwards
Cash-settled forward contracts, used predominately with respect to foreign exchange forwards.
Locked limit
A condition in the futures markets in which a transaction cannot take place because the price would be beyond the limits.
