Reading 48: Derivative Markets and Instruments Flashcards
Describe options.
Options are contingent claims because their payoffs depend on the underlying’s value in the future. Options are derivative instruments that give their holders the choice (not the obligation) to buy or sell the underlying from or to the seller (writer) of the option. The option to buy the underlying asset is known as a call option, while the option to sell the underlying asset is known as a put option.
What is a swap contract?
A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate, and the counterparty pays either 1) a variable series determined by a different underlying asset or rate or 2) a fixed series.
Describe forward contracts.
These are customized and private contracts between two parties, where one party has an obligation to buy an asset, and the counterparty has an obligation to sell the asset, at a price and future date that are agreed upon at the signing of the contract. If the price of the asset increases after inception of the contract, the buyer benefits while the seller loses out. Forward contracts can be written on equities, bonds, assets, or interest rates.
Explain the market efficiency of derivatives.
When asset prices deviate from the fundamental values, derivative markets offer a less costly method of taking advantage of the mispricing, as less capital is required, transaction costs are lower, and short selling is easier.
The ability to hedge various risks through derivatives increases the willingness of market participants to trade and improves liquidity in the market.
Explain the purpose of derivatives.
Derivatives allow investors to hedge away risks without trading the underlying item.
They improve risk allocation within markets as parties who do not want exposure to a particular risk can transfer it to those who do.
Describe the destabilization and systematic risk of derivatives.
The argument is that the very benefits of derivatives (low cost, low capital requirements, and ease of going short) result in an excessive amount of speculative trading that brings instability to the market. If an investor ends up on the wrong side of a trade, speculators can incur huge losses. These losses can trigger defaults on their creditors, creditors’ creditors, and so on, spreading instability throughout financial markets and the economy.
Describe future contracts.
These are standardized derivative contracts where one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a price agreed upon at contract initiation. For futures contracts, there is daily settlement of gains and losses, and the futures exchange (through its clearinghouse) provides a credit guarantee.
Identify the operational advantages of derivatives.
They entail lower transaction costs than comparable spot market transactions.
The markets are typically more liquid than the underlying spot markets.
They offer an easy way to take a short position on the underlying.
They allow users to engage in highly leveraged transactions, as a relatively small amount of money must be invested to take a position on a derivative compared to taking a position directly in the underlying item.
When do arbitrage opportunities exist?
Whenever similar assets or combinations of assets are selling for different prices. These opportunities abound when assets are mispriced. Arbitrageurs exploit these opportunities and trade on mispricings until they are eliminated and asset prices converge to their “correct” levels (where no arbitrage opportunities exist).
This aids in the determination of prices and improves market efficiency.
Explain credit default swaps (CDS).
A credit default swap (CDS) is a bilateral contract between two parties that transfers the credit risk embedded in a reference obligation from one party to another. It is essentially an insurance contract.
