Volume 1- Chapter 10 Flashcards
What is a derivative?
A financial contract whose value is derived from an underlying asset.
What are the two basic types of derivatives?
- Options
- Forwards
What rights does the buyer have in an option contract?
The right, but not the obligation, to buy or sell a specified quantity of the underlying asset.
What is the difference between a call option and a put option?
- Call option: right to buy the underlying asset
- Put option: right to sell the underlying asset
What is a forward contract?
A contract where both parties are obliged to trade the underlying asset in the future at a price agreed upon today.
List the common features of all derivatives.
- Contractual agreements between two parties
- Agreed-upon price
- Expiration date
- No up-front payment for forwards
- Premium payment for options
- Zero-sum game
What is the OTC derivatives market?
A loosely connected and lightly regulated network of dealers negotiating transactions directly.
What is one advantage of OTC derivatives?
Contracts can be custom designed to meet specific needs.
What is a derivative exchange?
A legal corporate entity organized for the trading of derivative contracts.
Identify one major difference between exchange-traded derivatives and OTC derivatives.
Exchange-traded derivatives have standardized contracts, whereas OTC derivatives can be tailored.
What is default risk in derivatives?
The risk that one party will not be able to meet its obligations under a contract.
True or False: Exchange-traded derivatives are heavily regulated.
True
Fill in the blank: The two general categories of underlying assets for derivative contracts are _______ and financial assets.
[commodities]
List some types of commodities that underlie derivative contracts.
- Grains and oilseeds
- Livestock and meat
- Precious and industrial metals
- Energy products
What are the predominant equity derivatives?
Equity options (options on individual stocks).
What are the most commonly used underlying assets in currency derivatives?
- U.S. dollar
- British pound
- Japanese yen
- Swiss franc
- European euro
Who are the primary users of derivatives?
- Individual investors
- Institutional investors
- Businesses and corporations
- Derivative dealers
What is hedging in the context of derivatives?
Using derivatives to protect the value of an anticipated or existing position in the underlying asset.
What role do derivative dealers play in the market?
They act as intermediaries, buying and selling to meet the demands of end users.
What is the purpose of hedging in derivatives trading?
Risk management to eliminate or reduce the risk of holding an asset or anticipating a future purchase.
Who are derivative dealers?
Intermediaries in the markets who buy and sell to meet the demands of end users and do not normally take large positions.
What types of derivatives can individual investors typically trade?
Exchange-traded derivatives, including options and futures.
What should individual investors consider before trading derivatives?
They should fully understand all risks and potential rewards and have a high degree of risk tolerance and risk capacity.
Name some types of institutional investors that use derivatives.
- Mutual fund managers
- Hedge fund managers
- Pension fund managers
- Insurance companies