Wk4b Flashcards
What is a derivative
A derivative is a financial instrument who’s value depends on, is derived from the value of some other financial instrument called the underlying asset
What is the purpose of derivatives
- is to transfer risk from one person or firm to another.
- By shifting risk to those willing and able to bear it, derivatives increase the risk-carrying capacity of the economy as a whole.
Why are derivatives different from outright purchases of bonds
- provide an easy way for investors to profit from price declines
- one persons loss Is another persons gain
What is the downside of derivatives
Allows individuals and firms to conceal the true nature of certain financial transactions
What is a forward
An agreement between buyer and seller to exchange a commodity or financial instrument for a specified amount of cash at a prearranged future date
What is a future
is a forward contract that has been standardised and sold through an organized exchange.
What does a future contract specify
the seller (short position) will deliver some quantity of a commodity or financial instrument
▶- to the buyer (long position) on a specific date
▶ called the settlement or delivery date, for a predetermined price.
Downside of futures
They are difficult to resell
How do forward and future contracts work
- No payments are made when the contract is agreed to
- The seller benefits from decline in the price of the underlying asset
- The buyer benefits form increases I the price of the underlying asset
Who mediates the contracts
The clearing cooperation operates like a large insurance company and is the counter party to both sides of the transaction
What is clearing cooperations do
- Guarantee that the parties will meet their obligations
- This lowers this risk buyers and seller face
- Post daily gains and losses on the contract to the margin account of the parties involved
If someone’s margin account falls below the minimum the clearing cooperation will sell the contracts and end the persons participation
What does the clearing cooperation require
- requires both parties to a futures contract to place a deposit with the cooperation
(Margin) - This guarantees that when the contract comes due, the parties will be
able to meet their obligations.
What is marking to marker
The clearing corporation also posts daily gains and losses on the contract to the margin account of the parties involved.
What do futures do
Transfer the risk between buyer and seller and though hedging or speculation
Fixed the price that the buyer will need to pay
Who may use futures contracts
Producer and users of commodities ans speculators who bet on price movement
Why are future contracts popular
They are cheap as you only need to invest a small amount to the margin account to purchase
What happens on the settlement date
the price of the futures contract must equal the price of the underlying asset the seller is obligated to deliver.
What is arbitrage
The practice of simultaneously buying and selling financial instruments in order to benefit from temporary price differences
What does an arbitrageur do
- They can buy at the low price and sell at the high price
- This increases demand in one market and supply in another
- The increase in demand raises price in that market
- the increase in supply lowers the price in the other market
- this continues until the prices are equal
What are options
Agreements between two parties the seller (writer)
And the buyer (holder)
What is a call option
The tight to buy a given quantity of an underlying asset at a predetermined price called the strike price on or before a specific date
What does the writer do
The writer must sell the share if and when the holder chose to use the call option
What does the holder do
They are not required to buy the shares
What is in the money
If the price of the stock is above the strike price of the call option and this is profitable
What is at the money
If the price of the stock exactly equals the strike price
What is out of the money
When the strike price exceeds the price of the stock
What is a put option
gives the holder the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date.
- this makes the writer obliged to buy the shares if the holder choses to excessive the option
What are the two types of options
American options can be exercised on any date from the time they are written to the expiration’s date
European options .
can be exercised only on the day they expire.
What does a call option ensure
that the cost of buying the asset will not rise.
What does the put option ensure
For someone who plans to sell the asset in the future, a put option ensures that the price at which the asset can be sold will not go down.
Who can take a large loss from options
Speculators willing to take the risk and bet that prices will not move against them.
Dealers, called market makers, who engage in the regular purchase and sale of the underlying asset.
What do market makers do
Own the underlying asset so they can deliver it, and
are willing to buy the underlying asset so they have it ready to sell to someone else
Why are options good
Options are very versatile and can be bought and sold in many combinations.
They allow investors to get rid of risks they do not want.
Finally, options allow investors to bet that prices will be volatile.
How do you price options (2)
- Intrinsic value: the value of the option if it is exercised immediately.
- Time value of the option: the fee paid for the option’s potential benefits.
Option price = Intrinsic value + time value of the option
What are swaps
Contracts that allow traders to transfer risk just like other deeivative
What are the two types of swaps
Interest-rate swaps which allow one swap party, for a fee, to alter the stream of payments it makes or receives.
B. Credit-default swaps (CDS) which are a form of insurance that allow a buyer to own a bond or mortgage without bearing its full default risk.
What are interest rate swaps
agreements between two counterparties to exchange periodic interest-rate payments over some future periods, based on an agreed-upon amount of principal: notional principal.
one party agrees to make payments based on a fixed interest rate, and in exchange the counterparty agrees to make payments based on a floating interest rate.
Why are swaps different from futures and options
Unlike futures and options, swaps are not traded on organised exchanges.
What is a credit default swap
is a credit derivative that allows lenders to insure themselves against the risk that a borrower will default.
The buyer of a CDS makes payments, like insurance premiums, to the seller, and the seller agrees to pay the buyer if an underlying loan or security defaults.
What does the CDS buyer give to the seller
The CDS buyer pays a fee to transfer the risk of default, the credit risk, to the CDS seller
CDS agreement often lasts several years and requires that collateral be posted to protect against the inability to pay of either the seller or the buyer of the insurance.
Why did cds contribute to the financial crisis (3)
Fostering uncertainty about who bears the credit risk on a given loan or security.
Making the leading CDS sellers mutually vulnerable.
Making it easier for sellers of insurance to assume and conceal risk.
