Ch 1 +2 - Derivatives Flashcards
Derivative
It is a contract whose value is derived from that of an underlying security.
Uses of derivatives
Hedge market risk
Speculate
Transition management
Control credit risk
Arbitrage
Synthetic index tracking
Income enhancement
Future
Is a standardised, exchange-tradable contract between two parties to trade a specified asset on a set date in the future at a specified price
Futures contract will typically specify
Unit of trading
How the settlement price is to be determined
Exact details of the underlying asset – type and quality
Delivery date
Trading hours
Form of quotation
Tick size
Method of calculating EDSP
Clearing party then acts as a party to every trade. Two key advantages to this:
Largely removes counterparty credit risk
Each contract is indistinguishable from all others (can close out positions)
Marked to market
Process of daily margin requirement changes. Reflects profits and losses
Open interest
Number of contracts outstanding at any one time that have not been closed out or expired.
It is an indication of liquidity and hence affects the bid offer spread.
Role of the Clearing House:
Counterparty to all trades
Guarantor of all deals (removing credit risk)
Registrar of deals
Holder of deposited margin
Facilitator of the marking to market process
Option
Gives an investor the right, but not the obligation, to buy/sell a specified asset on a specified future date at a set price (strike/exercise price)
Key differences between an Option and a Future
OTC (for some) vs exchange-traded
Premium
Right, but not obligation
Margin paid to clearing house by writer only (options)
Fundamental differences between un-margined forward and futures contracts
Customised contracts vs standardised
OTC market vs exchange
More credit risk with forwards traditionally
Less marketable
Less liquid
Less transparent
Delivery of asset - traditionally physical delivery with forwards
Lack of quoted market values
Forwards require ISDA documentation
Higher dealing costs (with OTC markets)
Forward
Is a non-standardised, OTC (privately negotiated) contract between 2 parties to buy (or sell) a specified asset on a set date in the future at a specified price.
Types of risks associated with the use of swaps:
Counterparty/credit risk (principle not at stake and typically pay margin through a CCP these days)
Market risk
Guaranteed Equity Products
These offer a return linked to an equity index, but with a minimum guaranteed return, often zero
Structured Notes
Non standard securities structured to meet particular risk and return requirements of investors.
Is a debt obligation (this is how it differs to a GEP) that also contains an embedded derivative component that adjusts the security’s risk and return profile
Either contain embedded options and/or provide payments that vary in some pre-specified way
