Chapter 6: Derivatives Flashcards
What are commodity markets?
Where raw or primary products are exchanged or traded on regulated exchanges.
They are bought and sold in standardised contracts.
What is a derivative?
A financial contract, set between one or more parties, whose price is based on the price of another asset known as an ‘underlying asset’, group of assets or benchmark.
These underlying assets can include stocks, bonds, commodities, currencies, interest rates, market indexes or even cryptocurrencies.
Derivatives can be used to mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation).
Trading of derivatives
- directly between counterparties (referred to as OTC trading)
- on an organised exchange (referred to as being exchange-traded)
What role do derivatives play in investment management?
Derivatives play a major role in the investment management of many large portfolios and funds, and are used for hedging, anticipating future cash flows, asset allocation change and arbitrage.
Examples of commodity
Oil, silver, wheat
What is hedging?
It is a technique employed by portfolio managers to reduce the impact of adverse price movements on a portfolio’s value.
What does anticipating future cash flows mean?
If PM expects to receive a large inflow of cash to be invested, then futures can be used to fix the price at which it will be bought and offset the risk.
What is arbitrage?
A commodity or security is purchased at a low price in one market and then sold at a significantly higher price in another market.
Derivatives trading offers an advantage in terms of arbitrage trading to benefit from the differences in pricing in different markets.
A risk-free profit.
What are Futures Derivatives?
A future is a legally binding agreement between a seller and a buyer on taking delivery of a good or commodity by a certain date and paying a prespecified amount for the delivery.
Futures are traded on a wide variety of things, perhaps most famously, commodities such as oil, gold and soybeans. But they’re also used for currencies, interest rates and indexes, giving traders, financial companies
What are the features of Futures contract?
- It is exchange-traded
- It is dealt on standardised terms (exchange specifies the quality of the underlying asset, the quantity underlying each contract, the future date and the delivery location)
What’s the difference between long and short position?
Long position is when the person is committed to buying the underlying asset at the pre-agreed price on the specified future date.
Short position is when a seller is committed to delivering the underlying asset in exchange for the pre-agreed price on the specified future date.
What does “covered” mean in relation to futures?
When the seller of the future as the underlying asset that will be needed if physical delivery takes place.
What does “naked” mean in relations to futures?
When the seller of the future does not have the asset that will be needed if physical delivery of the underlying commodity is required - risk could be unlimited here.
What is an option?
An option gives the buyer the right to buy/ sell a specified quantity of an underlying asset at a pre-agreed exercise price on or before a prespecified future date/s.
The seller grants the option to the buy in exchange for the payment of a premium.
The buyers of options are the owners of those options.
What happens when options are traded on an exchange?
They will be in standardised size and terms.
Investors can, from time to time, trade an option that is outside the standardised terms, and they will do so in the OTC market.
What is a call option?
It is when the buyer has the right to buy the assets at the exercise price if they choose to.
What is a put option?
It is when the buyer has the right to sell the underlying asset at the exercise price.
Who are “writers” of the options?
The sellers
What type of option gives the holder the right to sell an asset?
Put option
What is a swap?
A swap is an agreement to exchange one set of cash flows for another. Most commonly used to switch financing from one currency to another or to replace floating interest with fixed interest.
What is an interest rate swap?
The most common form of swaps.
They involve an exchange of interest payments and are usually constructed, whereby one leg of the the swap is a payment of a fixed rate of interest and the other leg is a payment of a floating rate of interest.
What is a physical market?
It concerns itself with procuring, transporting and consuming real commodities by shipload on a global basis.
What are the examples of commodity markets?
- Agricultural markets
- Base and precious metals
- Energy markets
- Power markets
- Plastics markets
- Emissions markets
- Freight and shipping markets
What is Derivatives Markets?
The derivatives markets exist in parallel to physical markets and serve to provide a price-fixing mechanism whereby all stakeholders in the physical markets can hedge market price risk.
