Chapter 6 - Derivatives Flashcards
(15 cards)
What are derivatives?
Financial instruments whose value is derived from an underlying asset (e.g. Equities, bonds, commodities, interest rates, currencies)
Purpose of Derivatives?
Used for hedging, speculation or arbitrage
Common types of derivatives?
-Futures contracts
-Forward contracts
-Options contracts
-Swaps
Futures contracts
-Standardised agreements traded on an exchange
-Oblige the buyer/seller to buy/sell the underlying asset at a fixed price on a future date.
-Used by companies and investors to lock in prices.
-Forward contracts
-Similar to futures but over-the-counter and customised
-More flexible but carry counterparty risk.
Options contracts
-Give the right but not the obligation to buy or sell an asset at a specified price before a certain date
-Call option: Right to buy an asset
-Put option: Right to sell an asset
The buyer pays a premium to the seller for this right
Uses of derivatives:
-Hedging
-Speculation
-Arbitrage
What is hedging?
-Reducing risk by taking an offsetting position
-e.g. a UK exporter uses currency futures to protect against GDP/USD fluctuations
What is speculation?
Aiming to profit from changes in market prices without owning the underlying asset
Higher risk- can result in large profit or large loss.
What is arbitrage?
-Exploiting price differences in different markets to make a profit with no risk
-Often involves buying and selling equivalent assets simultaneously.
What is meant by underlying asset?
The instrument the derivative is based on
What is strike price
Agreed price in an option contract
What is meant by premium
Price paid for an option
Risks of Derivatives?
-Market Risk
-Liquidity risk
-Leverage risk
Real world examples of derivatives?
Hedging - A pension fund hedges interest rate risk using interest rate swaps.
-Speculation - A trader buys oil futures expecting the price to rise.
-Arbitrage - Buying gold in London and selling simultaneously in New York at a higher price.
