Derivatives

Question 1

What are derivatives and how are they different?

Answer 1

• Derivatives are not assets like stocks and bonds; their value is derived from an underlying asset, such as a financial security or a commodity. Institutional investors and portfolio managers rely on derivatives and consider them sensible investments that can enhance returns and protect against the inherent risk in the market. For many investors, however, particularly smaller retail investors, derivatives are considered risky, complex investments. This viewpoint can be attributed to the fact that derivatives are specialized financial instruments created by market participants.
• A derivative is a financial contract between two parties whose value is derived from, or dependent on, the value of an underlying asset. The underlying asset can be a financial asset (such as a stock or bond), a currency, a futures contract, an index, or even an interest rate. It can also be a real asset or commodity, such as crude oil, gold, or wheat.

Question 2

What are the options and forwards structures of derivatives?

Answer 2

• The buyer in an option contract has the right, but not the obligation, to buy or sell a specified quantity of the underlying asset in the future at a price agreed upon today. The seller of the option is obliged to complete the transaction if called upon to do so.
• With forward contracts both parties oblige themselves to trade the underlying asset in the future at a price agreed upon today. Neither party has given the other any right; they are both obliged to participate in the future trade.

Question 3

What is the difference between over the counter and exchange traded derivatives?

Answer 3

• The OTC derivatives market is an active and vibrant market that consists of a loosely connected and lightly regulated network of dealers who negotiate transactions directly with one another. Negotiations take place primarily over the telephone or through computer terminals. The OTC market is dominated by financial institutions, such as banks and investment dealers, that trade with their large corporate clients and other financial institutions.
• A derivative exchange is a legal corporate entity organized for the trading of derivative contracts. The exchange provides the facilities for trading: either a trading floor or an electronic trading system—in some cases, both. The exchange also stipulates the rules and regulations governing trading in order to maintain fairness, order, and transparency in the marketplace. Derivative exchanges evolved in response to OTC issues, including concerns around standardization, liquidity, and default risk. Canada has one derivative exchange: The Montréal Exchange lists options on stocks, indexes, and U.S. currency, as well as exchange-traded forwards (futures) on bonds, money market rates, and indexes.
• In the OTC market, the terms and conditions of a contract can be tailored for specific users, who may choose the most appropriate terms to meet their particular needs. In contrast, for exchange-traded derivatives, the exchange specifies the contracts that are available to be traded.