Derivatives Basics Flashcards
What is a derivative?
An asset whose value is derived from the value of some other asset.
What is the underlying?
The security from which the value of the derivative is derived from
What are the 3 main risks of derivatives?
1) Counterparty Risk
2) Leverage
3) Complexity / Lack of transparency
What are the two ways derivatives are traded?
1) OTC
2) Exchanges
What is unique about OTC derivatives compared to exchange traded?
Far more bespoke
Limitless variations
Can be included into vanilla assets to create structured products
What change are OTC derivatives seeing in the way they are traded?
Often traded through a central counterparty now
This is to reduce overall credit risk
In simple terms what is a forward?
A contractual obligation made between two parties - to agree to exchange a specific quantity of an asset or commodity on a fixed date in the future.
1) It is legally binding
2) Terms can be customized
What is the primary risk of a forward?
One party could default (counterparty risk)
What is a future?
Effectively the same as a forward but traded over an organized and regulated exchange
(Two parties agree to buy / sell a fixed quantity of an asset or commodity, on a fixed date or between two dates)
What are the 3 key differences between a future and a forward?
A future is
1) Guarenteed against default
2) Standardized to promote active trading
3) Settled on a daily basis
What is a swap?
An agreement between two parties to exchange payments on regular future dates - where the legs are calculated on a different basis.
Where are swaps traded?
OTC - therefore has counterparty risk
What risks can swaps be used to manage?
1) FX Rate Risk
2) Interest Rate Risk (e.g. borrow variable can swap to fix)
3) Commodity Price
4) Share Price
What can swaps effectively be thought as being?
A series of forwards
What are the two types of options?
What right do they conver to the holder?
1) Call - The right to buy at a fixed price before a set date (bullish)
2) Put - The right to sell at a fixed price before a set date (bearish)
Why does the buyer of an option pay a premium?
For the flexibility
Where can options trade?
1) OTC
2) Standardized on exchanges
Give an example of a situation where a derivative has a greater liquidity than its underlying:
An index of assets
Individual liquidity is less than that of an index derivative
What are the 4 primary users of derivatives?
1) Speculation
2) Hedging
3) Arbitrage
4) Margin Traders
Why are derivatives used for speculation?
Buying derivatives contracts of the underlying is generally much cheaper - therefore the profit is greater
(although the risk can potentially be higher e.g. leverage)
What is an example of a derivative being used to speculate?
Think commodity price will rise
Buy exchange traded future
Sell contract if price rises
By doing so you have avoided the expensive delivery / storage costs but still profitted from underlying
What is hedging using derivatives?
Guarding against market variables using swaps, futures, forwards and optoins
What market variables can be guarded against?
1) Rates
2) Share prices
3) Commodity prices
4) FX Rates
5) Bond Prices
How does a company receiving a payment in foreign FX hedge?
Enter into a forward with a bank to receive a fixed amount of domestic currency when they get paid
