Topic 7: Derivitives Market Flashcards
(37 cards)
What is a derivative?
A financial asset that derives it value from some other asset.
Used to manage risk.
What is are the 4 most basic types of derivatives?
1) forwards
2) futures
3) options
4) swaps
What is a forward?
This is the fundamental derivative product, the others (options futures swaps) are variations.
- an agreement to buy/sell a quantity of an asset, at a set date in the future for an agreed price
- reduces risk and uncertainty ex: if you are buying a commodity like wheat (farmer cannot sell it till it’s harvested) and you know what the price is today and is exposed to the risk that the price may increase in the future. You enter in to a forward contract with the farmer to pay $7 per bushel, even though it is $6 today.
- say the price increases to $8 in the future, you have both hedged against the loss.
- the downside is that the downside. loss has been hedged but so has the ‘upside’ risk, the farmer cannot make a profit from the increased price.
What are the advantages of the forward contract?
- risk is hedged
- forward contracts are negotiated directly between 2 parties so there is lots of flexibility in their structure.
- can be based on any amount, for any commodity at any specified time.
Disadvantages of forwards?
- One party may be worse off (May want to enter into a FRA)
- if one party changes it’s mind then the contract is extremely difficult to get out of
- sometimes it’s difficult to find a willing counter party with the exact same needs to perfectly hedge the position
- will need a broker to negotiate costs nod this incurs a fee
– can find a financial institution to perform the role of intermediary - they will quote 2 way prices, the spread will be costly and make forward contracts expensive
What is a forward rate agreement?
Not just for currencies and commodities but any price, rate or index. Can hedge the risk to both parties, rather than one.
- used to manage risk
- (FRA) is commonly used to lock in IR’s by an organisation looking to borrow for invest in the near future
- they can lock in the interest rate, always less than 12 months (short term)
- the FRA is quite separate to the intended borrowing or investing, it simply a compensatory payment to the party that gets the lessor deal.
For example: FRA?
- company A want to borrow $1 mill, over 1 year, in 6 months
- company B wants to invest $1 mill for 1 year in 6 months
- current IR is 6%
- if IR rise by 1% the company A (borrower) will be 100 grand worse off
- if IR falls to 5% company B will be a 100 grand worse off
- if they enter into a Forward rate agreement then they lock in the IR at 6%
- the party that does not benefit gets a compensation from the party that does benefit, so the effective IR for them both is still 6%.
What is a future?
Similar to forwards however they are more standardised.
- available on particular commodities (gold/wool/oil of a particular purity)
- only available for particular amounts (100oz of gold,1000 bales of wool, 1000 barrels oil etc)
- specific maturity dates (15th day of March, June,September, December)
Advantages of futures?
-Because they are so standardised there is a secondary market for buying and selling futures.
This service is provided by the Sydney Futures Exchange
- because of the standardisation they are easy to unwind
- you can just sell an identical contract to get out of the position
- this will neutralise your position and you have no further obligation
What does it mean to ‘go long’ with futures?
This means you are buying a contract.
You are entering into a Contract to buy the underlying asset for the agreed price on the date of maturity.
What does it mean to ‘go short’ in a futures contract?
If you go short you are selling a futures contract.
You are agreeing to enter into a forward contract to sell the asset in the future.
(Remember - a future contract is a type of forward contract)
An example of a futures contract?
Suppose you buy a contract on 30th April 2013, no money has changed hands but the agreement is to b 100oz of gold at the forward price of $360 on 15th Sept 2015.
1st scenario:
You buy the gold (100oz @ $360 oz) at the maturity date
2nd scenario:
You close out your position by selling a gold futures contract. You have no liability under the contract and the difference (spread) at which you bought the contract and sold it will determine your profit/loss.
Your decision to sell would be influenced by a rise or fall in gold prices.
Uses for futures?
- hedging
- speculation (no existing risk present)
What is a margin call?
When you buy or sell you must deposit an amount of money into a margin account.
Changes in the contract over the day will change the value of your contracts and you margin account will be adjusted accordingly.
If it drops to half it’s value you must ‘top it up’, if you fail to do so then the exchange may close out your position.
How are futures settled?
In cash.
The profit or loss comes from closing out their position in the market.
You do not have to take large deliveries of commodities nor acquire them.
Less than 2% of futures contracts are settled by physical delivery.
What are options?
This is a contract that gives the buyer(or holder of the option) the right but not the obligation to buy an underlying asset at the agreed price on or before a future date.
The writer (seller) of the option doesn’t have any options and must perform the contract if the option is exercised.
What is a call option?
Gives the buyer of the option right to buy the underlying asset.
What is a put option?
Gives the buyer the right to sell the underlying asset.
What is a European option?
When the the option can only be exercised ON the MATURITY date
What is an American option?
An option that can be exercised ON or BEFORE maturity date.
These are different terms for historical reasons, both types can be found in all types with American options being the most popular in Australia.
What does it mean if an option is ‘in the money’?
If the difference in price of the asset and the exercise price is such that you could sell the the contract now and make a profit, then it is ‘in the money’.
What does it mean if the option is ‘at the money’?
If the asset price and exercise price are equal then it is ‘at the money’.
What if the option is ‘out of the money’?
Then the difference between the asset price and the exercise price, if it were to be sold immediately, would yield a loss. Therefore it is ‘out of the money’.
Example of in, out and at the money for options?
You buy an option that gives you the right to sell a BHP share. The exercise price is $25 and maturity is 1sept 2013.
If the share was more than $25 this is considered out of the money. You wouldn’t sell the share for $25 if was now worth $30. You would be realising a loss of $5.
If the share dropped to $20, then you would be in the money. If you sold now you realise a $5 profit.
If the share price and the exercise price remained at $25 each you are ‘at the money’.
