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Derivatives


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Derivative
Financial instrument whose value derives from other commodities or financial instruments.
Currency Option
Right, or option, to exchange a specific amount of a currency on a specific date at a specific rate.
Exchange traded and over the counter
2 types of markets in which derivatives are traded
Exchange Traded
standardized, virtually no credit risk, and goes through clearing house
over the counter
specific to your needs, goes through brokers over telephone/internet, contracts can be nonstandard, small credit risk
forward, future, swap
forward based derivatives
option-based derivatives
call and put
exotics
derivatives that can be crafted for specific needs, usually appear during crisis
long position
one who is buying is said to be in _______
short position
one who is selling is said to be in _______
Forward Contract
Contract that requires the exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate.
hedgers, speculators, arbitrageurs
participants in forward markets
Hedging
Technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing or selling futures contracts on an organized exchange.
Speculation
The act of trading in an asset, or conducting a financial transaction that involves considerable risk of losing up to all of the initial outlay, but offering the chance of substantial gains.
arbitrage
when an investor simultaneously buys something at some price in one market and seek to sell it for a higher price in another market
speculator
wants to profit on trade
hedger
wants to reduce risk
option contract
the right but not the obligation to buy or sell a commodity or security at a predetermined exercise price
swap transaction
forward contract that comes several times. It is the simultaneous buying and selling of a similar underlying asset or obligation of equivalent capital amount where the exchange of financial arrangement with more favorable conditions than they would otherwise expect
forward price for a contract
determined by taking the spot or cash price at the time of the transaction and adding it to a cost of carry
arbitrageurs
traders and market makers who deal in buying and selling futures contracts hoping to profit from price differentials between markets and/or exchanges
basis
the difference between the futures and spot prices at any time
financial futures
usually have a limited range of delivery dates based on a 3 month cycle and are cash settled
commodity futures
often have monthly or seasonal delivery dates and the contracts specify a delivery location
Call Option
buying shares
Put Option
selling shares
holder
buyer of an option. always has the right but not the obligation to exercise the contract
writer
seller of an option. has the obligation to perform the contract if the other party decides to exercise the same
option premium
an amount, which buyer of an option gives to the writer for getting the rights to perform the contract
naked or uncovered options
option writers who own the underlying instruments they are trading are said to issue _______
opening purchase
the buyer of an option becomes the holder
opening sale
the seller becomes the writer of the option
closing purchase
the holder of an option sells an option identical to that held - this removes the liabilities of the writer
closing sale
the writer buys an option identical to that written - this removes the liabilities of the writer
American options
options that give the holder the right but not the obligation to buy or sell the underlying instrument on or before the expiry date. The option can be exercised early
European options
options that give the holder the right but not the obligation to buy or sell the underlying instrument only on the expiry date. option can not be exercised early
expiry date
date and time after which an option may no longer be exercised
strike or exercise price
the fixed agreed price at which the underlying instrument may be bought or sold on exercise of an option
At The Money, ATM
underlying instrument price is equal to or near the strike price
In The Money, ITM
for an option that has a strike price such that if the option were exercised immediately a profit would be made
Out Of The Money, OTM
situation where no profit would be made immediately if option were exercised
premium of option
Intrinsic Value + Time Value
Intrinsic value of an option
the difference between the underlying and the strike price
Time Value
A dollar today is not the same value as a dollar two years from now
interest rate swap
an agreement between counter parties in which each party agrees to make a series of payments to the other on agreed future dates until maturity of the agreement
Currency Swap
Simultaneous purchase and sale of foreign exchange for two different dates.
commodity swap
agreement between counter parties in which at least one set of payments involved is set by the price of a commodity index. Usually a plain vanilla agreement that is purely financial involving no delivery of the physical commodity
equity swap
agreement between counter parties in which at least one party agrees to pay the other a rate of return based on a stock index, according to a schedule of future dates for the maturity pe…
Credit risk
possibility that borrower will not meet the scheduled repayments and default on their loan
Market risk
Reduce market risk through constructing a portfolio that uses multiple asset classes. Defensive stocks also reduce market risk.
Operational risk
failure of process or controls-possibility that something goes wrong and don't have the money to function
strategic risk
risks arising from activities such as entrepreneurial behavior of traders in financial institutions, misreading client requests, costs getting out of control, trading with inappropriate counter parties
moral hazard
the risk that one party to a transaction will engage in behavior that is undesirable from the other party's point of view