079_Derivative Markets and Instruments

8/13/2019 079_Derivative Markets and Instruments

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Derivative markets and

instruments


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The Nature of Derivatives

A derivative is an instrument whose value depends(is derived) on the values of other more basicunderlying variables (usually a stock, bond orcommodity price).

Derivatives are created and traded on two distincttypes of markets:

derivatives exchanges (organized tradingfacilities)over-the-counter markets (OTC)


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The OTC markets

The over-the counter market is animportant alternative to exchanges

It is a telephone and computer-linkednetwork of dealers who do not physicallymeet

Trades are usually between financialinstitutions, corporate treasurers, and fundmanagers


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Comparison Between exchangetraded and OTC traded derivatives

Exchange traded

standardized instruments

trade in accordance withrules and regulations of theexchange and are usually

subject to governmentalregulation

guaranteed by the exchangeagainst loss resulting fromthe default of one of the

parties

OTC traded

created by any two partiesoff of an exchange

the parties set their ownterms and conditions

each party assumes thecredit risk of the other party


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Classification of Derivatives

Derivatives

Forward commitments Contingent claims (Options)

Futures contracts(Exchange-traded)

Forward contracts(OTC traded)

Swaps(OTC traded)

Exchange-traded OTC traded


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The size of derivative markets

Measured by two indicators:

Market value= the economic worth of thederivative

Notional Principal= the amount of theunderlying on which the derivative is based


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Purposes of derivative markets

provide price discovery

facilitate risk management

make markets more efficient

lower transaction costs

Critics to derivatives:

excessively dangerous for unknowledgeableinvestors

linked to gambling.


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Terminology

BULL MARKETA bull market is a market in which prices are rising. When

someone is referred to as being bullish, that person hasan optimistic outlook that prices will be rising.


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Terminology (Cont.)

BEAR MARKET

A bear market is one in which prices are falling. Therefore, abearish view is pessimistic, and that person would believe

that prices are heading downward


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Terminology (Cont.)

SPOT MARKET

=A commodities or securities market in which goodsare sold for cash and delivered immediately.

Contracts bought and sold on these markets areimmediately effective.

=The spot market is also called the "cash market" or

"physical market", because prices are settled incash on the spot at current market prices, asopposed to forward prices.


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Terminology (Cont.)

GOING LONGThe party who owns an asset has what is termed a long

position.

Someone who is long in the market expects prices to rise.They expect to make money by later selling the contractsat a higher price than they originally paid for them.

Long position investment philosophy :

BUY LOW, SELL HIGH


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Terminology (Cont.)

GOING SHORTThe party who owes an asset has what is termed a short

position

The short seller believes that prices are heading downward,so he sells contracts that he thinks will be less valuablesometime in the future.

Short position philosophy :

SELL HIGH, BUY LOW


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DerivativesBasic notions

Derivatives are investments that derive their valuefrom some underlying quantity (usually a stock,bond or commodity price) Forward contractobligates the buyer to purchase the

underlying security on a given date for a specified priceArrangements between private partiesNot actively traded in any market

Futures contractobligates the buyer to purchase aspecified quantity of the underlying security on a given

date at a specified priceActively traded on futures exchanges until delivery dateCan earn gains/losses from simply trading the contract itself,

without every taking delivery of underlying goods


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DerivativesBasic notions (cont.)

Optionagreement between an option writer(who sells the option) and buyer

Option buyer has right (but not obligation) to buy

(call) or sell (put) underlying security at the pre-determined exercise price on a specified date

If option is exercised, option writer must followthrough

Many options expire unexercisedOptions actively traded at options exchanges and

OTC markets

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079_Derivative Markets and Instruments