2015 Study Session # 17, Reading # 57

DERIVATIVE MARKETS AND INSTRUMENTS

ETD = Exchange Traded Derivatives

2. DERIVATIVES: DEFINITIONS AND USES

Derivative a derivative is a financial instrument that derives its

value from the performance of an underlying asset.
Derivatives are similar to insurance both transfer risk from one
party to another.
Long position the purchaser of the derivative.
Short position the seller of the derivative.
Classes of derivative:
Forward commitments these instruments force the two
parties to transact in the future at a previously agreed-on price.
Contingent claims provide the right but not obligation to buy
or sell the underlying at a predetermined price.
Derivatives serves the following purposes:
Improve the performance of the markets of underlying
Used to create strategies.
Trade at lower transaction costs than spot market transaction.

3. THE STRUCTURE OF DERIVATIVE MARKETS

3.1 Exchange-Traded Derivatives Markets

ETD are standardized contracts whose terms & conditions are

precisely specified by the exchange.
Clearing process by which the exchange verifies the execution of a
transaction & record the participants identities.
Settlement process in which exchange transfer money from one
participant to another.
Margin bond credit guarantee by clearing house by requiring a cash
deposit.

3.2 Over-the-Counter Derivatives Markets

OTC derivative markets an informal network of market participants

that are willing to create & trade virtually any type of legal derivative.
OTC dealers typically hedge their risk by engaging in alternative
transaction.

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2015 Study Session # 17, Reading # 57

4. TYPES OF DERIVATIVES
4.1 Forward Commitments
4.1.1 Forward Contracts

Forward contract an over-the-counter contract in which two parties

agree that the buyer will purchase an underlying asset from the seller
at a later date & at a fixed price they agree on.
No money changes hand when contract is initiated.
Cash-settled forwards forward settled by exchange of cash but not
through delivery.

4.1.2 Futures

Futures contract a standardized derivative contract created &

traded on a futures exchange.
Settlement price average price of the final future trades of the day.
Initial margin a required minimum sum of money to support the
trade.
Maintenance margin amount of money that each participant must
maintain in the account after the trade is initiated.
Margin call a request to deposit additional funds.
Price limits a provision limiting price changes.
Limits up (down) upper (lower) price limit of a trade.
Locked limit occurred when the market reaches these limits &
trading stops.
The futures price converges to the spot price at expiration.

4.1.3 Swaps

Swap an over the counter derivative contract in which two parties

exchange a series of cash flows.
Types of swaps:
Fixed for fixed (both parties pay fixed rate).
Fixed for floating.
Floating for floating.
Floating for fixed.

4.2 Contingent Claims

4.2.1 Options

Option a derivative contract in which buyer, pays a sum of money to the seller & receive the
right to either buy or sell an underlying asset at a fixed price.
Call option provides the right to buy.
Put option provides the right to sell.
American-style option can be exercised before maturity.
European-style can be exercised only at maturity.
Exercise price fixed price at which underlying asset can be purchased.
Option premium sum of money paid by the option buyer.
In-the-money option when option value is positive for buyer & S > X where S = price at
maturity X = exercised price.
Out- of money = S < X
At the money = S = X

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2015 Study Session # 17, Reading # 57

4.2.2 Credit Derivatives

Credit derivative a class of derivative contracts b/w two parties, a

credit protection buyer & a credit protection seller, in which the latter
provides protection to the former against a specific credit loss.
Total return swap in which credit protection buyer offers to credit
protection seller the total return on the underlying bond.
Credit spread option a call option in which the underlying is the
credit spread (difference b/w yield of risky v/s yield of risk free bond).
Credit default swap (CDS) a derivative contract in which the
protection buyer makes a series of cash payments to the seller &
receives a promise of compensation for credit losses in case of default
of 3rd party.

4.2.3 Asset-Backed Securities

ABS a derivative contract in which a portfolio of debt instruments is

assembled & claims are issued on the portfolio in the form of tranches.
Credit risk is highest for junior tranches & lowest for senior tranches.

4.3 Hybrids

Derivatives can be combined with other derivative or underlying assets

to form hybrids. (e.g. options on futures).

4.4 Derivatives underlying

4.4.1 Equities usually individual stocks & stock indices.

4.4.2 Fixed-income instruments and interest rates derivative on
bonds are widely used.
4.4.3 Currencies currency risk is a major factor in global financial
markets & currency derivative market is large.
4.4.4 Commodities widely used to speculate in & manage risk
associated with commodity price.
4.4.5 Credit derivatives.
4.4.6 Other.

5. THE PURPOSES AND BENEFITS OF DERIVATIVES

5.1 Risk allocation, transfer, and management derivatives allow

trading the risk without trading the instruments itself.
5.2 Information discovery price discovery as futures price is
sometimes thought of as predictive.
5.3 Operational advantages derivatives have lower transaction costs
than the underlying.
Greater liquidity than underlying.
5.4 Market efficiency derivative markets offer less costly ways to
exploit the mispricing.
Investors can easily manage their risks with low cost.

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2015 Study Session # 17, Reading # 57

6. CRITICISMS AND MISUSES OF DERIVATIVES

6.1 Speculation and gambling speculators are thought to engage in

price manipulation & to trade at extreme prices.
Gambling typically benefits only a limited number of
participants.
6.2 Destabilization and systemic risk the very benefit of derivatives
results in an excessive amount of speculative trading that brings
instability to market.
Another criticism of derivatives is simply their complexity.

7. ELEMENTARY PRINCIPLES OF DERIVATIVE PRICING

7.1 storage agricultural commodities are the oldest from of

derivatives.
Commodity storage cost can be quite expensive.
7.2 arbitrage condition that two equivalent assets sell for different
prices, leading to an opportunity to buy at low price & sell at the high
price thereby earning RF without investing capital.
Law of one price arbitrage leads to this law as the combined
actions of arbitrageurs bring about a convergence of prices.

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