Derivative markets and instruments
The Nature of Derivatives
A derivative is an instrument whose value depends (is derived) on the values of other more basic underlying variables (usually a stock, bond or commodity price). Derivatives are created and traded on two distinct types of markets: derivatives exchanges (organized trading facilities) over-the-counter markets (OTC)
The OTC markets
The
over-the counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers
Comparison Between exchange traded and OTC traded derivatives
Exchange traded standardized instruments trade in accordance with rules and regulations of the exchange and are usually subject to governmental regulation guaranteed by the exchange against loss resulting from the default of one of the parties OTC traded created by any two parties off of an exchange the parties set their own terms and conditions each party assumes the credit risk of the other party
Classification of Derivatives
Derivatives
Forward commitments
Contingent claims (Options)
Futures contracts (Exchange-traded)
Forward contracts (OTC traded)
Swaps (OTC traded)
Exchange-traded
OTC traded
Main Derivatives Exchanges
Chicago Board of Trade (CBT or CBOT) first derivative market (1848) Chicago Mercantile Exchange (CME) -1874- biggest US derivatives exchange Chicago Board Options Exchange (CBOE) the biggest options exchange LIFFE (London) Eurex (Europe) the biggest in the world; is a combined GermanSuisse Exchange BM&F (Sao Paulo, Brazil) Bolsa de Mercadorias& Futuros de Brazil NYMEX TIFFE (Tokyo) Paris Bourse Korea Stock Exchange .................................. SIBEX (Romania) - BMFMS
The size of derivative markets
Measured
by two indicators: Market value = the economic worth of the derivative Notional Principal = the amount of the underlying on which the derivative is based
Purposes of derivative markets
provide
price discovery facilitate risk management make markets more efficient lower transaction costs Critics to derivatives: excessively dangerous for unknowledgeable investors linked to gambling.
Terminology
BULL
MARKET
A bull market is a market in which prices are rising. When someone is referred to as being bullish, that person has an optimistic outlook that prices will be rising.
Terminology (Cont.)
BEAR
MARKET
A bear market is one in which prices are falling. Therefore, a bearish view is pessimistic, and that person would believe that prices are heading downward
Terminology (Cont.)
SPOT
MARKET =A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective. =The spot market is also called the "cash market" or "physical market", because prices are settled in cash on the spot at current market prices, as opposed to forward prices.
Terminology (Cont.)
GOING LONG
The 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 contracts at a higher price than they originally paid for them.
Long position investment philosophy :
BUY LOW, SELL HIGH
Terminology (Cont.)
GOING
SHORT
The 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 valuable sometime in the future.
Short position philosophy : SELL HIGH, BUY LOW
Derivatives Basic notions
Derivatives
are investments that derive their value from 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 price
Arrangements
Futures contractobligates the buyer to purchase a specified quantity of the underlying security on a given date at a specified price
Actively
between private parties Not actively traded in any market
traded on futures exchanges until delivery date Can earn gains/losses from simply trading the contract itself, without every taking delivery of underlying goods
Derivatives Basic 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 predetermined exercise price on a specified date If option is exercised, option writer must follow through Many options expire unexercised Options actively traded at options exchanges and OTC markets
