Chapter Overview
In this chapter, you will delve into derivatives—complex financial instruments used for various financial strategies. You will explore what derivatives are, understand their underlying assets, and identify who utilizes them. This chapter covers the different categories of derivatives, including options, forwards, and futures contracts. You will also gain insight into rights and warrants, which allow investors to capitalize on the underlying stock linked to derivatives.
Learning Objectives
By the end of this chapter, you will be able to:
- Explain the differences between over-the-counter and exchange-traded derivatives.
- Identify the types of underlying assets on which derivatives are based.
- Describe how various market participants use derivatives.
- Explain call and put options and recognize option strategies used by market participants.
- Distinguish between forwards and futures contracts, as well as the strategies used by market participants.
- Differentiate between the features, benefits, and intrinsic value of rights and warrants.
Content Areas
The Role of Derivatives
- What derivatives are and their purpose in the financial markets
- The distinction between over-the-counter and exchange-traded derivatives
Types of Underlying Assets
- Different financial and physical assets that underlie derivatives such as stocks, bonds, commodities, and currencies
The Users of Derivatives
- Market participants including hedgers, speculators, arbitrageurs, and their roles in the derivative markets
Options
- Call and put options
- Option strategies such as straddles, strangles, and spreads
Forwards and Futures
- Explanation and differentiation between forward contracts and futures contracts
- Examples of how these instruments are used in hedging and speculative strategies
Rights and Warrants
- Definition and instruments’ features, benefits, and valuation
- Intrinsic and time value analysis of these securities
Spotlight on Key Terms and Definitions
Key terms you need to understand are defined in the glossary and appear in bold text throughout the chapter. Here are some crucial terms:
- American-style option: An option that can be exercised at any time before expiration.
- Arbitrage: The practice of taking advantage of a price difference between two or more markets.
- At-the-money: An option whose strike price is equal to the current market price of the underlying asset.
- Call option: A financial contract that gives the buyer the right, but not the obligation, to buy an asset at a specified price within a specified time.
- Covered call: A strategy involving holding the underlying asset and selling call options on that same asset.
- Derivative: A financial security whose value is dependent upon or derived from, an underlying asset or group of assets.
- European-style option: An option that can be exercised only at expiration.
- Exercise price: The price at which the underlying asset of an option can be bought or sold when the option is exercised.
- Forward contract: A customized contractual agreement to buy or sell an asset at a specified price on a future date.
- Futures contract: A standardized contractual agreement to buy or sell an asset at a specified price on a future date.
- Hedging: An investment strategy used to offset potential losses in one asset by making another investment.
- Intrinsic value: The difference between the underlying asset’s price and the option’s strike price, if it is in-the-money.
- Naked call: Selling a call option without owning the underlying asset or having the necessary position to cover the call.
- Option: A financial contract providing the buyer the right, but not the obligation, to buy or sell an asset at a set price on or before a given date.
- Option premium: The price that the buyer of the option pays to the seller for the rights conveyed by the option.
- Put option: A financial contract that gives the holder the right, but not the obligation, to sell an asset at a specified price within a specified time.
- Strike price: Another term for the exercise price, the specified price at which the underlying asset may be bought or sold.
- Underlying asset: The financial asset upon which a derivative’s price is based.
- Warrants: Long-term options issued by a company that give the holder the right, but not the obligation, to buy the company’s shares at a specified price before expiration.
Frequently Asked Questions (FAQs)
Q: What is the fundamental difference between a forward and a futures contract?
A: The primary difference lies in standardization and trading venue. Forwards are customized agreements traded over-the-counter, whereas futures are standardized contracts traded on an exchange.
Q: Who are the main participants in derivative markets?
A: The main participants include hedgers, who use derivatives to manage risk; speculators, who aim to profit from price changes; and arbitrageurs, who exploit price discrepancies.
Q: Why might an investor choose a call option?
A: An investor might choose a call option to gain leverage on the upward movement of the underlying asset’s price with limited risk.
Key Takeaways
- Derivatives play a pivotal role in the financial markets by providing tools for risk management and speculative opportunities.
- Options, forwards, and futures are the primary categories of derivatives, each with distinct features and user strategies.
- Understanding the underlying assets and market participants is critical to mastering derivative instruments.
- Rights and warrants offer additional ways for investors to benefit from movement in underlying stocks.
flowchart TB
subgraph TYPES_ORG1 ["Types and Users of Derivatives"]
DERIVATIVES
DERIVATIVES -->|Types of underlying assets| UNDERLYING_ASSETS
DERIVATIVES -->|Used by| USERS
UNDERLYING_ASSETS & USERS --> DERIV_RELATED
end
OPTIONS & OPTIONS -- strategies --> MARKET_PARTICIPANTS
FORWARDS -- features --> STRATEGIES
FUTURES -- strategies --> MARKET_PARTICIPANTS
WARRANTS & RIGHTS --> FEATURES
UNDERLYING_ASSETS -.Accessibility.-> MARKET_PARTICIPANTS
DERIVATIVES -.complements.-> WARRANTS & RIGHTS
UNDERLYING_ASSETS -.value.-> INTRINSIC_VALUES & TIME_VALUES
MARKET_PARTICIPANTS --> STRATEGIES
Be prepared to explore each of these topics in greater depth, using the glossary terms to build your vocabulary and comprehension.
Stay tuned for subsequent sections as we analyze how these derivatives and strategies apply in real-world scenarios.
📚✨ Quiz Time! ✨📚
## What is a derivative?
- [ ] A type of equity security
- [ ] A fixed-income instrument
- [x] A financial contract whose value is based on an underlying asset
- [ ] A form of currency
> **Explanation:** A derivative is a financial instrument whose value is derived from the value of an underlying asset, which can be stocks, bonds, commodities, or other financial instruments.
## Which of the following is an example of an exchange-traded derivative?
- [ ] Forward contract
- [x] Futures contract
- [ ] Swap agreement
- [ ] Private placement
> **Explanation:** Futures contracts are standardized and traded on exchanges, while forward contracts are typically traded over-the-counter.
## What is the primary function of hedging in the context of derivatives?
- [ ] Speculation to realize monetary gains
- [x] Reducing or managing risk
- [ ] Increasing market volatility
- [ ] Maximizing trading profits
> **Explanation:** Hedging involves taking positions in derivatives to offset potential losses in an underlying asset, thereby reducing risk.
## Which term describes an option that has no intrinsic value?
- [ ] At-the-money
- [ ] In-the-money
- [x] Out-of-the-money
- [ ] Covered
> **Explanation:** An option is "out-of-the-money" if it would not yield any profit to the holder if it were exercised, meaning the current market price of the underlying asset is less favorable than the strike price.
## What distinguishes a call option from a put option?
- [ ] A call option grants the right to sell, while a put option grants the right to buy
- [ ] A call option is a type of forward contract, while a put option is not
- [x] A call option grants the right to buy, while a put option grants the right to sell
- [ ] There is no difference between a call option and a put option
> **Explanation:** A call option allows the holder to buy the underlying asset at a specified price, while a put option allows the holder to sell the underlying asset at a specified price.
## What is a performance bond in the context of derivatives trading?
- [ ] A measure of profitability from trading derivatives
- [x] A good faith deposit or margin required to enter into and maintain a derivatives contract
- [ ] A type of government bond linked to derivatives
- [ ] The expiration date of a financial future
> **Explanation:** A performance bond, also known as margin, is the deposit required to ensure that parties meet their financial obligations in a derivatives contract.
## What is the defining feature of a European-style option?
- [x] It can only be exercised at expiration
- [ ] It can be exercised at any time before expiration
- [ ] It has a higher premium than other types of options
- [ ] It is only traded in European markets
> **Explanation:** A European-style option can only be exercised exactly at its expiration date, unlike American-style options which can be exercised at any time before expiration.
## Which of the following contracts is not standardized and typically traded over-the-counter?
- [x] Forward contract
- [ ] Futures contract
- [ ] Exchange-traded option
- [ ] Stock
> **Explanation:** Forward contracts are customized agreements between two parties and are traded over-the-counter (OTC), unlike futures contracts which are standardized and traded on exchanges.
## What is the purpose of the Canadian Derivatives Clearing Corporation (CDCC)?
- [ ] Speculating on market movements
- [x] Clearing and settling derivatives trades
- [ ] Offering brokerage services
- [ ] Issuing corporate bonds
> **Explanation:** The Canadian Derivatives Clearing Corporation (CDCC) is responsible for clearing and settling derivatives trades to ensure the integrity and reliability of the derivatives market.
## How is the intrinsic value of an option determined?
- [ ] By the time left until expiration
- [ ] By the trading volume
- [ ] By the volatility of the underlying asset
- [x] By the difference between the underlying asset's price and the option's strike price
> **Explanation:** The intrinsic value of an option is calculated based on how far “in-the-money” the option is, which is the difference between the underlying asset's current market price and the option’s strike price.
In this section
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10.1 Introduction
Explore the phenomenal growth and intricacies of various derivative instruments. Learn about the impact of market volatility, financial deregulation, and advances in technology on derivatives. Understand the role of derivatives in portfolios for institutional and retail investors.
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10.2 Role Of Derivatives
Understand the significant role derivatives play in financial markets, their classification, uses, and the differences between over-the-counter and exchange-traded derivatives.
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10.2.1 Features Common To All Derivatives
Explore the fundamental features common to all derivatives, including contractual agreements, pricing, expiration dates, and the zero-sum nature. Understand the essentials of forwards and options in derivative trading.
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10.2.2 Derivative Markets
Learn key concepts about derivative markets including their structure, types, features, and differences between the over-the-counter (OTC) market and exchange-traded derivatives.
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10.2.3 Exchange-traded Versus Over-the-counter Derivatives
Understand the key differences between exchange-traded and over-the-counter (OTC) derivatives markets, including standardization, liquidity, privacy, and default risk.
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10.3 Types Of Underlying Assets
Comprehensive guide on the various types of underlying assets in derivative contracts. Learn about commodities, financial assets, and the over-the-counter (OTC) markets.
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10.3.1 Commodities
An in-depth guide on commodities, their types, use in futures and options, and the factors influencing their prices. Learn more about the different categories, key terminologies, and their significance in financial markets.
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10.3.2 Financial Assets
A comprehensive guide on the explosive growth of financial derivatives, driven by factors like volatile interest rates, financial deregulation, globalization, and advances in information technology. This section delves into the most commonly used financial assets, such as equities, interest rates, and currencies.
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10.4 Users Of Derivatives
Learn about the various market participants who use derivatives, their roles, and how they utilize these financial instruments for speculation and risk management.
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10.4.1 Individual Investors
Comprehensive guide on individual investors and their involvement with exchange-traded derivatives
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10.4.2 Institutional Investors
Detailed guide on institutional investors and their use of derivatives including strategies like hedging, market entry and exit, arbitrage, and yield enhancement.
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10.4.3 Corporations And Businesses
Explore how corporations and businesses utilize derivatives for hedging risks related to interest rates, currencies, and commodities.
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10.4.4 Derivative Dealers
Learn about the role of derivative dealers in both exchange-traded and OTC markets in Canada, including the functions they serve and the key types of institutions involved.
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10.5 Options
A comprehensive guide to understanding call and put options, their positions and strategies, and how market participants utilize options.
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10.5.1 Options Terminology
Gain a thorough understanding of essential options terminology including strike price, option premium, expiration date, trading unit, and other key concepts.
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10.5.2 Option Exchanges
A detailed guide on option exchanges in Canada, including explanations of key terms, examples, and the structure of equity option quotes.
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10.5.3 Option Strategies For Individual And Institutional Investors
Understand the various option strategies used by individual and institutional investors, including detailed examples and calculations for trading call and put options on XYZ Inc. Learn speculative and risk management approaches, and the potential outcomes of different trading strategies.
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10.5.4 Option Strategies For Corporations
Learn about different option strategies that corporations employ to manage risk related to interest rates, exchange rates, and commodity prices.
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10.6 Forwards And Futures
Comprehensive guide distinguishing between forwards and futures contracts, used strategies, and categorization of underlying assets for investors preparing for the Canadian Securities Course certification exam.
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10.6.1 Key Terms And Definitions
Comprehensive guide on key terms and definitions in futures contracts, including concepts of margin requirements, marking to market, and cash-settled futures within the context of the Canadian Securities Course.
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10.6.2 Futures Trading And Leverage
Comprehensive guide on Futures Trading and Leverage including margin requirements, leverage effects, and safety considerations in futures trading.
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10.6.3 Futures Exchange
This chapter provides a detailed overview of the Montréal Exchange, including the listing of index futures, Government of Canada bonds, bankers’ acceptances, and the 30-day overnight repo rate.
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10.6.4 Futures Strategies For Investors
Explore key futures strategies for investors including speculative strategies and risk management techniques. Understand the benefits and risks associated with buying and selling futures.
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10.6.5 Futures Strategies For Corporations
Understand how corporations utilize futures to manage risks, gain insights on practical examples, and discern differences and similarities between forward and futures contracts.
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10.7 Rights And Warrants
Learn about rights and warrants and how they are used to raise capital in the Canadian securities market. Understand their features, benefits, and intrinsic value.
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10.7.1 Rights
A comprehensive guide on rights offers, intrinsic value of rights during ex-rights and cum-rights periods, and how rights are traded on stock exchanges.
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10.7.2 Warrants
Learn everything about warrants in this comprehensive guide: their characteristics, valuation, and advantages, along with essential definitions and key takeaways.
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10.8 Summary
A comprehensive summary of key aspects of derivatives discussed in this chapter including types of derivative contracts, participants, and their uses.