THE ROLE OF DERIVATIVES
1 | Explain the differences between over-the-counter and exchange-traded derivatives.
A derivative is a financial contract between two parties whose value is derived from, or dependent on, the value of an underlying asset. The underlying asset can be a financial asset (such as a stock or bond), a currency, a futures contract, an index, or even an interest rate. It can also be a real asset or commodity, such as crude oil, gold, or wheat.
Because of the link between the value of a derivative and its underlying asset, derivatives can act as a substitute for, or as an offset to, a position held in the underlying asset. As such, derivatives are often used to manage the risk of an existing or anticipated position in the underlying asset. They are also used to speculate on the value of the underlying asset.
Types of Derivatives
Some derivatives have more complex structures than others, but they all fall into one of two basic types: options and forwards. Both types are contracts between two parties: a buyer and a seller.
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Options: The buyer in an option contract has the right, but not the obligation, to buy or sell a specified quantity of the underlying asset in the future at a price agreed upon today. The seller of the option is obliged to complete the transaction if called upon to do so. An option that gives its owner the right to buy the underlying asset is a call option; one that gives the right to sell the underlying asset is a put option.
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Forwards: With forward contracts, both parties oblige themselves to trade the underlying asset in the future at a price agreed upon today. Neither party has given the other any right; they are both obliged to participate in the future trade.
Despite this fundamental difference between options and forwards, the two types of derivatives have shared features.
Comparison: Over-the-counter vs. Exchange-traded Derivatives
| Feature |
Over-the-counter (OTC) |
Exchange-traded (ETD) |
| Customization |
Can be highly customized |
Standardized contracts |
| Market |
Decentralized |
Centralized exchanges |
| Counterparty Risk |
Higher, due to lack of centralized clearing |
Lower, due to clearinghouses |
| Examples |
Forward contracts, swaps |
Options, futures contracts |
FAQs about Derivatives
Q1: What are the main purposes of using derivatives?
A1: Derivatives are primarily used for hedging risk and for speculation. They allow parties to manage exposure to various risks and speculate on the future direction of market prices.
Q2: How does the value of a derivative change over time?
A2: The value of a derivative changes with the price movements of its underlying asset. Other factors influencing derivative prices include time to expiration, volatility of the underlying asset, and interest rates.
Key Takeaways
- Derivatives derive their value from an underlying asset.
- They can be used for hedging or speculation purposes.
- There are two primary types of derivatives: options and forwards.
- Over-the-counter derivatives are customized and carry higher counterparty risk, while exchange-traded derivatives are standardized and offer lower counterparty risk.
Glossary
- Call Option: A financial contract that gives the holder the right to buy the underlying asset at a predetermined price within a specified period.
- Put Option: A financial contract that gives the holder the right to sell the underlying asset at a predetermined price within a specified period.
- Forward Contract: A customized contract between two parties to buy or sell an asset at a specified price at a future date.
- Underlying Asset: The financial or real asset upon which a derivative’s price is based.
Chart: Example of Option Payoff (Call and Put)
graph LR
A((Stock Price at Expiration))
A -- Call Holder Gains <!--> B((Profit #40;Call#41;))
A -- Stock Price < Strike Price --> C(((Loss #40;Call#41;)))
A -- Put Holder Gains --> D((Profit #40;Put#41;))
D -. Break-Even .-> E((Break-Even))
C -.-> E
Understanding the role, structure, and purpose of derivatives is crucial for effective risk management and speculation in the financial markets.
📚✨ Quiz Time! ✨📚
## What is the primary function of a derivative in financial markets?
- [ ] To serve as a long-term investment vehicle
- [x] To derive value from and manage risks associated with an underlying asset
- [ ] To act as a standalone financial instrument
- [ ] To only facilitate foreign currency transactions
> **Explanation:** A derivative is a financial contract whose value depends on the value of an underlying asset. Its primary functions include managing risks and speculating on price movements of the underlying asset.
## Which of the following is NOT a common underlying asset for derivatives?
- [ ] Stocks
- [ ] Commodities like gold or oil
- [ ] Interest rates
- [x] Physical property like real estate
> **Explanation:** Common underlying assets for derivatives include financial assets (stocks, bonds), commodities (gold, oil), currencies, interest rates, and indices. Physical properties like real estate are not typical underlying assets for derivatives.
## In an option contract, what right does the buyer have that the seller does not?
- [x] The right, but not the obligation, to execute the trade
- [ ] The obligation to buy
- [ ] The obligation to sell
- [ ] The right to receive ongoing interest payments
> **Explanation:** In an option contract, the buyer has the right, but not the obligation, to buy or sell the underlying asset. The seller, however, is obliged to fulfill the contract conditions if the buyer decides to exercise the option.
## What is a call option?
- [x] An option that gives the right to buy the underlying asset
- [ ] An option that gives the right to sell the underlying asset
- [ ] A forward contract that obligates the purchase of the asset
- [ ] A contract that only applies to commodities
> **Explanation:** A call option gives the owner the right, but not the obligation, to buy the underlying asset at a specified price within a specified period.
## What is a put option?
- [ ] An option that gives the right to buy the underlying asset
- [x] An option that gives the right to sell the underlying asset
- [ ] A forward contract that obligates the sale of the asset
- [ ] A contract involving interest rates only
> **Explanation:** A put option gives the owner the right, but not the obligation, to sell the underlying asset at a specified price within a specified period.
## How do forward contracts differ from options?
- [ ] Both parties have the obligation to complete the trade
- [x] Both parties have the obligation to complete the trade
- [ ] Only the buyer is obliged to execute the trade
- [ ] Neither party is obliged to complete the trade
> **Explanation:** In forward contracts, both parties commit to execute the trade of the underlying asset at a future date and agreed-upon price, unlike options where only the seller is obligated if the buyer chooses to exercise their right.
## What is a key characteristic common to both options and forwards?
- [x] They involve two parties: a buyer and a seller
- [ ] They give the seller the obligatory rights
- [ ] They must be traded on an exchange
- [ ] They only deal with stock assets
> **Explanation:** Both options and forwards involve two parties, a buyer and a seller. They are both forms of contractual agreements in the derivatives market.
## What is the main distinction between over-the-counter (OTC) and exchange-traded derivatives?
- [ ] OTC derivatives are standardized
- [x] OTC derivatives are customized, whereas exchange-traded derivatives are standardized
- [ ] Exchange-traded derivatives are privately negotiated
- [ ] OTC transactions must occur on an exchange
> **Explanation:** OTC derivatives are customized contracts negotiated directly between parties, while exchange-traded derivatives are standardized contracts traded on formal exchanges.
## Why are derivatives used in financial markets?
- [ ] To increase the inherent value of the underlying asset
- [ ] To eliminate market volatility
- [x] To hedge against risk and speculate on price movements
- [ ] To provide fixed income streams
> **Explanation:** Derivatives are used primarily to hedge against the risk of price movements in the underlying asset and to speculate on market price changes.
## In the context of a derivative, which of the following best describes a 'real asset'?
- [x] Commodities like crude oil, gold, or wheat
- [ ] Company stocks
- [ ] Exchange rates
- [ ] Bonds or fixed income securities
> **Explanation:** A 'real asset' in the context of derivatives typically refers to tangible assets like commodities (crude oil, gold, wheat) as opposed to financial assets or securities.
In this section
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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.