Overview
All derivatives have certain features in common. These features help define their function and usage in the financial markets. Understanding these fundamentals is crucial for those who engage in derivative trading or study them for certifications like the Canadian Securities Course.
Key Features of Derivatives
Contractual Agreements
All derivatives are contractual agreements between two parties (often called counterparties): a buyer and a seller. The agreements detail the rights (if any) and obligations of each party.
Pricing Agreement
Derivatives involve a price upon which both the buyer and the seller must agree. Buyers aim to purchase derivatives at the lowest possible price, while sellers seek to sell them at the highest possible price.
Expiration Date
Each derivative contract has an expiration date. By or on this date, both parties must fulfill their obligations or exercise their rights under the contract. Once the date passes, the contract is automatically terminated.
When creating a derivative contract, a specific price or formula for determining the future price of an asset is included. This applies to actions to be taken on or before the expiration date.
Types of Derivatives and Their Specific Features
Forwards
- No Up-Front Payment: Typically, forwards require no initial payment. However, occasionally one or both parties may put up a performance bond or good faith deposit to ensure the contract is honored.
Options
- Premium Payment: In options, the buyer makes a payment to the seller when the contract is initiated. This payment, known as a premium, grants the buyer the right to buy or sell the underlying asset at a preset price on or before the expiration date.
Zero-Sum Nature of Derivatives
Unlike other financial assets such as stocks and bonds, derivatives are often considered a zero-sum game. For every gain experienced by one party, the other party experiences an equivalent loss, disregarding any commission fees and transaction costs. Essentially, the financial outcome (gain or loss) is exchanged between the counterparties pari passu.
Frequently Asked Questions (FAQs)
What are derivatives?
Derivatives are financial contracts whose value is derived from an underlying asset, index, or rate. Common examples include options, futures, forwards, and swaps.
Why are derivatives considered a zero-sum game?
They are considered a zero-sum game because any profit one counterparty makes is matched by an equivalent loss to the opposite counterparty, excluding transaction fees.
Are there risks involved in trading derivatives?
Yes, trading derivatives involves significant risk, potentially including the loss of your entire investment. Both parties need to have a thorough understanding of the contracts and the market values of the underlying assets.
Key Takeaways
- Contractual Boundaries: Clear understanding of contractual rights and obligations is crucial.
- Price Agreement: The price needs alignment between buyers and sellers.
- Expiration Date: Adherence to the timeline for fulfilling obligations is key.
- Zero-Sum Mechanism: Be conscious of gain equating to the counterparty’s loss.
Glossary
- Counterparties: The two parties involved in a derivative contract.
- Premium: Initial payment made in an options transaction.
- Expiration Date: The date on which a derivative contract must be settled.
- Performance Bond: A deposit to ensure contract performance.
- Zero-Sum Game: A situation where one party’s gain is exactly balanced by the other party’s loss.
📚✨ Quiz Time! ✨📚
## What is a common characteristic of all derivative contracts?
- [ ] They are agreements involving only one party.
- [x] They are contractual agreements between two parties.
- [ ] They do not have a price.
- [ ] They lack an expiration date.
> **Explanation:** All derivatives involve contractual agreements between two parties (often called counterparties): a buyer and a seller. The agreements outline the rights and obligations of each party.
## How is the price of a derivative determined?
- [ ] By a regulatory authority
- [ ] Arbitrarily by the government
- [ ] It is fixed by the central bank
- [x] It is agreed upon by the buyer and the seller
> **Explanation:** The price of a derivative is agreed upon by the buyer and the seller. Buyers aim to purchase at the lowest possible price, while sellers aim to sell at the highest possible price.
## What happens to a derivative contract after its expiration date?
- [ ] It remains valid indefinitely.
- [ ] It can be renewed automatically.
- [ ] It can be renegotiated.
- [x] It is automatically terminated.
> **Explanation:** After the expiration date, a derivative contract is automatically terminated. Both parties must fulfill their obligations or exercise their rights before this date.
## Which type of derivative does not require an up-front payment?
- [x] Forward contracts
- [ ] Options
- [ ] Futures
- [ ] Swaps
> **Explanation:** With forward contracts, no up-front payment is required. However, sometimes a performance bond or good faith deposit may be made to ensure the terms are honored.
## What is the initial payment made by the buyer in an options contract called?
- [ ] Deposit
- [ ] Performance bond
- [x] Premium
- [ ] Margin
> **Explanation:** In an options contract, the buyer makes an initial payment to the seller known as a premium. This payment grants the buyer the right to buy or sell the underlying asset at a preset price.
## What is a unique characteristic of derivatives compared to financial assets like stocks and bonds?
- [ ] They always make a profit.
- [x] They are considered a zero-sum game.
- [ ] They represent ownership in a company.
- [ ] They pay dividends regularly.
> **Explanation:** Derivatives are considered a zero-sum game. Aside from transaction costs, the gain from a derivative contract by one party is exactly offset by the loss to the other party.
## What kind of deposit can be made with forward contracts to assure performance?
- [ ] Premium deposit
- [ ] Trading margin
- [x] Performance bond or good faith deposit
- [ ] Security interest
> **Explanation:** Sometimes one or both parties in a forward contract may make a performance bond or good faith deposit to provide assurance that the terms will be honored.
## When must the obligations of a derivative contract be fulfilled?
- [ ] After the expiration date.
- [ ] At any time regardless of the expiration date.
- [ ] Throughout the contract term.
- [x] On or before the expiration date.
> **Explanation:** The obligations or rights under a derivative contract must be fulfilled on or before the expiration date. After this date, the contract is terminated.
## In the context of an options contract, what right does the buyer obtain?
- [x] The right to buy or sell the underlying asset at a preset price.
- [ ] The obligation to execute the contract.
- [ ] The right to modify the contract terms.
- [ ] The right to receive dividends.
> **Explanation:** The buyer in an options contract gains the right to buy or sell the underlying asset at a preset price on or before the expiration date.
## What aspect of derivatives leads them to be classified as a zero-sum game?
- [ ] The underlying assets appreciate over time.
- [ ] They generate interest income.
- [x] The gain by one party is exactly offset by the loss to the other party.
- [ ] They provide social benefits.
> **Explanation:** Derivatives are a zero-sum game because the gain from the contract by one counterparty is precisely offset by the loss to the other counterparty, excluding transaction costs.