Overview
In this chapter, we discussed the following key aspects of derivatives:
Definition of Derivatives
A derivative is a financial contract between a buyer and a seller. Its value is derived from the value of an underlying asset, which can be:
- Commodities
- Financial Assets
- Indices
- Currencies
- Interest Rates
OTC (over-the-counter) derivatives are customizable, whereas exchange-traded derivatives are standardized contracts.
Types of Derivative Contracts
Option Contract:
- Grants the buyer the right to buy (call option) or sell (put option) the underlying asset by a certain date.
- Imposes an obligation on the seller to complete the transaction if called upon to do so.
Forward Contract:
- Imposes a trading obligation on both the buyer and the seller at a price agreed upon when they enter into the contract.
Futures Contract:
- A type of exchange-traded forward contract that is standardized and regulated.
- Investors buy futures either to profit from an increase in the price of the underlying asset or to lock in the purchase price. They sell futures to profit from an expected decline in price or to lock in the sale price.
Participants in Derivative Markets
The four types of participants in the derivatives market include:
- Individual Investors
- Institutional Investors
- Businesses and Corporations
- Derivative Dealers
- Investors, institutions, and businesses use derivatives to speculate or hedge risk.
- Dealers buy and sell derivatives to meet the demands of the end-users.
Types of Options
- Call Option: Gives its owner the right to buy the underlying asset. Used by investors to lock in a price for a future purchase or to speculate on a future rise in price.
- Put Option: Gives its owner the right to sell the underlying asset. Used by investors to lock in a sale price or profit from a future decline in price.
Rights and Warrants
- Right: A free privilege granted to shareholders by an issuing company to acquire additional shares in proportion to the number of shares already owned.
- Warrant: A security giving its holder the right to buy shares in a company from the issuer at a set price until expiration.
Pros and Cons
Advantages:
- Hedging against price fluctuations
- Increased leverage
- Potential for high returns with small investments
Disadvantages:
- Complexity and risk of significant losses
- Requires deep understanding and active management
Frequently Asked Questions (FAQs)
Q: What is the main difference between an option and a forward contract?
A: The main difference is in the obligation: a forward contract imposes a trading obligation on both the buyer and the seller, while an option contract grants the buyer the right to buy or sell but does not oblige them without a call.
Q: How do derivative dealers make money?
A: Derivative dealers profit by buying and selling derivatives to meet the demands of the end-users. They capitalize on the spread between buying and selling prices, fees, and commissions.
Q: Why do businesses use derivatives?
A: Businesses use derivatives primarily for hedging purposes to mitigate risk associated with price volatility of commodities, currencies, interest rates, etc.
Key Takeaways
- Derivatives are contracts whose value is derived from an underlying asset.
- They can be customized (OTC) or standardized (exchange-traded).
- Key participants include individual investors, institutional investors, businesses, and derivative dealers.
- Types of derivatives discussed include options, forward contracts, and futures.
- Rights allow shareholders to acquire additional shares for free, while warrants allow purchasing shares at a set price until expiration.
📚✨ Quiz Time! ✨📚
## What is a derivative in financial terms?
- [ ] A direct investment in stocks or bonds
- [ ] A physical commodity like gold or oil
- [x] A financial contract whose value is derived from an underlying asset
- [ ] A government bond
> **Explanation:** A derivative is a financial contract between a buyer and a seller, where its value is derived from the value of an underlying asset, which can vary from commodities to financial assets, indices, currencies, or interest rates.
## Which of the following accurately describes an option contract?
- [ ] It imposes trading obligations on both buyer and seller
- [x] It grants the buyer the right but not the obligation to buy or sell an underlying asset
- [ ] It cannot be customized
- [ ] It is always traded over-the-counter
> **Explanation:** An option contract grants the buyer the right to buy or sell the underlying asset by a certain date, and the seller must complete the transaction if called upon. This contrasts with a forward contract, which imposes obligations on both parties.
## Who are the four types of participants in the derivatives market?
- [ ] Individual traders, institutional traders, hedge funds, and market makers
- [ ] Retail investors, arbitrageurs, speculators, and regulators
- [x] Individual investors, institutional investors, businesses and corporations, and derivative dealers
- [ ] Investment bankers, retail investors, stockbrokers, and regulators
> **Explanation:** The four key participants in derivatives markets include individual investors, institutional investors, businesses and corporations, and derivative dealers. Each group uses derivatives for speculation or to hedge risk.
## What is a call option?
- [x] An option granting the right to buy the underlying asset
- [ ] An option granting the right to sell the underlying asset
- [ ] A futures contract to buy the underlying asset
- [ ] A forward contract to sell the underlying asset
> **Explanation:** A call option gives its owner the right to buy the underlying asset at a set price before the expiry date, often used to lock in future purchase prices or to speculate on price increases.
## What is the primary difference between exchange-traded and OTC derivatives?
- [ ] Exchange-traded derivatives are private contracts
- [ ] OTC derivatives are standardized
- [x] Exchange-traded derivatives are standardized contracts while OTC derivatives are customizable
- [ ] OTC derivatives have no market regulation
> **Explanation:** Exchange-traded derivatives are standardized in terms of contract size, expiration dates, and other key features, making them more regulated and less customizable than OTC derivatives which are tailored to specific needs.
## What is a futures contract?
- [x] An exchange-traded forward contract
- [ ] A type of currency swap
- [ ] A government bond
- [ ] A hedge fund strategy
> **Explanation:** A futures contract is an exchange-traded forward contract; it is standardized, highly regulated, and used to either profit from changes in asset prices or lock in purchase/sale prices.
## What is a warrant?
- [ ] A temporary trading halt
- [ ] A type of short sale
- [ ] A financial penalty
- [x] A security giving the holder the right to buy shares in a company at a set price until expiration
> **Explanation:** A warrant is a type of security that offers its holder the right to purchase shares of a company from the issuer at a predetermined price until the warrant expires.
## How do investors use put options?
- [ ] To lock in a future purchase price
- [x] To hedge against a potential decline in the value of an underlying asset
- [ ] To increase dividends
- [ ] To create synthetic bonds
> **Explanation:** Investors use put options as a hedge against a potential decline in the value of an underlying asset by granting the right to sell at a designated price before expiry.
## What is the primary purpose of derivative dealers in the market?
- [ ] To hedge risks for their own investments
- [ ] To speculate on extreme market movements
- [ ] To develop new financial indexes
- [x] To buy and sell derivatives to meet the demands of end users
> **Explanation:** Derivative dealers primarily act to buy and sell derivatives in the market to service the needs of end users by providing liquidity and facilitating trades.
## What is the function of a right in financial markets?
- [ ] To terminate a contract
- [ ] To auction assets
- [ ] To enforce regulatory compliance
- [x] To grant shareholders the privilege to acquire additional shares
> **Explanation:** A right is a privilege given by a company to its shareholders, allowing them to acquire additional shares in direct proportion to those already owned, which can be advantageous during expansions or debt reductions.