RMI2201 CH. 10 (VanBuskirk Online, Troy University)

define derivative

a contract between two or more parties whose value is based on an agreed upon underlying financial asset; term comes from the fact that value is derived from some underlying financial asset - a contract that transfers financial risk among the parties

what are some common examples of the underlying assets for derivatives

stocks, bonds, commodities, currencies, interest rates, and market indexes

T/F: what the underlying asset of a derivative is is determined by the two or more parties involved in the transaction

TRUE

what are the three most common types of derivatives?

1. Future Contracts

2. Forward Contracts

3. Options

other examples include swaps (like credit default swaps) and warrants

Define Future Contracts

type of derivative- they are legally binding agreements to buy or sell a particular security at a predetermined price at a specific time in the future; they are typically sold on exchanges

T/F: most future contracts take the delivery of products

FALSE: very few future contracts take the delivery of products; the contracts are typically unwound on the exchange with the parties taking opposite position in a different contract and the accounts settled with payment of profits or losses on the contract

give an example of a future contract

AGRICULTURE

a farming operation could enter a contract to sell soybeans at a predetermined price. he contract will state the amt of soybeans that will be sold at a specific dollar amt on a set date. this contract can be traded on the open market in a similar fashion to stocks and bonds. In theory, whoever holds the contract at expiration date is required to purchase the soybeans from the farmer at the price set in the contract. could be an advantage if the soybean market price is above contract price, or could result to the holder if the soybean market price is below contract price.

commodities such as soybeans and other agricultural products like corn and rice are primarily traded in Chicago at the Chicago Board of Trade. Livestock futures contracts are also traded in Chicago at the Chicago Mercantile Exchange. Cotton futures are traded primarily in New York and the Intercontinental Exchange

define forward contracts

a type of derivative - private contracts between two parties which are non-transferable and completely customized for the needs of both parties. these are very similar to future contracts but are typically NOT traded on an exchange.

give an example of a forward contract

a contract between a paper company and a newspaper printer. to keep costs stable, the newspaper company could enter into a forward contract with the paper company stating that they will buy a specific quantity of paper for a set price on a specific date; allows the newspaper printer to keep their paper cost stable regardless of a fluctuation in paper prices at that future time

T/F: neither forward or future contracts requires a premium or a cost to enter the contract

TRUE

define option contracts

a type of derivative - gives the holder the right to buy or sell the asset; they do not require the holder to execute the contract, they simply have the OPTION, purchased for a small sum (a premium) relative to the value of the underlying asset, to execute the agreement if the holder of the contract so chooses

they typically include:

1. a statement of what the asset is and the quantity of the asset to be bought or sold

2. clarifications on whether the holder has the right to buy (call option) or sell (put option) the asset

3. the strike price (or exercise price) which states the price when the option is exercised

4. the expiration date which states the last day the option may be exercised

5. the settlement terms which state how the asset will ve paid/delivered to the holder

What are the two types of options

calls and puts

What do investors who buy call options expect?

they expect the price of the underlying asset to rise and have the option of buying the asset at the contract or strike price. If the price rises above the call price, the investor buys at the strike price and can sell it for a profit. If it does not rise above strike price by the expiration date, the seller loses the cost of the option.

what do investors do with call options if they believe the price of the asset will decline?

they sell it

what do put options do?

they give the buyer the option to sell an underlying asset; the seller (writer) is obligated to buy the asset at the strike price if the holder of the option executes it before the expiration date.

why do investors buy put options?

they buy it if they think the underlying asset will decrease and have the option to sell at above market prices

what is a call option?

a contract between two parties to exchange a stock at a "strike" price by a predetermined date; one party, the buyer of the call, has the right but NOT an obligation to buy the stock at the strike price by the future date, while the other party- the seller of the call- has an obligation to sell the stock to the buyer at the strike price if the buyer exercises the option

what is a put option?

a contract between two parties to exchange a stock at strike price by a predetermined date. one party (the buyer of the put) has the right but not an obligation to sell the stock at the strike price by the future date, while the other party, the seller of the put has the obligation to buy the stock from the buyer at the strike price if the buyer exercises the option

What is the call option for the holder (buyer)?

BUY CALL

it gives the holder the right (but not obligation) to BUY the asset

what is the call option for the seller (writer)?

SELL CALL

requires the seller to SELL the asset

what is the put option for the holder (buyer)

BUY PUT

this gives the holder the right (but not obligation) to sell the asset

what is the put option for the seller (writer)

SELL PUT

this requires the seller to BUY the asset

_________ gives the buyer the option to sell an underlying asset

put option

_________ ________ is a legally binding agreement to buy or sell a particular security typically sold on exchanges

futures contract

______ _______ is a private contract between two parties which is non-transferrable and customizable and not typically traded on an exhcnage

forward contract

____ _______ is when the buyer believes the price of the underlying asset is expected to rise and has the option of buying the asset at the strike price

call option

What are the three types of derivative trading groups?

1. hedgers

2. arbitrageurs

3. speculators

what is the purpose of hedgers

a hedging trade offsets a business or market risk- the risk could be a commodity exposure, an interest rate, or a currency

what is the purpose of arbitrageurs

an abritrage trade is intended to take advantage of a mis-priced relationship that exists between a derivative and the commodity, currency, interest rate, or security it references

what is the purpose of speculators

a speculative trade is intended to profit from market price fluctuations- speculators will take the opposite side of a hedging or arbitrage trade

derivatives typically involve 2 groups of people- who are they

people looking to reduce their risk and those looking to take on that risk

using derivatives as a hedge is done by the group of people who want to....

reduce their risk: it is a way to offset downside risk of an investment or decision

for those looking to take on a risk, derivatives can be used to...

speculate: they can enter into agreements that take on risk in anticipation of a financial gain based on the belief an asset or financial market will change in a particular direction

what is an organization's goal with hedging?

to reduce risk already faced or control future exposures to risk

what is the primary benefit to hedging financial derivatives?

the reduction of potential risk by entering a contract with another party who has an opposite interest; if an organization loses money when prices of a certain underlying asset increases they might hedge against this. there may be another organization who makes more money when the price of a certain underlying asset increases- these two organizations can enter into a derivative transaction that offsets this price movement and it works to both organizations advantage

what is the disadvantage to hedging financial derivatives?

futures and forwards contracts require an obligation to act upon that asset on a pre-determined date- since derivatives involve a lot of prediction, there are times when prices will increase or decrease opposite of what would be typically expected, and atp hedging becomes a disadvantage becaus ethe purchaser ultimately pays more than they would have without a contract

what all does speculating involve?

- an attempt at predicting where the market is moving

- allows an organization to take on risk that it previously did not face

- it allows speculation to occur without ever owning the underlying asset

T/F: derivates are an international market, which makes it difficult for the US federal government to draft legislation to limit the danger of them

TRUE

what are the two most popular regulatory options for derivatives?

1. centralized clearing

2. improved price transparency and position transparency

what is centralized clearning?

it occurs when the central counterparty clearing house (CCP) clears and settles a transaction. CCs perform tow primary functions as the intermediary in a transaction: clearing and settlement. they are counterparties to the buyers and sellers and guarantee the terms of a trade- even if one party defaults on the agreement. they bear the lion's share of the buyer's and seller's credit risk when clearing and settling transactions

key steps regulators should focus on are:

1. Pressuring dealers to adopt specific numerical targets for lowering exposures (before collateral) on uncleared derivatives positions.

2. Increasing regulatory capital requirements for uncleared versus cleared derivatives.

3. Persuading dealers to clear a greater fraction of dealer-to-customer positions.

4. Fostering international coordination in the regulation, supervision, and failure resolution of clearing houses.

T/F: all derivates are traded on exchanges that act as central counterparty clearinghouses

FALSE: not all are- it is difficult to determine if even most derivatives are exchange traded since there is very little oversight over non-exchange derivatives

why is it necessary to improve price transparency and position transparency fro derivative markets?

they currently lack most reporting requirements of other assets which makes them have a secretive nature- improving these two things would go a long way towards minimizing risk involved and stabilizing the general valuation of the market

what percentage of the world goes to sleep hungry?

67%

what percentage of the world lives on $1 or less per day

20%

people living in abject poverty face risk of death due to...

lack of resources for healthcare

what are some social issues that poverty is related to?

healthcare, employment, education, climate change, natural disasters, violence, drug abuse,

T/F: wealthier people live longer than those in poverty

TRUE: wealthier people have a better quality of life with greater access to healthcare- with shorter life expectancy and lower levels of health, poor ppl's quality of life suffers, as does productivity

define productivity

the ability to contribute to the economy

T/F: the greater the GDP per capita, the longer the life expectancy for that country

TRUE: poorer countries with lower GDP per capita have much lower average life expectancies

T/F: life expectancies can be directly tied to education

TRUE: education contributes to the ability to earn greater amounts of income and grow wealth- in the US the difference in life expectancies can be tied to education

who, in america, has it worst when it comes to life expectancy?

black americans with little education/no degree

T/F: there is decreased demand for higher educated employees due to advanced technology and this has resulted in a decline of well-paying jobs for those without a degree, which may contribute to higher rates of risky lifestyle choices (drug and alcohol use)

FALSE: everything is true, except its an INCREASED demand for higher educated employees

what are the three broad classifications of resources necessary to produce?

capital

labor

technology

define labor

the human input needed to produce a product; the mental capacity and muscle used to create the desired outcome. common denominator for all levels of labor = human

define capital

the term used to identify resources other than human input- those non-human articles used to create the final product. more than money: these resources can be natural (ex. land, rare earth minerals, energy sources, access to water) or man-made (factories, tools, components, and inventories)

define technology

the "how" - it is the methods used that allow labor and capital to combine and produce the finished product. improved technology that generates greater productivity comes from the development of new ideas through education

how do we measure productivity?

the gross domestic product is one way

What does GDP provide?

a comprehensive measure of economic activity- the measure of final goods and services produced and does not double count intermediate goods and services used to produce the final result.

what are some caveats that must be considered when using GDP to measure productivity?

an increase in GDP could reflect a productivity increase, or simply just a rise in prices due to inflation; it also measures total value of production in a country and doesn't consider ownership of production resources (i.e. a toyota assembled in the US is counted in the US GDP even tho the ultimate profits go to a japanese corporation). GDP represents the value of production, but not necessarily who benefits

what must countries do to be productive and improve productivity?

they must make use of what resources are present and make choices regarding where to focus to obtain optimal outcomes - depending on the country's economic capabilities, the choices and options can be ulimited, with each choice affecting another (opp cost)

as more of a particular good is produced, the __________ ________ _______ rises at an increasing rate

marginal opportunity cost; as one product increases, another must decrease to produce both at an optimal level (PPC)

what can shift the PPC?

outwards: obtaining additional resources, improving the quality of resources, and/or raising the level of technology

what must be adjusted for us to really consider GDP as a (somewhat incomplete) measure of production AND societal well-being

1. gdp must be adjusted for inflation

2. gdp must be adjusted for population

this gives us REAL GDP PER CAPITA

why do we adjust GDP for inflation?

it allows any increase in GDP caused by a general increase in prices to be discounted- just bc the goods cost more does not mean that productivity has increased

if GDP rises due to productivity, then societal well-being may improve, but if it rises only due to inflation, there may be an overall decline

adjusting it gives us real GDP

T/F: if real GDP rises at a rate at or below population growth, there is still a slight increase in productivity

FALSE: there is really no productivity gain

what are some ways we can compare lesser developed countries to more developed ones?

GDP per capita and income distribution

T/F: the middle class is bigger in developed countries than less developed ones

TRUE: the three middle terciles in developed countries have a higher percentage of income distribution than the three middle terciles in developing ones; income inequality is greater in these developing countries

T/F: in lesser developed countries, a larger percentage of the population lives below the poverty line

TRUE

a ______ labor force is critical to improving productivity

trained

What can be done in the three groups of production to help lift communities out of poverty

Labor- there needs to be improved labor quality bc a labor force that works more efficiently can produce more. this can be achieved via educating the work force

Capital- there needs to be adequate material resources; they must be utilized or more must be acquired to produce products and raise productivity

technology: better technology can improve efficiency and reduce errors for enhanced quantity and quality. this product can be offered at a higher price, adding to the growth of the economy, and shifting the production possibilities curve outward

population growth may not be a major factor of poverty, but it is a major factor in creating...

scarcity

what are the issues that contribute to poverty in a society

quality and capabilities of labor force

stock of capitol and the accumulation of resources

technology

efficiency

population

what can the government do to help fix the economy?

- in lesser developed economies and countries, the gov may need to provide more direction and more resources to specific industries that will enable the country to emerge from poverty

-gov can be more involved in education; make efforts in training ppl to develop skills needed for the planned economic activity

- focus on infrastructure: the facilities needed to function and produce. its a way for the gov to increase productivity internally and increase incentives which attract foreign direct investment in a country

what is foreign direct investment

organizations not just foreign governments investing a country's infrastructure

ex. if Nike wants to open a manufacturing facility in Vietnam, they may also build roads or a port for the easier transport of their products. Infrastructure helps get the labor resources to where the capital resources are.

T/F: as gdp increases, so does government corruption

FALSE: as gdp decreases/declines, corruption rises

How can developed countries help increase productivity and contribute to a reduction of poverty and improved lifestyles in less developed countries?

1. humanitarian aid - providing food and water, medical resources, and other items needed by countries in crisis

2. financial aid - can be provided to help improve infrastructure or provide for citizen needs including food and education (sometimes this creates debt that cannot be repaid due to failures of projects)

3. partnerships - can be created to help in areas such as improving technology and health care. sharing knowledge can help improve the productivity and quality of life for citizens

4. outsourcing - providing jobs w appropriate training can increase income for citizens in less developed countries while reducing cost for the company. facilities such as call centers and technology centers are often outsourced to other countries

T/F: excessive aid can be a hindrance to efforts to reduce poverty and increase productivity

TRUE

ex) haiti. international aid is so pervasive that economic development becomes hindered, and they are actually worse off with all the aid

what can lesser developed countries' governments do to reduce poverty

1. Choose a form of Government - Communist/Capitalist/Socialist

2. Planned v. Unplanned Economy

3. Involvement in education

4. Infrastructure

5. Attract Foreign Direct Investment

what can developed countries' governments do to reduce poverty

1. Humanitarian aid

2. World Bank Loans

3. Partnerships and Cooperation

4. Outsourcing