Derivative 1-2

What is a derivative?

A financial security whose value is derived from the value of another asset or variable (the underlying) at a future date.

What is the underlying in a derivative contract?

The asset, security, or variable that determines the derivative's value.

Examples: Stock, bond, interest rate, currency, commodity, stock index.

Why is a derivative called a "derivative"?

Because its value is derived from (depends on) another asset or variable.

What are the four basic features of a derivative contract?

• Underlying

• Contract (specified) price

• Contract size

• Settlement date

What is the contract (specified) price?

The price agreed upon by the two parties when the derivative contract is created.

What is the contract size?

The quantity of the underlying asset covered by the contract.

What is the settlement date?

The future date when the contract is settled.

At contract initiation, what is the value of most derivative contracts?

Zero to both parties.

Exam Tip: The contract price is typically set so neither side has an advantage initially.

What is a deliverable derivative contract?

A contract where the underlying asset is physically delivered at settlement.

What is a cash-settled derivative contract?

A contract where the parties exchange cash instead of the underlying asset.

What are the two settlement methods for derivatives?

• Physical (deliverable) settlement

• Cash settlement

What is an exchange-traded derivative?

A standardized derivative traded on an organized exchange.

What does "standardized" mean for exchange-traded derivatives?

The contract terms (size, expiration, etc.) are predetermined by the exchange.

Who guarantees exchange-traded derivative contracts?

The central clearinghouse.

What role does the central clearinghouse play?

It becomes the buyer to every seller and the seller to every buyer, guaranteeing contract performance.

Why is counterparty risk lower for exchange-traded derivatives?

Because the central clearinghouse guarantees payment.

What is an over-the-counter (OTC) derivative?

A privately negotiated derivative contract between two counterparties.

What is the main advantage of OTC derivatives?

They can be customized to meet the needs of the counterparties.

What are the disadvantages of OTC derivatives?

• Less regulation

• Less transparency

• Higher counterparty credit risk

Why do OTC derivatives generally have greater counterparty risk?

There is typically no central clearinghouse guaranteeing the contract.

How can counterparty risk in OTC markets be reduced?

Through a central clearing mandate for certain OTC contracts.

Which type of derivative is more customizable?

OTC derivatives.

hich type of derivative is more standardized?

Exchange-traded derivatives.

Which market is generally more transparent?

Exchange-traded markets

Which market is generally less regulated?

OTC markets.

Which derivative market has lower counterparty credit risk?

Exchange-traded derivatives.