Topic 6: Derivatives

What is a derivative?

A type of financial contract whose value depends on the price or performance of something else.

What is a derivative contract?

A legal agreement between two counterparties.

What is the maturity of a derivative contract?

is the date when the contract comes to an end and the two parties complete their agreed transaction (settlement).

What is the underlying in a derivative?

The asset, group of assets or variable on which the derivative’s value depends.

Can the underlying be something other than an individual asset?

Yes. It can be standardised groups of assets or variables, such as interest rates or credit indices.

Why do market participants use derivatives?

To exchange cash flows in the future based on an underlying value.

What position does the buyer of a derivative have?

A long position, meaning they generally benefit when the underlying asset increases in value, without necessarily owning the asset itself.

What position does the seller of a derivative have?

A short position, meaning they generally benefit when the underlying asset decreases in value.

What is the contract size (notional amount)?

The agreed quantity or reference amount of the underlying asset that the derivative contract is based on, used to calculate its value or payments.

Can a derivative’s contract size change over time?

Yes. It may remain constant or change over the contract’s life.

What is an embedded derivative?

A derivative feature contained within another financial instrument.

Give 3 examples of embedded derivatives?

• Callable bonds

• puttable bonds

• convertible bonds

What are firm commitment derivatives?

Legal agreements that commit both counterparties to a future transaction.

Give 3 examples of firm commitment derivatives?

• Forward contracts

• future contracts

• swaps

What is a contingent claim?

a type of derivative where the transaction only happens if a particular condition is met or one party chooses to exercise their right.

What is the primary example of a contingent claim?

An option.

a type of derivative that gives one person the right, but not the obligation, to buy or sell an asset at an agreed price.

How can investors use derivatives to profit from falling prices?

By taking a short position, benefitting if the underlying value declines.

How can derivatives help diversify a portfolio?

They provide exposure to different assets or markets, spreading investment risk.

How can issuers use derivatives to manage commercial transaction risk?

Issuers (companies) use derivatives to protect themselves against changes in financial markets that could make a commercial transaction more expensive or less profitable.

How can derivatives create large market exposure with little cash?

Leverage allows large exposure to an underlying with a relatively small initial outlay.

What is spot market transactions?

You agree to buy something at the current market price and receive it straight away (or within the standard settlement period).

Why are derivatives attractive compared with spot market transactions?

They typically have lower transaction costs and greater liquidity.

How can issuers and investors use derivatives?

To increase or decrease their exposure to financial market movements.

What can equity derivatives be based on?

An individual stock, a group of sticks or stock index.

Give an example of a stock index used in equity derivatives?

FTSE 100

What is the most common derivative on individual stocks?

Options

What is an index swap (equity swap)?

A contract exchanging the return on one stock index for another index or an interest rate.

What types of derivatives are commonly traded on stock indices?

Options, forwards, futures, and swaps.

What can an investor exchange through an equity swap?

The return on one stock index for the return on another index or an interest rate.

How are options on individual stocks used by investors?

Investors buy and sell them to gain exposure to individual share price movements.

How do issuers use individual stock options?

They can use them as compensation for executives and employees.

What are bonds commonly used as in derivatives?

An underlying asset.

What derivatives can be based on bonds?

Options, forwards, futures, and swaps

Why can bond futures allow multiple bonds to be delivered?

Government issuers have many different bonds outstanding. Therefore, one standardised futures contract can specify a range of eligible bonds that can be delivered to settle the contract.

What is an interest rate in derivatives?

A fixed-income underlying , rather than an asset.

Which derivatives commonly use interest rates as their underlying?

Forwards, futures, and options

What is an interest rate swap?

A firm commitment to exchange interest rate payments.

Why do market participants use currency derivatives?

To hedge against foreign exchange risk in commercial and financial transactions.

What is foreign exchange risk?

the risk that changes in exchange rates will affect the value or cost of a transaction.

Why might an exporter use a forward contract?

To lock in an exchange rate and protect against currency fluctuations

What does an exporter agree to do in a currency forward contract?

Sell foreign currency and buy domestic currency at an agreed exchange rate.

How can an exporter match a forward contract to a delivery contract?

By agreeing the currency amount and settlement date to match the foreign payment.

How might an investor use currency futures?

By selling futures on a currency while holding investments denominated in that currency.

What are soft commodities?

Agricultural products, such as cattle and corn.