What is a derivative?
A bilateral contract or payments exchange agreement whose value derives from the value of an underlying asset or reference rate or index.
What are derivatives used for?
To provide a means for shifting risk from one party to a counterparty that is more willing or better able to assume that risk.
What are four objectives that can be achieved through the use of derivatives?
1) Hedge against market risk, 2) Management of assets and liabilities, 3) Lowering of funding costs and 4) Speculation for profit.
What are the four types of derivatives contracts?
Forwards, futures, swaps and options.
How do derivatives manage risk?
They enable a user to isolate, trade, and transfer one or more distinct risks. They are highly leveraged as they require little or no good faith deposit to secure the counterparties' obligations. Some parties are now requiring stricter margin requirements.
What is counterparty credit risk?
The risk of economic loss from the failure of an obligor to perform according to the terms and conditions of a contract or agreement. If a counterparty fails, the derivative contract is meaningless.
What happened with LTCM?
Long Term Capital Management (LTCM) was a hedge fund that received a private sector recapitalization facilitated by the Fed (bailout).
Why did the Fed choose to bailout LTCM?
They were concerned that rapid liquidation of LTCM's very large trading positions would cause a “fire sale” and destabilize the financial markets.
What are the two categories of derivatives according to the U.S. Treasury?
1) Privately negotiated and traded agreements, called over-the-counter (OTC) and 2) standardized agreements, called “exchange- traded derivatives”, which are traded through an organized exchange.
How do exchange-traded derivatives eliminate counterparty risk?
An organized exchange addresses the counterparty credit risk inherent in bilateral contracting by standardizing derivatives contracts to create a liquid market in the contracts themselves. They impose margin requirements.
How do exchanges eliminate their own counterparty risk?
By regulating its market participants to ensure their financial integrity. The clearinghouse guarantees each contract, and the members are jointly responsible for a failure of one of the members. There are also exchange-imposed margin and mark-to-market requirements.
What are the characteristics of an exchange-traded derivative?
1) Centralized marketplace, 2) Standardized terms, 3) Daily mark-to-market, 4) Constant maturity.
What are the characteristics of an over-the-counter derivative?
1) Bilaterally negotiated, 2) Flexible terms, 3) Collateral agreements, 4) Mature over time.
What are the reasons for using derivatives instead of direct spot transactions?
1) No need for immediate transaction in underlying, 2) Want to lock in price of underlying today, 3) Do not want to expend the entire cost of notional value of the underlying.
What is leverage?
The concept of making an investment with a small upfront monetary commitment using borrowed funds.
What is basis risk?
The risk arising from possible changes in the difference between the spot and futures price of a particular underlying. Any time a derivative is bade on an underlying that is not the exact risk a firm is trying to hedge, basis risk exists.
What is market risk?
The potential for changes in the market price for an item.
What are the four most common market risk factors?
Interest rates, foreign exchange rates, equity prices and commodity prices.
What are forwards?
Financial contracts in which two counterparties agree to exchange a specified amount of a designated product for a specified price on a specified future date or dates. Biggest drawback is counterparty credit risk. Terms are customizable (not standard) and they trade OTC. Parties are usually expected to make actual delivery. In re Borden Chemicals.
What is the primary purpose of a forward?
To facilitate the sale and delivery of a physical commodity and to assure the commodity's availability at a date in the future when it will be needed.
What is are futures?
Exchange-traded forward contracts with standardized terms.
What is the primary purpose of futures?
To transfer price risk rather than ownership of the underlying commodity.
How does delivery work for futures contracts?
Although terms for delivery are usually included in the contract, actual delivery of the underlying is uncommon. Mechanisms are usually involved that permit the parties to avoid delivery, either by cash settlement or an offsetting transaction.
Can futures contracts be traded OTC?
No. They are required by law to trade on federally licensed contract markets that are regulated by the CFTC.
What are 3 features of futures contracts that reduce counterparty risk?
1) They require a performance bond, aka “good faith”” margin deposit as collateral. 2) Marked to markt on a daily basis with exchange of cash flow reflecting the net market movement. 3) Futures exchanges recognize only exchange members as counterparties to individual transactions.
What features of futures make them more suitable for hedging than for mechandising?
1) Standardization of contract terms creates liquidity, 2) Participants can offset their positions without delivery requirements, 3) Instead of full value, can enter into contract with margin.
What is legal risk?
The potential for ambiguity in regulation to impede the smooth operation of a transaction.
What are foreign exchange futures?
Derivative contracts traded on exchange where the delivery of underlying currency is the subject matter of the contract.
What is an option?
A contract that transfers the right but not the obligation to buy or sell an underlying asset, instrument, or index on (European) or before (American) the option's exercise date at a specified price (the strike price).
What is a call option?
It gives the option purchaser the right but not the obligation to buy a specific quantity of the underlying on or before the option's exercise date at the strike price.