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Derivative markets and instruments

The Nature of Derivatives


A derivative is an instrument whose value depends (is derived) on the values of other more basic underlying variables (usually a stock, bond or commodity price). Derivatives are created and traded on two distinct types of markets: derivatives exchanges (organized trading facilities) over-the-counter markets (OTC)

The OTC markets


The

over-the counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers

Comparison Between exchange traded and OTC traded derivatives


Exchange traded standardized instruments trade in accordance with rules and regulations of the exchange and are usually subject to governmental regulation guaranteed by the exchange against loss resulting from the default of one of the parties OTC traded created by any two parties off of an exchange the parties set their own terms and conditions each party assumes the credit risk of the other party

Classification of Derivatives
Derivatives

Forward commitments

Contingent claims (Options)

Futures contracts (Exchange-traded)

Forward contracts (OTC traded)

Swaps (OTC traded)

Exchange-traded

OTC traded

Main Derivatives Exchanges


Chicago Board of Trade (CBT or CBOT) first derivative market (1848) Chicago Mercantile Exchange (CME) -1874- biggest US derivatives exchange Chicago Board Options Exchange (CBOE) the biggest options exchange LIFFE (London) Eurex (Europe) the biggest in the world; is a combined GermanSuisse Exchange BM&F (Sao Paulo, Brazil) Bolsa de Mercadorias& Futuros de Brazil NYMEX TIFFE (Tokyo) Paris Bourse Korea Stock Exchange .................................. SIBEX (Romania) - BMFMS

The size of derivative markets


Measured

by two indicators: Market value = the economic worth of the derivative Notional Principal = the amount of the underlying on which the derivative is based

Purposes of derivative markets


provide

price discovery facilitate risk management make markets more efficient lower transaction costs Critics to derivatives: excessively dangerous for unknowledgeable investors linked to gambling.

Terminology
BULL

MARKET

A bull market is a market in which prices are rising. When someone is referred to as being bullish, that person has an optimistic outlook that prices will be rising.

Terminology (Cont.)
BEAR

MARKET

A bear market is one in which prices are falling. Therefore, a bearish view is pessimistic, and that person would believe that prices are heading downward

Terminology (Cont.)
SPOT

MARKET =A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective. =The spot market is also called the "cash market" or "physical market", because prices are settled in cash on the spot at current market prices, as opposed to forward prices.

Terminology (Cont.)

GOING LONG

The party who owns an asset has what is termed a long position. Someone who is long in the market expects prices to rise. They expect to make money by later selling the contracts at a higher price than they originally paid for them.
Long position investment philosophy :

BUY LOW, SELL HIGH

Terminology (Cont.)
GOING

SHORT

The party who owes an asset has what is termed a short position The short seller believes that prices are heading downward, so he sells contracts that he thinks will be less valuable sometime in the future.
Short position philosophy : SELL HIGH, BUY LOW

Derivatives Basic notions


Derivatives

are investments that derive their value from some underlying quantity (usually a stock, bond or commodity price)
Forward contractobligates the buyer to purchase the underlying security on a given date for a specified price
Arrangements

Futures contractobligates the buyer to purchase a specified quantity of the underlying security on a given date at a specified price
Actively

between private parties Not actively traded in any market

traded on futures exchanges until delivery date Can earn gains/losses from simply trading the contract itself, without every taking delivery of underlying goods

Derivatives Basic notions (cont.)


Optionagreement between an option writer (who sells the option) and buyer
Option

buyer has right (but not obligation) to buy (call) or sell (put) underlying security at the predetermined exercise price on a specified date If option is exercised, option writer must follow through Many options expire unexercised Options actively traded at options exchanges and OTC markets