Risk management
DERIVATIVE
INSTRUMENTS
MARKETS
AND
Chapter 1: Derivative Markets and Instruments
Page 1 of 13
LOS 1.a: Define a derivative and distinguish between exchange-traded and over-the-counter derivatives.
A derivative is a security that derives its value from the value or return of another asset or security.
A physical exchange exists for many options contracts and futures contracts. Exchange-traded derivatives are standardized and backed by a clearinghouse.
Forwards and swaps are custom instruments and are traded/created by dealers in a market with no central location. A dealer market with no central location is referred to as an over-the-counter market.
They are largely unregulated markets and each contract is with a counterparty, which may expose the owner of a derivative to default risk (when the counterparty does not honor their commitment). Some options trade in the over-the-counter market, notably bond options.
LOS 1.b: Contrast forward commitments and contingent claims.
A forward commitment is a legally binding promise to perform some action in the future. Forward commitments include forward contracts, futures contracts, and swaps. Forward contracts and futures contracts can be written on equities, indexes, bonds, physical assets, or interest rates.
A contingent claim is a claim (to a payoff) that depends on a particular event. Options are contingent claims that depend on a stock price at some future date. While forwards, futures, and swaps have payments that are made based on a price or rate outcome whether the movement is up or down, contingent claims only require a payment if a certain threshold price is broken (e.g., if the price is above
X or the rate is below Y). It takes two options to replicate a future or forward.
LOS 1.c: Define forward contracts, futures contracts, options {calls and puts), and swaps and compare their basic characteristics.
In a forward contract, one party agrees to buy, and the counterparty to
INSTRUMENTS
MARKETS
AND
Chapter 1: Derivative Markets and Instruments
Page 1 of 13
LOS 1.a: Define a derivative and distinguish between exchange-traded and over-the-counter derivatives.
A derivative is a security that derives its value from the value or return of another asset or security.
A physical exchange exists for many options contracts and futures contracts. Exchange-traded derivatives are standardized and backed by a clearinghouse.
Forwards and swaps are custom instruments and are traded/created by dealers in a market with no central location. A dealer market with no central location is referred to as an over-the-counter market.
They are largely unregulated markets and each contract is with a counterparty, which may expose the owner of a derivative to default risk (when the counterparty does not honor their commitment). Some options trade in the over-the-counter market, notably bond options.
LOS 1.b: Contrast forward commitments and contingent claims.
A forward commitment is a legally binding promise to perform some action in the future. Forward commitments include forward contracts, futures contracts, and swaps. Forward contracts and futures contracts can be written on equities, indexes, bonds, physical assets, or interest rates.
A contingent claim is a claim (to a payoff) that depends on a particular event. Options are contingent claims that depend on a stock price at some future date. While forwards, futures, and swaps have payments that are made based on a price or rate outcome whether the movement is up or down, contingent claims only require a payment if a certain threshold price is broken (e.g., if the price is above
X or the rate is below Y). It takes two options to replicate a future or forward.
LOS 1.c: Define forward contracts, futures contracts, options {calls and puts), and swaps and compare their basic characteristics.
In a forward contract, one party agrees to buy, and the counterparty to