Wendy L. Pirie - Derivatives Workbook

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After completing this chapter, you will be able to do the following:

• define a derivative and distinguish between exchange-traded and over-the-counter derivatives;
• contrast forward commitments with contingent claims;
• define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics;
• describe purposes of, and controversies related to, derivative markets;
• explain arbitrage and the role it plays in determining prices and promoting market efficiency.

This first reading on derivatives introduces you to the basic characteristics of derivatives, including the following points:

• A derivative is a financial instrument that derives its performance from the performance of an underlying asset.
• The underlying asset, called the underlying, trades in the cash or spot markets and its price is called the cash or spot price.
• Derivatives consist of two general classes: forward commitments and contingent claims.
• Derivatives can be created as standardized instruments on derivatives exchanges or as customized instruments in the over-the-counter market.
• Exchange-traded derivatives are standardized, highly regulated, and transparent transactions that are guaranteed against default through the clearinghouse of the derivatives exchange.
• Over-the-counter derivatives are customized, flexible, and more private and less regulated than exchange-traded derivatives, but are subject to a greater risk of default.
• A forward contract is an over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a fixed price they agree upon when the contract is signed.
• A futures contract is similar to a forward contract but is a standardized derivative contract created and traded on a futures exchange. In the contract, two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated. In addition, there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.
• A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either a variable series determined by a different underlying asset or rate or a fixed series.
• An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.
• A call is an option that provides the right to buy the underlying.
• A put is an option that provides the right to sell the underlying.
• Credit derivatives are a class of derivative contracts between two parties, the credit protection buyer and the credit protection seller, in which the latter provides protection to the former against a specific credit loss.
• A credit default swap is the most widely used credit derivative. It is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of payments to the seller and receives a promise of compensation for credit losses resulting from the default of a third party.
• An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments made by the debt securities such that prepayments or credit losses are allocated to the most-junior tranches first and the most-senior tranches last.
• Derivatives can be combined with other derivatives or underlying assets to form hybrids.