Reading 57 LOS's

Question 1

LOS 57a: Define a derivative and distinguish between exchange-traded and over-the-counter derivatives

Answer 1

Derivative is a financial contract or instrument that derives its value from the value of the underlying asset.

Exchange Traded derivative trade on specialized derivative markets, with standardized contracts and a backing by a clearinghouse

• Standardization facilitates the creation of a more liquid market, but with a cost of flexibility
• Market Makers and speculators play an important role
• The exchange is responsible for clearing and settlement through its clearinghouse
• Exchange markets also have transparency

Over the Counter (OTC) markets- they don’t trade in an actual market, instead in an informal market. Dealer play a big role as they buy and sell the customized derivatives

• OTC markets are less regulated than exhange markets
• OTC markets offer more privacy and flexibility

Question 2

LOS 57b: Contrast Forward commitments and contingent claims

LOS 57c: Define forward contracts, futures contracts, options (calls and puts), and swaps and credit derivative, and compare their basic characteristics

Answer 2

Forward Commitments are legally binding obligations to engage in a certain transaction in the spot market at a future date at terms agreed upon today. They can be done on exhange or OTC and they include:

• Forwards where one party has an obligation to buy an asset and the counterparty has an obligation to sell, at a price and future date agreed upon
• Futures where one party , the buyer, will purchase an underlying asset from the other party, at a later date and price agreed upon. Unlike forwards that are settled on the date, futures are settled daily
• Swaps are an OTC derivative in which 2 parties agree to exchange a series of cash flows whereby one party pays a variable series and the other party pays a different variable series, or a fixed rate

Contingent claims is a derivative in which the outcome or payoff is determined by the outcome or payoff of the underlying asset, conditional on some event occuring

• Options payoffs depend on the underlying’s value in the future. Options give the holder the right, not the obligation, to buy (CALL) or sell (PUT) the underlying from or to the seller (writer) of the option
• Credit Derivative is a contract that transfers credit risk from one party to another party, where the latter protects the former against a specific credit loss. Most of these take the form of credit default swaps (CDS), which is a bilateral contract between 2 parties that transfers the credit risk embedded in an obligation from one party to another.
  
  • The reference obligation is the fixed-income security on which the protection is written.
  • The protection buyer makes a series of payments to the seller, to protect themselves of default risk
  • The protection seller earns the CDS spread over the term in return for assuming the credit risk

Example of a CDS is if we buy a bond from a company, we might enter into a CDS with that company. So we will pay the company payments in case they default. If they dont default then they earn the extra money. If they do then we can either get a physical settlement were we receive the full amount of the bond or a cash settlement where we receive cash payments.

Other types of credit derivative include:

• Total return swaps in which the underlying is a bond or loan
• Credit Spread options - they are typically call options based on a bond’s yield spread relative to a benchmark. If their is an increase in yield spread that call holder receives a positive payoff.
• Credit linked notes which where described in fixed income section

Asset-backed Securities (ABS) is a derivative in which a portfolio of debt instruments is pooled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments that come in from the pool of debt securities

Question 3

LOS 57d: Describe the purposes of and controversies related to derivative markets

Answer 3

Purposes and Benefits:

• Risk Allocation, Trasfer, and Management
  
  • derivatives allow investors to hedge away risks without trading the underlying itself
  • they improve risk allocation within markets as parties who do not want exposure to a particular risk can transfer it to those who do
• Information Discovery
  
  • certain form of derivative contracts provide an indication of the direction of the underlying
  • since derivative transactions require less capital, info can sometimes be reflected earlier than in securities
  • certain derivatives can be used to implement strategies that cannot be implemented with the underlying alone
• Operational Advantages
  
  • derivatives offer lower transaction costs than those in the spot market
  • Derivative markets tend to be more liquid
  • Derivatives offer an easy way to take a short position on an underlying
  • derivatives allow users to engage in highly levered transactions
• Market Efficiency
  
  • When asset prices deviate from the fundamental values, derivatives offer a less costly way of taking advantage
  • The ability to hedge risks encourages more trade leading to greater liquidity

Criticisms and Misuses of Derivatives

• Destabilization and systemic risk- The argument here is that the very benefits of derivatives results in an excessive amount of speculative trading that brings instability to the market. When they speculate wrong, they can lose big, and thus affect the rest of the system.
• Speculation and gambling for hedging to work, there must be someone willing to take on the risk. This falls into the hands of speculators who sometimes get the label as gambler
• Complexity the mechanics behind derivative contracts can be complex and difficult to understand

Question 4

LOS 57e: Explain arbitrage and the role it plays in determining prices and promoting market efficiency

Answer 4

When assets are mispriced, arbitrageurs exploit there opportunities and trade on the pricings until they are eliminated and asset prices converge to their correct level. So this is how arbitrage helps determine price, and since it helps push asset prices to their correct market value, it promotes market efficiency.