2. What AreThey?
• Google: a contract that derives its value from the performance of an
underlying entity.This underlying entity can be an asset, index, or interest
rate, and is often called the "underlying“.
• Investopedia: A security whose price is dependent upon or derived from one
or more underlying assets.The derivative itself is merely a contract
between two or more parties. Its value is determined by fluctuations in the
underlying asset.
3. Why?
• Flexible in usage
• Transfer risk from risk-adverse people to risk-oriented people
• Increase volume traded in the markets
• Increase savings and investments
6. Future Contracts
• Exchange-traded version of a forward contract
• “Novate”
• I agree to sell X tons of _______ in X months for $X
Pro:
• Tracks value of asset without having to own it
Con:
• Difficult to buy and sell
7. Options
• Writers vs. Holders
• Call Options vs. Put Options
• “I have the right to ____ shares at ____ within _____ months”
Pro:
• Flexibility that the future contract doesn’t offer
Con:
• Flexibility comes at a charge of a premium
MP
_(SP)_
Profit
_(Premium)_
Net Gain/Loss
8. Swaps
2 types:
1) Interest
2) Currency
Pro:
• Companies can reduce their borrowing costs
Con:
• Amounts are fairly large
9.
10. Instability in the Markets
• Defaults
• 1998 CFTC issued a proposal to regulate the derivative market
• Banks were reliant on derivative funds, so they didn’t want them regulated.
Regulation was overruled by Clinton administration and then by Congress.
• Today: Derivatives Market = $1,200,000,000,000
