Question 1 – What is the defining characteristic of a derivative?
The defining characteristics is that it exists on the back of another security. If this other security was to cease to exist, so would the derivative.
Question 2 – What determines the price of a derivative?
The price of a derivative is a function of a number of variables, depending on the derivative. In some instances, the derivative is only an exchange of securities or security for cash, and since the terms are defined for both parties, there is no market value as such (e.g. currency future, where at maturity each side sells a currency in exchange for another), whereas in other instances, the price is a result of two sources of value: intrinsic and time value.
Intrinsic value is the difference between the exercise and the market value of the underlying security (e.g. an option to buy shares in a company for £2, when the market price is currently £2.20 has an intrinsic value of £0.20), while the time value is the possibility that executing the derivative will result in a gain at maturity due to change in the market price of the underlying asset between now and the maturity date (e.g. in the example above, time value is given by the possibility that the share price will increase further between now and maturity and in so doing creating more value to the buyer of the option.
Question 3 – For what purpose would someone use a derivative?
There are two purposes of using derivatives:
· When one has a risky position, we can use derivatives to reduce or eliminate the risk of the existing position – this is called hedging
· When one doesn’t have a risky position, but we believe there will be a change in market conditions in a certain direction, we can put ourselves in a position to generate a profit when (and if) that change does take place, by using derivatives, in which case we are creating a risky position – this is called speculating
Question 4 – Who are the four main operators in derivatives markets?
The four main operators in the derivatives markets are:
· End-user – the investor who is buying/selling the derivative for one of the two purposes described in the previous question
· Market-maker – financial institutions who ensure the market “exists” by providing quotes that are taken up by the end-users
· Regulator – the name says it all, these are the bodies responsible for regulating the market, i.e. creating the rules under which the market is going to operate and ensuring they are adhered to buy all the participants
· Financial engineering – this are the financial institutions that create derivative products, i.e. identify needs appearing in the market (either by hedgers or speculators) and develop products for which there is likely to be a demand as they serve the needs previously identified.
Question 5 – What are the three main types of derivative product?
The main types of derivatives are: futures, forwards, options, and swaps (see lecture notes, book and/or previous tutorial questions solutions for further details).
Question 6 – Compare the risk & reward for the buyer of a derivative with the risk & reward for the seller (“writer”) of a derivative.
The buyer is the one who is paying to have control, while the seller is the one being paid to allow the buyer to have control.
As such, the buyer gets what they want, i.e. reduction/elimination of risk if they are hedgers or taking of risk if they are speculators.