Future and options market wiki
In finance, a derivative is a contract that derives its value from the performance of an underlying entity.
This underlying entity can be an assetindexor interest rateand is often simply called the " underlying ". In the United Statesafter the financial crisis of —, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks i. Derivatives are contracts between two parties that specify conditions especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount under which payments are to be made between the parties.
The components of a firm's capital structure, e. From the economic point of view, financial derivatives are cash flows, that are conditioned stochastically and discounted to present value. The market risk inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately.
Derivatives therefore allow the breakup of ownership and participation in the market value of an asset. This also provides a considerable amount of freedom regarding the contract design. That contractual freedom allows to modify the participation in the performance of the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be effectively weaker, stronger leverage effector implemented as inverse.
Hence, specifically the market price risk of the underlying asset can be controlled in almost every situation. There are two groups of derivative contracts: Derivatives are more common in the modern era, but their origins trace back several centuries.
One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.
Derivatives may broadly be categorized as "lock" or "option" products. Lock products such as swapsfuturesor forwards obligate the contractual parties to the terms over the life of the contract.
Option products such as interest rate swaps provide the buyer the right, but not the obligation to enter the contract under the terms specified. Derivatives can be used either for risk management i. This distinction is important because the former is a prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a risky opportunity to increase profit, which may not be properly disclosed to stakeholders.
Along with many other financial products and services, derivatives reform is an element of the Dodd—Frank Wall Street Reform and Consumer Protection Act of The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission CFTC and those details are not finalized nor fully implemented as of late Still, even these scaled down figures represent huge amounts of money.
And for one type of derivative at least, Credit Default Swaps CDSfor which the inherent risk is considered high [ by whom? It was this type of derivative that investment magnate Warren Buffett referred to in his famous speech in which he warned against "financial weapons of mass destruction". Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties.
Based upon movements in the underlying asset over time, however, the value of the contract will fluctuate, and the derivative may be either an asset i. Importantly, either party is therefore exposed to the credit quality of its counterparty and is interested in protecting itself in an event of default.
Option products have immediate value at the outset because they provide specified protection intrinsic value over a given time period time value. One common form of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay more for a policy with greater liability protections intrinsic value and one that extends for a year rather than six months time value.
Because of the immediate option value, the option purchaser typically pays an up front premium. Just like for lock products, movements in the underlying asset will cause the option's intrinsic value to change over time while its time value deteriorates steadily until the contract expires. An important difference between a lock product is that, after the initial exchange, the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the option if it has positive value i.
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future.
Both parties have reduced a future risk: However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing houseinsures a futures contract, not all derivatives are insured against counter-party risk.
From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract thereby paying more in the future than he otherwise would have and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer risk taker for one type of risk, and the counter-party is the insurer risk taker for another type of risk.
Hedging also occurs when an individual or institution buys an asset such as a commodity, a bond that has coupon paymentsa stock that pays dividends, and so on and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.
Derivatives trading of this kind may serve the financial interests of certain particular businesses. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement FRAwhich is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money.
If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.
Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset.
Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is less.
Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Speculative trading in derivatives gained a great deal of notoriety in when Nick Leesona trader at Barings Bankmade poor and unauthorized investments in futures contracts. The true proportion of derivatives contracts used for hedging purposes is unknown,  but it appears to be relatively small.
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:. According to the Bank for International Settlementswho first surveyed OTC derivatives in reported that the " gross market valuewhich represent the cost of replacing all open contracts at the prevailing market prices, Because OTC derivatives are not traded on an exchange, there is no central counter-party.
Therefore, they are subject to counterparty risklike an ordinary contractsince each counter-party relies on the other to perform. An "asset-backed security" is used as an umbrella term for a type of security backed by a pool of assets—including collateralized debt obligations and mortgage-backed securities Example: An empirical analysis" PDF.
Retrieved July 13, Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans.
The CDO is "sliced" into "tranches"which "catch" the cash flow of interest and principal payments in sequence based on seniority. The last to lose payment from default are the safest, most senior tranches. As an example, a CDO might issue the following tranches in order of safeness: Separate special-purpose entities —rather than the parent investment bank —issue the CDOs and pay interest to investors.
CDO collateral became dominated not by loans, but by lower level BBB or A tranches recycled from other asset-backed securities, whose assets were usually non-prime mortgages. A credit default swap CDS is a financial swap agreement that the seller of the CDS will compensate the buyer the creditor of the reference loan in the event of a loan default by the debtor or other credit event.
The buyer of the CDS makes a series of payments the CDS "fee" or "spread" to the seller and, in exchange, receives a payoff if the loan defaults. In the event of default the buyer of the CDS receives compensation usually the face value of the loanand the seller of the CDS takes possession of the defaulted loan. If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction ; the payment received is usually substantially less than the face value of the loan.
CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. In addition to corporations and governments, the reference entity can include a special-purpose vehicle issuing asset-backed securities.
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long positionand the party agreeing to sell the asset in the future assumes a short position.
The price agreed upon is called the delivery pricewhich is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes.
The forward price of such a contract is commonly contrasted with the spot pricewhich is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profitor loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk typically currency or exchange rate riskas a means of speculationor to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.
A closely related contract is a futures contract ; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. However, being traded over the counter OTCforward contracts specification can be customized and may include mark-to-market and daily margin calls. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.
In financea 'futures contract' more colloquially, futures is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today the futures price with delivery and payment occurring at a specified future date, the delivery datemaking it a derivative product i. The contracts are negotiated at a futures exchangewhich acts as an intermediary between buyer and seller. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be " long ", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be " short ".
While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange is to act as intermediary and mitigate the risk of default by either party in the intervening period.
For this reason, the futures exchange requires both parties to put up an initial amount of cash performance bondthe margin. Margins, sometimes set as a percentage of the value of the futures contract, need to be proportionally maintained at all times during the life of the contract to underpin this mitigation because the price of the contract will vary in keeping with supply and demand and will change daily and thus one party or the other will theoretically be making or losing money.
To mitigate risk and the possibility of default by either party, the product is marked to market on a daily basis whereby the difference between the prior agreed-upon price and the actual daily futures price is settled on a daily basis.
This is sometimes known as the variation margin where the futures exchange will draw money out of the losing party's margin account and put it into the other party's thus ensuring that the correct daily loss or profit is reflected in the respective account. If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account. This process is known as "marking to market". Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value i.
In finance, a put or put option is a stock market device which gives the owner of a put the right, but not the obligation, to sell an asset the future and options market wikiat a specified price the strikeby a predetermined date the expiry or maturity to a given party the seller of the put. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying. Put options are most commonly used in the stock market to protect against the decline of the price of a stock below a specified price.
In this way the buyer of the put will receive at least the strike price specified, even if the asset is currently worthless.
If future and options market wiki strike is Kand at time t the value of the underlying is S tthen in an American option the buyer can exercise the put for a payout of K-S t any time until the option's maturity time T.
The put yields a positive return only if the security price falls below the strike when the option is exercised. A European option can only be exercised at time T rather than any time until Tand a Bermudan option can be exercised only on specific dates listed in the terms of the contract. If the option is not exercised by maturity, it expires worthless.
The buyer will not exercise future and options market wiki option at an allowable date if the price of the underlying is greater than K. The most obvious use of a put is as a type of insurance. In the protective put strategy, the investor buys enough puts to cover his holdings of the underlying so that if a drastic downward movement of the underlying's price occurs, he has the option to sell the holdings at the strike price.
Another use is for speculation: Puts may also be combined with other derivatives as part of more complex investment strategies, and in particular, future and options market wiki be useful for hedging. By put-call paritya European put can be replaced by buying the appropriate call option and selling an appropriate forward contract.
The terms for exercising the option's right to sell it differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration.
The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long position in it. The advantage of buying a put over short selling the asset is future and options market wiki the option owner's risk of loss is limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited its price can rise greatly, in fact, in theory it can rise infinitely, and such a rise is the short seller's loss.
The put writer believes that the underlying security's price will rise, not fall. The writer sells the put to collect the premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already received.
Puts can be used also to limit the writer's portfolio risk and may be part of an option spread. That is, the buyer wants the value of the put option to increase by a decline in the price of the underlying asset below the strike price.
The writer seller of a put is long on the underlying asset and short on the put option itself. That is, the seller wants the option to become worthless by an increase in the price of the underlying asset above the strike price.
Generally, a put option that is purchased is referred to as a long put and a put option future and options market wiki is sold is referred to as a short put. A naked putalso called an uncovered putis a put option whose writer the seller does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock, but only if the price is low enough. If the buyer fails to exercise the options, then the writer keeps the option premium as a "gift" for playing the game.
If the underlying stock's market price is below the option's strike price when expiration arrives, the option owner buyer can exercise the put option, forcing the writer to buy the underlying stock at the future and options market wiki price.
That allows the exerciser buyer to profit from the difference between the stock's market price and the option's strike price. But if the stock's market price is above the option's strike price at the end of expiration day, the option expires worthless, and the owner's loss is limited to the premium fee paid for it future and options market wiki writer's profit.
The seller's potential loss on a naked put can be substantial. If the stock falls all the way to zero bankruptcyhis loss is equal to the strike price at which he must buy the stock to cover the option minus the premium received. The potential upside is the premium received when selling the option: During the option's future and options market wiki, if the stock moves lower, the option's premium may increase depending on how far the stock falls and how much time passes.
If it does, it becomes more costly to close the position repurchase the put, sold earlierresulting in a loss. If the stock price completely collapses before the put position is closed, the put writer potentially can face catastrophic loss.
In order to protect the put buyer from default, the put writer is required to post margin. The put buyer does not need to post margin because the buyer would not exercise the option if it had a negative payoff. A buyer thinks the price of a stock will decrease. He pays a premium which he will never get back, unless it is sold before it expires. The buyer has the right to sell the stock at the strike price.
The writer receives a premium from the buyer. If the buyer exercises his option, the writer will buy the stock at the strike price. If the buyer does not exercise his option, the writer's profit is the premium. A put option is said to have intrinsic value future and options market wiki the underlying instrument has a spot price S below the option's strike price K.
Upon exercise, a put option is valued at K-S if it is " in-the-money ", otherwise its value is zero. Prior to exercise, an future and options market wiki has time value apart from its intrinsic value. The following factors reduce the time value of a put option: Option pricing is a future and options market wiki problem of financial mathematics. Trading options involves a constant monitoring of the option value, which is affected by changes in the base asset price, volatility and time decay.
Moreover, the dependence of the put option value to those factors is not linear — which makes the analysis even more complex. The graphs clearly shows the non-linear dependence of the option value to the base asset price.
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