Introduction to Derivatives
At this point of the course, we have all been introduced to the basic investment instruments such as bonds and stocks. Now it’s time for us to make things a little bit more interesting. You may or may not have heard the term derivative, however it’s the most important term in the investment world today. Derivatives are a financial contract between two parties whose value is derived from an underlying asset. The underlying asset can be a financial instrument such as a stock or a bond, or it can be a commodity such as gold, silver, wheat and crude oil etc. There are two types of derivatives options and futures (sometimes also called forwards).
Over the counter ...view middle of the document...
With options however there is a cost involved while purchasing an option. The cost of the contract is the minimal cost that both sides have to pay when they sign a contract which is usually not much.
Options are contracts between two parties a buyer and seller. The buyer of an option has the right to exercise the option to buy or sell the stated quantity for a particular price which the contract was signed upon. However, the seller of the option has an obligation to complete the transaction if and only if the buyer of the option chooses to exercise the option. Call option gives the right to the buyer of the option to purchase the underlying at a future date at a particular price (usually used when the market price of the asset is expected to rise). Put optionsgives the right to the buyer of the option to sell a specified quantity of the underlying asset at a particular price (usually utilized when the market price of the asset is expected to fall)
Forwards are also contracts between a buyer and a seller. With futures however both parties are obligated to trade the underlying asset in the future at a specified price agreed upon at the time of the creation of the contract. Usually futures are utilized for commodities rather than financial instruments. However, there are no restrictions stating that futures cannot be used for financial instruments.
1. Equities: equities are one of the major portions of financial derivatives. These derivatives consist of a stock share being the underlying asset which the speculations are placed upon.
2. Interest rates: Exchange traded interest rate derivatives are based on interest rate-sensitive securities. In Canada, underlying assets of this kind would include bankers’ acceptances and Governmental bonds. All interest rates futures trading in Canada is held at the Bourse de Montréal. However in OTC (Over-the-counter) market, these trades work a little differently. The speculation is done on the floating interest rates themselves, and is therefore more risky. Examples of such underlying rates include the LIBOR (London Inter-Bank Offer Rate), the interest earned on Eurodollar deposits in London and the yields on Treasury Bills and Treasury Bonds. In this type of market the underlying asset is the floating interest rate itself.
3. Currencies: The most common underlying financial derivative are based on the US dollar, British pound, Japanese Yen, Swiss franc and Euro. The most commonly used types of derivatives include currency futures ranked 1st most popular, and currency derivatives such as interest rate caps, floors and collars which will be discussed later on. However, there are no currency derivatives listed on any of the Canadian exchange markets.
Hedging is one of the main components offered by derivatives which is highly used by individual investors and as well as institutional...