Derivatives

RECENT NEWS
Financial Times  Feb 14  Comment 
CFTC regulator gives industry six months’ grace period to comply with new standards
Financial Times  Feb 2  Comment 
Unprepared counterparties risk being shut out of swaps business after March shake-up
The Hindu Business Line  Feb 1  Comment 
The proposal to set up an expert committee to study and promote creation of an operational and legal framework to integrate the spot and derivatives market in the agricultural sector will help farme...
Mondo Visione  Jan 31  Comment 
Contango has just released a special report looking at the changing face of client derivatives clearing as regulation, higher capital requirements and constraints on revenue models are changing the way banks in particular look at their clients. In...
Mondo Visione  Jan 31  Comment 
The International Swaps and Derivatives Association, Inc. (ISDA) today announced that its Americas Credit Derivatives Determinations Committee resolved that a bankruptcy credit event occurred in respect of Avaya Inc. ISDA will publish further...
The Hindu Business Line  Jan 29  Comment 
SEBI has issued a circular laying out the criteria for evaluating commodity derivative contracts
The Economic Times  Jan 21  Comment 
Size of market, standardisation of commodity , durability or storability, geographical coverage, ease of doing business etc, should be examined, Sebi said.
Mondo Visione  Jan 19  Comment 
The Canadian Securities Administrators (CSA) today announced two new national instruments affecting over-the-counter (OTC) derivatives trading in Canada. The national instruments are part of Canada’s ongoing implementation of commitments to...
New York Times  Jan 18  Comment 
Aitan Goelman will leave the Commodity Futures Trading Commission as a wave of prosecutors and enforcers depart in the Obama administration’s final days.




RELATED WIKI ARTICLES
 

Derivatives are investment vehicles whose price is dependent on an underlying asset. The most common form of derivatives include stock options, futures & swaps. Options are contracts that give the holder the right but not the obligation to buy or sell a specific security at a pre-determined price on a pre-determined date. The two kinds of options are call and put options. A call holder has the right but not the obligation to “call” stock away from the call writer. So as the price of the underlying security, in this case a stock moves up (or down) the call option becomes worth more (or less). Since derivatives are essentially a contract with an associated value there are many forms of derivatives. Some companies use derivatives to hedge against natural resource price swings or fluctuations in weather that may affect yields.

Derivatives are used by investors to:

  • Provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative
  • Speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level)
  • Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out
  • Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives)
  • create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level)


Example: A lease option to buy a house. The lease contract has terms that give you the right to buy the house at a specific price any time you want (until the lease contract expires). Suppose the terms stated that you could buy the house anytime within the first year of leasing from the owner for 100,000. If the price of the house (local real estate boom) increased to 150,000 you could buy the house for 100,000 and then sell it for 150,000 for a profit of 50,000. If the price of house price dropped (perhaps crime increase) you would have no incentive to exercise your option to buy, so you let that contract expire (worthless) and you do not buy the house. As illustrated here, the contract derives its value NOT from the paper on which it is written, but from the actual market price of another object (the house in this case). This is the basic premise for instruments of specualation known as derivatives.

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