Derivative Markets and Financial Instruments

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Questions and Answers

What is the primary purpose of margin in derivatives trading?

To represent market fluctuations, reflecting the loss or gain made on that day.

How do arbitrageurs make money in the market?

By buying low-priced stocks and selling them at higher prices in a different market, exploiting market imperfections.

What is the main advantage of using derivatives in an investment portfolio?

It gives investors an arbitrage advantage, allowing them to buy an asset at a low price and sell it at a higher price in another market.

What is the primary purpose of buying derivatives in a portfolio?

To reduce volatility and increase gains through speculation, or to gain exposure to a market with a smaller outlay. Signup and view all the answers

What is the key difference between options and futures contracts?

Options give the right, but not the obligation, to buy or sell an asset, whereas futures contracts are standardized agreements to buy or sell an asset at a future date and price. Signup and view all the answers

How do forward contracts differ from futures contracts?

Forward contracts are custom agreements, whereas futures contracts are standardized contracts. Signup and view all the answers

What is the primary benefit of using derivatives to manage risk?

They help shield assets against market volatility and transfer risk, allowing investors to balance their portfolios. Signup and view all the answers

What is the main reason investors prefer derivatives over other investment instruments?

Derivatives offer an arbitrage advantage, allowing investors to buy low and sell high in different markets. Signup and view all the answers

What is the primary purpose of hedgers in the derivatives market?

To protect their portfolio against market risk and price fluctuations by assuming an opposite position concerning the derivatives market. Signup and view all the answers

What is the characteristic of a derivative that requires little initial net investment?

That it requires no initial net investment or little net investment relative to other types of contracts that have a similar response to changes in market conditions. Signup and view all the answers

What do derivatives derive their value from?

Contractually required cash flows from some other security or index. Signup and view all the answers

What is the main difference between hedgers and speculators in the derivatives market?

Hedgers are risk-averse and wish to protect their portfolio, while speculators are risk-takers who seek to earn large profits. Signup and view all the answers

What are some common examples of underlying assets used in derivatives?

Bonds, stocks, commodities, currencies, and indices. Signup and view all the answers

What is the primary goal of speculators in the derivatives market?

To earn large profits by taking risks. Signup and view all the answers

What is the characteristic of a derivative that is settled at a future date?

Derivatives are settled at a future date. Signup and view all the answers

Why do hedgers invest in derivative markets?

To protect themselves against market risk and price fluctuations. Signup and view all the answers

Study Notes

Derivatives: Meaning, Features, and Importance

Derivatives are financial instruments that derive their value from some other security or index, such as bonds, stocks, commodities, currencies, and indices.
They are complex financial instruments used for various purposes, including hedging and accessing additional assets or markets.

Characteristics of Derivatives

A derivative is a financial instrument whose value changes in response to changes in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or similar variable.
Derivatives require no initial net investment or little net investment relative to other types of contracts.
They are settled at a future date.

Participants of the Derivatives Market

Hedgers: risk-averse brokers and traders who invest in derivatives to protect their portfolio from market risk and price fluctuations.
Speculators: risk-takers who invest in derivatives to earn large profits, with a mindset opposite to hedgers.
Margin Traders: investors who pay a margin to participate in derivatives trading, which reflects market fluctuations.
Arbitrageurs: investors who make use of market imperfections to buy low-priced stocks and sell them at higher prices in different markets.

How Derivatives Work

Investors buy derivatives to reduce portfolio volatility, agreeing on a price for a deal in the present that will happen in the future.
Derivatives enable investors to gain exposure to a market with a smaller outlay than buying the actual underlying.

Why Invest in Derivative Contracts?

Derivatives offer an Arbitrage advantage, allowing investors to buy an asset at a low price and sell it at a higher price in another market.
Derivatives protect investors from market volatility and help shield their assets against market downturns.
Derivatives are a great way to transfer risk and balance out a portfolio.

Typical Examples of Derivatives

Options: contracts giving the right, but not the obligation, to buy or sell an asset at a specified price before a specified date.
Swaps: agreements to exchange cash flows or other financial instruments over a set period.
Futures: standardized contracts to buy or sell an asset at a future date and price.
Forward Contracts: custom agreements to buy or sell an asset at a future date and price.

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Description

Learn about derivative financial instruments, their characteristics, and importance. Understand how they derive their value from underlying assets or indices.