1.

0 Introduction
1.1 Derivatives
 A financial instrument whose value derives from the value of underlying asset.

1.2Exchange-Traded Market
 Trade standardized contracts defined by the exchange.
 Once two traders agreed on a trade, the exchange clearing house acts as
intermediaries between both parties to manage the credit risk.
o Traders do not have to worry about the creditworthiness of counterparties.
o Clearing house requires margin from both traders to ensure they will live up
to their obligations.

1.3 Over-the-Counter Market

 Larger than exchange market.
 Main participants: Banks, financial institutions, fund managers, corporations…
 Traders connect with each other via phone, email or interdealer broker.
 Banks often act as market maker for more commonly traded instruments.
o Always prepared to quote bid price (buying price) and offer price (selling
price).
 Participants can enter into any mutually accepted contract.

1.4 Differences between Exchanged-Traded and OTC Market

Exchange-Traded Market
Centralized system of trading.
Has a physical location to be operated
from.
Trades can only be performed during
specified trading hours only.
Often used by large corporations.
High trading costs.
Highly regulated, providing liquidity
and transparency.
Contracts are standardized.
Well-established companies trade to
expand their functions.
Trade occurs through a network Trade occurs bilaterally between two
involving multiple traders.
Over-the-Counter Market
Decentralized system of trading.
Trade can be done electronically via
phone, email, laptop, etc. at any place.
Trades can be performed at any time in a
day.
Often used by small businesses.
Low trading costs.
Lesser obligations to follow, prone to
fraud and less liquid.
Contracts are not standardized.
Provides access to securities that
otherwise not available on formal
exchange.
parties through a dealer.
1.5 Forward Contract
 An agreement to buy/sell an asset at a certain future time for a certain price.
 Traded in over-the-counter (OTC) market.
 Long position – Party that agrees to buy the underlying asset at a certain price at a
specified future date.
 Short position – Party that agrees to sell the underlying asset for a certain price at a
specified future date.
 Used to hedge foreign currency risk by locking the currency now, hoping that it will
increase/decrease in the future.
 Payoff from forward contract ( ST = Spot price of the asset at maturity; K = Delivery
price):
1. Long Position
 Profit when ST > K (buy at a much lower price that are locked in at the
present).
ST −K

2. Short Position
 Profit when K > ST (sell at a higher price that are locked in at the present).
K−S T

 No cost to enter into a forward contract.

 o Payoff is the total gain/loss of the trader.

1.6 Futures Contracts

 An agreement between two parties to buy/sell an asset at a certain future time for a
certain price.
 Traded on exchange.
 Contracts are standardized.
 Both parties may not necessarily know each other, thus the exchange provides a
mechanism that gives both parties a guarantee that the contract will be honoured.

1.6 Options
 Traded on both exchange and OTC.
 Call Option: Gives holder the right to buy the underlying asset by a certain date for
a certain price.
 Put Option: Gives holder the right to sell the underlying asset by a certain date for a
certain price.
 Two types of options:
1. European Option
 Can only be exercised at expiration.
2. American Option
 Can be exercised at any time up to expiration date.
 Gives holder the right to buy/sell.
o Holder can choose not to exercise their right.
 Four types of option holders:

Call Put
Long Buy Sell
Short Sell Buy
1.7 Traders
1. Hedgers
 Use derivatives to reduce risks faced from potential future movements of
market variables.
a. Forward/Futures Contract
 Neutralize risks by fixing the price that the hedger will pay/receive for the
underlying asset.
  No payment involved.
b. Options
 Provides an insurance in case the market does not move in the way they
assumed.
 Upfront payment is required.
2. Speculators
 Use derivatives to bet on future movement of a market variable.
a. Forward/Futures Contract
 Potential losses/gains can be very large.
b. Options
 Potential gains is large, but potential loss is limited to the amount paid for
the option.
3. Arbitrageurs
 Simultaneously taking offsetting positions in two or more instruments to lock in a
riskless profit.
 Not favourable by small investors as transaction costs would probably eliminate
the profit.
 Attractive to large corporations as they usually face very low transaction costs.
 Arbitrage opportunities are very rare and only last for a very short time.