Chapter One: Introduction

The derivatives market is bigger than the stock market when measured in terms
of underlying assets.

Value of the assets underlying outstanding derivatives transaction is several times

the world gross domestic product

Derivative: A financial instrument whose value depends on the values of other

more basic underlying variables.
More often the variables underlying derivatives are the prices of traded assets,
but derivatives can be dependent on almost any variable.

Why are derivatives important?

They are used as a risk management tool by which you transfer risk associated
from underlying asset to the party who’s willing to take the risk

Derivatives Exchange: A market where individuals trade standardized contracts

that have been defined by the exchange.
I.e CBOT and CME which have now merged to form CME Group

The clearing house takes care of credit risk by requiring each of the two traders to
deposit funds (known as margin) with the clearing house to ensure that they will
live up to their obligations.
Exchanges have largely replaced the open outcry system by electronic trading

Over-The-Counter Markets: Traders working for banks, fund managers, and

corporations contact each other directly. (no clearing house)
Many trades take place at OTC market rather than on an exchange. Once an OTC
trade has been agreed, the two parties can either present it to a central
counterparts CCP which is like an exchange clearing house, or bilaterally which
means the two parties will sign an agreement covering all their transactions with
each other.
Traditionally, participants in the OTC derivatives markets contact each other
directly or find counter parties for their trades using an inter dealer broker.
Banks usually act as market makers.

Number of derivatives transactions per year in OTC is smaller than exchange

traded but the average size of the transaction is much greater.

OTC markets have become regulated since 2008, why?

1-To reduce systemic risk
2-To increase transparency

Spot contracts: An agreement made between a buyer and a seller at time zero for
the seller to deliver the asset immediately and the buyer to pay for the asset
immediately.

Forward Contracts: An agreement to buy or sell an asset at a certain future time

for a certain price.
A forward contract is traded in the over-the-counter market
Long Position- Agrees to buy underlying asset on a certain specified future date
for a certain specified price
Short Position- Agrees to sell the asset on the same date for the same price.

Bid: Maximum price that a buyer is willing to pay for a share of the security
Ask/Offer: Minimum price a seller is willing to take for the same share of the
security

Basically, we see which seller is offering the lowest price and quote it and look for
buyer with highest ask and quote is.
If I am a buyer, I’ll look through the ask price (because I can’t demand my bid
price)
If I am a seller, I’ll look through the bid price
Profit from long position (St – K)

Where if St is lower than K (or X) then the long position will be negative and will
be at a loss since they’ll be obligated to pay higher than the spot market
The long position holder does not receive premium

Profit from short position (K – St)

Where if St is lower than K the short position will be at a profit since the seller
will sell at a price higher than the current market price.
Short position holder does not receive a premium
The payoff from a forward contract can be either positive or negative
It costs nothing to enter a forward contract (No premium)

Futures Contracts: An agreement to buy or sell an asset for a certain price at a

certain time that is traded on an exchange I.e SME Group

Futures are:
1- Traded in an active secondary market
2- Subject to greater regulations
3- Backed by a clearing house
4- Require daily settlements of gains and losses

Similarities between Forwards and Futures

1- Both are either deliverable or cash-settled contracts
2- Both have contract prices set, so each side of the contract has a value of
zero value at the initiation of the contract

Differences between them

1- Futures contracts trade on organized exchanges while Forwards are private
contracts and typically don’t trade.
2- Futures are standardized where Forwards are customized
3- A clearinghouse is the counterparty to all future contracts, while forwards
are contracts with the originating counterparty therefore has credit risk
4- Government regulates futures markets while forwards are usually less
regulated

Swaps Contracts: an agreement to exchange a series of payments on periodic

settlement dates over a certain time period

Swaps require no payment by either party at initiation

Swaps are custom instruments
Swaps are not traded in any organized secondary market
Swaps are unregulated
Most participants are large institutions
Options contracts: Gives the owner the right but not the obligation to either buy
or sell the underlying asset at a given price
An option buyer can choose whether to exercise
An option seller is obligated to perform if the buyer chooses to exercise
Options are traded both on an exchange and in the OTC markets

Types of Options
1- Call option is an option that gives the right to buy an asset at a certain date for
a certain price
2- Put option is an option that gives the right to sell an asset at a certain date for
a certain price

Option Positions
 Long Call: Buyer of a call option that has a right to buy
 Short Call: Seller of call option that is obligated to sell (Writer of Call
Option)
 Long Put: Buyer of put option that has a right to sell
 Short Put: Seller of put option that is obligated to buy (Writer of Put
Option)

The price of the option contract that you pay for buying is called an option
premium
Price in the contract is called strike or exercise price
The date is known as expiration or maturity

An American Option: Can be exercised at any time during its life

A European Option: Can be exercised only at maturity.

Most options traded on exchanges are American. European options are usually
easier to analyze.
One contract is usually an agreement to buy or sell 100 shares
Types of traders
Hedgers: (Risk Averse)
To reduce the risk that they face from potential future movements in the market

Speculators: (Risk Seeking)

To bet on the future direction of a market variable

Arbitrageurs: (Risk Neutral)

To take offsetting position in two or more instruments to lock in a profit.