"What are we gambling on -- the stock price, interest rate, commodities price..."
The basis of the derivative instrument, which is its price per unit.
What is a notional amount?
The type and number of units on which a derivative instrument will be based, such as number of shares, or pounds of wire.
What is the value or settlement amount of a derivative?
What the loser pays the winner at expiration.
The underlying (price basis) times the notional amount (number of units per price)
What is a derivative (in layman's terms) and why are they called derivatives?
It is legalized gambling. An over/under contract. Someone bets the rate will increase, someone else bets it will go down. There is always a winner and always a loser.
Because their value is based on (derived from) the value of some other instrument.
What are the three rules needed to label an investment as a derivative (vs an investment)?
Rule 1: The instrument must have one or more underlyings and one or more notional values.
Rule 2: The instrument does not require an initial investment, or the initial investment is less than what would be required for other types of contracts. (Example = an investment in stocks at $20/share for 100 shares would require an initial investment of $2,000, but the premium for an option to buy those shares is only $1/share or $200)
Rule 3: The settlement of the instrument can be made in cash (Example = if the notional amount is lbs. of copper, the settlement isn’t made in copper, it’s the cash equivalent of the copper that is sold).
What is the difference between a derivative and a hedge?
A hedge uses a derivative to offset changes (minimize the risk) in another item. For example, a hedge on a contract would offset potential loss. If the contract price is more than the market price at the time (a loss of money to the entity), the hedge would be designed to increase in price (sold for a gain) and the gain would offset the loss.
A derivative not used as a hedge is simply a gamble on the market that the entity will sell (or buy) the item for more (or less) than the market price. It isn’t used to offset a change in something else.
What is an options contract?
An opportunity, but not an obligation, to buy or sell something at a fixed price during a specific period of time.
What is the name of the options buyer?
What is the name of the options seller?
The holder purchases a put option. What does this allow the holder to do? Why would the holder purchase one of these? Is this an asset or a liability?
To sell an item in the future at a fixed price.
The holder is hoping the future market price is less than the put price. The holder will have a profit if the price goes down.
Example: I own 100 shares of stock purchased at $15/share. I buy a put option at $12/share. If the price drops to $10/share I can still sell at higher than the market.
This is a liability.
The holder purchases a call option. What does this allow the holder to do? Why would the holder purchase one of these? Is this an asset or a liability?
To purchase an item in the future at a fixed price.
The holder is hoping the future price goes higher than the call price. The holder will have a profit if the price goes up.
Example: I buy a call at $15/share. I want the share price to go above that ($17/share) so that I can buy it cheaper than market.
This is an asset.
What is a futures contract? Who negotiates these contracts?
An obligation to buy (call) or sell (put) underwritings at a specific notional price on a specific date.
These are publically traded; negotiated through a clearinghouse using standardized notional amounts and settlement dates.
What does it mean when a party takes a “long position” on a future’s contract?
That is the party who must purchase (call) the item in the future.
The holder makes a profit when the market prices exceed the strike price.
What does it mean when a party takes a “short position” on a future contract?
That is the party who must sell (put) the item in the future.
The writer makes a profit when the market price goes below the strike price.
What is a forward contract? Who negotiates these contracts?
The same as a futures contract except they are negotiated privately, sometimes with the assistance of an intermediary and are highly customizable.
What is a swap contract? Who wins?
These swap future payments over time.
The winner is the one who receives more than what they pay.