1. **Definition of derivatives**:
Derivatives are financial securities or instruments whose value is derived from the value of an underlying asset. The underlying asset can be a stock, bond, commodity, currency, or market index. The value of a derivative is directly linked to changes in the price or value of the underlying asset.
Example: Let's consider a call option on Company XYZ stock as a derivative. The value of the call option will be influenced by the price movements of the underlying Company XYZ stock. If the stock price goes up, the value of the call option will typically increase, and if the stock price goes down, the value of the call option will generally decrease.
2. **Features of derivatives**:
a. **Leverage**: Derivatives usually require only a fraction of the total value of the underlying asset as an initial investment. This allows investors to control a larger position in the market. For example, if a futures contract requires 10% margin, an investor can control a $10,000 worth of underlying asset with just $1,000.
b. **Risk Management**: Derivatives can be used for hedging, which means using them to offset potential losses in the value of an underlying asset. For instance, a wheat farmer can use futures contracts to lock in a price for the upcoming harvest, protecting against a potential decrease in wheat prices.
c. **Speculation**: Traders and investors can use derivatives to speculate on the future price direction of an underlying asset. By buying a call option on Company ABC stock, an investor can potentially profit from a rise in Company ABC's stock price without owning the stock directly.
d. **Diversification**: Derivatives enable investors to gain exposure to different markets or asset classes. For instance, through index futures, an investor can gain exposure to a broad market index like the S&P 500, diversifying their portfolio across multiple companies.
e. **Customization**: Derivatives can be structured and tailored to meet specific investment objectives and risk profiles of investors. Structured options, for example, can be customized to suit an investor's specific risk tolerance and return expectations.
3. **Uses of derivatives**:
a. **Hedging**: A company might use futures contracts to hedge against the risk of rising commodity prices, ensuring stable costs for its production. For instance, an airline can use oil futures contracts to protect itself against the risk of rising fuel prices.
b. **Speculation**: Traders may use options to speculate on the price movement of a stock, hoping to profit from significant price swings. For example, a trader may buy call options on a technology company expecting a positive earnings report, which could lead to a rise in the company's stock price.
c. **Diversification**: An investor might use exchange-traded funds (ETFs) that track broad market indices to diversify their portfolio across different asset classes. ETFs provide exposure to a diversified basket of assets without needing to buy each individual asset separately.
d. **Convertible Bonds**: A company might issue convertible bonds that allow bondholders to convert their bonds into a specified number of shares of the company's common stock. This gives bondholders the option to benefit from potential future stock price appreciation.
e. **Employee Compensation**: Stock options can be used as part of an employee compensation package, providing employees with the right to purchase company shares at a predetermined price. This incentivizes employees to work towards the company's success as they can benefit from future stock price growth.
4. **Linear derivatives**:
Linear derivatives have a payoff that is directly proportional to the change in the value of the underlying asset. Two common examples of linear derivatives are:
a. **Forward Contracts**: A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. The payoff is linear since the profit or loss depends on the difference between the contract price and the actual market price at expiration.
Example: Company X enters into a forward contract with Company Y to buy 1,000 barrels of oil at $70 per barrel in three months. If the oil price at the contract's expiration is $80 per barrel, Company X gains $10,000 (1,000 barrels * ($80 - $70)). If the price is $60 per barrel, Company X loses $10,000 (1,000 barrels * ($60 - $70)).
b. **Futures Contracts**: Futures contracts are similar to forward contracts, but they are standardized, exchange-traded, and often have daily settlement of gains or losses. The payoff remains linear as it is determined by the difference between the futures contract price and the prevailing market price at the time of closing the position.
Example: An investor buys a futures contract for 100 shares of Company Z at $50 per share. If the price of Company Z's stock rises to $60 per share when the investor sells the futures contract, they make a profit of $1,000 (100 shares * ($60 - $50)). If the price drops to $45 per share, they incur a loss of $500 (100 shares * ($45 - $50)).
In a linear derivative, the parties involved are exposed to a direct risk-reward relationship. For every unit gained by one party, an equal unit is lost by the other party, making it a zero-sum game.
5. **Non-linear derivatives**:
Non-linear derivatives have a payoff that is not directly proportional to the change in the value of the underlying asset. A common example of a non-linear derivative is:
a. **Options**: An option gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price on or before a specified expiration date. The payoff is non-linear because the option holder's potential gain or loss is influenced by the magnitude and direction of the underlying asset's price movement.
Example: An investor purchases a call option on Company M stock with a strike price of $100, paying a premium of $5 per share. If the stock price goes up to $120 at expiration, the option holder can exercise the option and make a profit of $15 per share ([$120 (stock price) - $100 (strike price)] - $5 (premium paid)). However, if the stock price is below $100 at expiration, the option will expire worthless, and the investor will lose the premium paid.
In a non-linear derivative, the potential profit or loss is not directly tied to the underlying asset's movement, and the option holder has asymmetric risk exposure. The option buyer can potentially benefit from favorable price movements while limiting their losses to the premium paid for the option.
**Question 1:** Which of the following best describes a derivative?
a) A security with a fixed interest rate
b) A financial instrument whose value is derived from an underlying asset
c) A government-issued bond
d) A stock issued by a newly established company
**Answer:** b) A financial instrument whose value is derived from an underlying asset
**Question 2:** What is the primary purpose of using derivatives in financial markets?
a) Generating stable fixed returns
b) Speculating on short-term price movements
c) Hedging against potential losses
d) Diversifying exposure to various asset classes
**Answer:** c) Hedging against potential losses
**Question 3:** Which type of derivative allows the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date?
a) Forward contract
b) Futures contract
c) Option
d) Swap
**Answer:** c) Option
**Question 4:** Linear derivatives, such as forward and futures contracts, have a payoff that is:
a) Directly related to the value of the underlying asset
b) Unrelated to the value of the underlying asset
c) Non-existent
d) Based on the interest rate of the underlying asset
**Answer:** a) Directly related to the value of the underlying asset
**Question 5:** Non-linear derivatives, like options, have a payoff that is:
a) Directly proportional to the change in the value of the underlying asset
b) Unrelated to the change in the value of the underlying asset
c) Inversely related to the change in the value of the underlying asset
d) Non-linear in relation to the change in the value of the underlying asset
**Answer:** d) Non-linear in relation to the change in the value of the underlying asset
**Question 6:** An investor who buys a stock option:
a) Has the obligation to buy the underlying asset at a specified price
b) Has the obligation to sell the underlying asset at a specified price
c) Has the right, but not the obligation, to buy the underlying asset at a specified price
d) Has the right, but not the obligation, to sell the underlying asset at a specified price
**Answer:** c) Has the right, but not the obligation, to buy the underlying asset at a specified price
**Question 7:** Which feature of derivatives allows investors to control a larger position with a smaller initial investment?
a) Hedging
b) Leverage
c) Diversification
d) Speculation
**Answer:** b) Leverage
**Question 8:** A company issues convertible bonds to its investors. What does this mean?
a) The company can choose to repay the bonds in cash or stocks, at its discretion.
b) The bondholders have the right to convert their bonds into a specified number of shares of the company's common stock.
c) The company can defer the bond payments until a future date.
d) The bondholders can convert their bonds into a different currency.
**Answer:** b) The bondholders have the right to convert their bonds into a specified number of shares of the company's common stock.
**Question 9:** Which type of derivative is traded on an organized exchange and has standard contract specifications?
a) Forward contract
b) Futures contract
c) Option
d) Swap
**Answer:** b) Futures contract
**Question 10:** Derivatives can be used for all the following purposes except:
a) Speculation on short-term price movements
b) Hedging against potential losses
c) Generating fixed returns
d) Diversifying investment exposures
**Answer:** c) Generating fixed returns
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