Futures and options basics wikipedia
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an assetindexor interest rateand is often simply called the " underlying ". In the United Statesafter the financial crisis of —, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories futures and options basics wikipedia financial instruments, the other two being stocks i.
Derivatives are contracts between two parties that specify conditions especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount under which payments are to be made between the parties. The components of a firm's capital structure, e.
From the economic point of view, financial derivatives are cash flows, that are conditioned stochastically and discounted to present value. The market risk inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately. Derivatives therefore allow the breakup of ownership and futures and options basics wikipedia in the market value of an asset.
This also provides a considerable amount of freedom regarding the contract design. That contractual freedom futures and options basics wikipedia to modify the participation in the performance of the underlying asset almost arbitrarily.
Thus, the participation in the market value of the underlying can be effectively weaker, stronger leverage effector implemented futures and options basics wikipedia inverse. Hence, specifically the market price risk of the underlying asset can be controlled in almost every situation.
There are two groups of derivative contracts: Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives may broadly be categorized as "lock" or "option" products. Lock products such as swapsfuturesor forwards obligate the contractual parties to the terms over the life of the contract. Option products such as interest rate swaps provide the buyer the right, but not the obligation to enter the contract under the terms specified.
Derivatives can be used either for risk management i. This distinction is important because the former is a prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a risky opportunity to increase profit, which may not be properly disclosed to stakeholders.
Along with many other financial products and services, derivatives reform is an element of the Dodd—Frank Wall Street Reform and Consumer Protection Act of The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission CFTC and those details are not finalized nor fully implemented as of late Still, even these scaled down figures represent huge amounts of money.
And for one type of derivative at least, Futures and options basics wikipedia Default Swaps CDSfor which the inherent risk is considered high [ by whom? It was this type of derivative that investment magnate Warren Buffett referred to in his famous speech in which he warned against "financial weapons of mass destruction". Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties.
Based upon movements in the underlying asset over time, however, the value of the contract will fluctuate, and the derivative may be either an asset i.
Importantly, either party is therefore exposed to the credit quality of its counterparty and is interested in protecting itself in an futures and options basics wikipedia of default. Option products have immediate futures and options basics wikipedia at the outset because they provide specified protection intrinsic value over a given time period time value.
One common form of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay more futures and options basics wikipedia a policy with greater liability protections intrinsic value and one that extends for a year rather than six months time value.
Because of the immediate option value, the option purchaser typically pays an up front premium. Just like for lock products, movements in the underlying asset will cause the option's intrinsic value to change over time while its time value deteriorates steadily until the contract expires. An important difference between a lock product is that, after the initial exchange, the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the option if it has positive value i.
Derivatives allow risk related to the price of the underlying asset to be transferred from one party futures and options basics wikipedia another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: However, there is still the risk that futures and options basics wikipedia wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract.
Although a third party, called a clearing houseinsures a futures contract, not all derivatives are insured against counter-party risk. From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract thereby paying more in the future than he otherwise would have and reduces the risk that the price of wheat will rise above the price specified in the contract.
In this sense, one party is the insurer risk taker for one type of risk, and the counter-party is the insurer risk taker for another type of risk. Hedging also occurs when an individual or institution buys an asset such as a commodity, a bond that has coupon paymentsa stock that pays dividends, and so on and sells it using a futures contract.
The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the futures and options basics wikipedia or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the futures and options basics wikipedia current assessment of the future value of the asset. Derivatives trading of this kind may serve the financial interests of certain particular businesses.
The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement FRAwhich is a contract to pay a fixed rate of interest six months after purchases on a notional amount of futures and options basics wikipedia.
If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings. Derivatives can be used to acquire risk, rather than to hedge against risk.
Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset.
Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at futures and options basics wikipedia high price according to a derivative contract when the future market price is less. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.
Speculative trading in derivatives gained a great deal of notoriety in when Nick Leesona trader futures and options basics wikipedia Barings Bankmade poor and unauthorized investments in futures contracts.
The true proportion of derivatives contracts used for hedging purposes is unknown,  but it appears to be relatively small. In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:. According to the Bank for International Settlementswho first surveyed OTC derivatives in reported that the " gross market valuewhich represent the cost of replacing all open contracts at the prevailing market prices, Because OTC derivatives futures and options basics wikipedia not traded on an exchange, there is no central counter-party.
Therefore, they are subject to counterparty risklike an ordinary contractsince each counter-party relies on the other to perform. An "asset-backed security" is used as an umbrella term for a type of security backed futures and options basics wikipedia a pool of assets—including collateralized debt obligations and mortgage-backed securities Example: An empirical analysis" PDF. Retrieved July 13, Asset-backed securities, called ABS, are bonds or notes backed by financial assets.
Typically these assets consist of receivables futures and options basics wikipedia than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans. The CDO is "sliced" into "tranches"futures and options basics wikipedia "catch" the cash flow of interest and principal payments in sequence based on seniority. The last to lose payment from default are the safest, most senior tranches. As an example, a CDO might issue the following tranches in order of safeness: Separate special-purpose entities —rather than the parent investment bank —issue the CDOs and pay interest to investors.
CDO collateral became dominated not by loans, but by lower level BBB or A tranches recycled from other asset-backed securities, whose assets were usually non-prime mortgages. A credit default swap CDS is a financial swap agreement that the seller of the CDS will compensate the buyer the creditor of the reference loan in the event of a loan default by the debtor or other credit event. The buyer of the CDS makes a series of payments the CDS "fee" or "spread" to the seller and, in exchange, receives a payoff futures and options basics wikipedia the loan defaults.
In the event of default the buyer of the CDS receives compensation usually the face value of the loanand the seller of the CDS takes possession of the defaulted loan. If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction ; the payment received is usually substantially less than the face value of the loan. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency.
In addition to corporations and governments, the reference entity can include a special-purpose vehicle issuing asset-backed securities. In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long positionand the party agreeing to sell the asset in the future assumes a short position.
The price agreed upon is called the delivery pricewhich is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes.
The forward price of such a contract is commonly contrasted with the spot pricewhich is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or futures and options basics wikipedia discount, generally considered in the form of a profitor loss, by the purchasing party.
Forwards, like other derivative securities, can be used to hedge risk typically currency or exchange rate riskas a means of speculationor to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract ; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.
However, being traded over the counter OTCforward contracts specification can be customized and may include mark-to-market and daily margin calls. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.
In financea 'futures contract' more colloquially, futures is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today the futures price with delivery and payment occurring at a specified future date, the delivery datemaking it a derivative product i.
The contracts are negotiated at a futures exchangewhich acts as an futures and options basics wikipedia between buyer and seller. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be " long ", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be " short ". While the futures contract specifies a trade taking place in the future, futures and options basics wikipedia purpose of the futures exchange is to act as intermediary and futures and options basics wikipedia the risk of default by either party in the intervening period.
For this reason, the futures exchange requires both parties to put up an initial amount of cash performance bondthe margin. Margins, sometimes set as a percentage of the value of the futures contract, need to be proportionally maintained at all times during the life of the contract to underpin this mitigation because the price of the contract will vary in keeping with supply and demand and will change daily and thus one party or the other will theoretically be making or losing money.
To mitigate risk and the possibility of default by either party, the product is marked to market on a daily basis whereby the difference between the prior agreed-upon price and the actual daily futures price is settled on a daily basis. This is sometimes known as the variation margin where the futures and options basics wikipedia exchange will draw money out of the losing party's margin account and put it into the other party's thus ensuring that the correct daily loss or profit is reflected in the respective account.
If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account. This process is known as "marking to market".
Thus on the delivery date, the amount exchanged is not the specified price futures and options basics wikipedia the contract but the spot value i.
Open interest also known as open contracts or open commitments refers to the total number of outstanding derivative contracts that have not been settled offset by delivery.
For each buyer futures and options basics wikipedia a futures contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered 'open'.
Many [ citation needed ] technical analysts believe that a knowledge of open interest can prove useful toward the end of major market moves. For some [ citation needed ] option traders, open interest indicates the intensity of trading in a financial instrument.
If open interest increases suddenly, it is likely [ citation needed ] that new information about the underlying security has been revealed, which may indicate a near-term rise in the underlying security's volatility. However, neither an increase in volatility nor open interest necessarily indicate anything about the direction of future price movements.
A leveling off of open interest following a sustained price advance is often [ citation needed ] an early warning of the end to an uptrending or bull market. Technical analysts view [ citation needed ] increasing open interest as an indication that new money is flowing into the marketplace.
From this assumption, one could conclude that the present trend will continue. Analogously, declining futures and options basics wikipedia interest implies that the market is liquidating, and suggests that the prevailing futures and options basics wikipedia trend is coming to an end.
A common misconception is that open interest is the same thing as the number of option contracts traded. The difference between the two can be explained with a short scenario here. Further, according to the definition of open interest in this entry, a change in open interest indicates a difference in the number of buyers and sellers of a financial instrument, or at a minimum an increase or decrease in the size of participants' positions.
Like volatility, it has no directional component, it is just a tally of unsettled contracts. For example, if trader X buys 2 futures contracts from trader Y who is the sellerthen open interest rises by 2. If another trader A buys 2 futures contracts from trader B, then the open interest rises to 4. Now, if trader X unwinds his position and the counter party is either Y or B, then the open interest in the system will reduce by that quantity.
But if X unwinds his position, and the counter party is a new entrant, say C, then the open interest will remain unchanged. The level of outstanding positions in the derivatives segment is one of the parameters widely tracked by the market. One complication involved when looking at futures and options basics wikipedia overall level of open interest in a futures market is the impact of deliveries.
In a physically-delivered commodity, when delivery ultimately takes place the contract that has been delivered is no longer included in the overall open interest tally. Open interest provide useful information that should be considered when entering an option position. First, let's look at exactly what open interest represents. Unlike stock trading, in which there is a fixed number of shares to be traded, option trading can involve the creation of a new option contract when a trade is placed.
Open interest will tell you the total futures and options basics wikipedia of option contracts that are currently open—in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment.
For example, say we look at Microsoft and open interest tells us that there have been 81, options opened for the March You may be wondering if that number refers to options bought or sold. The answer is that you have no way to know for sure how many transactions have taken place but you do know that there are 81, options contracts that remain open. Since there is 1 bought position and 1 sold position for each of these contracts, there are 81, positions that remain bought to 'open' and 81, positions that remain sold to 'open' for the March There are always the same number of positions on either side of the open transactions.
So, when an option is traded with one party opening and one party closing, the open interest remains unchanged. If both parties in the transaction are closing positions then the open interest decreases accordingly. If both parties are opening positions then the open interest goes up accordingly. One way to use open interest is futures and options basics wikipedia look at it relative to the volume of contracts traded. When the volume exceeds the existing open interest on a given day, this suggests that trading in that option was exceptionally high that day.
Open interest can help you determine whether there is unusually high or low volume for any futures and options basics wikipedia option. Open interest also gives you key information regarding the liquidity of an option. If there is no open interest for an option, there is no secondary market for that option. When options have large open interest, it means they have a large number of buyers and sellers, and an active secondary market will increase the odds of getting option orders filled at good prices.
So, all other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask. Increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend up, down or sideways will continue. Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. A knowledge of open interest can prove useful futures and options basics wikipedia the end of major market futures and options basics wikipedia. A leveling off of open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market.
An increase in open interest along with an increase in price is said [ citation needed ] to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.
The relationship between the prevailing price trend and open interest can be summarized by the following table: From Wikipedia, the free encyclopedia.
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