Derivatives Flashcards, test questions and answers

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What is Derivatives?

Derivatives are financial instruments derived from underlying assets that are used to hedge risk, increase leverage, and generate returns. Derivatives have been around for centuries and have become an integral part of the global financial system.Derivatives can be divided into two categories: exchange-traded derivatives (ETDs) and over-the-counter derivatives (OTCDs). Exchange-traded derivatives are standardized contracts traded on a regulated exchange. These contracts are highly liquid and allow for efficient price discovery. Examples of ETDs include futures, options, swaps, forward rate agreements (FRAs), and credit default swaps (CDS). Over-the-counter derivatives are customized bilateral agreements negotiated between two parties with terms set by the parties involved. Examples of OTCD’s include interest rate swaps (IRS), currency swaps, equity options, forwards, collars, and total return swaps (TRS). The main difference between ETDs and OTCDs is the degree of standardization. Exchange traded instruments have standardized terms while OTCDs have customized terms that are tailored to meet the needs of both parties involved in the agreement. This customization allows for more flexibility but also increases counterparty risk since there is no third party regulator overseeing the transaction. Derivatives provide numerous benefits to investors such as hedging risk against adverse market conditions, increasing leverage by providing access to debt financing at lower costs than traditional borrowing methods, generating returns through speculation on future prices or interest rates movements without having to own or hold any underlying asset directly ,and diversifying investments by allowing exposure to a variety of different markets at once. Derivatives can also help reduce transaction costs since they often involve smaller amounts than purchasing or selling large quantities of physical assets directly. Despite their many benefits however ,derivatives can be complex financial instruments with significant risks associated with them. Investors should understand these risks before entering into any derivative transaction including counterparty risk ,liquidity risk ,leverage risk ,market risk ,credit risk ,and legal/regulatory risks. It is important for investors to research these risks thoroughly in order to make informed decisions when considering derivative investments .