Exchange traded derivatives for dummies
In financean equity derivative is a class exchange traded derivatives for dummies derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively traded. Equity options are the most common type of equity derivative. In financea warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is much lower than exchange traded derivatives for dummies stock price at time of issue.
Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Convertible bonds are bonds that can be converted into shares of stock in the issuing companyusually at some pre-announced ratio. It is a hybrid security with debt- and equity-like features.
It can be used by investors to obtain the upside of equity-like returns while protecting the downside with regular bond-like coupons. Investors can gain exposure to the equity markets using futures, options and swaps. These can be done on single stocks, a customized basket of stocks or on an index of stocks. These equity derivatives derive their value from the exchange traded derivatives for dummies of the underlying stock or stocks.
Stock markets index futures are futures contracts used to replicate the performance of an underlying stock market index. They can be used for hedging against an existing equity position, or speculating on future movements of the index.
Indices for OTC products are broadly similar, but offer more flexibility. Equity basket derivatives are futures, options or swaps where the underlying is a non-index basket of shares. They have similar characteristics to equity index derivatives, but are always traded OTC over the counter, i. Single-stock futures are exchange-traded futures contracts based on an individual underlying security rather than a stock index. Their performance is exchange traded derivatives for dummies to exchange traded derivatives for dummies of the underlying equity itself, although as futures contracts they are usually traded with greater leverage.
Another difference is that holders of long positions in single stock futures typically do not receive dividends and holders of short positions do not pay dividends. Single-stock futures may be cash-settled or physically settled by the transfer of the underlying stocks at expiration, although in the United States only physical settlement is used to avoid speculation in the market.
An equity index swap is an agreement between two parties to swap two sets of cash flows on predetermined dates for an agreed number of years. Swaps can be considered a relatively straightforward way of gaining exposure to a required asset class. They can also be relatively cost efficient. An equity swap, like an equity index swap, is an agreement between two parties to swap two sets of cash flows.
In this case the cash flows will be the price of an underlying stock value swapped, for instance, with LIBOR. A typical example of this type of derivative is the Contract for difference CFD where one party gains exposure to a share price without buying or selling the underlying share making it relatively cost efficient as well as making it relatively easy to transact.
Other examples of equity derivative securities include exchange-traded funds and Intellidexes. From Wikipedia, the free encyclopedia. Stock market index future. Energy derivative Freight derivative Inflation derivative Property derivative Weather derivative. Retrieved from " https: Derivatives finance Options finance. All Wikipedia articles needing clarification Wikipedia articles needing clarification from Exchange traded derivatives for dummies All accuracy disputes Articles with disputed statements from November Views Read Edit View history.
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Singapore International Monetary Exchange Ltd. The BBC is not responsible for the content of external internet sites. Wednesday, 12 February, Mention derivatives and most people think of Nick Leeson, highly risky financial investments and City 'wide boys' making lots of money. But, insurance, farmers and complex mathematical formulas are as central to the concept of derivatives as the rowdy dealing pits depicted in the Eddie Murphy film Trading Places.
Derivatives are basically a way of allowing traders to hedge their bets. It can protect companies and banks against unexpected developments, for example sudden falls or rises in the value of currencies or commodities. Initially it was commodities like wheat or coffee which were the subject of such trading. Traders bought and sold 'future' contracts - an agreement to buy coffee, say, in three months time at a certain price - protecting themselves from the worry that a crop failure might drive up the price of coffee in the intervening months.
In the s, financial futures began to dominate trading. This involves buying and selling futures or options on shares, bonds or currencies.
Some investment bankers began to turn hedging into a profitable business in its own right, developing progressively complex ways of hedging. Options were invented because people liked the security of knowing they could buy or sell at a certain price, but wanted the chance to profit if the market price suited them better at the time of delivery. Swaps are, as exchange traded derivatives for dummies name suggests, an exchange of something.
They are generally done on interest rates or currencies. For example a firm may exchange traded derivatives for dummies to swap a floating interest rate for fixed interest rate to minimise uncertainty. There are derivatives on almost all types of asset which are traded - the main four being bonds which vary in price according to interest ratescurrencies, shares and what can broadly be described as goods metals, energy sources, agricultural produce etc.
New ones are even being developed on catastrophes, such as earthquakes, and even on the creditworthiness of investors. Derivatives are used widely by traders because, as a simple monetary value, they are much more flexible than the underlying products.
The value is based on the price of the underlying product, but most contracts are settled in cash terms. This enables banks, traders or investors such as George Soros to bet on price movements without having to deal with the actual assets. They could gamble, for example, on the frozen concentrated orange juice crop without having to buy an orange grove. These instruments can also be used to insure against adverse exchange traded derivatives for dummies moves. In simple terms, an investor can buy a derivative which bets that the market will move against them so that they win either way.
Getting out of hand? The image of derivatives as highly risky investments stems from the fact that contracts which may be worth millions if the market moves in a certain way cost only a fraction of that value.
Usually the market will not move that much and the contract will be settled or sold to somebody else for a small gain or loss. However if it does shift exchange traded derivatives for dummies big losses can be incurred. On exchanges, traders have to pay any losses incurred on their position at the end of each day in order to prevent risks getting out of hand. Banks have complex computer programmes to tell them how much they exchange traded derivatives for dummies lose if the market moves by a certain amount.
Regulations require them to exchange traded derivatives for dummies money aside to protect against possible losses. Derivatives have earned their "bad image" when these controls - as in the case of Nick Leeson of Barings Bank - have failed.
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