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Summary of Major
Points 1- Derivatives are financial instruments that have a value that derives from underlying economic conditions such as the price of a crop, default, interest rates, foreign exchange rates, among others. 2- There are four broad types of derivative contracts, forwards, futures, options and swaps. The more common are interest-rate swaps. 3- Derivatives contracts set today the conditions at which transactions will occur in the future. A common element that is pre-arranged is a price. The pre-arranged price is called forward price, futures price or exercise price depending on the derivative contract. 4- Most derivatives are initiated by counterparties that deal directly with each other, these are over-the-counter (OTC) derivatives. 5- The most common exchange-traded derivatives are interest-rate options and interest-rate futures. 6- A forward contract is an agreement between two counterparties to transact at a future date at a given price regardless of what the spot price is at the future date. Centralized counterparties, that mimic the clearing house of organized exchanges, have grown in importance following the 2008 financial crisis. 7- A futures contract is the same thing as a forward contract but it occurs on a traded exchange. All futures are between the clearing house and a counterparty willing to buy or sell in the future. The clearing house avoids taking a net position. 8- An option contract does the same thing as a futures but enforcing the contract is optional. The holder of the option can choose to transact or not at the pre-arranged price depending on what is more profitable. 9- A swap contract is an exchange of cash flows between two counterparties at pre-arranged terms. 10- The value of forwards, futures, and options depends on the difference between the spot price and the pre-arranged price. The value of a derivative also depends on other elements such as time and the risk-free rate. 11- Some derivatives explicitly or implicitly involve leverage, which can be used to boost the rate of return on equity on speculative portfolio strategies. 12- In order to enter a futures contract, the counterparty to the clearing house must post an initial margin, which is a deposit of funds in a brokerage account. Funds are credited or debited from the account to match gains or losses on futures. The counterparty is subject to margin calls if the funds in the account fall below a certain dollar amount called a maintenance margin.
Suggested readings
Hull, J.C. Options, Futures, and Other Derivatives for reader who want to learn the ins and outs of derivatives.
Casino Capitalism by Susan Strange focuses on the speculative and exotic aspect of the financial markets. A good read to get a nuanced understanding of derivatives and their uses.
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