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CHAPTER 11 DERIVATIVES MARKETS CHAPTER OBJECTIVES 1. The primary purpose of this chapter is to develop student understanding of futures, options, and swaps: how they work and are regulated, what is traded, and what are potential gains/losses and risks. 2. To develop student understanding of financial hedging techniques by providing numerous illustrations of how lenders and borrowers can reduce risk, guarantee the cost of funds, immunize portfolios, or guarantee investment returns by trading in the futures markets. 3. To compare and contrast futures, options, and swaps, their potential gains and losses, and their uses for hedgers and speculators. CHANGES FROM THE LAST EDITION 1. Tables and statistics have been updated. 2. A new People & Events box, titled “Talking and Trading Politics and Weather”, has been added to the chapter. 3. One of the end-of-chapter questions (#16 in the previous edition) has been deleted. CHAPTER KEY POINTS 1. Derivative securities derive their values from values of some other assets, real or financial. Derivatives can be used for both hedging and speculating. It is important that your students distinguish between these two activities. Hedgers strive to reduce or eliminate risk, while speculators consciously take on risk. 2. Both futures and forward markets allow traders to reduce future price risk by entering into contracts to buy or sell currency, security, or commodity at a set price at a specified time in the future. 3. Futures markets are more structured than forward markets in that uniform contracts are traded and buyers and sellers trade with the futures exchange rather than directly with each other. Thus, it is easier for people to liquidate their contracts prior to delivery, and very few deliveries are actually made on futures contracts. 4. Margin requirements are stipulated by futures exchanges to ensure that all parties will honor their futures contracts. Positions of traders are marked to market every day, reflecting daily value changes. If price movements are adverse, the contract holder may be required to deposit additional money in order to meet the maintenance margin requirements. If a trader does not add funds to answer the margin call, his positin is 1
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liquidated. This eliminated default risk from the futures markets. Forward transactions have no such provisions and therefore are not free from default risk. The advantage of forwards is that they are not standardized and thus can be tailored perfectly to the needs of the counterparties in terms of amount and maturity. 5. The futures markets, and options on futures contracts, are regulated by the Commodity Futures Trading Commission - which certifies contracts and guards against manipulation. The SEC regulates the trading of options on common equities. The futures exchanges practice self-regulation.
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