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Chapter 9 Derivative Securities and Derivative Markets Overview This chapter discusses the markets for futures and options contracts. The risk-sharing, liquidity, and information services provided by the markets for these derivative instruments are analyzed. The material in this chapter is fairly demanding and may be omitted in courses that emphasize policy. However, students do tend to find the material quite interesting. This interest seems to stem partly from the recognition that financial markets are capable of generating new instruments in response to changes in the economic environment and partly from the slightly exotic, “high finance” flavor of the material. Here, as elsewhere in the text, student interest is stimulated by spending time going over the financial listings (see Using the News . . . “Reading Financial Futures Listings”). The use of price patterns for futures contracts to predict interest rate movements will strike many students as being useful. The notion that speculation performs a useful function in these markets is one that students find counterintuitive, but intriguing. Instructors who plan to explore this material in greater depth may wish to flesh out the discussion of options and futures pricing with material from an advanced text (such as Edwards and Ma—see additional readings). More examples of the uses of futures and options are given in the additional readings. Outline I. Forward Transactions and Derivatives A) An increasing amount of trading in financial instruments takes place in derivative markets , in which participants buy and sell securities that derive there economic value from underlying assets. B) Assets traded in derivative markets, principally futures and options contracts, are called derivative instruments . C) In contrast to spot markets , in which settlement is immediate, forward transactions give savers and borrowers the ability to conduct a transaction now and settle it in the future. D) Although forward transactions provide risk sharing, they have liquidity and information problems. 1. Forward contracts are illiquid because they contain terms specific to the particular buyer and seller. 2. Forward contracts are also subject to default risk. II. Futures A) A futures contract is an agreement that specifies the delivery of a commodity or financial instrument at an agreed-upon future date at a currently agreed-upon price. B) The buyer of a futures contract assumes the long position , or the right and obligation to receive the underlying financial instrument at the specified future date.
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45 Hubbard • Money, the Financial System, and the Economy, Sixth Edition C) The seller assumes the short position , or the right and obligation to receive the underlying instrument at the specified future date.
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