FİNANSAL PİYASALAR VE KURUMLAR

It is clear that with globalization, a change process has started in the national economies. Because of this change process, the integration between the economic units has accelerated and the risks to which financial markets are exposed have increased considerably. The inadequacy of traditional instruments in managing these risks paved the way for the development of derivative instruments.

Derivative instruments whose performance is determined by underlying assets are generally classified as forward, futures, swap, and option contracts.

As also understood from the information given, the answer is E. All of them are classified as derivative instruments whose performance is determined by underlying assets.

A derivative as defined by Security and Exchange Commission (SEC) is: “a type of financial instrument whose value is derived from another underlying product”. By derivative product, we mean those financial instruments that derive its value from the performance of an underlying (asset). In other words, a derivative is a legal contract that involves two parties, a buyer and a seller who agree to do something for each other. Derivative contracts are recognized by the legal system as commercial contracts and they set the right and obligations of each involved party. For instance, let’s assume that there are two parties, A and B. In the contract, Party A agrees to sell an APPLE stock (AAPL) to party B for $200 after 3 months from now. Here, our underlying asset is AAPL and Party A is obligated to sell this stock to party B after 3 months. The value of this contract is based on the performance of AAPL. If the value of the stock rises from $191to $200, this contract will be valuable for Party B who is buying the underlying asset for $191. If AAPL price increases to $200 and Party A refuses to sell the stock to Party B, Party B can refer to the related authorities (lawyers, judges, and juries) to step in and resolve this issue.

As also understood from the information given, the answer is E. All of the statements related to derivatives in the options are correct.

There are two types of derivatives: forward commitments, and contingent claims. Forward commitments contracts (such as forward contracts, futures contracts, and swaps) provide a buyer or seller the ability to lock in a price to buy or sell an underlying asset whereas contingent claims (such as option) provide a buyer or a seller the right to buy or sell an underlying asset at a price previously fixed. Derivatives are useful instruments in financial markets through which a risk can be transferred from one party to another. Investors use derivatives to hedge risk arising from unexpected changes in the market value of an underlying asset. Moreover, derivatives are helpful in creating trading strategies. Derivatives are more liquid than the underlying asset and less costly in terms of participating in deals and transactions.

Derivatives are high leverage contracts that require a small amount of capital to initiate a derivative related contract.

There are two categories of markets where derivatives are created: Exchange-traded derivatives markets and Over-the-counter derivatives markets (OTC). Exchange-traded derivatives are standardized such that its terms and conditions are precisely specified by the exchange where OTC is the customizable contract that can be customized by the involving parties. In other words, derivatives exchange-trade standardizes every term and condition of contracts except their prices. For example, suppose an exchange introduces a standardized contract for metal Gold. It specifies the quality of gold, the quantity of gold, expiration date, and the location where the gold should be delivered. Normally, the price of a derivative contract is defined by buyers and sellers (long and short parties). Chicago Mercantile Exchange (CME) is an example of exchangetraded derivatives markets in which contracts such as futures and options are traded. CME is responsible for the clearing and settlement process. Clearing is the procedure by which an exchange settles a transaction and registers the buy and sell parties’ identities. The settlement is the procedure by which an exchange transfers money from one party to another. Since futures contracts are standardized contracts, it makes derivatives more liquid in comparison to OTC markets contracts. Moreover, the price process in the exchange-traded derivatives is more transparent in comparison to OTC markets.

As also understood from the information given, the answer is E. All of the statements related to derivatives and derivative markets in the options are correct.

When two parties get involved in a contract on an exchange-traded market, ultimately, one party will make a profit and the other party will lose money. Hence, the clearinghouse of the exchange provides a guarantee to the winning party that if the counterparty refuses to pay, the clearinghouse will pay instead.

Exchange-traded derivatives also provide credit guarantee and ensure that there will not be any credit risk.

Any participant that wants to engage in exchange-traded derivative needs to deposit cash usually called margin bond or performance bonds that secures that there will not be any default. The other attribute of clearing houses is that there are daily settlements and any party, which is in the profit as a result of the performance of the underlying asset, the clearinghouse deducts money from the losing party and adds them to the winner party. In the over-the-counter derivatives markets, investors directly trade legal derivative contracts without involving an intermediary. Such markets are also called informal derivative markets because the engaged parties are not obligated to carry out their promises. Though both buyer and seller of OTC contracts informally agree to buy or sell derivative contracts, there is still the possibility of a default. It is worth mentioning that the market makers make a profit through the bid-ask spread as they fulfill the needs of both buyer and seller through buying from a seller at one price and selling to a buyer at a higher price.

The OTC contracts are customized contracts, and they are less liquid than exchange-traded derivative contracts. They are also relatively less transparent.

As also understand from the information given, the answer is E. All of the statements related to derivative markets are correct.

There are three different types of forward commitments: Forward, Futures, and Swaps contracts, so the answer is C. Options are contingent claim contracts.

Forward commitments can be defined by Pirie (2017) as:

“contracts entered into at one point in time that require both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start. The parties establish the identity and quantity of the underlying, the manner in which the contract will be executed or settled when it expires, and the fixed price at which the underlying will be exchanged. This fixed price is called the ``forward price”.

To explain this definition, let us recall our previous example in which we assumed that both parties A and B sign a contract that states Party A will sell an APPLE stock (AAPL) to Party B, and Party B commits to buy the stock after 3 months. This type of contract is called a forward contract. In forward contracts, both involving parties agree to do something for one another after 3 months. Both sides of the forward contract agree on the underlying asset (AAPL) at a later point in time (3 months). They have established the identity of underlying (AAPL) and its quantity (1 stock) at a fixed price regardless of what it will cost at the expiration date. Both parties on the manner in which the contract will be executed or will be settled when it expires (whether to deliver the underlying asset physically or pay in cash). In brief, forward commitments have the following characteristics:

There are three different types of forward commitments: Forward, Futures, and Swaps contracts. We will discuss each type of forward commitments in the forthcoming sections.

As also understood from the information given, the answer is E. All of the statements related to forward commitments in the options are correct.

Futures contracts are the same as forward contracts except that futures contracts are organized, regulated and managed by an exchange. In other words, futures contracts are standardized. A futures contract as defined by Chisholm (2011) is:

“an agreement made through an organized exchange to buy or to sell a fixed amount of an underlying commodity or financial asset on a future date (or within a range of dates) at an agreed price”.

Unlike forward contracts, futures contracts require the existence of a legally recognized futures exchange that provides, manages and organizes these contracts. On the exchange, not all types of derivatives are allowed, only certain contracts are authorized for trading. Futures contracts can be accessed through both physical locations as well as through an electronic system. The derivative exchange has a mechanism that offers the two parties a guarantee against any default. An organized Exchange has a Clearing house through which it settles daily the losses and gains of futures contracts and protects itself against loss.

As also understood from the information given, the answer is E. All of the statements related to futures contracts in the options are correct.

A swap contract can be defined as an OTC contract between two parties who agree to exchange cash flows on regular dates, where one party pays a variable payment, and the other party pays either a fixed or variable amount calculated on a different basis. Since swap is an OTC contract, it contains terms and conditions such as the identity of the underlying asset, dates of payments, and the procedure of payment that are agreed upon and written in the contract. In currency swap trades, one party trades swaps currency for a fixed interest rate and where another party trades another currency for a floating interest. Traders usually exchange only the difference in interest payments. In swap trades, the principal traded is called notional.

As also understood from the information given, the answer is E. All of the statements related to sawps in the options are correct.

A contingent claim is a derivative that provides a buyer of option the right to buy or sell an underlying asset at a price previously agreed upon on a specified future date. Unlike forward commitment contracts, contingent claims give the holder of the contract the right, not the obligation to buy or sell an underlying asset. Its payoff also depends on the performance of the underlying asset.

Options are contingent claim contracts that provide the right but not the obligation to buy an asset at a specific price at a later date in the future.

As also understood from the information given, the answer is E. All of the statements related to contingent claims in the options are correct.

Options are contingent claim contracts that provide the right but not the obligation to buy an asset at a specific price at a later date in the future. In other words, the buyer pays a sum amount of money, known as premium, to the writer of a contract to receive the right to either buy or sell an underlying asset at a specific price at a later date in the future. In options, one side of the contract has the option to carry out the terms and the other side of contracts has obligation. Option contracts convey most of the characteristics of forward, and futures contract as options can be traded on the OTC markets. They can be customized as well as they can be traded on options exchanges as regulated standardized contracts. The customized options contracts are subject to default risk like forward contract, whereas standardized options are protected by clearing house of options exchange. With an option contract, the biggest money that a buyer may lose on the deal is the option premium of the deal, while the loss that the writer of option may face is virtually unlimited.

Almost all multinational corporations use options as a tool to manage their exposure to currency risk, and exchange rates are the underlying assets in their case.

Options are contingent claim contracts that provide the right but not the obligation to buy an asset at a specific price at a later date in the future. In other words, the buyer pays a sum amount of money, known as premium, to the writer of a contract to receive the right to either buy or sell an underlying asset at a specific price at a later date in the future. In options, one side of the contract has the option to carry out the terms and the other side of contracts has obligation. Option contracts convey most of the characteristics of forward, and futures contract as options can be traded on the OTC markets. They can be customized as well as they can be traded on options exchanges as regulated standardized contracts. The customized options contracts are subject to default risk like forward contract, whereas standardized options are protected by clearing house of options exchange. With an option contract, the biggest money that a buyer may lose on the deal is the option premium of the deal, while the loss that the writer of option may face is virtually unlimited.

Almost all multinational corporations use options as a tool to manage their exposure to currency risk, and exchange rates are the underlying assets in their case.

Based on the right to exercise a buy or sell, options contracts can be divided into two: call options and put options. A call option is the right to buy an underlying asset, while a put option is the right to sell an underlying asset. Additionally, options can also be divided into two types according to the time when options can be exercised: American Options and European Options. American Options can be exercised any time up to the expiration date, while European Options are exercised only on the expiration date.

As also understood from the information given, the answer is E. All of the statements related to option contracts in the options are correct.

While transacting on the futures market, it is required that both involving parties must deposit a minimum sum of money as an initial margin in their margin account, typically less than 10% of the futures price to cover possible future losses.

It can be said that both the long and the short parties are engaged in a zero-sum game, meaning that one participant’s gains are the other party’s losses.

Similar to futures and forward contracts, swap contracts do not require money exchange at the beginning of the contract, the initial value of a swap contract is zero.

Option exchanges are considered to be a zero-sum game in efficient markets. The gain or loss on one side of an agreement precisely counterbalances the gain or loss on the opposite side of the agreement.

As also understood from the information given, the answer is E. All of the statements related to derivative instruments in the options are correct

The value of a forward contract is positive to the short party if F₀(T) > S_T and negative if F₀(T) < S_T at expiration.

The value of a swap at the start of contract is typically zero, and the swap price is determined through replication.

The swap price is simply the present value (PV) of all net cash flow payments from the swap.

Throughout the life of a swap contract, the value of a swap also changes.

Swap rates are locked in for the future like in the case of a forward rate agreement. It is the same as locking in multiple forward rate agreements for different periods at different forward prices.

As also understood from the information given, the answer is E. All of the statements related to pricing and valuation of forward contracts in the options are correct.

Derivatives are useful instruments in financial markets through which a risk can be transferred from one party to another. Investors use derivatives to hedge risk arising from unexpected changes in the market value of an underlying asset. Moreover, derivatives are helpful in creating trading strategies. Derivatives are more liquid than the underlying asset and less costly in terms of participating in deals and transactions.