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Reading 56  Derivative Markets and Instruments (Intro)
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Equity, fixed-income, currency, and commodity markets are facilities for trading the basic assets of an economy. Equity and fixed-income securities are claims on the assets of a company. Currencies are the monetary units issued by a government or central bank. Commodities are natural resources, such as oil or gold. These underlying assets are said to trade in cash markets or spot markets and their prices are sometimes referred to as cash prices or spot prices, though we usually just refer to them as stock prices, bond prices, exchange rates, and commodity prices. These markets exist around the world and receive much attention in the financial and mainstream media. Hence, they are relatively familiar not only to financial experts but also to the general population.

Somewhat less familiar are the markets for derivatives, which are financial instruments that derive their values from the performance of these basic assets. This reading is an overview of derivatives. Subsequent readings will explore many aspects of derivatives and their uses in depth. Among the questions that this first reading will address are the following:

  • What are the defining characteristics of derivatives?

  • What purposes do derivatives serve for financial market participants?

  • What is the distinction between a forward commitment and a contingent claim?

  • What are forward and futures contracts? In what ways are they alike and in what ways are they different?

  • What are swaps?

  • What are call and put options and how do they differ from forwards, futures, and swaps?

  • What are credit derivatives and what are the various types of credit derivatives?

  • What are the benefits of derivatives?

  • What are some criticisms of derivatives and to what extent are they well founded?

  • What is arbitrage and what role does it play in a well-functioning financial market?

This reading is organized as follows. Section 2 explores the definition and uses of derivatives and establishes some basic terminology. Section 3 describes derivatives markets. Section 4 categorizes and explains types of derivatives. Sections 5 and 6 discuss the benefits and criticisms of derivatives, respectively. Section 7 introduces the basic principles of derivative pricing and the concept of arbitrage. Section 8 provides a summary.

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