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10.3.2 Financial Assets

A comprehensive guide on the explosive growth of financial derivatives, driven by factors like volatile interest rates, financial deregulation, globalization, and advances in information technology. This section delves into the most commonly used financial assets, such as equities, interest rates, and currencies.

Overview of Financial Assets

In recent decades, financial derivatives have experienced explosive growth, driven primarily by several key factors:

  • Increasing volatility in interest rates, exchange rates, and equity prices
  • Financial deregulation coupled with intensified competition amongst financial institutions
  • Globalization of trade and tremendous advances in information technology
  • Significant theoretical breakthroughs in financial engineering

Equity Derivatives

Equity derivatives are a large category of financial derivatives with equity as the underlying asset. The most predominant products in this category are equity options on individual stocks. These derivatives are predominantly traded on organized exchanges, such as:

  • Montréal Exchange
  • Chicago Board Options Exchange
  • International Securities Exchange
  • Boston Options Exchange
  • NYSE AMEX Options
  • NYSE ARCA Options markets

Interest Rate Derivatives

Interest rate derivatives traded on exchanges are generally based on securities that are sensitive to interest rate changes rather than the interest rates directly. In Canada, the underlying assets for these derivatives include banker’s acceptances and Government of Canada bonds. All Canadian futures trading related to interest rates occurs at the Montréal Exchange.

In Over-The-Counter (OTC) markets, interest rate derivatives typically are connected to well-defined and recognized floating interest rates, such as:

  • Treasury bill yields
  • Treasury bond yields
  • London Interbank Offer Rate (LIBOR)

Unlike market-traded derivatives that settle based on securities, OTC interest rate derivatives usually settle in cash, due to their basis on interest rates.

Currency Derivatives

Currency derivatives trades commonly involve major currencies like the U.S. dollar, British pound, Japanese yen, Swiss franc, and the Euro. Contracts in this area include:

  • Currency futures and options, traded on organized exchanges
  • Currency forwards and swaps, which are typically found in the OTC market

Did You Know?

A swap is a private contractual agreement between two parties. It allows them to exchange (swap) periodic payments in the future based on a predetermined formula. Essentially, swaps resemble a series of forward contracts packaged together. More details regarding swaps can be found in the Derivatives Fundamentals Course (DFC).

Key Takeaways

  • Equities: Equity derivatives mostly involve equity options on individual stocks and are traded on recognized exchanges.
  • Interest Rates: Interest rate derivatives in Canada are traded on the Montréal Exchange with the underlying assets being sensitive securities, such as banker’s acceptances and government bonds.
  • Currencies: Currency derivatives on exchanges include futures and options, while forwards and swaps are usually encountered in the OTC markets.

Frequently Asked Questions (FAQs)

Q1: What are the key drivers of the growth in financial derivatives?

  • A: Volatile interest and exchange rates, financial deregulation, enhanced competition among financial institutions, trade globalization, and significant strides in information technology.

Q2: What are the main venues for trading equity derivatives?

  • A: Equity derivatives are mainly traded on exchanges like the Montréal Exchange, Chicago Board Options Exchange, International Securities Exchange, among others.

Q3: How are interest rate derivatives typically settled?

  • A: OTC interest rate derivatives are generally settled in cash due to their foundation on interest rates rather than actual securities.

Q4: What is a currency swap?

  • A: A currency swap is a private agreement to exchange future periodic payments based on an agreed formula, acting similarly to a series of forward contracts.

Glossary

  • Equity Derivative: A financial instrument whose value is based on an underlying equity asset, most often an individual stock.
  • OTC (Over-The-Counter) Market: A decentralized market where participants trade securities directly between two parties without a central exchange or broker.
  • LIBOR (London Interbank Offer Rate): The interest rate at which banks offer to lend funds to one another in the international interbank market for short-term loans.
  • Swap: A financial agreement in which two parties exchange cash flows or liabilities from two different financial instruments.
    pie
	    title Composition of Currency Derivatives
	    "USD": 35
	    "GBP": 25
	    "JPY": 15
	    "CHF": 10
	    "Euro": 15

This diagram provides a typical distribution of currency derivatives by major currencies.


Continue to explore further sections for a greater understanding of financial assets and their integral role in modern finance.


📚✨ Quiz Time! ✨📚

🧐 Assess and Solidify Your Understanding

Welcome to the Knowledge Checkpoint! You’ll find 10 carefully curated quizzes designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you’re on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck! 🍀💪

## Which of the following is a primary reason for the explosive growth in financial derivatives? - [ ] Decreased competition among financial institutions - [ ] Stabilizing interest and exchange rates - [x] Increasingly volatile interest rates, exchange rates, and equity prices - [ ] Reduction in global trade > **Explanation:** One of the primary drivers for the growth in financial derivatives is the increasing volatility of interest rates, exchange rates, and equity prices, which necessitates the use of derivatives for risk management and speculative purposes. ## Where are equity options primarily traded? - [x] Organized exchanges - [ ] Over-the-counter (OTC) markets - [ ] Directly between financial institutions - [ ] At financial education institutions > **Explanation:** Equity options are predominantly traded on organized exchanges such as the Montréal Exchange and the Chicago Board Options Exchange. ## What is the underlying asset for the majority of equity derivatives? - [x] Individual stocks - [ ] Interest rates - [ ] Foreign currencies - [ ] Commodities > **Explanation:** The underlying asset for the majority of equity derivatives is individual stocks. ## Where does all interest rate futures trading in Canada take place? - [x] Montréal Exchange - [ ] Toronto Stock Exchange - [ ] New York Stock Exchange - [ ] International Securities Exchange > **Explanation:** In Canada, all interest rate futures trading takes place at the Montréal Exchange. ## How are OTC interest rate derivatives typically settled? - [ ] By physical delivery of underlying securities - [x] In cash - [ ] By swapping physical assets - [ ] Through international settlement systems > **Explanation:** OTC interest rate derivatives are generally settled in cash because they are based on interest rates, not actual securities. ## Which of the following is a common underlying rate for OTC interest rate derivatives? - [x] London Interbank Offer Rate (LIBOR) - [ ] Gold prices - [ ] Residential mortgage rates - [ ] Municipal bond yields > **Explanation:** The London Interbank Offer Rate (LIBOR) is a common underlying rate for OTC interest rate derivatives. It represents the interest earned on Eurodollar deposits in London. ## Which of these currencies is commonly used as an underlying asset in currency derivatives? - [ ] Australian dollar - [ ] Indian rupee - [x] U.S. dollar - [ ] Mexican peso > **Explanation:** The U.S. dollar is one of the most commonly used underlying assets in currency derivatives. ## What type of currency derivative is traded in the OTC market? - [ ] Currency options - [ ] Currency futures - [x] Currency forwards - [ ] Direct currency buys/sells > **Explanation:** In the OTC market, currency forwards are commonly traded. ## What are swaps essentially equivalent to? - [ ] Futures contracts - [ ] Option contracts - [x] Series of forward contracts packaged together - [ ] Equity derivatives > **Explanation:** Swaps are essentially equivalent to a series of forward contracts packaged together. They involve exchanging periodic payments in the future based on an agreed formula. ## What is a major advantage of financial deregulation mentioned in the text? - [ ] Decreased global trade - [ ] Increased regulation in financial markets - [x] Intensified competition among financial institutions - [ ] Higher transaction costs > **Explanation:** Financial deregulation leads to intensified competition among financial institutions, which has been a significant force behind the growth of financial derivatives.

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Saturday, July 13, 2024