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Derivative Financial Market

In the derivative financial market, products (derivatives) are traded whose prices are derived from objects in the monetary markets (e.g. shares, bonds, indices, currencies). These so-called "underlying assets" are subject to changing market prices. Derivatives make it possible to uncouple such market-price risks from the underlying asset and trade them separately.

Derivative instruments enable risk transfer: investors can transfer unwanted risks to other, more risk-tolerant market participants. The actual investments are comparatively small when measured against the amounts that are involved. Large sums can be controlled with little capital. Price fluctuations in per cent of the invested capital are much greater than price fluctuations in the underlying asset. This is called "leverage". Trading in derivative instruments offers great potential returns, but it also entails a great potential for loss.

Motives for using derivatives

Motive Description
Hedging Derivatives are used to hedge individual positions (micro hedge) or a number of financial instruments (macro hedge).
Speculation Derivatives can be used to consciously take on market-price risks in order to achieve a return.
Arbitrage Derivatives enable the exploitation of differences between the price of a given capital asset in different markets. This is called "arbitrage".

Derivatives with symmetrical or asymmetrical risk profiles

In the case of derivatives with symmetrical risk profiles (unconditional forward transactions), the two parties (buyer and seller) agree that a certain amount of the underlying asset will be delivered at a predetermined price on a predetermined future date. Price changes in the underlying asset result in mirror-image profit and loss profiles for the buyer and seller. Derivatives with symmetrical risk profiles include futures, forward rate agreements and swaps.

Derivatives with symmetrical or asymmetrical risk profiles

Derivatives with asymmetrical risk profiles (conditional forward transactions) such as options and option-like products (warrants, caps, floors etc.) gives the buyer the right, but not the duty, to buy (call) or sell (put) an underlying asset within a contractually determined period. The buyer's loss exposure is therefore limited to the paid premium whereas the seller theoretically has unlimited loss exposure and limited profit potential.

Exchange-traded or OTC derivatives

Derivatives are traded either on a stock exchange or in an over-the-counter (OTC) market. Derivatives traded OTC are not regulated in terms of their features and contractual provisions.

Exchange-traded derivatives are divided into those traded on a futures exchange such as Eurex (options and futures) and those traded in a spot market such as SIX Swiss Exchange. On-exchange trading of options and futures on a futures exchange such as Eurex features standardised contracts (products) and the deposit of margins for the purpose of smooth trading.

For more information on Structured Products, visit www.six-structured-products.com