1.2After a trade has taken place, a clearinghouse matches the buyers and sellers keeping track of their obligations and payments. Traders that deal directly with a clearinghouse are called clearing membersIf you buy a share of stock as an individual, your transaction ultimately is cleared through the account of a clearing memberDerivative exchanges are always associated with a clearing organization because such traders must also be cleared and settledThe substitution of one counterparty for another is known as novationOver the Counter (OTC): large traders trade many financial claims directly with the dealer, bypassing organized exchangesWhy buyers and sellers would transact directly:Easier to trade a large quantity directlyMight wish to trade a custom financial claim that is not available on an exchangeTrade a number of different financial claims at onceMeasures of Market Size and ActivityTrading volume: counts the number of financial claims that change hands daily or annually. On stock exchange, trading volume refers to the number of shares traded. On an option exchange, trading volume refers to the number of options traded, but each option on an individual stock covers 100 shares of stockMarket value: “market cap” of the listed financial claims on an exchange is the sum of the market value of the claims that could be traded, without regard to whether they have been traded. A firm will 1 million shares and a share price of $50 has a market value of $500 millionNotional value: measures the scale of a position, usually with reference to some underlying asset. Suppose the price of a stock is $100 and that you have a derivative contract giving you the right to buy 100 shares at a future date. The notional value of such contract is 100 shares or $10,000Open interest: measures the total number of contracts for which counter-parties have a future obligation to performStock and Bond MarketsBond market is similar in size to stock market, but bonds generally trade through dealers rather than on an exchange, also much less frequentlyDerivatives MarketDerivatives exchanges trade products based on a wide variety of stock indexes, interest rates, commodity prices, exchange rates, and even nonfinancial items such as weatherThe introduction and use of derivatives in a market often coincides with an increase in price risk in that marketThe link between price variability and the development of derivatives markets is natural—there is no need to manage risk when there is no riskPerspectives on DerivativesThe end-user perspective: end-users are the corporations, investment managers, and investors who enter into derivative contracts for the reasons listed in the previous section: to manage risk, speculate, reduce costs, or avoid a rule regulation. Have a goal (i.e. risk reduction) and care about how a derivative helps to meet that goalThe market-maker perspective: Market makers are intermediaries, traders who will buy derivatives from customers who wish to sell, and sell derivatives to customers who wish to buy. Charge a spread to make money: buy at a low price and sell at a high price. After dealing with customers, market-makers are left with whatever position results from accommodating customer demands.The economic observer: use of derivatives, the activities of the market-makers, the organization of the markets, and the logic of the pricing models to try and make sense of everything1.5 The Buying and Short-Selling of Financial AssetsTransaction Costs and the Bid-Ask SpreadThe price at which you can buy is called the offer price or ask price, and the price at which you can sell is the bid priceThe difference between the price at which you can buy and the price at which you can sell is the bid-ask spreadBid price is what the market-maker pays; hence it is the price at which you sell. The offer price is what the market-maker will sell for; hence the price you will pay. The terminology reflects the position of the market-makerWays to Buy or SellA marker order is an instruction to trade a specific quantity of asset immediately at the best price that is currently availableAdvantage: executed as soon as possibleDisadvantage: you might have been able to get a better price had you waitedA limit order is an instruction to trade a specific quantity of the asset at a specified or better priceHaving your limit order filled depends on whether or not someone is willing to trade at that priceShort-SellingThe sale of a stock you do not already own is called a short-saleWhen we buy something, you are said to have a long position in that thing. This transaction is a form of lending in that we pay money today and receive money back in the futureShort sale is opposite of a long sale. It entails borrowing shares of stock from an owner and then selling them to receive cash. Some time later, we buy back the stock, paying cash for it, and return it to the lender. A short sale can be viewed as borrowing money. You receive money now and repay later, paying a rate of interest that is usually unknownThree reasons to short sale:Speculation: makes money if the price of the stock goes down (sell high then buy low)Financing: way to borrow money and frequently used as a way of financing; very common in the bond marketHedging: you can undertake a short-sale to offset the risk of owning the stock or a derivative of the stock. This is frequently done by market-makers and tradersRisk and Scarcity in Short-SellingCredit risk of the short-sellerA haircut serves to protect the lender against your failure to return the asset when the price rises. In practice, short-sellers must have funds—called capital—to be able to pay haircuts. The amount of capital places a limit on their ability to short-sellScarcity of shares that can be borrowedThe rate of interest paid on the collateral is going to depend on how many people want to borrow wine from the particular vintage producer, and how many are willing to lend it. The rate paid on collateral is called different things in different markets: the repo rate in bond markets and the short rebate in the stock market. The difference between this rate and the market rate of interest is another cost to your short-sale2.1 Forward ContractsForward Contracts: it sets today the term at which you buy or sell an asset or commodity at a specific time in the futureTime at which the contract settles is the expiration date. The asset or commodity on which the forward contract is based is called the