In this one exam solution, it mentioned the fact that "the derivative may be geared"... what does that mean, or how is a derivative geared? I understand gearing to mean borrowing against equity to hopefully improve returns...for example in a good market due to the probably fixed interest expense of the debt
Gearing can also be achieved with derivatives because you don't need all the capital you are putting at risk. For example if you had £10k and wanted to invest in gold, you could buy £10k of gold and wait for the price to rise (or fall). However you could also use a derivative future contract, which might allow you to speculate on something like £200k of gold while only needing £10k of capital. This means that you have "geared" your investment 20 times, and so a 1% increase in the price of gold would increase your portfolio by 20%.
cjno1, going by your answer, arent all derivatives geared by definition, then? because you need only 10k to invest in gold worth 200k. and the rise or fall in gold price will have a gearing effect on the derivative price.
A good question! As has been indicated by the previous responses, there are broadly two different types of gearing in derivatives: direct gearing within the value, as for options (as mentioned by didster) and the gearing that can arise through needing to post margins, as for futures (as mentioned by cnjo1). So yes, most derivatives have some element of gearing - but not necessarily all. For example, there is no inherent gearing within a forward contract if there is no collateral/margin requirement.
