Legal Definitions - paper market

A paper market refers to a financial market where instruments known as derivatives are traded. Unlike a market for physical goods or direct ownership of assets like stocks or bonds, a paper market deals with contracts or agreements whose value is derived from an underlying asset. These underlying assets can include commodities (like oil or gold), currencies, interest rates, stocks, or market indexes. The term "paper" emphasizes that these transactions involve contractual obligations or rights, rather than the immediate exchange of the tangible asset itself.

Here are some examples to illustrate the concept of a paper market:

• Imagine a large airline company that needs to purchase millions of gallons of jet fuel every month. To protect itself from sudden increases in oil prices, the airline might enter into a futures contract to buy a specific quantity of oil at a predetermined price several months in the future. This contract is traded on a paper market. The airline isn't buying physical barrels of oil today; instead, it's buying a contractual right to purchase oil at a set price later. The value of this contract is derived from the underlying price of crude oil.

• Consider a multinational technology company based in the United States that expects to receive a significant payment in Japanese Yen in three months for software sold in Japan. The company is concerned that the Yen might weaken against the US Dollar by then, reducing the dollar value of their payment. To mitigate this risk, they could enter into a forward contract with a bank to exchange a specific amount of Yen for US Dollars at a fixed exchange rate in three months. This forward contract is a transaction in the paper market, as they are trading a future currency exchange agreement, not physically exchanging currencies today. The contract's value is tied to the future Yen/Dollar exchange rate.

• An individual investor believes that a particular pharmaceutical company's stock price will significantly increase after an upcoming drug trial announcement, but they don't want to commit a large amount of capital to buy the actual shares immediately. Instead, they might purchase call options on that company's stock. A call option is a contract that gives the investor the right, but not the obligation, to buy a certain number of shares at a specific price before a particular date. This options contract is traded in a paper market because the investor is buying a derivative instrument whose value is directly linked to the underlying stock's price, without actually owning the shares themselves.