10- Derivatives and other instruments

Question 1

What is a Futures contract?

Answer 1

A Futures contract is an agreement to buy or sell a specified quantity of a specified asset on a specified future date at a price agreed today

Question 2

What is a Forward contract?

Answer 2

An OTC Future

Question 3

What is a Contingent Liability?

Answer 3

A contingent liability transaction describes a derivative position where the possibility of a future obligation is uncertain

Question 4

What is the formula for Fair value of a future?

Answer 4

Fair value of future = Cash price of underlying + Costs of carry

Question 5

What is cost of carry?

Answer 5

The benefits from holding the underlying e.g. dividends or coupon

Question 6

What is the formula for basis?

Answer 6

Basis = Cash price - Futures price

Question 7

What is Backwardation?

Answer 7

Where there is a greater benefit than cost to holding the asset, the fair value of the future is lower than spot price (positive basis)

Question 8

What is Contango?

Answer 8

Where there is a greater cost than benefit to holding the asset, fair value of the future is higher than spot price (negative basis)

Question 9

What is Beta?

Answer 9

Sensitivity of a stock relative to the market as a whole

Question 10

What is the formula for contracts needed to hedge?

Answer 10

Fund value/(future price x tick value) x beta

Question 11

What is the difference between European and American options?

Answer 11

American options can be exercised on any date whereas European options only on expiry

Question 12

What is the maximum profit on a long call?

Answer 12

Infinite

Question 13

What is the formula for max loss on selling a put?

Answer 13

(Strike x tick value) - premium

Question 14

What is the formula for option premium?

Answer 14

Premium = Intrinsic value + Time value

Question 15

What is the formula for Intrinsic value of a call?

Answer 15

Intrinsic value = Spot price - Strike price
Vice versa for put

Question 16

When is an option ‘In the money’?

Answer 16

When intrinsic value is positive e.g. for a call when Spot is greater than Strike

Question 17

What is the Time value of an Option?

Answer 17

Time value is the amount over and above the intrinsic value that an investor will pay to buy an option

Question 18

What are the 4 main greeks?

Answer 18

• Delta
• Theta
• Vega
• Rho

Question 19

What does Delta measure?

Answer 19

The sensitivity of on option’s premium to the spot price

Question 20

What does Theta measure?

Answer 20

The sensitivity of on option’s premium to the time to maturity

Question 21

What does Vega measure?

Answer 21

The sensitivity of on option’s premium to the underlying’s volatility

Question 22

What does Rho measure?

Answer 22

The sensitivity of on option’s premium to interest rates

Question 23

What is the formula for Delta?

Answer 23

Delta = Δoption premium/Δspot price

Question 24

What are the 2 main volatility trades?

Answer 24

Straddles and Strangles

Question 25

What is the logic behind a long volatility trade?

Answer 25

If you buy options and volatility rises, the premium will too and you can sell them for a profit

Question 26

How is a Straddle composed?

Answer 26

Go long/short a call and a put at the same strike price

Question 27

How is a Strangle composed?

Answer 27

Go long/short a call and take the same position on a put with a lower strike price

Question 28

What is Tick size?

Answer 28

The minimum price move on the contract

Question 29

What is Tick value?

Answer 29

The profit or loss made for a 1 tick move in the contract

Question 30

What is the PnL formula for a Bond future?

Answer 30

PnL = No of ticks moved x Tick value x Contracts traded

Question 31

What are the 5 main types of Interest rate swaps (IRS)?

Answer 31

-Vanilla swap: fixed for floating
-Basis swap: floating for floating
-Swaption: an option to enter into a swap
-Payer swap: agreeing to pay a fixed interest rate
-Receiver swap: agreeing to receive a fixed interest rate

Question 32

How does an equity/total return swap (TRS) work?

Answer 32

Total return payer buys equity for direct exposure, offers this total return to a swap bank in exchange for a rate, swap bank does the same to a total return receiver

Question 33

How does a Credit default swap (CDS) work?

Answer 33

Investor in an underlying asset can pay a swap premium to a bank in exchange for a cash payment should asset default

Question 34

What is a synthetic CDO?

Answer 34

A CDO that is secured against the premiums on the referenced debt, rather than the referenced debt itself

Question 35

What is an Unfunded credit derivative?

Answer 35

Where the credit protection seller makes no upfront payment e.g. CDS

Question 36

What is a Funded credit derivative?

Answer 36

Where the credit protection seller makes an upfront payment e.g. CDO

Question 37

What are 3 main advantages of the Distributed ledger?

Answer 37

-Produces a trustworthy and reliable record by consensus
-Prevents a single point of failure as numerous nodes are used
-Removes costs and delays

Question 38

Who are the 2 main central counterparties (CCPs) in the UK?

Answer 38

LCH.Clearnet & ICE Clear Europe

Question 39

What is Initial margin?

Answer 39

A returnable good faith deposit

Question 40

What is Variation margin?

Answer 40

Daily receipts and payments of unrealised profits and losses

Question 41

What is tick value?

Answer 41

Minimum price increment of an instrument

Question 42

How are the prices of interest rate futures quoted?

Answer 42

100 minus an interest rate