4. Derivative Fundamentals Flashcards

Question

When does the buyer/seller of the futures contract generate gain/loss?

Answer 1

- buyer (long position): realize a gain (loss) when prices move higher (lower). - seller (short position): realize a gain (loss) when prices move lower (higher).

Answer 2

- tick value: defines the monetary value of the min price fluctuation per futures contract - eg: Using corn futures, the price quotation for this commodity derivative is in cents per bushel & the smallest price fluctuation is 0.25 US cents. - the tick value for corn futures would be USD 0.0025 × 5,000 = USD12.50 (0.25 cents/100 = 0.0025 dollar) - formula: tick value (Vt) = Tmin (min price increment) x contract size

Answer 3

- The first two characters identify the contract type - third character identifies the expiry month - last two characters identify the expiry year • CL = Crude Oil • X = November • 16 = 2016 In other words, CLX16 is a crude oil futures contract that will expire in Nov 2016.

Answer 4

- difference between the spot & futures prices & is computed as: bt = St - Ft where, Ft = Futures price at time t St = Spot price at time t - usually the front month (i.e. the nearest expiry month) futures price that is used to compute the basis * front month: shorter length of time that contract can be purchased, most traded & liquid — Ft & St = narrow

Answer 5

When spot and futures price move by the same amount until maturity — changes in basis is nil

Answer 6

futures price will need to converge to the spot price as the contract approaches expiry — If not, it would imply a potential for arbitrage

Answer 7

- negative basis (spot price remains below futures price until expiry) — bt = St - Ft - to profit: short futures contract & buy spot (buy low, sell high) — leads to increase in supply of futures contract & increase demand for the underlying — prices will then converge

Answer 8

- positive basis (spot price remains above futures price until expiry — bt = St - Ft - to profit: buy futures @ lower price & sell @ higher spot price — leads to increase demand for futures & decrease in supply of futures contract — prices will then converge

Answer 9

• There are changes in the holding costs (e.g. interest rates, storage, transportation, etc.) of the underlying asset. • The asset to be hedged isn’t identical to the asset underlying the futures contract (aka cross/proxy hedging) — the greater the difference, the larger the basis risk • The hedger is unsure about the exact date that the asset will be bought/sold. • The hedge requires the futures contract to be unwound before its delivery month (also known as calendar basis risk). • The contract has a different delivery point to what the seller needs (also known as locational basis risk)

Answer 10

When the basis increase (decrease) = strengthening (weakening) of the basis

Answer 11

When the futures contracts are trading at a premium to the spot price (i.e. futures price is above the expected spot price) — further the expiry, the larger the premium (i.e. upward sloping forward curve).

Answer 12

When futures prices are trading at a discount to the spot price — the nearer the expiry, the smaller the discount (i.e. downward sloping forward curve)

Answer 13

production issues. Eg: if a natural gas refinery needs to shut down for maintenance reasons & refining capacity drops, the price of natural gas for immediate delivery could potentially spike — spot price of an asset can become more expensive than the cost of future deliveries when there is a severe shortage of the asset.

Answer 14

1. initial margin: amount of funds that the trader must deposit with the broker at the time the contract is entered into. - margin account: where the margin is deposited - At the end of each trading day, the margin account will be adjusted by the trader’s gain/loss — mark-to-market. 2. maintenance margin: threshold for the margin account that’s used to trigger margin call. - if the amount in the margin account is below the maintenance margin at the end of the trading day (due to mark-to-market losses), the broker will notify the trader via a margin call to top up the account back to the initial margin - extra funds to be deposited = variation margin

Answer 15

[± (FT -Ft)/min price increment] x no. of futures contracts x tick value ± long/short position Tick value: min price increment x contract size

Answer 16

Yes, often its around 75% of the initial margin

Answer 17

Most brokers pay an interest on the balance in the margin account, so these funds don’t represent a genuine cost for the trader as long as the interest is comparable to those from other similar deposits.

Answer 18

- brokerage firm is required to pay the exchange when its clients have made losses, but it will also be paid by the exchange when its clients have made gains. - the exchange acts as the intermediary that ensures the funds from the losing traders are used to compensate the winning traders — zero-sum game

Answer 19

Futures are marked-to-market daily — resets its value to 0 at the end of each trading day, which implies that the realized gains/losses have a potential interest accrual component to them.

Answer 20

contract between 2 parties to exchange currencies in the future at a contractual rate determined today — Settlement requires the exchange of the underlying currency notional (i.e. physical settlement)

Answer 21

• hedging • Speculating on future exchange rate direction • Arbitraging between closely related instruments

Answer 22

Full hedge ratio = value of risk exposure / contract size - value of the risk exposure needs to be in the same currency as the futures contract unit — converted at the spot FX rate observed at the start of the hedge

Answer 23

Futures contract between buyers & sellers with interest-bearing security as the underlying — locks in a future interest rate for future borrowing/lending

Answer 24

exempted from US banking regulations as its a market for USD deposits outside of the USA

Answer 25

if the yield is 0.85% p.a., the price of the interest rate futures contract will be quoted as 100 – 0.85 = 99.15

Answer 26

purchasing = lending money in the future selling = borrowing money in the future

Answer 27

buying = lock-in borrowing rates Selling = lock-in lending rates

Answer 28

BPV = Notional × d × 0.01% - eg: change of one basis point (0.01%) in the yield will change the contract’s value - d: day count fraction

Answer 29

• Hedging against interest rate risks by fixing the future interest rate today. - Futures buyers/(sellers) are locking in to future lending (borrowing) rates • Speculating on future interest rate changes. - Buyers (sellers) of futures speculate on a decline (rise) in future interest rates • Relative value trading by speculating on different sections of the yield curve. • Arbitraging between closely related instruments.

Answer 30

- use different futures contracts over different maturities to hedge the underlying risk exposure — expiry dates are selected to match the cash flows of the asset to be hedged, locking in an average rate of interest over the life of the loan/deposit — aka lock-in the present forward curve.

Answer 31

when theres sufficient liquidity for the futures contracts of longer term maturities (liquidity tends to be lower for longer dated contracts compared to the shorter dated ones). Otherwise, market frictions will cause inefficiency in the hedge.

Answer 32

• Opportunity costs if the forward curve moves in favor of the underlying asset exposure. • Lack of liquidity in futures contracts that are further out in the curve (longer dated maturity lower liquidity)

Answer 33

- uses the most liquid futures contract (front month contract — contract closest to maturity) to hedge an underlying exposure of longer maturity. - the chosen contract month is selected to maximize the correlation amongst contracts & to minimize the hedging error. - Since the life of the exposure is longer than the front month futures contract, the latter will need to be ROLLED OVER to the next most liquid contract upon maturity and so on. - assumes that the price of the shorter-term futures contracts evolves in the same way as the longer-term futures contracts.

Answer 34

when longer-term futures are insufficiently liquid to be traded.

Answer 35

• The basis is locked in only for the front month futures contract — uncertain for the subsequent rolls. • Risk of decorrelation between the short-term hedge & longer term underlying asset • high transaction costs due to more contracts being traded • higher possibility of breaching position limits due to the larger volumes • market is in backwardation (spot price > futures price), short (long) stack hedge generates negative (positive) cash flows at the rollover dates • market is in contango (spot price < futures price), a long stack hedge (short) will generate losses (gains)

Answer 36

- strip hedge: preferred when there’s sufficient liquidity in longer term contracts and/or if the hedger does not want to speculate on the forward curve. - stack hedge preferred when transaction costs for longer term futures are high and/or when there is an opportunity to take advantage of the shape of the forward curve, e.g. contango/backwardation, speculative view, etc.

Answer 37

agreement to buy/sell a predetermined amount of a commodity at a specific price on a specific date in the future.

Answer 38

1. Cash-settled: involves the settlement of net cash on the settlement date — difference between the spot & futures price - doesn’t involve the physical delivery of asset 2. Physical Delivery: involves the literal physical delivery of the underlying asset(s) - contract holder with short (long) position: will deliver (accept delivery of) the commodity

Answer 39

1. storage costs: need special facilities to store & transportations if need to be delivered 2. convenience yields: benefit/premium associated with holding the underlying commodity, rather than its derivative. - eg: commodity production disrupted either by external factors (e.g. weather, wars, etc.) or internal issues (e.g. factory maintenance, staff on strike, etc.), leading to a shortage — market enters into backwardation = MORE PROFITABLE TO HOLD THE ACTUAL COMMODITY than owning contracts for future delivery. - the higher the convenience yield, the lower will be the futures price relative to its spot price

Answer 40

- For financial futures, the asset quality isn’t applicable given their standardization (e.g. LIBOR is just the interbank offer rate without referencing any concept of quality, EURUSD is just the exchange rate for EUR & USD) & fungible nature - Commodities has various degrees of quality — required to specify the quality of the underlying product as part of the standardization procedure.

Answer 41

• Hedging against commodity price risk by fixing the future price today. • Speculating on future commodity price changes. • Relative value trading by speculating on different sections of the commodity forward curve. • Arbitraging between closely related instruments.

Answer 42

OTC market — trades are negotiated directly between parties

Answer 43

International Swaps and Derivatives Association (“ISDA”) Master Agreement — legal doc that stipulates the details of the swap contract

Answer 44

contractual agreement where 2 parties agree to exchange a series of future cash flows over a specific period of time

Answer 45

1 party pays a fixed rate whereas the other party pays a floating rate, with both sets of payments in the same currency — notional amount never exchanged since it’s in the same currency, only net amount

Answer 46

- Swap curve: plots swap rates (the fixed rate leg) across all available maturities from year 1 to year 20. - Swap rate: incorporate interbank borrowing rates + banks’ creditworthiness — rate at which banks lend to each other.

Answer 47

- swap rates for the same maturities are higher due to priced-in premiums — Treasury yield curve reflects the risk free rate BUT the swap curve has the banking system’s credit risk priced in as a premium

Answer 48

1. Central banks don’t intervene in the swap market — swap curve better reflects the prevailing interest rate environment. 2. Swap rates are available at varying maturities, whereas gov treasury yield has specific benchmark maturities like 3, 5, 7 years etc — swap curve better represent the entire interest rate spectrum. 3. Swap rates reflect banks’ credit risk, whereas gov treasury yields are mostly risk-free — swap rates in different countries are more comparable.

Answer 49

difference between the swap rate & the comparable maturity treasury notes.

Answer 50

1. Hedge Interest Rate Risk: can issue bond/borrow via floating rate to lower borrowing cost but exposed to the risk of rising interest rate. - can use IRS as a payer (paying fix rate, receiving float rate) to hedge 2. Obtain Better Funding Rates: converting a fixed rate liability into a floating rate liability (vice versa) allows borrowers to obtain the cheapest cost of funding. - corp with a higher credit rating pays less (interest costs) to raise funds — hence corp with the lower credit rating can use IRS to get better financing terms. 3. Speculate: IRS don’t need upfront capital (exchange only net amount) — low-cost (from capital perspective) avenue to speculate interest rates. - expect interest rate to go up: go into IRS as a buyer (payer) — pay fixed rate & receive floating rate - expect interest rates to drop: go into an IRS as a receiver — receive fixed rate & pay floating rate.

Answer 51

measures the sensitivity of a portfolio/bond’s value to changes in interest rate

Answer 52

fixed rate bond as PV of the fixed cash flow is sensitive to changes in interest rates. - floating rate bond has minimal duration as future cash flows are dependent on ever-changing interest rates — PV of the future cash flow will be stable regardless of changes in interest rates.

Answer 53

Duration (asset) – Duration (liability) 1. For a fixed payer in a swap, swap duration will be negative — duration of asset (receive floating rate) < duration of liability (pay fixed rate). 2. For a fixed receiver in a swap, swap duration will be positive — duration of asset (receive fixed rate) > duration of liability (pay floating rate). Hence, corps can enter into interest rate swap as a fixed payer (receiver) to decrease (increase) their portfolio duration.

Answer 54

interest rate risk & counterparty risk.

Answer 55

KLIBOR: benchmark used to decide the coupon in floating rate bonds = risk profile in the interbank system will affect the pricing

Answer 56

swap where the exchanges of interest payments over the contracted period are made in 2 different currencies — can be both fixed, both floating or 1 fixed & one floating

Answer 57

Some CCS only exchange principal at the beginning, some only at the end whereas others may have no principal exchange at all.

Answer 58

1. The two currencies that will be swapped 2. The spot rate used to calculate the principal amounts — removes the FX risk during the life of the swap. - The principal exchanged at the beginning of the contract will be swapped back at the end of the swap’s maturity at the same rate. 3. Whether or not there is an exchange of principal at the initiation & termination of the swap — Purpose of the swap must be determined — If the purpose is to create synthetic liabilities/exposure in another currency, no need for exchange of principal at initiation. 4. The interest rates applicable on both currencies — which interest rates each of the 2 parties is paying. The swap can be fixed to floating, floating to fixed, fixed to fixed, or floating to floating — If a floating rate is being paid, the reference rate needs to be specified. 5. The frequency of the exchange of interest payments. 6. The tenor of the swap

Answer 59

1. hedge foreign currency risk 2. create synthetic foreign currency asset/liabilities 3. Gain access to cheaper funding

Answer 60

Interest rate & currency risks

Answer 61

agreement between 2 parties in which 1 party purchases protection from another party against losses from a default of a reference entity. - used to transfer the credit risk of a reference entity from the protection buyer to the protection seller — CDS buyer pays the seller a premium (CDS Spread) for a contingent payoff (based on the agreed notional principal) if the reference entity default

Answer 62

• bankruptcy filing. • credit downgrade. • Failure to make interest payment. • Restructuring of its company debts/consolidation of debts in the company.

Answer 63

protection buyer bought 2-year CDS with a notional of $10m & premium of 300bps: - Premium payment = Notional × Spread × Daycount = $10m × 3% × 0.25* = $75k * premium paid quarterly. assume that ABC Corp default between year 1 & 2 — contingent leg is triggered & the protection seller will pay (with Loss Given Default (LGD) = 70%): Contingent payoff = Notional × Loss given default = $10m × 70% = $7m

Answer 64

1. Hedging a. used to manage the default risk from holding debt. - If the loan default, proceeds from the CDS can offset the losses b. address concentration risk. - gain exposure to an industry — diversify loan portfolio without any cash outlay, as CDS creates a synthetic credit exposure 2. Trading: speculating/arbitraging - add liquidity to the market + aid price discovery - eg: investor buy CDS protection on a company to speculate that its gonna default or sell protection if it thinks that the company’s creditworthiness might improve. 3. Synthetically create a new financial instrument - combine CDS with other securities to create new financial instruments with desired risk-return profile. - eg: collateralized debt obligations (“CDOs”) — gets credit exposure to a portfolio of fixed income assets without owning those assets through CDS

Answer 65

bid/offer price: amount the market maker is willing to buy/sell the CDS - Premiums are paid in arrears.

Answer 66

1. The probability of default (“PD”) - likelihood of default by the reference entity — fluctuates over time 2. The loss given default (“LGD”) - expected amount of loss when default occurs. 3. Credit curve - shows the spread over treasuries of different maturities for a single bond issuer. - upward sloping credit curve = default probability in the near term is less than longer term maturities. - flat credit curve = default probability is uniform - inverted credit curve: default probability in the near term is higher

Answer 67

agreement in which 1 party makes payments based on a set rate (fixed/variable) while the other party makes payments based on the total return of an underlying asset (could be equity index/loans/bonds) - Total return = income generated & capital gains of the underlying asset. - BUT if the price of the underlying asset falls, the total return receiver needs to pay the other party the amount by which the asset has fallen in price. At maturity, the total rate of return receiver may choose, but is not obligated, to purchase the reference asset at the prevailing market price.

Answer 68

it allows the party to receive the total return benefit from an underlying asset without actually having to own it — minimal cash outlay upfront

Answer 69

1. Enables creation of an off-balance sheet synthetic asset — OBS reduces administrative cost & is subject to less regulatory requirements. 2. Avoids being classified as the legal owner of the asset, hence may eliminate tax obligation associated with owning the asset. 3. take advantage of leverage — investors don’t need to make initial cash payment, but still receive a positive net payment if the underlying asset appreciates — can get higher return on capital, as lesser initial capital is needed to obtain a large exposure to the underlying asset. - When the underlying asset appreciates in value, the return with leverage is much higher than the return when there is no leverage.

Answer 70

1. Total return swap hedges both price risk & default risk of the underlying asset. - With the funds obtained from deposit, banks will use some to invest in income generating assets BUT has price risk because assets may devalue — enter into a TRS as a total return payer (receive fixed rate & transfer the price risk away) 2. Facilitate deferring gains/losses of the reference asset. - An investor can pay the total rate of return on the asset to defer the loss of the underlying asset. - eg: to improve the appearance of a company’s financial statement this quarter, the company can opt to realize the loss of its securities in next quarter by entering into a total return swap as the total return payer. This way, the company is protected against further loss and able to sell the asset at the end of the contracted period of the swap, bringing the loss forward. 3. short the underlying asset without borrowing the asset - Borrowing an asset for the purpose of shorting it may be be costly — enter into a TRS as a total return payer — price of the underlying asset drop, investor gain by receiving the fixed/floating rate as well as the amount by which the asset has fallen in price.