4. DERIVS (PART OF CHAP 4) Flashcards

Question 1

Q

What is a deriv
- types?

Answer

A

Deriv = financial instrument whose value depends on the value of another underlying asset
Leveraged instruments with little/no upfront payment
settled @ future date

Exchange traded
- options
-futures

OTC
- forwards
-swaps
-options
-CFDs

Question 2

Q

Risks of derivatives

Answer

A

Legal/regulatory risk - inadequate consents to undertake contract, mitigate with compliance and internal control

Counterparty risk = risk that counterparty of contract fails to fulfil obligation. Mitigate with XC traded, diversifying counterparties, internal controls

Market risk = risk that market may develop differently than expected

Complexity - deriv may behave differently than expected because of naivety/failure to appreciate risks involved

Termination - risk of termination by various events. mitigate by defining acceptable termination events, setting limits on counterparty termination options

Liquidity risk = rsk that position cannot (Easily) be unwound at or near market price - mitigate with collateral reqs

Valuation = risk that adequate and timely market valuation cannot be obtained - resulting in incomplete collateral posting

Question 3

Q

Inflation hedging

Answer

A

Most common = inflation swap
inflation payer = payer inflation floating rate e.g. CPI
Inflation receiver/fixed rate payer = pays fixed swap rate
both on notional principal amount
inflation risk transferred to inflation payer
single payment made on contract @ maturity

Question 4

Q

Most futures not delivered - what happens?

Answer

A

Closed out - opening buyer may avoid delivery by making closing sale before delivery date

Settled physically - cash settlement on monetary loss or gain

Question 5

Q

Calc profit/loss on futures contract

Answer

A

P/L = number of ticks x tick value x number of contracts

Question 6

Q

Derivative markets

Answer

A

XTD= standardised contract that trade son XC
futures, options
- minimized CP risk
-standardized
-liquid and cheap

OTC -financial contract that does not trade on an asset exchange, and which can be tailored to each party’s needs
swaps, forward, options, CFDs
- non fungible
-bespoke
-counterparty risk (reduced with EMIR = mandatory CCP clearing and enhanced collateral agreements)
-traded directly

Question 7

Q

Futures

Answer

A

Promise to buy/sell an asset @ fixed date in future @ fixed price

Standardized terms - specifies quality, date, delivery location so only price is negotiable

XTD
Guaranteed by exchange
Liquid, cheap and easy to trade
Fixed, standard delivery dates: March, June, Sept, Dec
Mostly cash settled
Reduced counterparty risk due to clearing house
Relatively low initial costs
Regulated.

Question 8

Q

Futures buyer and seller

Answer

A

Buyer = long
Commits to pay the agreed price and receive the underlying/cash on
agreed date
- Believes price of the underlying will rise

Seller = short
commits to sell @ agreed price on agreed date /pay cash difference
Believes price of UL will fall

Question 9

Q

What is margin

Answer

A

= collateral/deposit that investor has to deposit with CH to cover risk of default on a trade

Margin is small % of notional principal on which derivative is based

Question 10

Q

What does marked to market mean

Answer

A

Deriv marked to market = value adjusted to reflect current market value of UL and any P/L that has occurred that trading day

Records up to date change in value
reduces credit risk
means pricing isnt stale

Question 11

Q

initial margin

Answer

A

calculated by CH @ outset of trade
- paid by CM to compensate for future possible losses
- can be collateral, cash, bank guarantees, CDs, gov bonds, T-bills
-re computed every bis day - intra day margin called to top up
-returned when position is closed out
-CM deposit margin on their net positions with CH (e.g if they have 10 long contracts and 5 short, require margin on 5 long)

spot month margin = increased margin in delivery month due to speculative and delivery pressures

Question 12

Q

variation margin

Answer

A

- collected by CH from CM is contract suffers from adverse price movements not covered by initial margin
- must be cash and in currency of contract
  -positions marked to market @ close based on daily settlement price
CM collects from buyer and pays to CH
- must be transferred within 1 hr

Variation margin = ticks moved on the day x tick value x no of contracts

Question 13

Q

Maintenance margin

Answer

A

Agreement between CM and client (not involving CH)

-may ask client to deposit more than initial margin to enable variation margin to be easily taekn

once credit breaches maintenance limit - then CM issues margin call and client must top up acc to full amount

Question 14

Q

Futures strategies
- hedging

Answer

A

Number of contracts needed to hedge

Req no. of contract = (portfolio value/ futures value) x h

futures val = futures price x contract size

equities h = Beta
bonds; h = portfolio duration/futures duration

Question 15

Q

Hedging with gilt futures

Answer

A

if you think val of portfolio will decline due to rising rates
sell gilt futures to hedge
as rates rise, futures price will fall and seller will receive margin payments

no. of contracts to sell = (portfolio val / futures val) x h

h = portfolio duration/futures duration

futures val = 1000 x futures price
1 contract = per 100k nom
price = per 100 nom

Question 16

Q

OPTIONS

Answer

A

= RIGHT not obligation to buy/sell specific asset @ specific price on/before specific date

buyers have right, selers have obligation

upfront payment = option premium
futures have margin @ outset but that is returned (type of insurance pol basically)

call = right to buy
put = right to sell

can be XTD or OTC
listed equity options = deliverable
other cash settled
only option writers are required to make inital/variation margin payments given buyer has right not obligation

Question 17

Q

LONG CALL OPTION

Answer

A

bullish - anticipating price rising

right but not obligation to buy @ strike price on specific date
max loss = limited to premium paid

limited loss w/ unlimited gain
BE = strike + prem

Question 18

Q

SHORT CALL OPTION

Answer

A

Bearish

Other side of long
= seller promises to sell UL @ fixed price in future if buyer exercises

BE = strike + premium received
Profit declines as UL value increases

Max gain = premium
max loss = unlimited

covered call = when you own the UL and sell the call
income maximiser funds do this to generate more income from equities and dont believe price will most substantially

Question 19

Q

LONG PUT

Answer

A

BEARISH
right to sell UL @ fixed price

BE = strike - premium
lower strike = lower premium (as waiting for price to fall more before exercising)

limited gain (UL value can only fall to 0)
limited loss (prem paid)

Long UL and long put = caps losses to premium but dampens upside
Long put can offset long position in UL

Question 20

Q

SHORT PUT

Answer

A

=bullish = writing/selling a put option (selling the right to sell)
max profit = premium

writer is obliged to buy @ strike price if long exercises option
believes price of UL will stay above strike price + option will expire worthless

Question 21

Q

Euro/American/Bermudan/Asian options

Answer

A

Euro = exercise by 6pm on last trading day only (3rd fri in expiry month)

American = exercise by 5.20 on any bis day before the expiry day (3rd fri in expiry month)

Bermudan = number of discrete dates on which you can exercise option

Asian style =payoff depends of avg price of UL over certain period

Question 22

Q

CFDs

Answer

A

OTC deriv contract between 2 parties to exchange diff between opening and closing prices of specific financial instrument

Cash settled

Trade on margin (initial and variation)

Leveraged instruments - max loss not limited to initial investment

Gains subject to CGT and losses can be offset unlike spread betting (considered gambling)

Daily funding charge - equiv to borrowing cost of full amount of investment paid by buyer to seller or else noone would buy the equity

Manufactured divi - paid by seller to buyer (so the buyer has the experience of owning the equity and the seller cannot own stock and sell CFD to have no exposure to stock but still receive divi)

No stamp duty as no ownership

Adv
Allow seller to short stock without owning UL
No set end date
Allows exposure to foreign markets
No stamp duty

Disadv
Leverage can amplify losses
Extreme price vol
weak industry regulation, not allowed in US

Question 23

Q

LT currency swap

Answer

A

Involves exchange of principal (sometimes) and interest in one currency for the same in another over an agreed period of time
Interest payments are exchanged @ fixed dates through life of contract
Orig principal is reexchanged @ the end

Uses:
- favourable loan rates in the currency than if they borrowed directly in the market
- hedging transaction risk on foreign currency loans they have already taken out

3 types
- fixed v fixed = pay fixed rate in one currency and receive fixed rate in another
- fixed v floating = exchanged fixed rate in 1 currency vs floating in another
- floating v floating = exchange two floating rates +/- a spread

generally not netted as in different currencies

US company issues 5y GBP bond and swaps it to USD SOFR
Cheaper than issuing FRN in domestic market

Question 24

Q

Total return swap

Answer

A

A swap agreement where 1 party pays the total return of a reference asset (any periodic cash flows and capital gains) and the other party pays a set rate (either variable or fixed) plus any losses on the reference asset

Total return payer hedges losses on reference assets
Receiver gains exposure to asset w/out owning it
IF TR payer doesnt own asset - they are speculating on it’s decrease in val - shorting it w/out needing to own UL/borrow.

Question 25

Q

Equity swap

Answer

A

OTC deriv where total return of stock/basket/equity index is swapped for fixed/floating leg + any losses on the reference stock
Usually equity leg v floating leg
sometimes equity leg x equity leg

Useful to circumvent restrictions on foreign stock purchase
Notional amount changes w/ every payment as value of UL changes to reduce credit risk

Diagram

Question 26

Q

COMMODITY SWAPS

Answer

A

cash settled
2 types: fixed v floating and price for interest

FIXED V FLOATING
- swapping the fixed price of a commodity for a variable price
- useful given significant vol of commodity prices and their supply/demand to hedge risk
- define amount/grade of commodity, fixed price, frequency of swaps.
- on settlement compare fixed with floating and make net payment

USES
-jeweller pays fixed rate in swap to hedge increase in the price of gold
-miner pays floating price and receives fixed to hedge against decrease in price/certainty of CFs (they receive the fixed price in the market)

PRICE FOR INTEREST
- value of fixed amount of commodty is exchanged for floating/fixed rate interest payment

Question 27

Q

ADV and DISADV of convertibles to issuer and holder

Answer

A

Adv to issuer
- issue debt with cheaper coupons vs standard debt issue
- interest payments are tax deductable unlike equity finance
- no immediate loss of voting control
- deferral of dilution
-issuers w/ poor credit rating can issue @ lower yield
- allows issuance of unsecured debt (if no assets to back) without prohibitive coupon payments

DisAdv to issuer
- if comp performs poorly, still obliged to make coupon payments unlike divi and redeem for cash if holder doesnt convert
- cannot be sure that it is issuing deferred share capital
- (deferred) dilution of equity

Adv to Investor
- Fixed income security offering downside protection if shares fall in value (tho subordinated debt) with equity uplift
- Higher coupon yield vs divi but lower than straight bond
- better liquidity vs straight bond

Disadv to investor
- if shares dont go up, yield has been scarified vs straight bond
- no voting rights
-dilution to existing holdings
-often callable
-low priority of debt in repayment (subordinated)

Question 28

Q

Adv and disadv of warrants to issuer and investor

Answer

A

Adv to issuer
- equity sweetener to debt issue - cheapens debt in terms of yield required
- cash raised immediately but share issuance deferred (no divi/interest to pay now)
- if share price falls warrant won’t be exercised
-often detached from debt post issue and traded separately

Disadv to issuer
- issued @ big discount to current share price
- dilutive on exercise (more divi to pay)

Adv to investor
- geared investment in shares - cheaper than buying shares themselves, similar to call option
- debt + warrant = way of securing an income yield while keeping high equity perf available (similar to convertible, but warrant can be detached and traded separately)

Disadv to investor
- geared, so potential losses can be extreme if shares underperform
-risk of takeover : expiry date is accelerated to takeover date so lots of time value is lost. could become worthless if warrant is newly issued.

Question 29

Q

What is a warrant

Warrant vs call?

Answer

A

Warrant = entitles holder to buy certain no. of UL shares of company for set period @ predetermined price. Company issues new shares if exercised
- often attached as sweetener to debt issuance

Warrants
- issued by and exercisable on company
- terms decided by company/not standardised
-longer expiry (yrs)
-dilutive
-not voting rights

Call options
-XC traded
- standardised by XC
-shorter expiry (m)
- Existing shares
-no voting rights

Question 30

Q

Convertibles

Answer

A

Bond with embedded option giving the holder the right but not obligation to convert the bond into a fixed number of shares of the issuer (during a certain defined period of the bond’s life)
- usually exercise if conversion rights are more attractive that prevailing market price of shares
- typically pay lower coupon because of embedded option to convert
- employed as a deferred shares - issuer assumes conversion @ conversion date/period
- conversion rights often expressed as no. of shares/£100 NV
subordinated debt - senior creditors must be pid in full before any payments made to holders in event of insolvency

Question 31

Q

conversion ratio

Answer

A

= no. of shares a bond converts to (usually per 100 NV)

Question 32

Q

conversion price

Answer

A

=convertible price/no. of shares
= share price where conversion is advisable

if bond only converts @ maturity = nominal val/conversion ratio

Question 33

Q

conversion value

Answer

A

= share price x conversion ratio

Question 34

Q