410 Midterm 2

Question 1

put call parity

Answer 1

a principal referring to the static price relationship, given a stock price, between the prices of european put and call option of the same class (i.e. same underlying, strike price and expiration date).

Question 2

forward interest rate

Answer 2

a type of interest rate that is specified for a loan that will occur at a specified future date.

Question 3

black scholes fomula

Answer 3

the model is a mathematical model of a financial market containing certain derivative investment instruments. from this model, one can deduce the formula, which gives a theoretical estimate of the price of european style options.

Question 4

covered interest pariry

Answer 4

a condition where the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. as a result, there are no interest rate arbitrage opportunities between those tow currencies.

Question 5

convenience yield on a commodity

Answer 5

the benefit or premium associated with holding an underlying product or physical good, rather than the contract or derivatives product.

Question 6

underlying

Answer 6

1. In derivatives, the security that must be delivered when a derivative contract, such as a put or call option, is exercised.
2. In equities, the common stock that must be delivered when a warrant is exercised, or when a convertible bond or convertible preferred share is converted to common stock.

Question 7

Convenience yield on a commodity

Answer 7

The benefit or premium associated with holding an underlying product or physical good, rather than the contract or derivative product.

Question 8

Duration of a bond

Answer 8

A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices.

Question 9

Yield curve

Answer 9

A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.

Question 10

Interest rate swap

Answer 10

Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.

Question 11

Interest rate immunization

Answer 11

a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund’s or a firm’s assets will increase or decrease in exactly the opposite amount of their liabilities, thus leaving the value of the pension fund’s surplus or firm’s equity unchanged, regardless of changes in the interest rate.

Question 12

Foreign exchange swap

Answer 12

An agreement to make a currency exchange between two foreign parties. The agreement consists of swapping principal and interest payments on a loan made in one currency for principal and interest payments of a loan of equal value in another currency.

Question 13

Documentary letter of credit

Answer 13

A Documentary Letter of Credit (LC) is a written undertaking given by a bank on behalf of an Importer to pay the Exporter a given sum of money within a specified time, providing that the Exporter presents documents which comply with the terms laid down in the Letter of Credit.

Question 14

Standby letter of credit

Answer 14

Standby letters of credit are created as a sign of good faith in business transactions, and are proof of a buyer’s credit quality and repayment abilities.

Question 15

DLOC V.S. SLOC

Answer 15

both types were created to assure the parties in a commercial transaction that contractual obligations will be honored.

Question 16

Asset swap

Answer 16

Similar in structure to a plain vanilla swap, the key difference is the underlying of the swap contract. Rather than regular fixed and floating loan interest rates being swapped, fixed and floating investments are being exchanged.

Question 17

Plain vanilla swap

Answer 17

The most basic type of forward claim that is traded in the OTC market between two private parties, usually firms or financial institutions.

Question 18

Yield to maturity

Answer 18

The rate of return anticipated on a bond if held until the end of its lifetime.

Question 19

Interest rate collar

Answer 19

An investment strategy that uses derivatives to hedge an investor’s exposure to interest rate fluctuations. The investor purchases an interest rate ceiling for a premium, which is offset by selling an interest rate floor. This strategy protects the investor by capping the maximum interest rate paid at the collar’s ceiling, but sacrifices the profitability of interest rate drops.

Question 20

Securities class action lawsuit

Answer 20

a lawsuit filed by investors who bought or sold a company’s securities within a specific period of time (known as a “class period”) and suffered economic injury as a result of violations of the securities laws.

Question 21

Efficient portfolio

Answer 21

A portfolio that provides the greatest expected return for a given level of risk, or equivalently, the lowest risk for a given expected return. also called optimal portfolio.

Question 22

Hedge fund

Answer 22

Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns. Because hedge funds may have low correlations with a traditional portfolio of stocks and bonds, allocating an exposure to hedge funds can be a good diversifier

Question 23

Call option v.s. put option

Answer 23

A call option gives its buyer the option to buy an agreed quantity of a commodity or financial instrument, called the underlying asset, from the seller of the option by a certain date (the expiry), for a certain price (the strike price). A put option gives its buyer the right to sell the underlying asset at an agreed-upon strike price before the expiry date.

Question 24

Futures vs. forward contract

Answer 24

The main differentiating feature between futures and forward contracts — that futures are publicly traded on an exchange while forwards are privately traded(OTC) — results in several operational differences between them. This comparison examines differences like counterparty risk, daily centralized clearing and mark-to-market, price transparency, and efficiency，and customization(forward).

Question 25

OTC vs. exchange traded

Answer 25

1. In exchange markets, there’s a regulator (exchange) through which transactions are completed, while in OTC markets there is no regulator.
2. Exchange markets have less chances of price manipulation, while the many competing traders in OTC markets can manipulate prices.
3. Exchange markets ensure transaction security, while OTC markets are prone to fraud and dishonest traders.

Question 26

American vs. European optio

Answer 26

1. Trading close time is different.
2. The Right To Exercise
   Owners of American-style options may exercise at any time before the option expires, while owners of European-style options may exercise only at expiration.

Question 27

Cash settled vs. physical settled for credit default swaps

Answer 27

In case of the cash settlement, the protection seller makes payment equal to a pre-determined value to the protection buyer, it will compensate the protection buyer for the decline in the obligation’s value.
In case of physical settlement, the protection seller will pay the face value of the asset to the buyer and the buyer will give the reference asset to the seller.

Question 28

Facultative vs. treaty reinsurance

Answer 28

Facultative insurance is reinsurance for a single risk or a defined package of risks.
Treaty Reinsurance is a pre-negotiated agreement between the primary and the reinsurer.

Question 29

Interest rate swap vs interest rate immunization vs interest rate collar

Answer 29

1. Interest rate swap: change from fixed interest rate to floating interest rate.
2. Interest rate immunization: in a portfolio, make sure the interest rate gain and loss at least cancel out each other.
3. Interest rate collar: use derivatives to hedge investor’s exposure to interest rate fluctuation. Related to interest rate ceiling and floor. Interest

Question 30

Put call parity vs covered interest parity

Answer 30

1. Put call parity: referring to a static relationship, given a stock price, between the price of European put and call option of the same class (e.g. same underlying, strike price, and expire date).
2. Covered interest parity: a condition where the relationship between interest rate and the spot and forward currency value two countries are in equilibrium, so there is no arbitrage opportunity between the two countries.

Question 31

Interest rate swap vs foreign exchange swap vs credit default swap vs asset swap

Answer 31

1. Interest rate swap: exchange a fixed payment for a floating payment that is linked to a interest rate (LIBOR)
2. Foreign exchange swap: an agreement to make currency exchange between foreign parties, consisting swapping principal and interest payment on a loan.
3. Credit default swap(CDS): to transfer the credit exposure of fixed payment product between parties
4. Asset swap: Similar in structure of a vanilla swap, the key different is the underlying of the swap. Rather than fixed and floating loan interest rate being swapped, fixed and floating investments are being swapped.

Question 32

risk premium

Answer 32

An asset’s risk premium is a form of compensation for investors who tolerate the extra risk - compared to that of a risk-free asset - in a given investment.

Question 33

collateralized debt obligation

Answer 33

A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors.

Question 34

strict priority rules

Answer 34

A rule that stipulates the order of payment - creditors before shareholders - in the event of liquidation. The absolute priority rule is used in bankruptcies to decide what portion of payment will be received by which participants.

Question 35

lookback option

Answer 35

An exotic option that allows investors to “look back” at the underlying prices occurring over the life of the option and then exercise based on the underlying asset’s optimal value. This type of option reduces uncertainties associated with the timing of market entry.

Question 36

surety bond

Answer 36

A surety bond or surety is a promise by a surety or guarantor to pay one party (the obligee) a certain amount if a second party (the principal) fails to meet some obligation, such as fulfilling the terms of a contract.

Question 37

bond duration vs bond maturity

Answer 37

1. bond maturity: A bond’s maturity is the length of time until the principal must be paid back.
2. bond duration: used to measure interest-rate sensitivity.

Question 38

static vs. dynamic hedging

Answer 38

1. A static hedge is a one-time fixed strategy created to hedge an existing option or position. Once created, it is not adjusted at all.
2. A dynamic hedge is taken out by the hedger with a view to having to continually adjust the hedge as the underlying that is itself being hedged moves. It is a technique of risk management.

Question 39

hedging vs. speculating

Answer 39

1. Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset.
2. Speculators make bets or guesses on where they believe the market is headed.

Question 40

asset swap vs. fixed-floating interest rate swap

Answer 40

1. Interest rate swap: exchange a fixed payment for a floating payment that is linked to a interest rate (LIBOR)
2. Rather than fixed and floating loan interest rate being swapped, fixed and floating investments are being swapped.

Question 41

Monte Carlo Valuation Method

Answer 41

calculate the value of an option with multiple sources of uncertainty or with complicated features.

Question 42

hedge fund vs mutual fund

Answer 42

1. similarity: both are managed portfolio. the investor can get instant diversification and get the professional management of their money.
2. difference: hedge fund can take short positions, and have less restrictions than mutual fund. hedge fund are managed more aggressively than mutual fund, with leverage and take speculative position. what’s more, hedge fund’s availability is limited.

Question 43

time arbitrage

Answer 43

An opportunity created when a stock misses its mark and is sold based on a short-term outlook with little change in the long-term prospects of the company.
in this case, investors may increase their chance of outperforming the market, and for company, there is often a good chance of a rebound long term.

Question 44

certainty equivalent

Answer 44

A guaranteed return that someone would accept, rather than taking a chance on a higher, but uncertain return.