45 & 46: Derivatives Flashcards
Either the long or short in the forward contract will make a cash payment at contract expiration and the asset is not delivered
Cash settlement
Can be used for futures (exchanged traded forward contracts)
The standardized terms of a future (exchanged traded) give it far more flexibility to traders, giving rise to a strong secondary market and greater:
liquidity; uniformity of the contract terms broadens the market for the futures by appealing to a greater number of traders.
For a futures contract, once the account margin (based on the daily settlement price) falls below the maintenance margin level, it must be returned to the:
Initial margin level
To avoid closing out a futures position
when a combination of two securities will produce a certain payoff in the future that produces a return that is greater than the risk-free rate of interest
arbitrage opportunity
The reason there may be a difference in price between a forward contract and an identical futures contract is that a futures position has:
daily settlement;
makes or requires cash flows during its life
Price of derivatives is established at:
established at contract initiation, so that the price at initiation is 0
The value of futures and swaps, throughout the life of the contract:
may vary; due to daily cash settlement & floating rate changes
Changes during the life of the contract, with opposite gains & losses to the long & short
How do benefits & costs impact the no-arbitrage froward price at initiation?
- Benefits, decrease the price (F < Spot)
- Costs, increase the price (F > Spot)
used to hedge the interest rate exposure of a floating-rate loan
forward rate agreements
Differences may exist between forward and futures prices for otherwise identical contracts if futures prices are correlated with:
interest rates
When interest rates and futures prices are uncorrelated the prices of forward and futures on the same asset will be:.
equal
Short FRA position gains when:
Short (Seller) of FRA gains when floating rates decline
Obligation to make payment in the event that the reference interest rate increases above the contract prices
Used to lock in an interest rate for future borrowing or lending
FRA
Long position in FRA gains when:
Long (Buyer) position of FRA gains when interest rates increase
Buyer exchanges fixed rate agreement for floating rate agreement
The underlying instrument in a FRA:
interest rate
Financial instrument that transforms the underlying asset’s performance
Derivative
The price used to determine the daily gains and losses in the margin account:
Settlement Price
In using a one-period binomial model to value an option the expected payoff at the end of one period is discounted at the:
Risk-free rate
A bank borrows for 360 days and simultaneously lends the proceeds for 90 days. This transaction creates a synthetic forward rate agreement (FRA) closest to:
long position in a 90-day FRA on 270-day LIBOR.
A hedger could replicate a 90-day long FRA position on 120 day LIBOR by:
Lending at 90 day LIBOR & borrowing at 210 day LIBOR
(borrow for full time, lend for first portion)
Profit of a forward or futures contract at expiration=
Profit @ expiration= Value of option - Option premium
Expiration= Spot price- contract price
Intrinsic value (exercise value) =
The amount the option is in the money
Option Premium=
(price of the option)
Option premium = Intrinsic value + Time value
Intrinsic value/exercise value = amount in the money
If out of the money: option premium= time value
Time value > 0, before expiration
Greater volatility in the price of the underlying asset will have what effect on the value of a call option and the value of a put option?
Values of call and put options will both increase
An option’s value can fall no lower than zero (it will expire out of the money), volatility will increase an option’s upside potential
Law of one price: two assets with identical cash flows, regardless of future events, should:
Have the same price
Interest rate swaps are:
Forward commitements
Interest rate swap in which the parties exchange one floating rate obligation for another:
Basis Swap
Can be replicated by a series of off-market FRAs with a non-zero value at initiation, but present values that sum to zero at swap initiation
Interest Rate Swap
Each FRA has a forward rate = fixed rate in in the intere rate swap
Buying the right, but not the obligation to exercise the call and buy at a specified price
Buyer of call option
Long asset exposure
Has the obligation to sell a specified asset to the buyer, at a specific price, if the buyer of the call option exercises before expiration
Writer (seller) of call option
Short asset exposure
Has the right but not the obligation to sell at a specifed price, in the future
Buyer of put option
Short asset exposure
Investor beleives the stock price will drop below the exercise price, before expiration
Has the obligation to buy the asset from the buyer, at a specified price, if the buyer exercises before expiration
Seller of put option
long asset exposure
(think of insurance company- buys the costs to repair a car for a premium… profits off the volume of put option premiums sold)
Long asset exposure: the amount invested in the long position > amout invested in the short position
Allows the owner to exercise the option any time before expiration
American option
American option value > = European option value
Except for:
Call options on dividend paying stocks
in the money put options
Options can only be exercised at expiration
European
Investor believes that the stock price will drop below the exercise price, before expiration:
Buyer of put option
If the stock price drops below the exercise price, the buyer will be able to sell at a higher price & make a profit
Measures the sensitivity of a derivatives value to the price of the underlying asset:
Delta
A put buyer and call buyer can experience a maximuim loss of:
Option premium
