7. DERIVS Flashcards

Question

Hedging with gilt futures

Answer 1

- 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

Answer 2

HOLDER has right not obligation to buy/sell specific asset @ specific price writer/seller of option has obligation upfront payment = 'option premium' futures have margin upfront payment but that is returnable XTD or OTC call = right to buy option = right to sell

Answer 3

= 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

Answer 4

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

Answer 5

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

Answer 6

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

Answer 7

=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

Answer 8

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

Answer 9

= INTRINSIC VALUE + TIME VALUE IV= economic value of option if it were exercised now (measure of how far in the money an option is by comparing strike and asset price) TV = option prem - any intrinsic value = represents uncertainty remaining before expiry - underlying asset price (higher = more valuable call, less valuable put) -strike price (higher = less valuable for call, more val for put) -time to maturity = longer term, greater risk to writer option may expire ITM = higher prem -implied vol of UL = higher vol = higher prem -income yield on UL = greater = more valuable put and less valuable call -ST IR = higher = greater val of call (more income on cash not committed to buying UL), less valuable put

Answer 10

variables used to assess an option's risk DELTA = sensitivity of an options premium to a 1% move in UL security price -vanilla options = rough proxy for likelihood option will be exercised 100% = certain to be exercised ITM. 0% = imminently about to expire OTM GAMMA= sensitivity of delta to a 1% change in UL price (i.e. rate of change of delta). short dated ATM options will see delta change dramatically for a small change in UL (large gamma). Gamma is bell curve shaped with higher curve for shorter dated. VEGA = sensitivity of premium to 1% change in implied volatility. Bell curve, highest for long dated ATM options. THETA= sensitivity of an options premium to changes in time remaining to expiry. Measure of time decay of an option (highest for short dated, ATM options)

Answer 11

CHEAPENS UP LONG CALL - bull spread = profits with rising market - call option = right to buy not obligation -strike/expiry/premium/option types Buy Low strike call. Sell high strike call Low strike (100p) call = more expensive (higher IV) = 15p premium high strike call (150p) = cheaper 10p prem net prem = -5p max profit = difference between strikes - abs val of net prem BE= low strike + net prem abs value (calls) as UL price rises to low strike: max loss = net prem @100p low strike, exercise long call @150p high strike price - short call exercised against you max profit = 45p -moderately bullish - cheapen low strike call by selling high strike as dont think price will rise beyond DEBIT SPREAD - net premium is neg

Answer 12

Put option = right but not obligation to sell Bull spead - profits with rising market BULL = Buy low strike (100p). Pemium -10p Sell high strike (150p). Premium +15p CREDIT SPREAD: Net premium = +5p Max loss = diff in strikes - abs val of net prem = 150p-100-5 = 45p Max gain = net premium BE = 150p-5p = 145p Puts = high strike - net prem MODERATELY BULLISH - earning income with short put - capping losses with long put - think market will stay above 150p strike price

Answer 13

Bear strat =profit as market falls Put option = right but not obligation to sell BUY HIGH strike (150p) put -15p SELL LOW strike (100p) put +10p Net prem = -5p = DEBIT SPREAD Max profit = diff in strikes - net prem abs value = 150-100-5 = 45p BE puts (high strike - net prem = 150-5p = 145p CHEAPENS UP LONG PUT WITH SHORT PUT Moderately bearish - think market will fall but not below 100 give up some upside to cheapen long put

Answer 14

Call option = right not obligation to buy Bear strat = profits with falling market BUY HIGH strike call (150p) -10p Sell Low strike call (100p) +15p CREDIT SPREAD - net premium =+5p Max loss = diff in strikes - abs val of net prem = 150-50-5=45p BE (calls) low strike + net prem = 100+5 = 105p As market falls below 150p, exercise long call if market fell to 100 - short call would be exercised against you MILDY BEARISH limits losses of selling a short call useful for income fund to limit losses

Answer 15

(straddles the strike) Long vol trade Buy call (-11p) Buy put (-10p) with same ATM strike (call will be more expensive) 125p same expiry same UL Call = RTB, put =RTS Net prem = -10-11 = -21p Max gain = unlimited BE points = 125 +/- net premium If market rises (long call ITM) if market falls (long put ITM) Between BE points - lose money as neither option ITM Quite expensive vol trade Makes money so long as market moves Profit in either direction

Answer 16

Short vol trade SELL CALL (11p) SELL PULL (10p) (same expiry, same UL, same strike 125p) put = RTS, call = RTB Net prem = 10+11 = 21 Max loss= unlimited BE points = strike +/- net prem CREDIT trade = income generating used when trader doesnt think UL price will change dramtically

Answer 17

Cheap version of a long strangle Define options BUY HIGH STRIKE (150p) CALL -5p BUY LOW STRIKE (150p) PUT -5p Same UL, same expiry Net premium = -5-5= -10p = debit trade Max gain is unlimited BE = low strike - net prem and high strike + net premium LONG VOL TRADE cheaper than straddle but need more volatility to profit very bullish on volatility

Answer 18

Short vol trade what is an option? SELL HIG STRIKE CALL (150p) +5p SELL HIGH STRIKE PUT (100p) +5p Max profit = 5+5 = 10p = net premium DEBIT SPREAD Max loss = unlimited BE = low strike - net prem high strike + net prem Short volatility trade - dont think price will move significantly Less premium than with straddle but keep premium over longer range of price movements

Answer 19

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

Answer 20

= [A / (1+ q) ] x no. of shares A = price of regular call option q= percentage increase in shares

Answer 21

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.

Answer 22

= warrant price + exercise price - share price / share price = time value/share price GEARING RATIO = share price/ warrant price

Answer 23

Gives holder the right but not obligation to buy (call warrant) or sell (put warrant) the UL asset @ strike price by exercise date - issued by financial instits -listed secs on exchange - give exposure to range of UL instruments (stocks, bonds, commodities) - securitised derivative = option is covered by UL financial instrument -non dilutive as issued by financial instit - max loss = premium paid. No margin calls etc - avg life = 1-2yrs (longer than options) -easier to access than options

Answer 24

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

Answer 25

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 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)

Answer 26

Contingent convertibles - hybrid secs issued by banks and auto converted into equity if contractually pre agreed trigger event occurs aka AT1 bonds - created post GFC = help undercapitalized banks and to reduce the potential for taxpayer-funded bailouts and satisfy requirements imposed by Basel III - often triggered if a bank's capital adequacy ratios are breached - conversion removes debt from the liability side of the balance sheet allowing bank to continue UW loans -high return and high risk - can be written down to 0

Answer 27

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

Answer 28

=convertible price/no. of shares = share price where conversion is advisable if bond only converts @ maturity = nominal val/conversion ratio

Answer 29

= share price x conversion ratio

Answer 30

For bonds you MUST CONVERT @ MATURITY - work out whether you convert and get shares or redeem for NV 1. assume conversion @ maturity 2. calc future share price @ maturity (share price x (1+g)^n) 3. calc future conversion value @ maturity = conversion ratio x future share price price bond as usual using future conversion value if >100 100 if future conversion value <100

Answer 31

Assumes conversion when divi income exceeds convertible income - estimates date when divi will equal convertible coupon 1. find conversion value today = share price x conversion ratio 2. calc basic divi on all shares = divi/share x conversion ratio 3. sum the PV of differences between the coupon and the future expected divi TABLE W/ COLUMNS year ! interest on debt ! grown divi ! income pickup ! PV of pickup ! 4. sum present val of income pickups (until they crossover) and add to today's conversion value

Answer 32

Convertibles priced as a bond with an embedded equity option value comprised of = val of conventional bond + value of equity option (warrant) Warrant price = equity call option premium / (1+q)

Answer 33

OTC deriv contract to buy/sell and asset @ fixed price on fixed date long = obliged to buy short = obliged to sell

Answer 34

Enables you to fix an IR in advance Enables you to take a view on whether rates or rising/falling No principal amount borrowed or lent - CF arises from difference between fixed and floating rate based on notional principal e.g you take out a £10mn 6m loan with interest payments set to 3m rate 0-3m you know the rate. risk is the 2nd 3-6m payment 3v6 FRA can lock in rates between 3 and 6 months FRA overlays loan - cash settles the difference between FRA and benchmark rate You pay fixed amount (4%) to FRA provider If benchmark loan rate goes up to 5%, you pay 4% and the FRA pays difference (1%) If benchmark rate goes down to 3%, you pay 3% on loan and difference (1%) to FRA provider FRA vs IR swap IR swap is over much longer period = baso avg of multiple FRAs with constant rate

Answer 35

USD uses days in year as 360 Sterling = 265

Answer 36

Can also use first principles and derive spot rates

Answer 37

Provide right not obligation to enter benefit from rising/falling rates (as FRAs require you to pay out if rates move against you) European style - exercise on day only Pay premium as % of notional principal amount CAP = call on ST IR Protects loan as rates rise. Pays out difference between reference rate and strike rate if rates rise FLOOR = put on ST IR Pays out if rates fall (protects deposits from falling rates/speculation) COLLAR = BUY CAP, SELL FLOOR (Buy call, sell put) With same premium (so costless) but different strikes high strike cap and low strike floor selling floor cheapens cap (dont think rates will fall to floor strike price)

Answer 38

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) 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

Answer 39

Exchange of CFs based on different interest rates in same currency based on notional principal (pre set schedule of payments and calcs) Typically one leg fixed and one leg floating to gain/decrease exposure to prevailing market rates Notional principal never exchanged Long term (years) In contract: notional principal, fixed rate, maturity, floating rate index, frequency of reset Diagram. Blue chip thinking rates will decrease and bond yield is high. Small bis want to hedge loan rate Bank - want to offset IR risk Paying fixed rate = benefit if rates rise Paying floating = benefit if rates fall Mandatory CCP clearing to remove CP risk post EMIR Can be cancelled/terminated early - need agreement from both parties mark to market value of swap calc and exchanged

Answer 40

Options on swaps - physically delivered, actually receive swap 'strike price' is fixed rate Payers swaption = right to enter into swap (@ exercise date) and pay fixed rate Call on interest rates Receivers swaption = right to enter into swap @ exercise day and recieve fixed rate Put on interest rate '1yr 5yr receivers strike 5%' = 1 yr option on a 5yr IR swap with strike 5%

Answer 41

Interest rate swap where both payment streams reference a floating rate = 2 parties agree to swap variable interest rates based on different money market reference rates Useful to hedge against IR risks where you borrow and lend @ different rates Can speculate on rate movements (time period, cross currency) examples 3m LIBOr v 6m LIBOR (same rate different period) US IM LIBOR v IM SOFR (same currency different rates) 3m SONIA v 3m SOFR (cross country) (technically any floating for floating swap)

Answer 42

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

Answer 43

Swap where floating leg is referenced to an overnight index rate TONA - Tokyo ESTR - Euro SOFR - US SONIA - UK overnight leg isnt paid everyday (credit risk, expensive, admin, long) - compounded and paid per period (i.e. monthly) - can do asset swap (e.g. swapping 5% return on fixed rate bond for OI) thereby receive income more quickly and frequently) -arbitrage = borrow in O/N market and lend for 3m, the transact swap where you pay O/N and receive 3m for potential gain. - If bank borrows for 1 yr but would prefer to fund on daily basis due to IR risj - OIS where they receive 1 yr fixed and pay O/N rate - liability swap = issues bond @5%, OIS where you pay O/N rate and receive 5% fixed

Answer 44

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.

Answer 45

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

Answer 46

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

Answer 47

Variance swap - allows investor to hedge against/speculate on future price movements (vol) of UL asset One leg's payments are linked to the realized variance of the UL (price of UL record on daily basis often closing price) and other leg pays fixed amount Provides pure exposure to volatility of the UL (variance = vol squared) Options also allow you to speculate on vol but are more expensive and carry directional risk. price also related to time to expiration etc

Answer 48

Typically owned by its members or by the XC whose contracts it clears OCC (options clearing corp in US) - jointly owned by several exchanges ICE Clear Europe - owned by exchanges and clearing members CME - division of exchange itself OTC Clearing HK limited - owned by 12 shareholders including 5 mainland chinse banks SA JSE Clear owned by the JSE

Answer 49

Increased concern over CP risk and XC wanted to diversify has led to XC offering clearing facilities and guarantees to range of OTC procs CH does not assign or match buyers to sellers (as contract is already agreed OTC) - does monitor and guarantee delivery Attractive for long term contracts Once OTC contract is cleared = subject to standard reqs of margin, delivery procedures etc Both parties of trade must be exchange members and have direct or indirect clearing relationship with CH as usual

Answer 50

ADV - more flexible = can be tailor made for specific needs - in some areas the market is significant so can gain access to areas may not be able to get to otherwise -major role in companies providing customers with stable pricing DISADV - No secondary market for OTC derivs as terms not standardises - Can be transacted directly between buyers and sellers with no CCP - credit risk -opaque market with fewer regs so large systemic risk -speculative nature of market can cause market integrity issues