7.2 Forward commitments and contingent claim features and instruments Flashcards
forward commitments
an obligation to trade
can be exchange-traded contracts (e.g., futures) or over-the-counter (OTC) contracts (e.g., forwards and swaps
contingent claims
provide the buyer with the right to trade
A forward contract
an agreement to make a trade at a future date
One party agrees to pay the forward price for an underlying asset and the other party agrees to sell at that price on a specific date.
The buyer of a forward contract has long exposure to the price of the underlying and benefits from any appreciation.
The forward contract seller is said to be short the underlying and benefits from any depreciation in its price.
A futures contract
similar to a forward contract in that there is an agreement to purchase an underlying asset for a specific price on a specified date
Differences between forwards and futures include:
- Futures contracts are standardized, while forward contracts are customized terms.
- Futures contracts trade on a public exchange with a clearinghouse that guarantees the performance of all traders. Forward contracts trade OTC with no performance guarantees, so traders must do their own assessment of counterparty credit risk.
- Futures contracts are marked to market, which allows traders to realize gains or losses at the end of each day. By contrast, gains and losses for forward contracts are not realized until expiration.
- Futures contracts are highly liquid instruments because it is much easier to take offsetting positions when trading standardized contracts. By contrast, forward contracts are usually held to maturity.
an initial margin deposit (typically less than 10% of the futures price) from both parties upon initiation
This serves as a performance bond to provide some assurance of the parties’ ability to cover possible future losses.
daily settlement
At the end of each trading day, the clearinghouse credits gains to one party’s margin account based on the change in the futures price
all contracts are marked to the end-of-day settlement price.
A margin call is made if
if an account balance drops below the maintenance margin
After receiving a margin call, a party must deposit sufficient funds to bring the account balance back to the initial margin level.
Note that it is not sufficient to bring the balance back to the maintenance margin
the variance margin
The amount required to bring an account back up to the initial margin level
The number of outstanding contracts for a particular underlying and settlement day is known as
the open interest
A swap
can be thought of as a series of forward contracts, meaning that cash flows are exchanged on more than one date.
swaps are privately negotiated OTC transactions and each party is exposed to the risk that the other party will default. If the swap is registered with a central counterparty, both parties may be required to meet margin provisions.
Swaps are widely used instruments, with interest rate swaps being particularly popular
For contingent claims, the payoff occurs if
if a specific event happens.
Examples include options, credit derivatives, and asset-backed securities
An option
gives its owner the right, but not the obligation, to buy or sell an underlying asset
As with other derivatives, an option’s key terms (e.g., the underlying asset, exercise price, maturity date) are specified in advance
A call option
grants the right to buy the underlying asset
a put option
grants the right to sell the underlying asset
European-style options
can only be exercised at maturity
American-style options
can be exercised any time after initiation
The value of an option after initiation depends on the
on the price of the underlying asset relative to the option’s exercise price
when are option buyers exposed to counterparty credit risk
if their options are in the money
Credit default swap (CDS) contracts
the most common type of credit derivative
These instruments are insurance-like contingent claims based on an underlying issue or index, with the buyer getting protection against adverse credit events (e.g., bankruptcy, failure to pay, involuntary restructuring)
The credit protection buyer makes a series of cash payments in return for compensation from the credit protection seller if a defined loss event occurs.
Which of the following risks is most likely greater for futures contracts than forward contracts?
A
Credit risk
B
Cash flow risk
C
Interest rate risk
B
Cash flow risk
With the mark-to-market feature of futures contracts, the investor must have daily cash on hand to pay for any adverse deviation, so there is cash flow risk.
An initial margin deposit for a futures contract is most likely:
A
a performance bond.
B
a margin account’s minimum allowable balance.
C
required of the short party only if the daily settlement price falls below the price specified in the contract.
A
a performance bond.
The initial margin requirement is required of both parties to a futures contract upon initiation. It serves as a performance bond to provide some assurance of the parties’ ability to cover possible future losses.
A swap contract is most accurately described as an:
A
over-the-counter contingent claim.
B
exchange-traded forward commitment.
C
over-the-counter forward commitment.
C
over-the-counter forward commitment.
It is over-the-counter and not exchange-traded because it is a private, customizable transaction and not a public, standardized good.
Assuming there are no defaults, what best describes a difference between forward commitments and contingent claims?
A
Forward commitments are traded over the counter, while contingent claims are traded on exchanges.
B
The occurrence of a future payoff is uncertain for contingent claims and certain for forward commitments.
C
A party must own the underlying asset to enter a forward commitments, while this requirement does not exist for contingent claims.
B
The occurrence of a future payoff is uncertain for contingent claims and certain for forward commitments.
Forward commitments have transaction terms that are agreed upon at initiation, whereas contingent claims have payoffs that are uncertain until they actually occur.
Which of the following is most likely an example of an exchange-traded forward commitment?
A
Call options
B
Futures contracts
C
Forward contracts
B
Futures contracts
futures contracts are exchange-traded forward commitments.
