Alternative Investments and Derivatives Flashcards
What is a future?
An exchange-traded contract to buy (or sell) an asset at a specified future date for a certain price. The price is determined at the time the contract is agreed, and the contract imposes an open-ended obligation on the holder until expiry or closing out. Future’s are binding and their is an obligation to sell/buy.
what is a swap?
An agreement between two parties to exchange a series of cash flows over a period of time. The most common type is an interest rate swap, where one party swaps floating rates of interest for fixed rates.
What does a long position refer to and why may someone take a long position?
Refers to the buyer of the future who is ‘long’ of the contract and is committed to buying the underlying asset at the pre-agreed price on the specified future date.
Longs traders make money in a rising market and is hoping that the price of the underlying asset will rise.
There is a difference between trading futures and being the actual buyer of a future.
What does a short position refer to and why may someone take a long position?
Refers to the seller of the future who is committed to delivering the underlying asset in exchange for the pre-agreed price on the specified future date.
Shorts make money in a falling market, by fixing the price before hand i.e. they can sell an asset at a price which is higher than the future market price.
If someone holds gold in their portfolio and believes the value of gold will fall in the short-term, they may wish to take a short position - enter into a short futures contract.
If the price of gold falls, they have an obligation to deliver the item at a set time and price and they will receive the pre-agreed price for their gold, which is higher than the market price.
What is a forward?
a direct deal between two parties, not sold on the exchange as futures contracts are. So, very similar to futures contract, just not sold on the exchange
What is counterparty risk?
The risk that the obligation from either side will not be met. For derivatives traded on an exchange this risk is removed by the LCH Clearnet - which does not exist for forwards.
Why might an investment manager choose to hedge portfolios against adverse market movements?
The portfolio manager’s mandate may require equities to be held within the portfolio, regardless of market conditions.
Selling a large portfolio would move the price of the shares against the portfolio manager, taking time and resulting in significant dealing costs.
Futures markets, being more liquid than securities markets, would not move the price of the transaction against the portfolio manager and would be completed more swiftly.
Futures incur lower dealing costs
What is the hedging ratio?
The number of contracts required to hedge a portfolio is known as the hedging ratio, and the future is priced in index points with a tick value of £10 per index point.
A tick is the smallest price movement and is expressed in terms of money or an index. Tick
value is the profit or loss that arises when prices move by one tick.
How could an investment manager use futures to hedge his holding in the FTSE 100.
The FTSE 100 index future can be used to hedge a portfolio position. they would short the future by selling a certain number of contracts.
The FTSE 100 index future contract is a standardised, with each valued at £10 per index point.
If the FTSE index future is 7,275, each contract is worth £10 × 7,275 = £72,750.
To know how many contracts to sell = value of the portfolio you want to hedge / the value of the futures.
An investment manager has a portfolio of major UK equities valued at £1 million and believes that the FTSE will fall and wants to hedge their position. Assuming the FTSE 100 is priced at 7,200 and the future priced at 7,275, how would the fund manager calculate how many to sell if they wanted to cover their entire FTSE position.
If the FTSE fell to 6900, taking the futures price to 6975, what loss would be incurred by the portfolio and what gain would be made by the futures?
£1,000,000 / 7,275x £10 = 13.7, rounded up to 14 contracts
Loss to portfolio = £1,000,000 x (6900 / 7200) = £958,333 = loss of £41,667
Gain on the future:
The future has fallen by 300 points at £10 per index point = £3,000 per contract
Investment manager has sold 14 contracts, so the profit on the future is £42,000.
What is Margin and how is it calculated?
If the initial margin charge is 5% and the price of a three-month gold future contract is £1,380 per troy ounce, calculate, showing all your workings, the cost of hedging 100 troy ounces of gold, using a three months futures contract.
An amount that futures exchanges require from the trader as its clearing houses will guarantee settlement of each contract and initial margin provides some assurance that any obligations can be fulfilled. The initial margin is returnable once the position is closed and varies according to the market conditions for the underlying asset –the more price volatility, the higher the margin.
100 x £1,380 = £138,000
£138,000 x 5% = £6,900
Explain briefly why a three month’s futures contract might not be the best way to hedge a position.
- Margin calls if market moves against him.
- Volatility of underlying commodity.
- Need for constant monitoring.
- Usually limited to professional/institutional investors.
- Complex investment/special broker test before dealing.
- Possibility of unlimited loss.
- Underlying must be delivered.
What is an option?
Give the buyer (holder) the right, but not the obligation, to buy or sell an underlying asset at a fixed price (strike price) on, or before, a given date in the future.
Difference between the role of a buyer and seller with regards to an option?
Only the seller of an option has an obligation, while the buyer has a choice. With a future, both the buyer and the seller have an obligation.
what does the buyer pay a seller with regards to an option?
The buyer of an option pays a premium (price paid for the option) to the seller. There is no premium involved when buying futures, but there is when trading options.
What is a call option with regards to the seller (writer) and buyer (holder) position
A call option gives the buyer of the option the RIGHT to buy the underlying asset.
The seller of a call option has an OBLIGATION to sell the underlying asset to the option holder.
What is a put option with regards to the seller (writer) and buyer (holder) position
A put option gives the buyer of the option the RIGHT to sell the underlying asset.
The seller of a put option has an OBLIGATION to buy the underlying asset from the option holder.
What is a strike price?
price at which the option specifies the underlying asset may be bought or sold.
The choices open to the holder of an option are to.
- exercise the option;
- sell the option before expiry; or
- let the option expire worthless.
Calculating the profit on a call option if sold:
ABC shares are trading at 400p per share and you believe that the share price is going to rise. You buy a call option to speculate on this potential movement.
The call option gives you the right to buy 1,000 shares at 400p each and you pay a premium of 20p per share for the right to do so. Let’s assume you are correct and the share price rises to 500p after ABC announces surprisingly good results. The price of the call option will rise (as you have the right to buy the shares at 400p) to, say, 110p.
What is the profit made if you sell the call option?
premium = 200p x 1000 shares = £200
Call option = 110p x 1000 shares = £1,100
£1,100 - £200 = £900 profit.
