Basics W1-Wx Flashcards
What are forward and futures contracts?
The obligation to buy/sell the underlying asset at a pre-specified price and on a pre-specified date.
Note: Forwards are bilaterally traded, meaning they are OTC and not listen on exchange
Simplified:
A deal to buy or sell something at a set price on a specific date in the future.
Differences:
Exchange of monies;
✓ Forwards: money changes hands only on the agreed
delivery date.
✓ Futures: money changes hands throughout the contract
lifetime via a process called marking to market.
Forward contract with no cashflows are exchanged at the date on which the contract is struck.
What are options?
Options are among the most liquid and useful financial instruments.
Definition: an option gives its owner the right, but not the obligation, to buy or sell a given quantity of a specified asset at some particular future date for a pre-determined price, known as the strike price or exercise price.
Call vs Put options
Call:
the right to buy the underlying asset for a pre-specified price and on (or before) a pre-specified date.
Put:
the right to sell the underlying asset for a pre-specified price and on (or before) a pre-specified date.
When to exercise options
What are exotics?
more complicated, less common derivative securities. They
include more complex option contracts.
E.g., lookback options (payoff is determined at the expiration date) and compound options (Call on a Call, etc).
What are swaps?
With example
Swaps: the exchange of cashflows for a pre-specified period of time. The cashflows are determined by some preset rule and are based on the value of some underlying assets.
Simplified:
An agreement to exchange money or payments over time, based on how an underlying value changes.
Example:
Imagine two companies, A and B:
Company A has a loan with a fixed interest rate of 5%.
Company B has a loan with a variable interest rate (based on market changes).
To benefit from their respective situations, they agree to swap their interest payments:
Company A will pay Company B’s variable interest rate.
Company B will pay Company A’s fixed interest rate of 5%.
This way, Company A can benefit if variable rates drop, and Company B gets the stability of a fixed rate. This is a simple example of an interest rate swap.
At-The-Money (ATM)
In-The-Money (ITM)
Out-The-Money (OTM)
Explanation
ATM: Strike price = Current market price.
ITM: (ITM) option is used when an investor wants to lock in a profit or hedge against losses
Example:
You own a stock currently trading at $100 and are concerned the price might fall. You buy an ITM put option with a strike price of $105.
If the stock price drops to $90, the ITM put option allows you to sell the stock for $105, minimizing your loss.
This ITM option is useful for protecting your investment during a volatile market.
OTM: The strike price is less favorable than the current market price (e.g., higher for call options or lower for put options).
Example:
If the stock’s market price is $50 but the strike price is $60, the option is OTM because it’s not profitable to buy at $60 when the stock is available for $50.
What does Over-The-Counter mean? (W/ Example)
OTC stands for Over-the-Counter, which refers to financial instruments like stocks, bonds, derivatives, or currencies traded directly between two parties rather than on a centralized exchange.
OTC is when trades happen directly between two parties, not on a public exchange. It’s flexible but comes with the risk that one side might not keep their end of the deal.
What is marking to market?
Marking to market ensures gains and losses on futures contracts are settled daily. Here’s how it works:
Daily Settlements: Any gains or losses are calculated daily and transferred between the buyer and seller.
Clearinghouse: An organization ensures both parties meet their financial obligations.
Margin Accounts: Traders deposit money (initial margin) and add more (variation margin) if losses occur.
Price Adjustments: The contract value updates to reflect current market prices.
This daily process ensures no large payments are required at the end and reduces default risk.∙ Margin account: an account holding monies deposited by a party to a futures contract.
∙ Initial margin: the initial amount the party must deposit in the margin account when the contract is opened.
∙ Variation: as the market price of the futures contract changes the balance in the margin account is altered accordingly.
✓ The party who is gaining has money is deposited in his/her margin account and vice versa.
∙ Maintenance margin: if the balance in the account falls below a pre-specified value, the party must top up the balance in the account to the initial margin. This is called a margin call.
If margin call is not met, the position must be liquidated
What is absence of arbitrage pricing?
Plus the two key implications
Absence of arbitrage means prices are set so no one can make a guaranteed, risk-free profit by exploiting market differences. It ensures fair and stable markets.
Definition: an arbitrage opportunity is said to exist when one can construct one of the following;
∙ A portfolio with zero set-up cost (i.e. a zero price portfolio) but a chance of positive subsequent payoffs (and no chance of a negative payoff).
∙ A portfolio with a negative set-up cost and zero payoffs thereafter.
A first key implication of absence of arbitrage is as follows;
The law of one price: if two portfolios have identical payoffs in all states of nature, they must have the same price.
If two portfolios give exactly the same results in every situation, they must cost the same.
A second implication is;
The law of payoff dominance: if portfolio A guarantees a payoff at least as great as portfolio B in all states of nature, then portfolio A must command a greater price than portfolio B.
If Portfolio A always pays more than or equal to Portfolio B in every situation, Portfolio A should be more expensive.
Computing no arbitrage price on a forward
Example
Present value (PV) formula for I
PV formula for series of cashflows (PART 1)
PV formula for series of cashflows (PART 2)
Futures pricing in continuous time
Currency forwards (FX) definitions
No arbitrage currency forward price example
Building hedges
Here are some rules for building hedges;
∙ When you’re long the underlying then hedge by shorting the future and vice versa.
∙ Choose the futures with which to hedge an asset by maximising correlation between
changes in the asset price and changes in the futures price.
∙ If possible find a future that is written on the asset itself.
∙ If you’re hedging for a short period, then choose a future
with maturity slightly greater than the hedge horizon
∙ For long term hedges, choose liquid hedging instruments and roll them over if need be.
∙ Hedges may require cash (through margin calls) so make sure you have some available.
Define the gamma and vega of an option. Give a clear explanation of how they measure option risk and how, if at all, they are related.
How do central clearing and netting affect the operations of financial markets? How do you expect their more widespread use to affect trading in swap markets?
