Ch 19 Derivatives

Question 1

What are derivatives

Answer 1

Securities whose price is dependent on the price of other assets or value of other variables

Question 2

What is an important feature of derivatives

Answer 2

Contact between two parties, profits for one is loss for the other

Question 3

What are two types of derivatives markets

Answer 3

Over the counter
Exchange Traded

Question 4

What are over the counter markets

Answer 4

Central dealer making specialised deals for investors. Dealer matches parties to eachother in opposite positions. There is an element of credit risk as this isn’t supervised

Question 5

What are exchange traded markets

Answer 5

This is where derivatives can be bought and sold.

Here contracts are standardised and parties deal with the clearing house who take a margin payment to reduce credit risk

Electronically or open outcry system

Question 6

What is the person who sells a derivative called

Answer 6

A writer of the contract or Short party

Question 7

What is the person who buys a derivative called

Answer 7

Long party

Question 8

What are forwards and futures

Answer 8

Contracts that obligate both parties to trade a specified asset at a specified date for a specified price (strike price)

Question 9

What is the difference between a future and a forward

Answer 9

Futures are traded on exchanges

Forwards exchanged over the counter

Question 10

In a long forward position what is the pay off

Answer 10

St - k (share price at maturity - strike price)

Question 11

What is the payoff to a short party of a forward

Answer 11

K-St

Question 12

What is the difference in buying and selling and underlying asset vs future or forward

Answer 12

You don’t need to buy a real asset , the amount of money exchanged at outset of the transaction is zero with forward contracts and very small futures

Question 13

What is speculation

Answer 13

When people purchased derivative contracts that could expose them to massive profits or losses for a small initial investment

Question 14

What is a less risk strategy with futures

Answer 14

Hedging

Question 15

What is hedging

Answer 15

Reduction in probability of losses as a result of adverse movements in the market

Question 16

What is an option

Answer 16

Contract creating the option to trade an asset at a specified date for a specified amount

Question 17

Explain details of an option

Answer 17

Able to let an option expire if unfavourable and will only lose premium payments

Question 18

Difference between European and American options

Answer 18

European only exercised at maturity

American can be exercised at any time

Question 19

What is a call option

Answer 19

Gives the holder the right to buy an asset

Question 20

What is a put option

Answer 20

The right to sell the underlying asset at a future date for a specified strike price

Question 21

What is a the call option formula

Answer 21

Market price - strike price - premium

Question 22

Why is it riskier to short a call option

Answer 22

Because losses are infinite and profits maximise to premiums

Question 23

What is a European put option

Answer 23

Offers the holder the right but not obligation to sell an asset at a future date for a given price

Question 24

What are the uses of derivatives

Answer 24

Reduces or removes investment risk (hedging)
Increase investment risk in order to enhance returns (speculation)
Change notional composition of portfolio assets without investors having to buy or sell

Question 25

How do futures and options provide people with leverage

Answer 25

Investor gains increased exposure to the market for the same or less investment than un leveraged investors

Question 26

What are arbitrageurs

Answer 26

Take offsetting positions in two or more instruments in order to make a certain profit from mis pricing

Assets could be traded on different exchanges but same underlying asset