ch 4 Principles of Exchange Traded Derivatives Flashcards
What is the fair value of a futures contract?
Fair value = Cash price of underlying + Cost of carry.
What are the components of cost of carry in futures pricing?
Financing cost, storage, insurance, and interest rates.
How is the fair value of an equity index future calculated?
Cash index price + foregone interest - dividend yield.
What happens to futures pricing in a contango market?
Futures price is above the spot price due to net cost of carry.
What is backwardation in futures pricing?
A market where the futures price is lower than the spot price due to net benefit of carry.
What is the principle of convergence in futures contracts?
As futures approach delivery, their price converges with the spot price.
What is cash and carry arbitrage?
Buying the asset in the cash market and selling the corresponding futures if futures price > fair value.
What is reverse cash and carry arbitrage?
Selling the asset in the cash market and buying futures if futures price < fair value.
What is an arbitrage channel in futures pricing?
A range of values where futures prices deviate from fair value but arbitrage is not profitable.
How is basis calculated in futures trading?
Basis = Cash price - Futures price.
What does a negative basis indicate?
The market is in contango, meaning the futures price is above the spot price.
What does a positive basis indicate?
The market is in backwardation, meaning futures price is below the spot price.
What is basis risk in hedging?
The risk that basis fluctuates, leading to imperfect hedging results.
How do traders speculate on basis movements?
If basis is expected to strengthen: Buy cash and sell future. If expected to weaken: Sell cash and buy future.
What is intrinsic value in options pricing?
The profit an option holder would make if the option were exercised immediately.
What is time value in options pricing?
The extra premium paid for an option due to the possibility of price movement before expiry.
What factors determine time value?
Time to expiry and volatility of the underlying asset.
What happens to time value as an option nears expiry?
Time value decreases, reaching zero at expiration.
What is delta in options trading?
The sensitivity of an option’s price to changes in the underlying asset’s price.
What is gamma in options trading?
The rate of change of delta as the underlying price moves.
What is vega in options trading?
The sensitivity of an option’s price to changes in implied volatility.
What is theta in options trading?
The rate at which an option loses value over time (time decay).
What is rho in options trading?
The sensitivity of an option’s price to interest rate changes.
What is the put-call parity theorem?
C - P = S - K, ensuring no arbitrage between equivalent option strategies.
What is an arbitrage opportunity under put-call parity?
If synthetic long is cheaper, buy it and sell the future (reversal). If synthetic short is cheaper, sell it and buy the future (conversion).
What are the two methods of premium payment for options?
Upfront (T+1) for equity options; on close for options on futures.
What happens to call option values when dividends increase?
Call option time value decreases, put option time value increases.
What happens to call option values when interest rates rise?
Call option time value increases, put option time value decreases.
