ch 5 OTC Derivs Flashcards
OTC list:
more flexibility
better hedge
less liquidity
less regs
less transparency
more confidentiality
more counterparty risk
What is an OTC market?
A decentralized market for trading derivatives without a central exchange. Offers flexibility but historically lacked transparency.
How do OTC markets differ from exchanges?
OTC markets allow custom contracts but have higher counterparty risk. Exchanges use standardized contracts and have central clearing.
What are the advantages of OTC derivatives?
Customization, wide range of assets, and confidentiality. Used for hedging, speculation, and risk management.
What are the risks of OTC derivatives?
Counterparty default, liquidity issues, regulatory risk, and lack of price transparency compared to exchange-traded derivatives.
What is a forward contract?
A customized OTC agreement (future) to buy/sell an asset at a future date and fixed price. Not standardized or traded on exchanges.
What is an FX forward?
An OTC contract to exchange currencies at a future date at a predetermined rate. Used for hedging or speculation.
What is a non-deliverable forward (NDF)?
An FX forward where no physical delivery occurs, and settlement is based on the difference in exchange rates. (similar to CFD) used for speculation/hedging in restrictive country. cash settle only implied profit/loss
What is interest rate parity (IRP)?
A principle ensuring forward exchange rates reflect interest rate differentials, preventing risk-free arbitrage.
What is a currency swap?
An agreement to exchange cash flows in different currencies over time, including principal and interest payments.
What is an interest rate swap (IRS)?
A swap where parties exchange fixed and floating interest rate payments, used to manage interest rate risk.
What are the key components of an IRS?
1) Term length, 2) Notional amount, 3) Payment frequency, 4) Fixed vs floating rate.
What is a basis swap?
A swap exchanging one floating rate for another, typically based on different reference benchmarks.
What is a swaption?
An OTC option granting the right to enter an interest rate swap at a future date.
What are amortizing and accreting swaps?
Amortizing swaps reduce the notional amount over time, while accreting swaps increase it.
What is a rollercoaster swap?
A swap where the notional amount varies over time, increasing or decreasing at scheduled intervals.
What is a credit default swap (CDS)?
A contract where a buyer pays premiums for protection against a borrower’s default or credit event.
What triggers a credit default swap payout?
1) Bankruptcy, 2) Default, 3) Debt restructuring, 4) Government intervention, 5) Credit downgrade.
What is a total return swap?
A swap where one party receives the total return of an asset, while paying a fixed or floating rate.
What is an equity swap?
A type of total return swap where returns from an equity index or stock are exchanged for a fixed return.
What is an asset swap?
A bond combined with an interest rate swap, allowing investors to change fixed to floating rates or vice versa.
What is a credit-linked note (CLN)?
A debt security where repayment depends on a credit event occurring, transferring credit risk to investors.
What is an option in OTC markets?
A derivative contract giving the right, but not the obligation, to buy or sell an asset at a set price.
What is the difference between OTC and FLEX options?
OTC options are privately negotiated; FLEX options are exchange-traded but allow some customization.
What is a European-style option?
An option that can only be exercised at expiration, unlike American options, which can be exercised anytime.
What is a barrier option?
An option activated or deactivated when the underlying asset reaches a specific price level.
What is a lookback option?
An option whose payoff is based on the highest or lowest price of the underlying asset over a period.
What are caps, floors, and collars?
1) Caps: Limit the maximum interest rate. 2) Floors: Set a minimum rate. 3) Collars: Combine both for hedging.
What is an ISDA Master Agreement?
A standardized legal contract governing OTC derivatives, outlining netting, termination, and credit risk provisions.
What is trade capture in OTC markets?
The process of recording and verifying trade details to ensure accurate transaction processing.
What is trade confirmation?
The process where counterparties agree on trade details, ensuring accurate documentation and reducing disputes.
What is position keeping?
Monitoring and managing open positions, including risk exposure and profit/loss tracking.
What is settlement in OTC derivatives?
The process of transferring payments and finalizing obligations between counterparties.
What are the risks of poor trade processing?
Late settlements, regulatory breaches, financial losses, and increased operational risks.
What is Straight Through Processing (STP)?
A system that automates trade execution and settlement, reducing errors and improving efficiency.
What is central clearing in OTC markets?
A mechanism where a clearinghouse acts as an intermediary, reducing counterparty risk.
What is collateral management?
The process of managing margin requirements to mitigate credit risk in OTC transactions.
What is a margin call?
A request for additional collateral to cover potential losses in a derivative position.
What are the benefits of electronic OTC trading?
Improved transparency, faster execution, and reduced operational risks.
What are the key regulations impacting OTC markets?
Dodd-Frank Act, EMIR, and MiFID II enforce reporting, central clearing, and trade transparency.
What is an exchange-traded derivative (ETD)?
A standardized contract traded on regulated exchanges, reducing counterparty risk.
What are collateralized debt obligations (CDOs)?
Securities backed by a pool of loans, categorized into different risk tranches.
What is a variance swap?
A swap where one leg is based on realized variance, and the other on implied volatility.
What is an overnight index swap (OIS)?
A swap where floating payments are based on an overnight rate like SONIA or SOFR.
What is a forward rate agreement (FRA)?
An OTC contract to lock in an interest rate for a future period, used for hedging. forward on interest rate
What is an Asian option?
An Asian option is a type of option where the payoff is based on the average price of the underlying asset over a set period, rather than its price at expiration. It helps reduce volatility risk and is commonly used in commodities and FX markets.
What are the two types of Asian options?
Average Price Option (APO) – The payoff is based on the average price of the underlying.
Average Strike Option (ASO) – The strike price is determined as the average price of the underlying over time.
Why are Asian options used?
Asian options help smooth out price fluctuations, making them useful for commodities and FX markets where prices can be highly volatile.
What is a Ratchet Option?
A Ratchet Option (or Cliquet Option) is a series of options where profits are locked in at regular intervals, and the strike price resets to the current market price for the next period.
What is a Compound Option?
A Compound Option is an option on another option, meaning it gives the right to buy or sell another option. It is useful for hedging uncertainty before committing to a full option position.
What are the main types of Compound Options?
Call on a Call (CoC) – Right to buy a call option.
Call on a Put (CoP) – Right to buy a put option.
Put on a Call (PoC) – Right to sell a call option.
Put on a Put (PoP) – Right to sell a put option.
What is a structured product?
A financial instrument combining derivatives with traditional assets, offering customized risk-return profiles. Structured products include callable/putable bonds, convertible bonds, index-linked notes, equity-linked notes, and capital-protected products.
What is a callable bond?
A callable bond can be redeemed early at the discretion of the issuer. It allows the issuer to repay the bond before maturity, usually when interest rates fall, to refinance at a lower cost.
What is a putable bond?
A putable bond can be redeemed early at the discretion of the holder. It allows the bondholder to sell the bond back to the issuer before maturity, usually when interest rates rise, to reinvest at higher rates.
What is a convertible bond?
A convertible bond includes convertible loan stock, which can be converted into ordinary shares, and convertible gilts, which can be converted into other gilts. This allows investors to benefit from equity appreciation while receiving bond interest.
What are index-linked notes?
Index-linked notes are bonds where both the coupon payments and capital repayments are linked to an inflation index. They provide inflation protection to investors.
What is a capital-protected product?
A capital-protected product consists of a zero-coupon bond and a long option, ensuring that the principal is protected while allowing for potential upside. A variation of this is a capital-protected loan, where an investor takes a loan to buy equity but also buys a put option to hedge against market downturns.
What is an equity-linked note?
An equity-linked note is a structured product where the yield is determined by the performance of an equity index or stock. It allows investors to gain exposure to equity markets while potentially benefiting from downside protection.
How does a capital-protected loan work?
A capital-protected loan involves an investor taking out a loan to purchase equities, while also buying a put option to hedge against market declines. If the market falls, the put option ensures that the investor can sell the shares at a price that covers the loan repayment.
What are the benefits of structured products?
Structured products offer customized risk-return profiles, allowing investors to gain exposure to various assets while managing risk through derivatives. They provide capital protection, inflation hedging, and participation in different markets.
What are the risks associated with structured products?
Structured products carry risks such as market risk, liquidity risk, credit risk of the issuer, and complexity in pricing and valuation. Some structured products also have limited secondary market liquidity, making it harder to exit positions.
How do capital-protected products balance risk and return?
These products protect the principal investment through a zero-coupon bond while allowing for participation in market gains using a long call option. This setup ensures that investors do not lose their initial investment while still gaining market exposure.
