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FIN 301 > Ch. 7 - Derivatives and Risk Management > Flashcards

Ch. 7 - Derivatives and Risk Management Flashcards

1
Q

Derivative

A

A financial instrument whose value is derived from the value of some other underlying asset (pr possibly more than one)

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2
Q

What are some examples of derivatives

A
  • A contract to supply a tonne of coffee in 3 months
  • A futures position in gold for delivery in June
  • An option to buy 1000 barrels of oil at $40 by September
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3
Q

What are the major types of derivatives?

A
  • Forwards
  • Futures
  • Options
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4
Q

How are forwards traded?

A

Forwards are traded over the counter (OTC) via a private contract

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5
Q

How are futures traded?

A

Futures are traded via an exchange

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6
Q

Forwards Contract Specification

A

Customized/Negotiated (can define anything you want because it is over the counter)

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7
Q

Futures Contract Specification

A

Standardized (i.e. decided by the exchange). However, futures contracts may have range of quality, delivery locations, and dates.

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8
Q

Forwards Price

A

Settled at termination

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9
Q

Futures Price

A

Settled daily (determined by market participants through competitive bidding and asking)

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10
Q

Forwards Security

A

No money or guarantees are required, but securities (i.e. collateral) can be negotiated

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11
Q

Futures Security

A

Margin account required

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12
Q

Who takes on risk for a forward?

A

Risk is borne by counterparties

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13
Q

Who takes on risk for a future?

A

Risk is borne by clearing house

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14
Q

What is the most typical closure for forward contracts?

A

Forwards typically do not have an early option for either party to exit. The contracts are therefore typically carried through until delivery where a physical delivery or cash settlement happens depending on the agreement.

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15
Q

What is the most typical closure for futures contracts?

A

Futures contracts can be closed on the futures exchange by trading the opposite position. Most futures contracts are offset prior to delivery.

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16
Q

Strike Price

A

Fixed price at which the owner of an option can buy or sell the underlying asset

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17
Q

Call

A

The right (but not obligation) to buy a pre-agreed quantity of the underlying asset for a pre-agreed price (strike price) by a pre-agreed date (expiration date)

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18
Q

Put

A

The right (but not obligation) to sell a pre-agreed quantity of the underlying asset for a pre-agreed price (strike price) by a pre-agreed date (expiration date)

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18
Q

Holder

A

The party who bought the option and paid the premium. They have the right to decide whether to buy (call) or sell (put)

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19
Q

Writer

A

The party that sold the option and earned the premium. They have no choice if the option is exercised against them

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20
Q

Fill in the blanks: The call holder ___________________________________

A

bought the right to buy

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21
Q

Fill in the blanks: The call writer ___________________________________

A

sold the right to buy

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22
Q

Fill in the blanks: The put holder __________________________________

A

bought the right to sell

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23
Q

Fill in the blanks: The put writer __________________________________

A

sold the right to sell

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24
Q

Open Interest (OI)

A

The number of contracts that are outstanding

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25
Q

What are the potential assets options can be written on?

A
  • Stocks
  • Commodities
  • Precious Metals
  • Interest Rates
  • Futures
26
Q

Business Risk

A

Whether a company can generate the revenue needed to cover operating costs

27
Q

Financial Risk

A

Whether a company can manage its financial leverage and debt

28
Q

Hedger

A

Has a genuine interest in the underlying asset. They are willing to pay something to reduce their risk

29
Q

Speculator

A

Has no interest in the underlying asset. They aim to make a profit (on average) by trading and they expect to earn something from taking on risk.

30
Q

Long underlying

A

You hold (own) the asset

31
Q

Short underlying

A

You need to buy the asset

32
Q

Long call

A

You hold the right to buy some asset

33
Q

Short call

A

You have written a call on some asset (you may be forced to sell it)

34
Q

Long put

A

You hold the right to sell some asset

35
Q

Short put

A

You have written a put on some asset (you may be forced to buy it)

36
Q

What is specified in an option contract?

A
  • Underlying asset (includes quality of asset)
  • Quantity of underlying (contract size)
  • Type of option (call or put)
  • Method of settlement
  • Strike price or rate
  • Expiry date
  • Exercise style (e.g. American or European)
37
Q

What major specification is not included in an option contract

A

An option contract does not specify the price or premium of the underlying asset

38
Q

American Exercise Style

A

Can exercise rights on any day until the expiry date of the contract

39
Q

European Exercise Style

A

Can only exercise rights on the expiry date of the contract

40
Q

In-the-money

A

Holder will exercise their rights

41
Q

At-the-money

A

Holder may or may not exercise their rights (there is a great deal of uncertainty)

42
Q

Out-of-the-money

A

Holder will not exercise their rights

43
Q

Hedging

A

Aiming to reduce your risk exposure

44
Q

Speculation

A

Aiming to increase your risk exposure for an expected profit

45
Q

Arbitrage

A

Making a profit from mispriced instruments (risk-free)

46
Q

Covered Call

A

Writing a call option on the underlying that you hold

47
Q

Protective Put

A

Buying a put option on the underlying that you hold

48
Q

Vertical Spreads

A

Same option type, same strike price, same expiry date

49
Q

Horizontal Spreads

A

Same option type, same strike price, different expiry dates

50
Q

Diagonal Spreads

A

Same option type, different strike prices, different expiry dates

51
Q

Straddle

A

Combination of option types, same strike price, same expiry date

52
Q

Strangle

A

Combination of option types, different strike prices, same expiry date

53
Q

What are the different methods of pricing options?

A
  • Bounds
  • Binomial Pricing
  • Black-Scholes-Merton Model
54
Q

Why can’t Discounted Cash Flow (DCF) analysis be used to price options?

A

The expected cash flows of the payoffs keep changing with the underlying price

55
Q

Why can’t CAPM be used to price options?

A

The option beta keeps changing with the underlying price and also with time (higher beta with more time to expiry)

56
Q

How does higher stock price influence the value of calls and puts?

A

Higher stock prices make calls more valuable and puts less valuable

57
Q

How does higher strike price influence the value of calls and puts?

A

Higher strike prices make calls less valuable and puts more valuable

58
Q

How does a higher risk free rate influence the value of calls and puts?

A

A higher risk free rate makes calls more valuable and puts less valuable

59
Q

How does a longer time to expiration influence the value of calls and puts?

A

A longer time to expiration makes both calls and puts more valuable since there is a higher chance of a favourable outcome for the option holder

60
Q

How does higher volatility influence the value of calls and puts?

A

Higher volatility makes both calls and puts more valuable (increases the chances that an option expires in-the-money)

61
Q

How do dividends influence the value of calls and puts

A

Dividends reduce the value of call options (because they reduce the stock price) and increase the value of put options

62
Q

Delta of an option (Black-Scholes-Merton)

A

Tells us how much an option’s value changes per dollar change in the underlying value

63
Q

Implied Volatility

A

The volatility derived from the option prices in the market. It increases as the option becomes increasingly out-of-the-money or in-the-money

FIN 301 (15 decks)

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