Ch. 7 - Derivatives and Risk Management

Question 1

Derivative

Answer 1

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

Question 2

What are some examples of derivatives

Answer 2

• 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

Question 3

What are the major types of derivatives?

Answer 3

• Forwards
• Futures
• Options

Question 4

How are forwards traded?

Answer 4

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

Question 5

How are futures traded?

Answer 5

Futures are traded via an exchange

Question 6

Forwards Contract Specification

Answer 6

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

Question 7

Futures Contract Specification

Answer 7

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

Question 8

Forwards Price

Answer 8

Settled at termination

Question 9

Futures Price

Answer 9

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

Question 10

Forwards Security

Answer 10

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

Question 11

Futures Security

Answer 11

Margin account required

Question 12

Who takes on risk for a forward?

Answer 12

Risk is borne by counterparties

Question 13

Who takes on risk for a future?

Answer 13

Risk is borne by clearing house

Question 14

What is the most typical closure for forward contracts?

Answer 14

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.

Question 15

What is the most typical closure for futures contracts?

Answer 15

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

Question 16

Strike Price

Answer 16

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

Question 17

Call

Answer 17

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)

Question 18

Put

Answer 18

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)

Question 18

Holder

Answer 18

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

Question 19

Writer

Answer 19

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

Question 20

Fill in the blanks: The call holder ___________________________________

Answer 20

bought the right to buy

Question 21

Fill in the blanks: The call writer ___________________________________

Answer 21

sold the right to buy

Question 22

Fill in the blanks: The put holder __________________________________

Answer 22

bought the right to sell

Question 23

Fill in the blanks: The put writer __________________________________

Answer 23

sold the right to sell

Question 24

Open Interest (OI)

Answer 24

The number of contracts that are outstanding

Question 25

What are the potential assets options can be written on?

Answer 25

- Stocks - Commodities - Precious Metals - Interest Rates - Futures

Question 26

Business Risk

Answer 26

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

Question 27

Financial Risk

Answer 27

Whether a company can manage its financial leverage and debt

Question 28

Hedger

Answer 28

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

Question 29

Speculator

Answer 29

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.

Question 30

Long underlying

Answer 30

You hold (own) the asset

Question 31

Short underlying

Answer 31

You need to buy the asset

Question 32

Long call

Answer 32

You hold the right to buy some asset

Question 33

Short call

Answer 33

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

Question 34

Long put

Answer 34

You hold the right to sell some asset

Question 35

Short put

Answer 35

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

Question 36

What is specified in an option contract?

Answer 36

- 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)

Question 37

What major specification is not included in an option contract

Answer 37

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

Question 38

American Exercise Style

Answer 38

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

Question 39

European Exercise Style

Answer 39

Can only exercise rights on the expiry date of the contract

Question 40

In-the-money

Answer 40

Holder will exercise their rights

Question 41

At-the-money

Answer 41

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

Question 42

Out-of-the-money

Answer 42

Holder will not exercise their rights

Question 43

Hedging

Answer 43

Aiming to reduce your risk exposure

Question 44

Speculation

Answer 44

Aiming to increase your risk exposure for an expected profit

Question 45

Arbitrage

Answer 45

Making a profit from mispriced instruments (risk-free)

Question 46

Covered Call

Answer 46

Writing a call option on the underlying that you hold

Question 47

Protective Put

Answer 47

Buying a put option on the underlying that you hold

Question 48

Vertical Spreads

Answer 48

Same option type, same strike price, same expiry date

Question 49

Horizontal Spreads

Answer 49

Same option type, same strike price, different expiry dates

Question 50

Diagonal Spreads

Answer 50

Same option type, different strike prices, different expiry dates

Question 51

Straddle

Answer 51

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

Question 52

Strangle

Answer 52

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

Question 53

What are the different methods of pricing options?

Answer 53

- Bounds - Binomial Pricing - Black-Scholes-Merton Model

Question 54

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

Answer 54

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

Question 55

Why can't CAPM be used to price options?

Answer 55

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

Question 56

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

Answer 56

Higher stock prices make calls more valuable and puts less valuable

Question 57

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

Answer 57

Higher strike prices make calls less valuable and puts more valuable

Question 58

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

Answer 58

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

Question 59

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

Answer 59

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

Question 60

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

Answer 60

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

Question 61

How do dividends influence the value of calls and puts

Answer 61

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

Question 62

Delta of an option (Black-Scholes-Merton)

Answer 62

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

Question 63

Implied Volatility

Answer 63

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