Chapter 1:1 General Introduction Flashcards
What is a Future?
A contract to buy an underlying asset for a pre-agreed price for a future date (i.e. to buy a sofa for £1k in 2 months time).
Where are Futures traded?
On stock exchanges + standardised contracts.
What is a Forward?
Similar to a Future, but are traded OTC + customisable terms of contracts.
What are Options?
Paying a sum to reserve the right to buy an underlying asset for a pre-agreed price in the future (i.e. paying £30 to reserve the right to buy a sofa for £1k in 2 months time - if the price of the sofa changes in the interim, this does not affect the option holder thus risk is hedged).
What is the Primary use of Derivatives?
To hedge against risk for individuals and organisations.
What are the 3 ways in which futures are used?
1) Hedging.
2) Speculation.
3) Arbitrage.
What is Hedging?
Protecting the position in the underlying market by taking positions in the futures market.
(If a fund manager has a portfolio, they may take a position in a relevant equity index who’s profits will offset any losses made by the portfolio).
What is the Success of a Hedge based on?
It’s Basis - How closely correlated the portfolio is to the relevant index (i.e. low correlation is better).
What is a Perfect Hedge?
One that is risk-free.
What is Speculation?
Investors buying or selling futures contracts hoping to make a profit from adverse price movements (i.e. if an investor speculates the price of an underlying to go up, they’ll buy the underlying or futures contracts for the underlying).
Why would Investors purchase a Future of an Underlying rather than the Underlying itself?
Futures are geared, meaning for smaller initial investments you can get greater exposure to gains and losses. However, investors must provide margins, or sustain capital, to keep the position open.
How long are Speculative Investments typically held for?
High risk and Short term.
What is Arbitrage?
Investors exploiting price anomalies between 2 different markets for the same underlying or instrument.
What does Arbitrage result in?
Risk-free profit, which is realised once the prices in the 2 markets are back in line and the arbitrageur closes out its positions (mis-pricing indicates that the prices of the contract must come back in line).
What are the 3 types of Arbitrage?
1) Intertemporal.
2) Geographical.
3) Value-Chain.
