Chapter 1 - An Overview of Derivatives (Done)

Question 1

What is arbitrage?

Answer 1

Academic or pure arbitrage refers to the simultaneous purchase and sale of instruments that are perfect
equivalents in the hope of taking advantage of pricing discrepancies between them to earn a risk-free profit. Most real world arbitrage,
however, is not pure. There usually is some element of risk.

Question 2

What is a call option?

Answer 2

The right to buy (and lock in a purchase price) is referred to as a call option as the call buyer has the right
to call the underlying asset from the
call writer (seller) during the life of the contract.

Question 3

What is a comparative advantage?

Answer 3

The mechanism through which the
cost of new or existing debt may be
reduced by an interest rate or currency swap. Specifically, two companies with complementary relative advantages may come together and design a swap to reduce the financing costs of both companies.

Question 4

What are counterparties?

Answer 4

The buyer and seller of a derivative
contract.

Question 5

What are exchange-traded derivatives?

Answer 5

Forward and option products that
trade on an organized exchange.

Question 6

What is a forward?

Answer 6

In a forward transaction, two parties
agree to terms of a trade which is to
be carried out some time in the future. The buyer does not pay the agreed upon price right away, nor does the seller deliver the underlying interest. Payment and delivery take place at a specified date in the future, known as the delivery date. The delivery price is agreed upon when the contract is entered into. Forwards that trade on an exchange are typically referred to as futures contracts. Forwards that trade OTC are typically referred to as forward agreements.

Question 7

What is hedging?

Answer 7

An attempt to reduce risk by making
transactions that reduce exposure to
market fluctuations. Hedging with
derivatives involves taking an opposite position in the derivative instrument of the asset to be hedged (or one that is very close to it) that is equal in size.

Question 8

What is leverage?

Answer 8

The ability to control large dollar
amounts of an underlying interest
with a comparatively small amount of
capital. Leverage can greatly magnify
the effect of price changes in an
underlying interest.

Question 9

What is an option?

Answer 9

A derivative instrument that gives
the purchaser the right, but not the
obligation to, buy or sell an underlying asset at a certain price (exercise price) on or before an agreed upon date. For this right the purchaser pays a premium to the seller (writer) of the option. The writer has an obligation, if called upon to do so by the purchaser, to buy, in the case of puts, or sell, in
the case of calls, at the exercise price.

Question 10

What is the over-the-counter market?

Answer 10

A market that generally consists of a
loosely connected network of brokers
and dealers who negotiate transactions directly with one another primarily over telephone lines and/or computer terminals.

Question 11

What is a performance bond?

Answer 11

What is often required upon entry into a futures contract is a performance bond or good-faith deposit, which gives the parties to a transaction a higher level of assurance that the terms of the contract will eventually be honored. The performance bond is often referred to as margin.

Question 12

What is premium?

Answer 12

The price of an option.

Question 13

What is a put option?

Answer 13

The right to sell (and lock in a sale
price) is referred to as a put option
as the put buyer has the right to put
the underlying asset to the put writer
(seller) during the life of the contract.

Question 14

What is a swap?

Answer 14

A private, contractual agreement
between two parties used to exchange (swap) periodic payments in the future based on an agreed to formula. Swaps are essentially equivalent to a series of forward contracts packaged together.

Question 15

What is time to expiration?

Answer 15

All derivative contracts have a specific
time to expiration. Both parties must
honour the contract’s obligations, or,
if they plan to, exercise the rights (i.e.,
the buying or selling of a specified
underlying interest) of the contract by
expiration. The contract is automatically terminated upon expiration.

Question 16

What is an underlying interest?

Answer 16

The value of a derivative instrument is based on an underlying interest which may be a commodity such as wheat or a financial product such as a bond or stock, a foreign currency, or an economic/stock index.

Question 17

How are derivatives a zero-sum game?

Answer 17

Describes the fact that, commission
fees and bid-ask spreads aside, the
gain from a derivative contract by one counterparty is exactly offset by the loss to the other counterparty.

Question 18

Provide a detailed summary of the content covered in this chapter.

Answer 18

Despite negative media attention and widespread confusion about derivative instruments, many corporations and other institutions are continuing the practice of using derivatives primarily to manage risk and less frequently to lower costs, enhance returns, facilitate market entry and exit, and engage in arbitrage activities. These users
recognize that the benefits of using derivatives outweigh the potential risks by a wide margin. There are two basic types of derivatives – options and forwards – and two ways that they can be traded – on an exchange and over the counter. Option-based products allow holders to lock in a maximum purchase price or minimum selling price, while still
allowing for windfall gains. The benefits, however, are not free, given that holders must pay a premium, the size of which must be taken into consideration when deciding on an appropriate derivative strategy.
Forward-based products also allow users to lock in a future sale or purchase price. However, because forwards represent obligations, there is no avenue for windfall gains. The user is locked into a price regardless of which way the market price moves. Unlike options, however, users of forward-based contracts do not have to pay an upfront fee. Although there are significant differences between different derivative products, they are all used to achieve the same financial goals. Some users prefer the features of option-based products, while others prefer forwards. Some prefer OTC products, while others would rather take advantage of the features that exchange-traded products offer.
It must be reiterated that derivative products do not create risk. They simply transform it or transfer it between counterparties. They may transform one type of risk, such as market risk, into a more manageable type of risk, such as basis risk; or they may transfer an unwanted risk to more efficient managers so that corporations can concentrate
on their core business operations.
If used correctly and sensibly, derivatives are an essential risk management tool. They are flexible and versatile, and, in most situations, they are the best hedging instrument available in the marketplace. In volatile economic and business conditions, derivatives may help to reduce a firm’s exposure to market risks such as interest rate risk, foreign exchange risk, and stock market volatility. They may help stabilize earnings through the reduction of these risks. They are cost-efficient and provide liquidity to the markets. Effective use of derivatives may lower funding costs for users by exploiting comparative advantages between counterparties due to market inefficiencies or credit risk differences. Derivatives such as currency swaps also help companies gain access to otherwise unattainable
markets. However, although derivatives help market participants achieve financial goals, they must be used with caution. The real danger of derivatives does not lie in their complexity, but rather in their capacity for leverage. To limit the potential danger of derivatives, a company must approach a risk management program with a clear
objective and with strong internal control and monitoring procedures in place. In summary, many corporations, financial institutions, and government agencies have used and are continuing to use derivative instruments as risk management tools. While the recent negative media coverage involving derivatives reminds us of potential dangers, the benefits of derivatives are clear to users. Derivatives will continue to
be an integral part of business strategy for years to come.

Question 19

Explain generally what derivatives are, including the commonalities and differences between the various
types and how they are used.

Answer 19

A derivative is a financial instrument whose value is based on an underlying interest or asset.

Question 20

Describe the features that are common to all derivatives.

Answer 20

All derivatives:

• Are contractual agreements between two parties known as counterparties
• Have a specific time to expiration
• Establish a price or formula today for exchanging payments at some point in the future
• Facilitate the use of leverage
• Are zero-sum games.

Question 21

Differentiate between option-based and forward-based derivatives.

Answer 21

An option gives the holder the right, but not the obligation, to either buy (in the case of a call option) or sell
(in the case of a put option) a specified amount of an underlying interest at a specified price within a certain time frame. A forward contract obligates one party to buy and the other to sell a specified amount of an underlying interest
at an agreed-upon price at a specified time in the future.

There are three primary differences between options and forward contracts:

• Option-based contracts give their holders the right to buy (calls) or sell (puts), while forwards represent
  obligations to buy or sell.
• Options have value at expiration only if the price of the underlying interest is above (in the case of calls) or below (in the case of puts) a trigger price known as the exercise price. Forwards develop value as soon as the forward price changes relative to the entry or delivery price.
• The cost to enter an option contract is known as the premium. Forwards have no value upon entry (delivery
  price equals forward price), so there is no cost to enter a forward contract.

Question 22

Differentiate between exchange-traded and over-the-counter derivatives.

Answer 22

Refer to the table on your phone.

Question 23

Identify the various financial needs clients may have that derivatives can address.

Answer 23

Reduce risk (i.e., hedge):
- Hedging is accomplished by taking the appropriate position in a derivative so that potential losses in the cash market are offset by gains in the derivative.
- Reduce costs (e.g., exploit comparative advantages)
Swaps can be used to help companies reduce financing costs.
- Efficiently enter and exit a market
Derivatives can be used to enter or exit a market more efficiently than using the underlying asset (less required capital, lower transaction costs, etc.)
- Enhance yield by selling options provides additional income to portfolios.
- Speculate…
Taking a long or short position in any derivative will expose speculators to that market’s price movements.
Derivatives provide a low-cost, leveraged, and efficient way to speculate in financial and commodity markets.
- Arbitrage…
Derivatives can be used to simultaneously buy and sell the same or related asset on two different markets to exploit price inefficiencies.
- Product Structuring…
The use of derivatives allows product engineers to provide investors with highly focused investments that are
targeted to the investor’s risk profile, return requirements, and market expectations.

Question 24

Identify the operational considerations firms that use derivatives must consider.

Answer 24

• The use of derivatives must be integrated into an overall risk management program.
• Organizations planning on using derivatives must establish strong internal controls and monitoring of their derivatives operations.

Question 25

List five features that all derivative instruments share.

Answer 25

All derivatives…

• are contractual agreements between two parties.
• have a specific time to expiration.
• establish a price or formula today for exchanging payments at some point in the future.
• facilitate the use of leverage.
• are zero-sum games.

Question 26

An investor is trying to decide between purchasing an option or a forward contract on a Government of Canada bond. List three differences between options and forwards.

Answer 26

Three differences between options and forwards include…

• Option-based contracts give their holders the right to buy or sell while forwards represent obligations.
• Options only have value at expiration if the price of an underlying asset is above (in the case of calls) or below (in the case of puts) a trigger price known as an exercise price.
• There is a cost to entering an option contract known as the premium. There is no cost to entering a forward
  contract.

Question 27

If a speculator bought an ABC Co. call option with an exercise price of $60 and paid a premium of $2, over
what price would ABC stock have to rise in order for the speculator to earn a profit on the exercise of that
option?

Answer 27

$62. The price of ABC must be above the strike price plus the premium paid for the call option in order for the speculator to earn a profit upon exercise.

Question 28

When does a forward contract begin to develop value for the two counterparties?

Answer 28

A forward contract develops value (either positive or negative) as soon as the forward price starts to deviate
from the contract’s delivery, or entry, price.

Question 29

A Canadian company has just exported US$800,000 worth of merchandise to the U.S. Payment is to be received three months later in U.S. funds. The company is considering hedging its exposure to the risk that the Canadian dollar will strengthen against the U.S. dollar over the next three months. To protect against a potential rise in the Canadian dollar, the exporter can take a long position in Canadian dollar futures contracts or use OTC forward exchange agreements. List and briefly explain four key differences between derivatives that
trade on an exchange and those that trade over-the-counter.

Answer 29

Four key differences between exchange-traded and OTC derivatives include…

• Exchange-traded derivatives are standardized while OTC derivatives are custom designed.
• Exchange-traded derivatives are guaranteed by a third-party while OTC derivatives have no third-party
  guarantor.
• Exchange-traded derivatives have daily settlement. OTC derivatives are settled only at the end of the contract.
• Exchange-traded derivatives can in most cases be easily terminated prior to expiry. OTC derivatives are not
  as easily offset.

Question 30

A dress manufacturer anticipates needing 1,000 pounds of cotton in three months. Cotton currently trades in the spot market at US$0.82 per pound and, at this price, will provide the manufacturer with the minimum desired profit margin on its products. The company has decided to use cotton futures to hedge its price risk.

i. If the manufacturer did not hedge the future purchase, which of the following spot prices for cotton in three months would put the company at risk?

a. US$0.75 per pound.
b. US$0.80 per pound.
c. US$0.82 per pound.
d. US$0.95 per pound.

ii. How would the company hedge its price risk using cotton futures?

a. Go long enough cotton futures to cover the entire purchase.
b. Go short enough cotton futures to cover the entire purchase.
c. Go long enough cotton futures to cover the first half of the purchase and go short enough cotton futures to cover the second half of the purchase.
d. Go short enough cotton futures to cover the first half of the purchase and go long enough cotton futures to cover the second half of the purchase.

iii. What other factors should the company consider before making the decision to hedge?

Answer 30

i. d. US$0.95 per pound.

Since the manufacturer needs to purchase cotton in the future, a higher price than US$0.82 per pound
will result in a lower than desired profit margin.

ii. a. Go long enough cotton futures to cover the entire purchase.

Since the manufacturer needs to purchase cotton in the future, it should go long enough cotton futures
to cover the entire purchase.

iii. The size of the hedge, the timing match between the anticipated purchase and the expiration of the futures contract, and how much basis risk the company is willing to accept.

Question 31

In three months, a Canadian importer will be buying US$1 million worth of a new product from an American supplier. The importer will be paying for the product in U.S. dollars. It wishes to hedge its currency risk between now and when the invoice has to be paid. Currently, $1 Canadian buys US$0.79.

i. Is the importer at risk if the Canadian dollar appreciates or depreciates relative to the U.S. dollar?

ii. If the importer decides to use a Canadian dollar option-based derivative to hedge the currency risk, what should it do?

a. Buy a call option on the Canadian dollar.
b. Write a call option on the Canadian dollar.
c. Buy a put option on the Canadian dollar.
d. Write a put option on the Canadian dollar.

iii. Describe the advantages and disadvantages of using option-based derivatives versus forward-based
derivatives.

Answer 31

i. The importer is at risk that the Canadian dollar will depreciate relative to the U.S. dollar, which means that it will take more Canadian dollars to buy the US$1 million.

ii. c. Buy a put option on the Canadian dollar.

To protect itself from a decline in the value of the Canadian dollar, the importer should buy a Canadian
dollar put option. If the Canadian dollar does decline, the put option should show a profit to help offset
or reduce the increased cost for Canadian dollars in the spot market.

iii. The major advantage of using an option-based derivative is that the user can experience windfall gains.
For example, if the Canadian dollar rose the importer would let the put option expire worthless and would
be able to buy the US$1 million with fewer Canadian dollars. If a forward contract was used the importer would be locked in to the lower rate.
Another advantage of buying options versus buying or selling forward-based derivatives is that the purchase of options will not result in any margin calls. Options have two major disadvantages relative to forwards. The first is that an up-front fee (known as the premium) has to be paid. Forwards have no such fee.
The second disadvantage is that options have a non-linear relationship with the underlying interest. At expiration, the underlying price must exceed (in the case of calls) or fall under (in the case of puts) the strike price in order for the option to have value. Forwards have a linear relationship with their underlying asset.

Question 32

List two reasons why a portfolio manager may prefer entering and exiting an equity market by using a stock market index derivative as opposed to buying or selling individual equities in the conventional way.

Answer 32

Two reasons include…

• Less transaction costs.
• Buying or selling large numbers of equities may induce adverse price pressures.

Question 33

Distinguish between academic arbitrage and “real-world” arbitrage.

Answer 33

Academic arbitrage involves no investment, and locks in a risk-free profit. Real-world arbitrage usually involves some investment and is not always risk-free

Question 34

List two steps that a company embarking on a derivatives program should take to limit the potential danger of derivatives.

Answer 34

First, the use of derivatives should be incorporated into an overall risk management program. Second, the
organization must establish strong internal controls and monitoring for its derivatives operation.

Question 35

How is it that hedging does not eliminate all unwanted risks?

Answer 35

Hedging reduces price risk but does not eliminate all risks, such as production risk (e.g., crop failure), basis risk (difference between futures and spot prices), and other market uncertainties (e.g., changes in demand).

Question 36

What is the role of the swap dealer in an interest-rate swap?

Answer 36

To act as a counterparty for two other counterparties. Refer to image on your phone for further clarification.