Chapter 1: Introduction to Derivatives Flashcards
How are Forwards Traded?
Using what platform?
OTC
What is Usually Paid for the Right to an Option?
What is the cost to the holder?
A premium
What are the 3 Ways Futures can be Used?
Why are they used?
- Speculation
- Hedging
- Arbitrage
Why Might an Investor Who Speculates a Rise in Market Prices, Use Futures?
As opposed to a regular buy/hold?
As they can be highly geared (leveraged), where small expenditure can give large exposure.
High risk, high reward.
What is a Perfect Hedge?
A risk free position.
What is the “Basis”?
In respect of portfolios?
How closely a portfolio is linked to an Index.
What is Intertemporal Arbitrage?
YOU WERE OUT O… ……. THERE!!
When the prices between the one month and six month LME zinc contracts are “Out of line”.
What is Geographical Arbitrage?
Between two identical contracts across multiple exchanges, are priced differently.
What is Value-Chain Arbitrage?
Being very Crude!!
As between the prices of crude oil and refined products.
What is a Future?
Definition
Legal agreement between two parties to make or take delivery of a specific quantity and quality of a specified asset on a fixed future date at an agreed price today.
What are the Futures Exchanges?
- ICE Futures (Europe)
- CME Group (US)
- Shanghai Futures Exchange (China)
What is the Contract Specification?
Where the terms of each contract are standardised in a legal document.
What do Exchnages Specify for Futures?
Out of the negotiators hands.
Minimum permitted movement in price and the method of quotation.
What is the Price Movement and Quotation for Wheat Futures?
Weed smoking gardener lad.
- Quote is a “Per Bushel” basis
- Minimum movement is 0.25 of a cent ($0.0025)** full tick size**
- Each contract represents 5,000 bushels, so the full tick value is $12,50
What is the Fixed Future Date Often Reffered to as?
Contract month.
What is Meant When a Contract is Fungiable?
Identical to and substituable with others traded on the same exchange.
What Does Fungiability and Standardisation Provide?
- Easy to Trade
- Liquidity
What are the Main Advantages of Futures?
- Fungiability
- Counterparty risk removed by novation
- Low broker fees, due to liquidity and saftey
What is the Risk to the Seller of the Future Limited to?
It isnt. It is unlimited.
What is a Forward?
Definition.
Legally binding agreements to make or take delivery of a specified quantity of a specific asset at a certain time in the future for a pirce that is agreed today.
What are the Main Benefit of Forwards over Futures?
For an Investor.
- Customisability.
- They may not be marked to market daily, casuing lower admin. ie. an investor wont need to top up his account frequently to meet price changes as often.
What is the Main Disadvantages of Fowards?
What does this lead to?
- Counterparty risk and default risk
- Lower liquidity due to non fungiability
- Leads to higher fees for OTC Forwards.
How is a Forward Price Agreed?
Using the spot price of the underlying.
What is a Contract for Difference?
Allows investors ro benefit from capital gains from a particular underlying index, stock, currency or commodity without having to physically own or pay for it.
What is a Key Feature of a CFD?
They do not have a set maturity.
Why are CFDs Cost Efficient?
2 reasons
As they pay no stamp duty, nor a brokers fee.
What is a Typical Margin Deposit Required by Brokers for a CFD?
For leveraged positions
10-30% of the contracts value
Are Most CFDs Intra-day Trades?
Yes as most positions are held overnight and incur an interest charge.
What are the Two Key Differences Between Spread Betting and CFDs?
There are 2.
- CFDs do not have a fixed maturity / expiration date.
- Spread betting in the UK is considered gambling and therefore isnt taxed. CFDs are subject to capital gains tax
How are Brokers Compensated for Spread Betting?
Through the price they quote, not commission.
Where has Spread Betting Been Banned?
Think population.
US, China, India and most of Europe.
What Contract Does the More Popular Form of Spread Betting Utilise?
Short term interest rate contract.
What are the 2 Types of Spread Bet?
Down Bet and Up Bet.
What is an Option?
Definition, think Intro.
Gives the buyer the right, but not the obligation, to buy (call) or sell (put) a particular asset at a particular price, on or before a specified future date.
What is an Option on Future?
Gives the holder the right but not the obligation, to become the buyer (call) or seller (put) of a specified futures contract.
What is Long on an Options Contract?
Definition. What are the names?
The buyer of an options contract, also called the holder or owner of the contract.
What is Short on an Options Contract?
Definition. What are the names?
The seller of an options contract, also called the writer of the contract.
What is the Strike Price?
The price at which the option can be exercised.
What is the Settlement Price?
The price that determines the payoff when the option expires.
What is a Premium?
How is this paid?
- The cost of the option to the buyer.
- These are non-returnable and are paid by the option holder to the option writer.
- Paid via their broker to the clearing house, which is then passef to the counterparties broker.
What is In-the-Money?
How is this measured and What is the Opposite?
The extent to which the options contract is in profit. Quoted as the difference between the strike price and the price of the underlying asset.
Vice versa would be Out-the-Money.
What is At-the-Money?
Considered breaking even.
What is Intrinsic Value?
Only options that are in the money have intrinsic value.
What is Extrinsic Value?
Where option premiums differ from the options intrinsic value, where the option value is being derived from factors other than just the price of the underlying asset, for example time value, implied volatility and interest rates.
What is Time-Value?
The extrinsic value that the market assigns to an option, given the probability that there may be a change to the instinsic value of the option.
Are Longer Options Considered to Have a Higher Time-Value?
Why?
Yes, as the increase in time means there is a greater chance of the option being in the money.
What is a European Style Option?
An option that can be exercised on its expiry date only.
What is an American Style Option?
A for Any.
An option where the holder can exercise on any day during its life.
What is an Asian-Style Option?
An option where the payoff by the average underlying price over the entire length of a specified part of the contract.
What is an “Average Strike Option”?
An asian style option where the strike price is determined by the average traded price over the life of the option.
What is a Bermudan-Style Option?
Why are they called this, are they expensive?
Between a European and American Style Option, where by can be exercised at specific pre-defined intervals up until maturity. These premium are more expensive that European, but cheaper than american.
What is a Lookback Option?
Is this exotic?
Where the strike price is dependant on historical prices of the underlying market, the buyer has the right to buy/sell either the highest/lowest rice over the specified time period.
Yes
What is a Barrier Option?
Is this Exotic?
Is another type of path dependant option, whose existance and payoff is determined whther it sits inside or out of its predetermined price.
Yes
What are the Two Types of Barrier Option?
Boxing and cricket bats.
Knock-in option - that is activated or starts to exist once the underlying asset has
reached the predetermined price.
Knock-out option - when it is purchased, it exists, but it ceases to exist if the
underlying asset reaches the predetermined price.
What is a Binary Option?
Is this exotic?
Pays a fixed amount or nothing at all depending on the underlying price of the asset.
(AKA Digital options)
Yes
What is a Chooser Option?
Is this exotic?
Is an option which allows the owner to decide whether the would like a call or put at a specified time during the options life.
Yes
What is a Compound Option?
Is this exotic?
The right to purchase another option, with specific strike prices at pre-determined dates, during the option’s life. There are four types of compound options: calls on calls, calls on puts, puts on calls and puts on puts. There will, therefore, be two strike prices and two expiration dates
What is a Rainbow Option?
An option with multiple or a basket of underlying assets, e.g. currrencies and commodities.
What is the Break Even Formula of an Option?
Strike price + Premium
What is the Maxiumum Loss and Maximum Profit of a Long Call?
Loss - Premium Paid
Profit - Unlimited
What is the Maxiumum Loss and Maximum Profit of a Short Call?
Loss - Unlimited
Profit - Limited to the premium
What is the Maxiumum Loss and Maximum Profit of a Long Put?
Loss - Premium paid
Profit - Unlimited
What is the Maxiumum Loss and Maximum Profit of a Short Put?
Loss - Unlimited
Profit - Premium Paid
When is there No Counterparty Risk to the Seller?
Regarding options
When the option is out-the-money and the premium has been paid there is no risk it will be exercised.
When is there Counterparty risk to the Buyer?
Regarding options
When the option is in/at-the-money and has intrinsic value, when the option is exercised
How is Profit and Loss Calculated on a Long Call?
Loss = Premium paid
Gain = (Expiry Price - Strike) - Premium
How is Profit and Loss Calculated on a Short Call?
Gain = Premium
Loss = (Expiry Price - Strike) - Premium
How is Profit and Loss Calculated on a** Long Put**?
Gain = (Expiry Price - Strike) - Premium
**Loss ** = Premium Paid
How is Profit and Loss Calculated on a Short Put?
Loss = (Expiry Price - Strike) - Premium Paid
Gain = Premium
What is a Flex Option?
What is the concept?
Are hybrid exchange traded products. The concept is to provide an exchange traded product, which will offer greater flexibility by mixing strengths of classic standardised options, with OTC (negotiable) options.
What can be Customised on a Flex Option?
EEE
Exercise price, exercise style and expiry date.
How is Counterparty Risk Reduced with Flex Options?
What risks remain?
Given they are exchange traded, the use of a central clearing house.
However, liquidity, market and operational risk, remain notable for Flex option risk management.
What are the 2 Aspects of Wholesale Trading Activities?
Flex Options
- Exchange for Physical (EFP)
- Exchange for Swap (EFS)
What is an Exchange for Physical (EFP)?
An off market transaction that involves the swapping of an OTC position for a futures position.
What is an Exhange for Swap (EFS)?
An off market transaction that involves the swapping of an OTC swap for a series of futures contracts.
Why is Options Gearing Great for Hedging but also Risky?
Example from the book.
It can provide large exposure to an assets performance with little capital. i.e You buy and 850 call for 20 premium and the share price rises from 800 to 880, this would be a a 50% profit ((30-20) / 20), compared to 10% on a long position (800 -> 880 = 10%.)
However, if this only rises to 808 for example you wouldnt exercise the option, and lose 100% of your investment, but but would have made 1% on a long position.
What is the Intial Margin?
In regards to futures contracts?
This collateral Iis a small fraction fo the contracts face value, in case things “go wrong”. Therefore brokers only requiring on a small fraction of the futures cost up front illludes to gearing.
In other words because the buyer only pay a small proportion of the assets price but have access to the full potetnial of the asset.
What is Gearing AKA?
What do traders say?
Leverage
How are Derivatives Prices Decided?
What method?
Price discovery - with buyers and sellers stating their bid / offers.
What are Liquid Markets Often Known as?
What does this mean? What is the opposite?
Deep - narrow bid offer spread
Shallow - wide bid offer spread
What are the Main Components of Liquid Markets?
There are 4.
- Many buyers and sellers
- Small bid/offer spreads
- Low commission
- Large amounts can be traded without major price movements (elasticity)
What Does the Open Interest Represent?
What is this representing?
Number of Cumulative Open Positions.
The total number of long or short positions that remain outstanding at the end of a particular trading day.
What is Immediacy?
Regarding Liquidity?
The time needed to succesfully trade a certain amount of a contract or asset at a specific cost.
What is Slippage?
Where a large order affects the market price and therefore, affects the value of the next order that is to be placed.
What is Resilience in Financial Markets?
The speed in which the market returns to normal after large price movements.
What is an Interest Rate Swap?
An OTC derivative, where two counterparties exchange one stream of future interest payments against another, based on another specified principal amount over a set period.
What are the Forms of Swaps?
There are 3, what are they AKA.
- Fixed / Floating (Vanilla or Coupon Swap)
- Floating / Floating (Basis Swap)
- Fixed / Fixed (Type of FX swap)
How do Each Legs of the Swap Pay Eachother?
Net or Gross?
Net payment at each payment date.
