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CISI: Derivatives > Chapter 1: Introduction to Derivatives > Flashcards

Chapter 1: Introduction to Derivatives Flashcards

1
Q

What is the difference between a future and a forwards?

A

Futures are traded on an exchange with standardised contracts
Forwards are traded OTC with custom terms

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2
Q

What are the three ways that derivatives are used?

A

Speculation
Hedging
Arbitrage

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3
Q

What is speculation?

A

Seek to make profit on market moves
Derivatives have high levels of gearing

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4
Q

What is hedging?

A

Taking an opposite position in the futures market to guard against adverse price movements

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5
Q

What are the 3 types of arbitrage and what do they mean?

A

Intertemporal - Prices on different maturity contracts for same asset are “out-of-line”
Geographic - Price difference between two identical contracts on different exchanges
Value-chain - As between the prices of crude oil and refined products

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6
Q

What is arbitrage?

A

Exploiting price anomalies between two different markets
They undertake a transaction whereby they buy the asset at the lower price in one market and, at the same time, sell it at the higher price in the other market.

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7
Q

What is a future?

A

Legal agreement between two parties to make or take delivery of a specific quantity and quality of a specified asset at a fixed future date and price.

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8
Q

Where did futures originate?

A

Agricultural markets
Japan - 1730
Egypt - 1861

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9
Q

How are futures standardised?

A

Using a legal document called the contract specification.

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10
Q

Why is contract specification important? (3)

A

Standardise futures trading
Promotes transparency across an exchange
Details precisely what is acceptable in terms of the quality and type of asset

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11
Q

What is minimum permitted movement?

A

The minimum price movement of a set quantity of an asset.
E.g. wheat futures
Minimum movement is 0.25c per bushel
Minimum quantity (contract) is 5,000 bushels
Thus minimum price per contract is $12.50

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12
Q

How are dates of delivery decided and how are they quoted?

A

By the futures exchange
Although it will be a set day, it is quoted as the month of delivery

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13
Q

What does fungibility mean in futures?

A

The contracts are identical and substitutable with others on the same exchange

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14
Q

What are the benefits of standardisation and fungibility? (2)

A
  • contracts are easy to trade as they have set terms, and
  • the concentration of activity provides liquidity, as measured by volume.
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15
Q

Is the profit and loss of each side of a trade in futures equal and opposite?

A

No, we often have to factor in brokerage fees and arrangements

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16
Q

What are the main advantages of futures? (3)

A

Fungibility - standard contracts
Counterparty risk - Reduced when central clearing house novates contracts
Cost - lower cost thanks to standardisation

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17
Q

What is market risk?

A

The variance of the market price when entering a futures contract

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18
Q

What is the benefit of forwards when it comes to capital usage?

A

They may not be marked-to-market daily, meaning that investors may not need to post cash to sustain a losing position

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19
Q

What are the advantages of forwards over futures? (4)

A

flexibility
better margining
wide range of assets
available from most commercial banks

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20
Q

Where are forwards commonly traded?

A

FX market

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21
Q

What is a physical market?

A

One where physical delivery is common

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22
Q

Why might an airline use forwards?

A

To lock in the price of jet fuel

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23
Q

How are CFDs contracts usually set up?

A

Most brokers will usually provide a CFD contract to investors that closely mimics the most fungible exchange-traded product.

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24
Q

Are CFDs considered OTC?

A

Yes

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25
Q

What cost efficiencies do CFDs offer? (3)

A

No stamp duty
No broker fee
Cheaper than shorting

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26
Q

What margin deposit do brokers require for CFDs?

A

10-30%

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27
Q

What is the time period of most CFDs?

A

Intraday

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28
Q

Why are most CFDs traded intraday?

A

Holding overnight incurs interest cost

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29
Q

When do CFDs expire/mature?

A

As decided by the investor, no set deadline

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30
Q

What is the difference between CFDs and spread betting?

A

CFDs do not have fixed expiry date
Spread betting is considered gambling and has different tax laws
Spread Betting doesn’t usually have commission

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31
Q

What is the most popular spread betting asset?

A

short-term interest rates
(STIR)

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32
Q

What is an option?

A

A contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a particular price on or before a particular date.
The seller will assume an obligation.

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33
Q

Can you get options on derivatives?

A

Yes, all major derivatives exchanges offer options based on their futures contracts.

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34
Q

What is the seller of an options contract known as? (2)

A

Contract writer
Going short

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35
Q

What is the difference between strike and exercise price?

A

Nothing, same thing.

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36
Q

What is the strike price?

A

The price at which the option can be exercised.

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37
Q

What is the settlement price?

A

Price that determines pay-off when option expires

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38
Q

What is the premium?

A

What cost of option to the buyer.

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39
Q

How is premium settled to the writer?

A

The holder pays the premium via their broker, who then passes
it on to the clearing house for the account of the counter-party’s broker.

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40
Q

What does in or out of the money refer to?

A

The difference between the strike price and the underlying price.

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41
Q

What does at-the-money refer to?

A

Breaking even on an option
Strike = underlying

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42
Q

What is IV, Intrinsic Value?

A

Only options that are in the money have this.
IV = Current - Strike

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43
Q

What is Extrinsic Value?

A

Where options premium differs from the IV, the rest of the value is derived from “extrinsic value”.

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44
Q

What factors make up extrinsic value? (3)

A

Time value, implied volatility, interest rates

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45
Q

What is time value?

A

Probability there may be an increase in the intrinsic value of an option
Options with long expiry date tend to have higher time value as chance of being in-the-money is higher

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46
Q

What is a European-style option?

A

Can only be exercised on expiry day
Remember E for European and Expiry

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47
Q

What is an American-style option?

A

Can be exercised at any point
A for American and Any day

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48
Q

What is an Asian-style option?

A

Option where the pay-off is not determined by underlying price at maturity but by the average underlying price over the entire length or specified length of the contract.

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49
Q

What are the two common versions of Asian options?

A
  • Strike price set at the beginning and the settlement price is the average asset price over the life of the option
  • Strike price is the average traded price over the life of the option
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50
Q

What is an average strike option?

A

Asian-style option where the strike price is the average traded price over the life of the option

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51
Q

What is a Bermudan-style option?

A

Option where early exercise is restricted to certain dates during its life, usually a series of dates in regular intervals

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52
Q

Assuming all factors are the same, how are European, American and Bermudan premiums ranked in price order?

A
  1. American
  2. Bermudan
  3. European
    Flexibility increases the cost
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53
Q

Which options are considered vanilla vs exotic? (4)

A

Vanilla
European
American
Exotic
Asian
Bermudan

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54
Q

What is a lookback option?

A

Strike price is dependent on the historical price
Owner has the right to exercise at highest/lowest price over set period

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55
Q

What is a barrier option?

A

Pay-off depends on whether an asset as reached a pre-determined price

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56
Q

What is a knock-in option?

A

Type of Barrier option
One that is activated once the underlying asset has reached a pre-determined price.

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57
Q

What is a path-dependent option?

A

Lookback, Asian, Barrier option
An exotic option whose payout that can vary based on the path the underlying asset’s price takes over its life or at certain times during the option’s life.

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58
Q

What is a knock-out option?

A

Type of Barrier option
An option that ceases to exist once the underlying asset has reached a pre-determined price.

59
Q

What is a binary option sometimes known as?

A

Digital option

60
Q

What is a binary option?

A

Pays a fixed amount or nothing at all, depending on underlying price

61
Q

What is a chooser option?

A

Allows holder to determine whether it is a call or a put, for a pre-determined time

62
Q

What is a compound option?

A

Gives the owner the right to purchase another option with specific strike prices at different dates.

63
Q

What are the four types of compound option?

A

calls on calls
calls on puts
puts on puts
puts on calls

64
Q

What is a rainbow option?

A

Option on multiple underlying assets

65
Q

What are rainbow options otherwise known as? (3)

A

Multi-asset options, correlation options and basket options.

66
Q

What is the break even price of a call?

A

Strike price plus premium

67
Q

What is the seller of an options break even point?

A

Strike price plus the premium

68
Q

What is the break even price of a put?

A

Strike price minus premium

69
Q

What is the maximum profit on a put?

A

Strike price minus premium (assuming underlying falls to 0)

70
Q

When would an option have counterparty risk?

A

When it has intrinsic value, ATM or ITM, and the buyer would elect to exercise it.
OTM options do not carry counterparty risk

71
Q

What is a FLEX option?

A

Hybrid exchange-traded products, which introduce some OTC features.
Concept is to provide an exchange-traded product with negotiable terms

72
Q

Who pioneered FLEX options and when?

A

Chicago Board Options Exchange (CBOE) in 1993

73
Q

What parameters can be specified by users in FLEX options?

A

Ones that are normally specified by the exchange such as exercise price, style and expiry date

74
Q

What main risk do FLEX options decrease?

A

Credit risk, where counterparty does not have sufficient capital to pay. Subset of counterparty risk

75
Q

How do FLEX options reduce credit risk?

A

Settled through an exchange central clearing house.

76
Q

What other risks do FLEX options decrease? (3)

A

Market, liquidity, operational

77
Q

What are the two aspects of wholesale trading facilities for FLEX options?

A

EFP - Exchange for Physical
EFS - Exchange for Swap

78
Q

What is an Exchange for physical trading facility?

A

Off-market transaction for FLEX options that involves swapping of an OTC position for a futures position

79
Q

What needs to be true for a Exchange for physical to occur?

A

OTC side and futures components must be similar in terms of value and quantity

80
Q

What is an Exchange for swap trading facility?

A

For FLEX options, involves swapping an OTC swap for a series of futures contracts.

81
Q

What needs to be true for a Exchange for swap to occur?

A

The OTC swap must have a price correlation so that the futures are suitable instrument for hedging in the cash market transaction.

82
Q

What benefits do exchange for physical transactions have?

A

CP credit exposure can be reduced when OTC is replaced with futures position
Reduced balance sheet requirements, positions can be netted
24-hour trading

83
Q

What are the risks of exchange for physical transactions?

A

Increased operational risk
Mark-to-market accounting and daily-margin settling is a burden

84
Q

What is gearing?

A

Measure of cash/initial investment versus the actual value of underlying asset.

85
Q

How does gearing differ between futures and options?

A

Options are intrinsically geared, proportional to the premium vs price
Futures are geared using margin, where you have to post up collateral in case of losses.

86
Q

How are prices determined in derivative markets?

A

Through price discovery with buyers and sellers stating prices.

87
Q

What is it called when due to a high volume of buyers and sellers price does not change significantly with changes in demand?

A

Low price elasticity of demand

88
Q

What are the four main elements of a liquid market?

A

many buyers/sellers
small spreads
low commissions
large amounts can be traded without moving price

89
Q

How can liquidity be quantified? (2)

A

Volume traded
Looking at the number of cumulative open positions (open interest)

90
Q

What does open interest measure?

A

The total number of long or short positions that remain outstanding at the end of the trading day

91
Q

What are the three other measures of liquidity?

A

Immediacy - time needed to trade a certain amount of a contract
Market depth - size of market above/below current trading price
Resilience - Speed with which prices return to former levels after a large transaction, can only be measured over a period of time.

92
Q

What two ways can a derivatives contract be entered?

A

Standardised contracts on exchanges
Negotiated between two counterparties OTC

93
Q

What do exchange traded derivative products require participants to do?

A

Put collateral aside in the form of margin to mitigate risk.

94
Q

Who administers the margin for exchange traded derivative products?

A

A Central Counterparty (CCP)
clearing house, e.g. ICE Clear

95
Q

What bodies supervise the use of margin for OTC transactions? (2)

A

Basel Committee on Banking Supervision (BCBS)
Board of the International Organization of Securities Commissions (IOSCO)

96
Q

Which key regulations impacted derivatives since 2008? US and EU

A

US - Dodd-Frank
EU - European Market Infrastructure Regulation

97
Q

How can you reduce counterparty risk with OTC derivatives?

A

Review credit rating of CP
Some can be cleared through CCPs

98
Q

Why may an investor choose to hedge with an OTC vs exchange-traded derivative?

A

They can more precisely match the underlying exposure, structuring a more effective edge.

99
Q

What is a swap?

A

OTC derivative contract where two counterparties exchange the cash flows or liabilities from two different financial instruments.

100
Q

Why are swaps considered to be derivatives?

A

Because their valuation is based upon the value of other assets

101
Q

What is an interest rate swap?

A

Where two counterparties exchange one stream of future interest payments against another.
Payment streams are considered the legs of the swap.

102
Q

What is the “plain vanilla” swap?

A

Fixed/floating rate swap
Exchanging interest cash flows for fixed and floating rate loans

103
Q

What is a basis swap?

A

Floating/floating swap

104
Q

What instrument is a fixed/fixed swap used for?

A

FX

105
Q

What happens on each payment date for a swap?

A

A net payment will be made between the two participants based on the difference between the two rate of the underlying principal

106
Q

How is the floating rate determined?

A

On the swaps reset date.
E.g. for a fixed versus six-month floating swap the reset date is every six months

107
Q

What happens to a swap after agreed payment date?

A

Either party can initiate action to cancel or end the swap.

108
Q

What is a swaption?

A

Buyer pays an upfront sum for the right to enter into a swap agreement by a pre-agreed dare in the future.
Buyer has the option to enter into a swap.

109
Q

What is the eurozones inflations index?

A

HICP, Harmonised Index of Consumer Prices

110
Q

What is a zero-coupon inflation product?

A

Derivative based on inflation rate, only one flow at the maturity date of a swap of a fixed amount vs floating amount.

111
Q

What is the maturity range for inflation swaps?

A

5-30 years

112
Q

What is a currency swap?

A

Involves trading the principal AND interest in one currency for the same in another currency, for an agreed period of time.

113
Q

What are equity swaps?

A

Swap with payments linked to the performance of equities or an equity index

114
Q

Why are equity swaps used?

A

Avoid withholding tax
Leverage
Avoid foreign ownership restrictions

115
Q

What kind of swap is used for a synthetic portfolio?

A

Equity Swaps

116
Q

What is an equity basket swap?

A

Underlying assets are a range of securities, however it is not a standard index e.g. SP500 so it is traded OTC

117
Q

What is an equity forward swap?

A

OTC contract between two parties to buy or sell an individual asset at a specified future time at a price agreed today.

118
Q

What is a variance swap?

A

The payment is linked to the realised variance (price movements) over the life of the swap. Commonly based on the assets closing price.
Other side of the swap pays a fixed amount - agreed upfront.

119
Q

What is the attraction of a variance swap?

A

Provides pure exposure to volatility as opposed to call/put options which have to be delta hedged.
Profit/loss depends on the difference between implied and actual volatility.

120
Q

What does it mean so that a value at signing is zero for a swap?

A

When the fixed leg is equal to the value of the floating leg.
For example for dividend swaps, the fixed leg will be the amount of the total expected dividend.

121
Q

What types of equity forwards pay dividends?

A

Total return forwards

122
Q

What is an asset swap?

A

Change the interest rate or currency exposure of an investment.
An investor might, for example, buy a FRN and also transact a swap to receive a fixed interest rate and pay SONIA. The result will be a synthetic fixed-rate investment.

123
Q

What is the advantage of an asset swap?

A

An investor is able to choose the underlying asset and customize their exposure.

124
Q

What is a disadvantage of an asset swap?

A

Banks offering this will have to hedge their exposure to the underlying asset, limits available counterparties, illiquid market.

125
Q

What is a total return swap?

A

One of the legs pays the total return on a particular financial asset (interest, dividends, fees, capital appreciation), amount can be negative.

126
Q

What will the other leg of a total return swap typically be?

A

A floating-rate interest rate, in essence a TRS duplicates borrowing funds to invest into another asset

127
Q

What are the benefits of a TRS?

A

Investor mantains liquidity, doesn’t have to purchase physical asset
Invest in restricted exchanges

128
Q

What is a mark-to-market (MTM) swap?

A

Swap is revalued regularly, and loss or gain is paid or received. Removes any credit risk.
Same effect as closing-out the existing swap, settling its current value and putting in place a new one.

129
Q

What is a FX resettable swap?

A

A swap that has the the structure of a basic currency swap and an MTM swap.

130
Q

What is exchanged at the beginning of most FX swaps?

A

Principal

131
Q

What is a commodity swap?

A

Payment leg related to the price of a specific commodity
Fixed-for-floating - can fix the price you receive with a CP

132
Q

What is a commodity price-for-interest swap?

A

Value of the specified commodity is exchanged for a floating-rate interest payment

133
Q

What is an amortising swap?

A

When a swap is taken to match loan payment, the notional value of the swap will decrease alongside the value of the loan.

134
Q

What is an accreting swap?

A

Opposite of amortising, value of the swap increases over time

135
Q

What is a rollercoaster swap?

A

Swap that has a notional that may rise or fall repeatedly in line with seasonal borrowing requirements

136
Q

What is a forward start swap?

A

One that is agreed today but the exchange of funds takes place at a future date.

137
Q

How are forwards start swaps usually priced?

A

Two partially offsetting swaps.
For example, a one-year swap and a five-year swap could partially offset to create a four-year swap, starting in a year’s time.

138
Q

What is a clearing broker?

A

Broker-dealer that acts as the clearing agent
They can transact on their own account as well on behalf of clients

139
Q

Why are clearing brokers known as “principal-agent”

A

broker-dealers
principal - trading their own book, become a CP in a transaction
agent - facilitate a transaction between a client and exchange

140
Q

What is an executing broker?

A

A broker that finalizes or executes an order on behalf of a client

141
Q

What is an IDB? Inter-dealer broker

A

Intermediary between other market participants, such as brokers and/or market makers who wish to stay anonymous

142
Q

What is a futures commission merchant?

A

Entity registered with the CFTC, which solicits business from others for execution on a listed commodities exchanged.

143
Q

What does CFTC stand for?

A

Commodity Futures Trading Commission

CISI: Derivatives (10 decks)

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