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FCA Derivatives > Chapter 1: Introduction to Derivatives > Flashcards

Chapter 1: Introduction to Derivatives Flashcards

1
Q

What are the 3 most common forms of arbitraging with derivatives?

A

Inter-temporal, geographic and value chain.

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2
Q

What is the full tick value of a derivative?

A

The minimum price movement on exchange-traded derivatives. Used to prevent incremental price movements on contracts.

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3
Q

What are the main advantages of futures contracts?

A

Fungibility - the standardisation of specific contracts, with some variable features. Increases liquidity.
Counterparty risk - through novation, the buyer and seller remove exposure to credit / default risk.
Cost - Low risk, high fungibility and volume often means lower costs.

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4
Q

Forwards can be not Marked-To-Market (MTM). What does this mean?

A

If a forward is MTM returns are delivered at the maturity / redemption date of the contract. Can used to reduce working capital with brokers and for greater tax efficiency.

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5
Q

What the main advantages of investing in forwards (as opposed to futures)?

A

Flexibility - all parts of the contracts are customisable.
Better margining and collateral terms.
Wider range of underlying assets.
Available from most commercial banks.

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6
Q

What are CFDs?

A

Contract for Differences (CFDs) allow a party to achieve the capital gains from an underlying without physical delivery at any point in the contract. Return paid = price at start = price at end of the contract.

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7
Q

What fees do buyers of CFDs avoid?

A

Stamp duty and brokers fees. Capital gains tax is still applicable to CFDs.

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8
Q

What are the characteristics of a CFD? What range of leverage is available to the buyer of CFD? When do CFDs mature?

A

Cash settlement / delivered.
Sold by stockbrokers and commercial banks.
No expiry date - they are rolled over each day as long as margin payments are made.
Leveraged - usually 10%-30%

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9
Q

What are the differences between spread betting and investing in CFDs?

A

CFDs do not have fixed maturity / expiry date.
Spread betting is traded definitely in taxation. CFDs are subject to GCT.
CFDs buyer pays commission whilst buyer only pays spread in spread betting.

Both are highly leveraged and commonly used by retail investors.

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10
Q

What is one of the most popular spread betting trades?

A

Involves a Short Term Interest Rate (STIR) and a 3 month short sterling future.

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11
Q

What is an option?

A

Gives the buyer the right, but not the obligation, to buy an underlying asset at fixed price at a specified future date or dates.

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12
Q

What is the difference between strike price and settlement price of an option?

A

Settlement price is market price of the underlying at maturity. Strike price is the buyer of option can exercise the option at.

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13
Q

What is the Extrinsic Value of an option?

A

Extrinsic value = Premium - Intrinsic Value. EV is derived from anything that is not related to price such as time value, implied volatility and interest rates.

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14
Q

What are the different exercise styles on options?

A

European - can only be exercised on maturity dates.
Bermudan - can be exercise on a range of specified dates before maturity and on maturity.
American - can be exercised throughout the whole lifecycle of the contract.
Asian - 2 types:
The strike price is the average market price across the duration of the contract OR
The settlement price is the average market price across the duration of the contract

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15
Q

What is a lookback option?

A

A lookback option allows the buyer to purchase or sell the asset at either the lowest or highest price in the contracts duration.

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16
Q

What is a barrier option?

A

A barrier option is cancelled or started (depending on the type of the option) when the market price reaches a pre-determined limit or price. There are 2 types:
Knock-In
Knock-Out

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17
Q

What is a binary option?

A

Binary option either pays a fixed amount or nothing at all depending on market price of underlying at specified times.

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18
Q

What is a chooser option?

A

Allows the buyer to choose whether it is a call or put at a specified point in the options lifetime.

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19
Q

What is a compound option?

A

Allows the buyer to purchase another option at a specified price and time.

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20
Q

What is a rainbow option and what are other names for a rainbow option?

A

A rainbow option is based on a basket of underlying assets. A.K. basket options, multi-asset options and correlation options.

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21
Q

What is a FLEX option?

A

A FLexible EXchange (FLEX) option is a n option which is exchange traded. However, unlike usual exchange traded products, part of the options contract is customisable.

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22
Q

What are Exchange for Physical and Exchange for Swap transactions?

A

EFP - swapping an OTC position for a futures position.
EFS - swapping an oTC swap for a future, or series of futures, positions. The OTC swap must have price correlation with the relevant future.

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23
Q

What are the benefits of completing Exchange For Physical?

A

Reduction of counterparty credit risk
Reduced balance sheet and margining requirements through netting OTC positions against futures positions.
EFPs are traded 24hrs globally

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24
Q

What are the risks associated with Exchange for Physical transactions?

A

Switching from OTC positions to futures can increase operational risk. MTM margin calls and accounting add operational complexity.

25
Q

What is a warrant?

A

Similar to an option, holders are given the right to but an asset at a set price. These are usually attached to a bond.

26
Q

What is gearing?

A

The measure of the initial investment in establishing an open position.

27
Q

What is liquidity in the shares market?

A

The ease shares can be converted into cash.

28
Q

What are the main elements of a liquid market?

A

Many buyers and sellers
Small spreads
Low commissions
Large volumes and small price movements

29
Q

What are the 4 main measures of liquidity?

A

Open interest - measures volume of open positions
Immediacy - time to trade a specified volume of contracts and at what cost.
Market depth - measures the size of the order book above or below the current market price.
Resilience - speed at which market prices return to former levels after a transaction

30
Q

What are the 3 main forms of Interest Rate swaps?

A

Fixed/floating - A.K.A a coupon swap, swap of interest rate cashflows for fixed and floating rate loans
Floating/floating - basis swap. Each payment stream based on a FRN.
Fixed/Fixed - foreign currency swap. Both parties pay a fixed interest rate in the principal amount.

31
Q

What are inflation-linked swaps?

A

Exchange of cashflows with one or both swaps referencing an inflation index. Inflation indexes include HICP, RPI and CPI.

32
Q

What is a zero coupon inflation product and why would a market participant use a zero coupon inflation product?

A

A swap linked to an inflation rate. Only financial flow is at maturity. Market participants will use these to:
hedge or speculate on inflation rates
evaluate inflation linked securities such as Treasury Inflation-Protected Securities
Hedge against tightening monetary policy

33
Q

What is a currency swap?

A

When principal and interest is exchanged in 2 different currencies. Used by major banks to obtain foreign currency at advantageous rates. Also used to hedge foreign currency loans already taken.

34
Q

How have currency swaps developed?

A

Currency swaps can now be entered into with:
Fixed interest in one currency for floating in another
Fixed interest for fixed interest in another currency
Floating interest in one currency for floating.

35
Q

What is an equity swap?

A

Where one, or both, payments are linked to the performance of underlying equities

36
Q

Why would an investor use an equity swap?

A

To access prohibited markets, such as equities that trade on the Chinese exchange. Equity swaps can also be used to synthetically create a portfolio.

37
Q

What is an equity basket swap?

A

Where one or both cashflows swapped are derived from the performance of a non-index basket of shares.

38
Q

Are swaps traded OTC or on an exchange?

A

Always OTC traded.

39
Q

Are options traded OTC or on an exchange?

A

The options market Is bigger for OTC contracts, but they are also exchange traded.

40
Q

What is a variance swap?

A

Similar to an equity swap, but variance swaps allow investors to speculate on future price movements on a variety of assets. The other side of the swap will pay a fixed amount.

41
Q

Why are variance swaps used instead of volatility swaps?

A

Volatility swaps may require delay hedging, whereas variance swaps provide pure exposure to the underlying asset. Profit depends solely on difference between implied and actual volatility.

42
Q

What is the difference between implied and actual volatility?

A

Implied volatility is the statistical prediction of volatility using supply and demand and previous historical data. Actual volatility is the realist volatility during the lifetime of a financial contract.

43
Q

What is a dividend swap?

A

A dividend swap exchanges a fixed payment for only the dividend of a specified equity. At the start of the contract the fixed leg will be equal to the floating leg.

44
Q

What is similarity between a variance swap and a dividend swap?

A

1 side will always be a fixed amount.

45
Q

What is an asset swap?

A

An asset swap changes the currency or interest rate exposure. This is done through one leg being rate to a published rate and the other being a fixed leg, meaning the investor is speculating on the increase of the published rate. The investor will buy a FRN to then guarantee a profit if it increases.

46
Q

What is an advantage of using an asset swap?

A

The investor has flexibility in choosing:
credit quality
liquidity
competitive pricing

47
Q

What is a drawback of an asset swap for the bank/financial entity facilitating the transaction

A

As asset swaps have to be marketed by major financial institutions, it is difficult for major banks to hedge the underlying in these transactions and therefore there can be a lack of availability unless major banks want to take a position in the market. Banks will usually charge large spreads to protect against potential losses.

48
Q

What is a Total Return Swap (TRS)?

A

A TRS pays 1 leg which is linked to the whole return of a specified asset. This includes dividends and share price fluctuations.

49
Q

What are the benefits for an investor using TRSs?

A

An investor can maintain liquidity rather than tying funds up.
TRSs can be paid in bullet form which is tax advantageous and requires less operational management as margin / collateral calls are not made as often.
TRSs can be used to access restricted markets such as the Chinese equites markets.

50
Q

What is a Mark To Market (MTM) swap?

A

MTM swaps revalue periodically, paying the appropriate cashflows on period basis. The subsequent cashflow will provide a gain or loss based on the previous settlement.

51
Q

What is an FX resettable swap on example of?

A

A combination of an MTM swap and a basic currency swap. Resettable indicated MTM nature where each period where cashflow is paid is the same as replacing the previous contract with a new contract.

52
Q

Why are the majority of swaps MTM?

A

If swaps are paid in bullet form, the seller is exposed to unacceptable levels of counterparts credit risk.

53
Q

What is a commodity swap and what structure does it follow and is it cash or physically settled?

A

A commodity swap involves paying or receiving a cashflow based on the return of an underlying commodity. These have been popular following increased supply and demand as a result of a volatility in the commodity markets. A commodity swap usually is fixed for floating, analogous with an interest rate swap. Cash settled.

54
Q

What is a commodity price-for-interest swap?

A

Value of fixed amount of specified commodity is exchanged for a floating interest payment.

55
Q

What are amortising, accreting and rollercoaster swaps?

A

Amortising - swap payments decrease over time.
Accreting - swap payments increase over time.
Rollercoaster - swap payments increase and decrease at denoted periods. Can be used to match seasonal borrowing requirements.

56
Q

What is a forward start swap?

A

A forward start swap is agreed today but the swap starts at a later date.

57
Q

What do the buy-side and sell-side of a market reference?

A

Sell-side market participants include market makers and firms giving prices to the markets. Buy-side firms include price takers in the markets such as portfolio managers or brokers acting as principal or agent in the market.

58
Q

What is the difference between prime, clearing, introducing and exciting brokers?

A

Prime broker - acts on behalf of client in the market, managing trades from their own account and performing the trade processing behind a trade. Custody included.
Clearing broker - acts as a clearing agent in connection with transaction. Acts as party between a client and clearing service.
Introducing broker - broker-dealer that will not hold client funds and effects transactions through a clearing broker.
Executing broker - executes an order on client behalf.

59
Q

What is a Futures Commission Merchant (FCM)?

A

A broker registered with the Commodity Futures Trading Commission (CFTC) and executes business on registered commodity exchanges for its clients

FCA Derivatives (9 decks)

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