Chapter 10

Question 1

What are the characteristics of OTC derivatives market?

Answer 1

Lightly regulated, dominated by financial institutions, no regular trading hours, open nights, weekend and holidays, contracts can be custom to meet specific needs and can be more complex than exchange traded derivates.

Question 2

What are the cahracteristics of exchange-traded derivates?

Answer 2

Provides facilities for trading: trading floor or electronic trading system, exchange stipulated rules and regulations, more liquid and less default risk. The Montreal exchange is the only derivative exchange.

Question 3

What is hedging?

Answer 3

form of risk management to protect an existing position int he underlying asset.

Question 4

What are derivate dealers and what role do they play in OTC market?

Answer 4

They are market makers that stand ready to buy/sell contracts. They take the other side of the positions entered into by end users. They are the chartered banks, their investment dealer subsidiaries and the large foreign banks and investment dealers

Question 5

What is call vs put option?

Answer 5

Call: right to buy
put: right to sell

Question 6

Who is long and who is short when trading options? (buyer vs seller)

Answer 6

buyer is in a long position
seller is in a short position

Question 7

What is american style option

Answer 7

Can be exercised at any time, up to and including the expiration date. All exchange-traded stock options in NA are american-style

Question 8

what is European style option

Answer 8

Can be exercised only on the expiration date. Mostindex options are European style

Question 9

What is a long-term equity anticipation securities

Answer 9

long-term option oferring same risk and rewards and regular options

Question 10

What is opening transations vs offsetting transaction?

Answer 10

opening: investor establishes new position in an option contract

offsetting: position is liquidated prior to expiration by offsetting the position, essentially cancelling it.

Question 11

What is intrinsic value of option?

Answer 11

It is the in the money portion of a call/put

Question 12

What is time value of option?

Answer 12

The amount that an option is trading above its intrinsic value

Question 13

What is open interest when describing options?

Answer 13

Total number of options ina series that are currently outstanding and have not been closed or exercised. traded in batches of 100

Question 14

What is covered call vs naked call writing?

Answer 14

Covered call writer owns the underlying stock and uses this position if they are assigned.

naked call writers do not own the underlying stock and must purchase it before it can be sold to buyer (loss is technically unlimited because there is no limit to future price)

Question 15

What is performance bond?

Answer 15

it is a good faith deposit to give other side a level of assurance that terms to a forward will be honoured

Question 16

what is covered vs naked vs cash-secured put writing?

Answer 16

Covered: not very common as a covered put puts the seller in a short position with the stock.

naked: prepared to buy the stock but have no specifically earmarked amount of cash to buy it (loss is limited, price cant go below 0$)

cash-secured: setting aside an amount of cash equil to the strike price

Question 17

Who is long and who is short in futures contract?

Answer 17

long position –> buyer of contract
short position –> seller of contract

Question 18

Who sets the minimum and maintenance margin rates for future contracts?

Answer 18

The exchange where shares are traded

For futures it is generally between 3-10% (MUCH more leveraged compared to 30-80% for equities)

Question 19

What is marking to market

Answer 19

It is the daily settlement of gains and losses on futures

Question 20

When do exchange traded options typically expire?

Answer 20

The third friday of the expiration month, generally listed with terms of nine months or less.

Weekly options are listed for trading at open on thurdays and expire on any of the five fridays following the listing date

Question 21

What is the difference btween a future and a forward?

Answer 21

Future is traded on exchange and is standardized

Forward: can have weird terms, less liquid (one of 2 basic derivatives)

Question 22

What is a right?

Answer 22

privilege granted to existing shareholders that allows them to acquire additional shares from issuing company. Rights do not cost more money. E.g. give 1 right to each existing shareholder and it costs 10 rights to buy 1 share.

Question 23

What is the Subscription price/offering price of a right?

Answer 23

The price shareholders pay to purchase additional shares of a company, almost always lower than market price

Question 24

What is Record date for rights?

Answer 24

date at which list of shareholders who receive rights is recorded (Shares trade cum-rights before this date and ex-rights after)

Question 25

What are the courses of action a rights holder can do?

Answer 25

1. exercise some/all of the rights
2. sell some or all rights
3. buy additional rights to trade or exercise
4. do nothing (worst option, but rights are not automatically exercised)

Question 26

What is the intrinsic value of rights?

Answer 26

Since they are normally issued at a subscription price lower than market price, they have an intrinsic value.

Intrinsic value Ex-Rights Period = (Stock price - Exercise price)/(number of rights needed to buy share)

Intrinsic value Cum-Rights Period = (Stock price - Exercise price)/(n + 1)

Question 27

How does trading rights work?

Answer 27

When common shares of a company are traded on the exchange, the rights are traded automatically. On TSX and TSX Venture, trading stops at noon on the expiry day.

Question 28

What is regular delivery?

Answer 28

Rights must be settled by the second business day after transaction takes place (same as stock settlement)

Question 29

What is a warrant?

Answer 29

Gives the holder the right to buy a share at a set price, similar to call options but issued by company itself.

Almost always issued as part of package which contains new dbet or preferred shares, help make these more attractive (Called a sweetener).

They can be sold immediately or after a certain period. Expiration can last up to several years