Chapter 10: Derivatives Flashcards
1
Q
what is derivative?
A
- a financial contract whose value is derived from the value of an underlying asset (financial asset, a currency, a futures contract, an index, an interest rate, or commodities, such as crude oil, gold, or wheat)
- Derivatives can be used offset to a position held in the underlying asset or to speculate on the value of the
underlying asset.
2
Q
What are the two basic types of derivatives?
A
- Option (The option buyer has the right to buy or sell a specified quantity of the underlying asset in the future at a price agreed upon today. The option seller is obliged to complete the transaction) -> Buyer have to pay the fee when signing the contract
- Forward (both parties oblige themselves to trade the underlying asset in the future at a price agreed upon today) -> no up-front payment is required
3
Q
What is call option?
A
The buyer in the option contract
4
Q
What is put option?
A
The seller in the option contract
5
Q
What are the common features of derivatives?
A
- They are agreements between two parties with right or obligation.
- Both parties have agreed on the price.
- They have an expiration date. After that date, the contract is automatically terminated.
- They are considered a zerosum game (Aside from commission fees and other transaction costs), the gain from one party = the loss from the other.
6
Q
What is performance bond or good-faith deposit?
A
When signing a forward contract, no payment required but s one or both parties make a performance bond or
good-faith deposit to give higher level of assurance for the contract.
7
Q
Where do the derivatives trade?
A
- OTC market
2. in organized exchanges
8
Q
What are the characteristics of OTC derivatives?
A
- Active and vibrant market with a loosely connected and lightly regulated network of dealers.
- Dealers negotiate over the telephone or through computer terminals with no trading floor or regular trading hours.
- Mostly financial institutions.
- Contracts can be custom designed to meet specific needs.
9
Q
What are the characteristics of derivatives traded in organized exchanges?
A
- Is a legal corporate entity organized provides the facilities for trading: either a trading floor or an electronic trading system or both.
- Stricter rules and regulations governing trading in order to maintain fairness, order, and transparency in the marketplace.
- Advantage: standardization, liquidity, and default risk.
- In Canada, The Montréal Exchange (or Bourse de Montréal) lists options on stocks, indexes, and U.S. currency, exchange-traded forwards (futures) on bonds, bankers’ acceptances, and indexes.
10
Q
What are the differences between organized exchanges and OTC?
A
- STANDARDIZATION AND FLEXIBILITY
- PRIVACY
- LIQUIDITY AND OFFSETTING
- DEFAULT RISK
- REGULATION
11
Q
Compare organized exchanges and OTC in term of standardization and flexibility?
A
OTC: more flexible (can be tailored for sepcific users)
Organized exchanges: each contract has standardized terms and other specifications
12
Q
Compare organized exchanges and OTC in term of privacy?
A
OTC: general public nor others cannot know about the transaction
Organized exchanges: all transactions are recorded and known to the general public
13
Q
Compare organized exchanges and OTC in term of liquidity and offsetting?
A
OTC: cannot be easily terminated or transferred. In many cases, these contracts can only be terminated through negotiations between the two parties
Organized exchanges: they can be terminated
easily by taking an offsetting position in the contract.
14
Q
Compare organized exchanges and OTC in term of default risk?
A
OTC: Most client was selected to have certain levels of creditworthiness. So OTC market is limmited to instituational customers.
Organized exchanges: not a significant concern. For Montreal Exchange futures, Canadian Derivatives Clearing Corporation ( CDCC) is responsible for clearing)
to establish certain levels of creditworthiness. And limitted to institutional clients.
15
Q
Compare organized exchanges and OTC in term of Regulation?
A
OTC: generally unregulated
Organized exchanges: regulated environment, all about fairness, transparency, and an efficient secondary market
Because exchange-traded contracts are public.
16
Q
Summerais about exchange trade?
A
- Traded on an exchange
- Standardized contract
- Transparent (public)
- Easy termination prior to contract expiry
- Clearinghouse acts as third-party guarantor ensuring contract’s performance to both trading parties
- Performance bond required, depending on the type of derivative
- Gains and losses accrue on a day-to-day basis
- Heavily regulated
- Delivery rarely takes place
- Commission visible
- Used by retail investors, corporations, and institutional investors
17
Q
Summerais about OTC?
A
- Traded largely through computer and/or phone lines
- Terms of the contract agreed to between buyer and seller
- Private
- Early termination more difficult
- No third-party guarantor
- Performance bond not required in most cases
- Gains and losses generally settled at the end of the contract, rather than marking to market
- Much less regulated
- Delivery or final cash settlement usually occurring
- Fee usually built into price
- Used by corporations and financial institutions
18
Q
What are The two general categories of underlying assets for derivative contracts?
A
- commodities
2. financial assets
19
Q
Who often buy commodiities derivative contracts?
A
- Producer, merchandisers, and processors buy commodity futures and options to protect themselves from fluctuating commodity price
- speculators use commodities to profit from the fluctuating prices.
20
Q
What are the types of commodities that unerlie derivative contracts?
A
• Grains and oilseeds (e.g., wheat, corn, soybeans, and canola)
• Livestock and meat (e.g., pork bellies, hogs, live cattle, and feeder cattle)
• Forest, fibre, and food (e.g., lumber, cotton, orange juice, sugar, cocoa, and coffee)
• Precious and industrial metals (e.g., gold, silver, platinum, copper, and aluminum)
• Energy products (e.g., crude oil, heating oil, gasoline, natural gas, and propane)
Most popular are soybeans, crude oil, copper (cu), gold and silver.
21
Q
Why financial derivatives have an explosive growth recently?
A
- Increasingly volatile interest rates, exchange rates, and equity prices
- Financial deregulation and intensified competition among financial institutions
- Globalization of trade and the tremendous advances in information technology
- Extraordinary theoretical breakthroughs in financial engineering
22
Q
What are the most commonly used finanacial derivatives?
A
- Equity
- Interest rate
- Currencies
23
Q
What are the characteristic of Equity derivatives?
A
- a large category of financial derivatives especially equity options (options on individual stocks). - traded mainly on organized exchanges (the Montréal Exchange, the Chicago Board Options Exchange, the International Securities Exchange, the Boston Options Exchange, the NYSE AMEX Options, and the NYSE ARCA Options markets)
24
Q
What are the characteristic of Interest rate derivatives?
A
- generally based on interest rate-sensitive securities rather than on interest rates directly.
- All interest rate futures trading in Canada takes place at the Montréal Exchange.
- In the OTC market, interest rate derivatives are generally based on well-defined and well-known floating interest rates. (rather than an actual security, the contracts are settled in cash).
25
What are the characteristic of Currencies derivatives?
- The most commonly used are the U.S. dollar, British pound, Japanese yen, Swiss franc, and European euro.
- The types of contracts traded include currency futures and options on organized exchanges, and currency forwards and currency swaps in the OTC market.
26
What is swap?
- A swap is a private, contractual agreement between two parties used to exchange (swap) periodic payments (exchange the cash flow) in the future based on an agreed to formula.
- Swaps are essentially equivalent to a series of forward contracts packaged together.
27
What are the main users of derivatives?
1. Individual investor (end users : speculate, risk management - hedging)
2. Institutional investor (end users : speculate, risk management - hedging)
3. Businesses and corporations (end users : speculate, risk management - hedging)
4. Derivative dealers (intermediaries in the market, do not normally take position)
28
What are the characteristics of individual investors in derivatives?
- only able to trade exchange-traded derivatives.
- Can use to speculative strategies only if they have a high degree of risk tolerance
- use for Risk management strategies.
- Individuals can open a special type of account with a full-service or self-directed brokerage firm
- investment advisors at full-service firms and investment representatives at selfdirected firms must be properly licensed.
29
What are the characteristics of institutional investors in derivatives?
- Include mutual fund managers, hedge fund managers, pension fund managers, and insurance companies, among others.
- Purpose: speculative and hedging
- Traded both on the exchange and OTC
30
How strategy market entry and exit work?
- More efficient and cost-effective to carry out temporary change to portfolio using derivatives than trading the underlying assets directly (trade directly fee: commission, bid-ask spreads, creating adverse price pressure in the market)
31
How strategy market entry and exit work?
- More efficient and cost-effective to carry out temporary change to portfolio using derivatives than trading the underlying assets directly (trade directly fee: commission, bid-ask spreads, creating adverse price pressure in the market)
32
How strategy arbitrage work?
- refers to a scenario where the same asset or commodity is traded at different prices in two separate markets. (purchasing low in one market and selling high in the
other market simultaneously)
- no risk.
33
How strategy Yields work?
Yield enhancement is a method of boosting returns on an underlying investment portfolio by taking a speculative position based on expectations of future market movements. The most popular way to enhance an investment’s yield is by selling options against the position.
34
What are the characteristics of businesses and corporations in derivatives?
- Main reason is for hedging purposes. (interest rate, currency, and commodity price risk)
- Hedging risk by buying a forward or call option.
- Risk management tool.
35
What are the characteristics of derivative dealer?
- stand ready to buy or sell contracts at any time.
- Exchange-traded market makers include banks, investment dealers, and professional individuals
- play crucial rold in OTC market.
- In Canada, main OTC derivative dealers are chartered banks and their investment dealer subsidiaries as well as subsidiaries of large foreign banks and investment dealers.
36
What is long position in Options?
the buyer
37
What is short position in Options?
The seller (writer)
38
What is call option?
An option that gives the holder right to buy and seller obligation to sell underlying asset.
39
What is put option?
An option that gives the holder right to sell, and seller obligation to buy.
40
What are the four position of Options?
Long call, Long Put, Short Call, Short put.
41
What are the characteristics of Long call?
- Pay premium
- Right to buy
- Expect the price will rise
42
What are the characteristics of Long put?
- Right to sell
- Pay premium
- Expect the price will fall
43
What are the characteristics of Short call?
- obligation to sell
- receive premium
- expect price will fall or remain the same
44
What are the characteristics of Short Put?
- Obligation to buy
- receive premium
- expect price will remain or rise
45
what is the syntax (cú pháp) to summarize the option?
(number of contract) + (underlying asset) + (expiration month) + (strike price) + (option type)
Ex: 10 XYZ December 50 Calls
46
What are the term in Options?
1. Strike price (exercise price)
2. Option premium (always quoted on a per unit basis)
3. Expiration date (usually third Friday of expiration month)
4. Trading unit (in North American is 100 shares/contract)
5. Americanstyle or Europeanstyle options
6. Long-term Equity Anticipaton securities (long-term contract offering same risks and rewards as regular option)
7. Open transaction (act of initiating a trade -> establishes a new position in an option)
8. In-the-money (have profit)
9. Out-of-the-money (suffer loss) and At-the-money (strike price = market price)
10. Intrinsic value (value of certainty, positive when option in-the-money and = 0 when it out or at the money)
11. Time value (represents the value of uncertainty)
47
What is weekly options?
- Weekly options are listed for trading at the open on Thursdays, with expiration dates on any of the five Fridays following the listing week.
- Providing more trading opportunities (taking advantage of earning releases, government reports, and central banks’ interest rates policy announcements.)
48
What can happen to a option long or short position befre expiration date?
1. The position will be offest (Transfer or most popular entering an offsetting order (opposite with the current position))
2. Long position holding party exercise the option. (Short position holding is called to be assigned on the option)
3. Long position holding party will let the option expire worthless.
49
When will a call option holder is in-the-money?
Market price > strike price
50
When will a put option holder is in-the-money?
Market price < strike price
51
How to calculate Intrinsic Value of an In-the-Money Call Option?
Price of Underlying – Strike Price
52
How to calculate Intrinsic Value of an In-the-Money Put Option?
Strike Price – Price of Underlying
53
What is intricsic value?
the amount that the owner of an in-the-money option would earn by immediately exercising the option and offesting all position.
54
What is time value in Options?
Prior to the expiration date, most options trade for more than their intrinsic value. The option’s time value is the amount that an option is trading above its intrinsic value.
55
How to calculate time value of Options?
Option Price – Intrinsic Value = Time Value
| Option Price = Intrinsic Value + Time Value
56
If a call option on XYZ with a strike price of $55 is trading for $6 when XYZ stock is trading at $60, How much is the option's time value?
1$
| $6 – ($60 – $55) = $1
57
What do the Montréal Exchange lists options on?
individual stocks, stock indexes, financial futures, exchange traded funds (ETFs), and the U.S. dolla
58
What is ETFs?
An exchange traded fund (ETF) are a basket of stocks that track a specific market index , sector or commodity. ETFs are in many ways similar to mutual funds; however, they are listed on exchanges and ETF shares trade throughout the day just like ordinary stock.
59
What does this symbol (Opt Int) mean in option exchange?
Open interest - the total number of option contracts in the series that are currently outstanding and have not been closed out or exercised
60
What are the different option strategies for individual and institutional investors?
1. Buying call options (Long call)
2. Writing call options (Short Call)
3. Buying put options (Long Put)
4. Writing put options (Short Put)
61
What is Buying call options strategies?
- Purpose: speculate (earn profit) or manage risk (protect from the stock price moves higher)
- Expect: price increase
- Challenge for speculate: select appropriate expiration date and strike price to maximum profit.
- Way to close position: exercise options or sell the option to get profit.
62
What is Writing call options strategies?
- primarily for premium income -> are primarily speculative (but still they can use to manage risk)
- Two types: coverd call (writer own the underlying stock) and naked call (do not own the underlying stock)
63
What is Buying put options strategies?
- expected price to decline
| - both for speculative and managing risk
64
What is writing put options strategies?
- primarily for the income premium.
- primarily speculative in nature, but they can be used to manage risk as well.
- 2 types: covered or naked.
- Covered put writing technically combining a short put with a short position in the stock.
- Another put writing strategy is the cash-secured put writing. (writing a put and setting aside an amount of cash equal to the strike price or can be invested in short-term, liquid money market security).
- Naked put writers have no position in the stock and have not specifically earmarked an amount of cash to buy the stock.
65
What is the options strategies for corporations?
- Do not often speculate mostly for risk management.
| - Common risks: interest rates, exchange rates, or commodity prices
66
What is forward?
- A contract between two parties: a buyer and a seller. The buyer of a forward agrees to buy the underlying asset from the seller on a future date at a price agreed on today. Both parties are obligated to participate in the future trade.
- Forwards can trade on an exchange or OTC market.
- The predominant types of forward are based on interest rates and currencies
67
What is future contract?
When a forward is traded on an exchange, it is called a futures contract.
68
What are the types of future contract?
1. Financial futures are contracts with a financial asset as the underlying asset (Stocks, Bonds, Currencies, Interest rates, Stock Indexes)
2. Commodity futures are contracts with a physical asset as the underlying asset. (Precious and base metals, Crude oil and natural gas, Grains and oilseeds, Meats and dairy, Lumber)
69
?What are the key term in Forward and Future?
- Buyer Futures = buy the underlying asset = long position in the futures contract
- Seller of Futures = sell the underlying asset = short position
- No premium just establishing a price in the future time. -> most parties end up offsetting their positions prior to expiration, only a few deliveries actually take place.
- If a contract is held to the expiration date, the seller is obliged to deliver the underlying asset and accept payments from the buyer. Likewise, the buyer is obliged to accept the delivery of the underlying asset and make payments to the seller.
- Futures are standardized with respect to the amount of the asset underlying each contract, expiration dates, and delivery locations. Standardization allows users to offset their contracts prior to expiration and provides the backing of a clearinghouse.
70
What is cash-settled Futures?
Futures that there is no underlying assets delivery (ex: index Futures) but only cash payment from one party to the other base on the performance of underlying assets on the expiration date.
• Strike price > market price -> the long pay the short.
• Strike price < market price -> the Short pay the long
- Like other futures contracts, cash-settled futures can be offset prior to expiration.
71
What is margin requirement in Futures?
- Buyers and sellers must deposit and maintain adequate margin in their futures accounts.
- to provide a level of assurance
72
What are the types of margin in Furtures?
1. Initial margin (original margin) : is required when entering to the contract.
2. Maintenance margin: minimum account balance
73
What is Marking to market in Futures?
- is settlement of gains and losses At the end of each trading day.
74
How is Futures leverage?
- Futures margin requirements are typically 3% to 10% of a contract’s value. In contrast, investors can buy or sell equities with margin deposits ranging from 30% to 80%.
- A futures trader could decide to deposit a contract’s full value as margin -> no leverage at all
75
where do Futures list in Canada?
The Montréal Exchange (It offers contracts on index futures, two-year, five-year, and 10-year Government of Canada bonds, bankers’ acceptances, and the 30-day overnight repo rate)
76
What are the Futures stategies for investors?
- Buy Futures (Long)
| - Sell Futures (Short)
77
What are the purpose of buying Futures? (Long)
1. speculative strategy: to profit from the rising prices with no intention of actually buying the underlying asset. just to sell the futures contract at a higher price.
2. risk management: to lock in a purchase price. In this case, the investor does not offset the contract. At expiration, the investor takes delivery of the underlying asset for the amount agreed upon when the contract was originally bought.
78
What are the purpose of selling Futures? (Short)
1. speculative strategy: to profit from decreased prices with no intention of actually selling the underlying asset. just wants to buy back the futures in the market at a lower price.
2. risk management: to lock in a selling price to sell the underlying asset for the agreed amount when the contract was originally sold.
79
What are the Futures stategies for corporation?
- to manage risk in the same way that investors do.
- Even though they take futures positions consistent with their risk management needs, companies usually offset
their positions before expiration, rather than actually making or taking delivery of the underlying asset -> so they can deal with their regular partner.
80
What are the difference between Option and Right and Warrants?
Similarity: give their owners the right, but not the obligation, to buy a specific amount of stock at a specified price on or before the expiration date.
Differences:
+ rights and warrants are usually issued by a company as a method of raising capital.
+ Rights are usually very short term (4-6 weeks), Warrants tend to have 3-5 years to expiration.
81
What is Rights?
- Is a right to buyadditional shares directly from the issuing company with no commission to excersice the Right.
- The offering price < market price.
- All common shareholders who are in the record books on the record date receive rights.
- Common way: issuing one right for each outstanding common share. A certain number of these rights are required to buy one new share.
- Rights can be traded on the market.
82
What is ex-rights shares date?
On the business day before the record date, the shares trade ex-rights. Anyone buying shares on or after the ex-rights date is not entitled to receive the rights from the company.
83
What is cum-rights shares date?
Between the date of the announcement that rights will be issued and the ex-rights date, the stock is said to be trading cum rights. Anyone who buys the stock is entitled to receive the rights, if they own the stock until at least the record date.
84
Where do Rights trade?
- Listed on the exchange that lists the underlying common stock.
- Price of Rights changes as the price of the common stock fluctuates (not necessarily to the same degree).
85
What can the Rights holder do with the Rights?
1. Exercise some or all of the rights and acquire the shares
2. Sell some or all of the rights
3. Buy additional rights to trade or exercise later
4. Do nothing and let the rights expire worthless (no benefit)
86
What is intrinsic value of Rights?
- Since issued price < market price -> Rights have intrinsic value since issued.
- Price of Rights = intrinsic value + time value (because it is short term so time value is very little)
87
How to calculate intrinsic value of Rights during the ex-right periods?
= (market price - excersise price)/n
| n: The number of rights needed to buy one share
88
How to calculate intrinsic value of Rights during the cum-right periods?
- During this time, the rights are embedded in the common stock so the common stock’s price represents the value of the rights and the value of the stock.
- (market price - excersise price)/(n+1)
89
What is regular delivery of Rights?
A rights transaction be settled by the second business day after the transaction takes place -> similar setllement day of Rights to stock.
90
What is Warrants?
- is a security that gives its holder the right to buy shares in a company from the issuer at a set price for a set period of time.
- issued by the company itself as part of a package that also contains a new debt or preferred share issue -> make these issues more attractive to buyers.
- Once issued, warrants can be sold either immediately or after a certain holding period. The expiration date of warrants, which can extend to several years from the date of issue.
91
How to valuing Warrants?
- Warrants may have both intrinsic value and time value.
- Intrinsic value = market price - exercise price
- Time value is the amount by which the market price of the warrant exceeds the intrinsic value. (Time value fall over time).
92
Why investor buy Warrants?
Leverage potential. (Warrant price is much lower than the price of the underlying security, and generally moves in the same direction)
