Chapter 10: Derivatives and Other Instruments Flashcards
1
Q
Futures
A
- Agreement between two parties, one agreeing to sell, one to buy.
- Terms and conditions of trade are made now, but the trade will be in the future
- Once contract is made it is binding on the parties
- exchange traded
2
Q
What is the long position of a future?
A
The future buyer of the underlying asset, things the price of assets will rise.
* max gain is unlimited, max loss is limited to the price of the future
3
Q
Short position of a future
A
- Future seller
- thinks the price of the underlying assets will fall
- max gain is limited to the price of the future, max loss is unlimited
4
Q
What is the fair value of a future
A
- the cash price of underlying + cost of carry
- carry includes: interest rates, storage, insurance
5
Q
Basis
A
- quantifies the difference between the cash price of the underlying assets and the futures price
- Basis = cash price - futures
6
Q
Contango
A
- means that basis is negative = the cash price is less than the price of the future
7
Q
Backwardation
A
- means that basis is positive, cash price is greater than the price of the future
- might occur where a temporary shortage of the underlying, pushing up the price and producing a back market
- can occur when there is an overall benefit rather than cost of carry
8
Q
Contingent liability
A
- the investor faces a potential liability uncertain at the present time
- all futures transactions are contingent liability transactions
9
Q
Forwards
A
- OTC traded
- higher degree of flexibility to the parties involved, no exchange to standardise the terms of the contract
- direct counterparty risk with opposite side of trade
*No central market place
10
Q
Contracts for difference
A
- Describes a cash settled derivative, no physical delivery
- example: interest rate futures and futures in equity index
- many are physically settled
- pays the difference in the settlement price between the open and closing trades
11
Q
Arbitrage
A
- risk-free profit by exploiting anomalies and inconsistencies in the prices between two related but different markets
- ex. if cars were cheaper in France than UK, buy French car and sell in the uk
12
Q
When can arbitrage be used?
A
- between an index and its derivative
- if an asset and the cost of carry is cheaper than the price on the future contract, an investor can exploit it by buying and holding the asset and shorting the future (agreeing to sell at a future date)
13
Q
Closing out of a future - what is is and how is it done?
A
- to sell the future before its expiry date
- achieved by entering into a second equal but opposite contract in order to offset the terms and conditions of the first
- ex. if agreed on an opening purchase, they make a closing sale
14
Q
Roll contracts
A
- used to extend a future contract whereby the investor does not want to proceed to take delivery or make delivery, but want to remain exposed to the asset
- involves two trades, one to close our the current contract that is approaching delivery, and a second to open a new position in a longer-dated contract
15
Q
Roll yield
A
*for roll contracts, the two contracts will not be priced the same
* in a contango market, the far dated contract will be priced higher –> negative roll yield
16
Q
What can be used to hedge?
A
- futures, buy shorting FTSE 100 futures, if the market does down, they will be hedged, and if the market goes up, they will lose money BUT their portfolio will rise
17
Q
What does beta measure?
A
Volatility of a portfolio in relation to the index
If higher than 1 = more volatile, if less than 1 = less volatile
18
Q
What is beta hedging
A
- uses beta to determine how many future contracts are needed for the hedge
- if beta 1.2 this means 1.2 x as many future contracts are needed as before
19
Q
Options
A
- gives the buyer the right to buy or sell an underlying asset at a fixed price on or before a given date in the future
- buyer has a choice (seller has a potential obligation)
20
Q
Difference between futures and an option?
A
- in options, the buyer has a choice
- the buyer of an option pays a premium to the seller
21
Q
Call option
A
Right to buy the underlying asset
22
Q
Put option
A
Right to sell the underlying asset
23
Q
Short position
A
Sell
24
Q
Long position
A
Buy
25
American vs. European style options
* America style = buyer can exercise their rights at any time
* Europeans = can only exercise at expiry
26
What losses/gains are there for the buyer and seller of a call option?
* Max profit for buyer = unlimited
* Max Loss for buyer = the premium
* Breakeven point is strike price plus premium
27
Delta - what it is & calculation
* measure of the sensitivity of the option premium to changes in the underlying value of the asset
* Delta = Change in Option Premium / Change in price of the underlying asset
28
Is the delta positive or negative for calls?
* positive, between 0 and 1
29
How will interest rates rising affect equity call options?
* the time value of call options increase and premium increases
30
What is the benefit of using options to hedge?
* only down-side risk is hedged, do not need to execute the option if does not want to
31
Covered Call
* made up of a short call option and a long position in an underlying asset
* used to generate income in a static market
32
When are protective puts normally used?
To hedge against a falling market
33
Who are the main operators in the swap market?
Financial organisations, such as banks and other money market institutions
34
What type of market are SWAPS traded on
OTC
