Chapter 10 - Derivatives (Done)

Question 1

What is a derivative?

Answer 1

A derivative is a financial instrument whose value is dependent on or derived from the value of an underlying asset. The underlying asset can be stocks, bonds, commodities, currencies, interest rates, or market indexes.

Question 2

What type of derivative can be customized and why?

Answer 2

Over-the-counter (OTC) derivatives can be customized because they are traded directly between two parties without going through an exchange. This allows the terms of the derivative contract, such as the underlying asset, amount, and settlement date, to be tailored to meet the specific needs of the parties involved.

Question 3

Is an exchange-traded derivative more or less likely to result in the delivery of the underlying asset compared to OTC derivatives? Why?

Answer 3

Exchange-traded derivatives are less likely to result in the delivery of the underlying asset compared to OTC derivatives. This is because exchange-traded derivatives, like futures and options, often have standardized contracts that are frequently settled in cash rather than through the physical delivery of the asset. The standardized nature of these contracts and the presence of a clearinghouse reduce counterparty risk and facilitate easier trading and settlement.

Question 4

What type of derivative is standardized? What kind of characteristics are standardized?

Answer 4

Futures and options traded on exchanges are standardized derivatives. The characteristics that are standardized include the contract size, expiration date, exercise price (for options), and the underlying asset. Standardization ensures liquidity and simplifies the trading process.

Question 5

Can you list five commodities that underlie derivative contracts?

Answer 5

• Crude oil
• Gold
• Silver
• Corn
• Natural gas

Question 6

What kind of financials underlie derivative contracts?

Answer 6

Financial assets that underlie derivative contracts include stocks, bonds, interest rates, market indices, and currencies.

Question 7

Who are the four main participants in derivatives transactions?

Answer 7

• Hedgers: Use derivatives to mitigate or manage risk associated with price movements of an underlying asset.
• Speculators: Aim to profit from price movements in the underlying asset.
• Arbitrageurs: Seek to profit from price discrepancies in different markets or derivative instruments.
• Margin traders: Use derivatives to gain leveraged exposure to an underlying asset, often using borrowed funds.

Question 8

What is the difference between speculating and hedging?

Answer 8

Speculating involves taking on risk with the hope of making a profit from price movements in the market. Hedging, on the other hand, involves taking a position in a derivative to offset or reduce the risk associated with potential price movements of an underlying asset.

Question 9

What are options?

Answer 9

Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time period. There are two types of options: call options and put options.

Question 10

Who has rights and who has obligations in an option contract?

Answer 10

In an option contract, the buyer (holder) has the right, but not the obligation, to exercise the option. The seller (writer) has the obligation to fulfill the contract if the buyer decides to exercise the option.

Question 11

What are call option buyers hoping will happen to the underlying stock?

Answer 11

Call option buyers are hoping that the price of the underlying stock will increase above the exercise price before the option expires, allowing them to buy the stock at a lower price and potentially sell it at a profit.

Question 12

What are put option buyers hoping will happen to the underlying stock?

Answer 12

Put option buyers are hoping that the price of the underlying stock will decrease below the exercise price before the option expires, allowing them to sell the stock at a higher price than the market price and potentially profit from the difference.

Question 13

What must an option buyer pay to purchase a contract? Who does the option buyer pay?

Answer 13

An option buyer must pay a premium to purchase an option contract. The premium is the price of the option and it is paid to the option seller (writer).

Question 14

What is the difference between American-style options and European-style options?

Answer 14

American-style options can be exercised at any time before the expiration date, giving the holder more flexibility. European-style options can only be exercised on the expiration date.

Question 15

When is a call option in-the-money?

Answer 15

A call option is in-the-money when the current price of the underlying asset is higher than the exercise price of the option.

Question 16

When is a put option out-of-the-money?

Answer 16

A put option is out-of-the-money when the current price of the underlying asset is higher than the exercise price of the option.

Question 17

What is time value?

Answer 17

Time value is the portion of the option premium that reflects the amount of time remaining until the expiration date. It represents the potential for the option to gain value due to favorable price movements of the underlying asset.

Question 18

Why would an investor write a call option?

Answer 18

An investor might write (sell) a call option to generate income through the premium received from the option buyer. This strategy, known as covered call writing, is often used when the investor expects the underlying asset’s price to remain stable or decrease slightly.

Question 19

What is the difference between a covered call writer and a naked call writer?

Answer 19

A covered call writer owns the underlying asset and sells call options against it, which limits their risk to losing potential upside gains. A naked call writer does not own the underlying asset and sells call options, exposing them to potentially unlimited risk if the asset’s price rises significantly.

Question 20

What is the maximum risk of a naked call writer? A naked put writer?

Answer 20

• The maximum risk of a naked call writer is theoretically unlimited because the price of the underlying asset can rise indefinitely.
• The maximum risk of a naked put writer is the exercise price of the put option minus the premium received, multiplied by the number of shares, as the asset’s price can drop to zero.

Question 21

What does marked-to-market mean?

Answer 21

Marked-to-market is the daily adjustment of the value of a futures contract to reflect its current market price. This process ensures that gains and losses are realized and settled on a daily basis, reducing the risk of default by either party.

Question 22

What is the difference between futures contracts and forward agreements?

Answer 22

• Futures contracts are standardized, exchange-traded agreements to buy or sell an asset at a predetermined price on a specified future date. They are marked-to-market daily and have lower counterparty risk due to the involvement of a clearinghouse.
• Forward agreements are customized, over-the-counter agreements between two parties to buy or sell an asset at a predetermined price on a specified future date. They are not standardized or traded on exchanges and carry higher counterparty risk.

Question 23

Why would an investor buy a futures contract?

Answer 23

An investor might buy a futures contract to speculate on the future price movements of an underlying asset, to hedge against potential price fluctuations, or to gain leveraged exposure to the asset without having to pay the full price upfront.

Question 24

What is a warrant?

Answer 24

A warrant is a financial instrument that gives the holder the right, but not the obligation, to buy a company’s stock at a specific price before the warrant’s expiration date. Warrants are often issued by companies as a way to raise capital.

Question 25

What are the key differences between rights and warrants?

Answer 25

• Rights are short-term, often expiring within a few weeks or months, and are typically issued to existing shareholders to buy additional shares at a discount.
• Warrants are long-term, often expiring in several years, and can be issued to anyone, not just existing shareholders. They typically have a higher exercise price than rights.

Question 26

When do rights begin to trade separately from the related stock?

Answer 26

Rights begin to trade separately from the related stock once they are issued and distributed to shareholders. This usually happens shortly after the announcement of the rights offering.