Chapter 11: Derivatives

Question 1

Contracts that derive their value from the performance of an underlying asset, event, or outcome.

Answer 1

Derivatives

Question 2

An action that reduces uncertainty or risk

Answer 2

Hedge

Question 3

An agreement between two parties in which one party agrees to buy from the seller an underlying at a later date for a price established at the start of the contract.

Answer 3

Forward contract

Question 4

The risk that the other party to the contract will not fulfill its contractual obligations.

Answer 4

Counterparty risk

Question 5

Similar to a forward contract in that it is an agreement that obligates the seller, at a specified future date, to deliver to the buyer a specified underlying in exchange for the specified futures price. The main difference is that they are standardized contracts that trade on exchanges. The buyers and sellers do not necessarily know who is on the other side of the contract.

Answer 5

Futures contract

Question 6

The buyer of the option has the right, but not the obligation, to buy or sell the underlying. Unilateral contract because only one party to the contract (the seller) has a future commitment that, if broken, represents a breach of contract.

Answer 6

Option contract

Question 7

An investor who buys a _____ has the right (but not the obligation) to buy or call the underlying from the option seller at the exercise price until the option expires.

Answer 7

Call option

Question 8

An investor who buys a _____ has the right (but not the obligation) to sell or put the underlying to the option seller at the exercise price until expiration.

Answer 8

Put option

Question 9

Typically derivatives in which two parties exchange (swap) cash flows or other financial instruments over multiple periods (months or years) for mutual benefit, usually to manage risk

Answer 9

Swaps

Question 10

A swap contract that allows companies to swap their interest rate obligations (usually a fixed rate for a floating rate) to manage interest rate risk, to better match their streams of cash inflows and outflows, or to lower their borrowing costs

Answer 10

Interest rate swap

Question 11

Enables borrowers to exchange debt service obligations denominated in one currency for equivalent debt service obligations denominated in another currency.

Answer 11

Currency swap

Question 12

These are not truly swaps. Like options, these are contingent claims and unilateral contracts. The seller is providing protection to the buyer against declines in value of the underlying. The seller does this in exchange for a premium payment from the buyer; the premium compensates the seller for the risk of the contract.

Answer 12

Credit Default Swaps (CDS)