Chapter 11: Future and options

Question 1

Future

Answer 1

a STANDARDISED, EXCHANGE-TRADABLE contract to buy (or sell) an underlying asset on an agreed basis in the future

Question 2

Forward

Answer 2

a NON-STANDARDISED, NON-EXCHANGE-TRADABLE, contract to buy (or sell) an underlying asset on an agreed basis in the future

Question 3

Long party

Answer 3

Having a positive economic exposure to an asset - the part that has contracted to buy the underlying asset

Question 4

Short party

Answer 4

Having a negative economic exposure to an asset - the part that has contracted to sell the underlying asset

Question 5

European call option

Answer 5

The right to BUY an underlying asset on a SPECIFIC expiry date for an agreed price

Question 6

American put option

Answer 6

The right to SELL an underlying asset on a ANY date for an agreed price

Question 7

Option premium

Answer 7

Price paid to the writer of an option for an option

Question 8

Trade option

Answer 8

STANDARDISED, EXCHANGE TRADABLE option

Question 9

Strike price / Exercise price

Answer 9

The price at which an underlying asset can be purchased (for a call) or sold (for a put) to the option writer

Question 10

Warrant

Answer 10

Option issues by an company in its own shares

Question 11

Initial margin

Answer 11

A deposit made to the clearing house when a future deal is agreed

Question 12

Minimum maintenance requirement

Answer 12

Minimum level of margin that a customer must maintain in his margin account

Question 13

Variation margin

Answer 13

Extra margin required when the margin account drops below the minimum required level

Question 14

Option writer

Answer 14

The only party who pays margin under a traded option contract

Question 15

Clearinghouse

Answer 15

Organisation that acts as a “party to every trade” and reduces the counterparty default risk to each customer under a future contract

Question 16

What derivatives and equities to use in a bear market (5)`

Answer 16

• Invest in companies not affected by the economic cycle, e.g., utilities, food
• Invest in well-diversified companies (e.g., multinational or local with many lines of business) losses in one may be offset by gains in another
• Short position in futures - locking in price
• Write call options - if share price falls the option wont be exercise but can benefit from option premium
• Buy put option - locking in price, fall in the market is offset by gains in option contract

Question 17

How can margins be used to manage credit risk

Answer 17

• Clearing house requires an initial margin by both parties when they enter into a futures contract
• The initial margin is used to protect exchange against default from another party due to adverse movements in price
• Each party’s credit exposure changes daily, these adjustments to margin accounts are made daily (marking to market)
• Variation margin is required should the margin account fall below the minimum maintaince requirement