Chapter 11 pt. 2 - Other Investment Classes: Derivatives

Question 1

Derivative

Answer 1

Financial instrument whose value is dependent on the value of another underlying asset.

Question 2

Forward contract

Answer 2

• A contract to buy (or sell) an asset on an agreed basis in the future.
• Credit risk dependent on counter party

Question 3

Futures contract

Answer 3

-A STANDARDISED contract, TRADED ON A
RECOGNISED EXCHANGE, to buy (or sell) an asset on
an agreed basis in the future.
-Liquid market due to high amount of identical futures

Question 4

Uses of Derivatives (4)

Answer 4

• Reduce risk (hedging)… market or credit risk
• aid in asset allocation
• speculation… increase risk to enhance returns
• arbitrage

Question 5

Functions of the exchange

Answer 5

• Set the details of standardised contracts
• Authorise who can trade on the exchange
• Bring buyers and sellers together
• Operate sub-institution called the clearing house

Clearing house guarentees each side of the original deal, removes credit risk to both parties.

Question 6

Option

be able to adapt into defn for call or put option

Answer 6

Gives an investor the right - but not the obligation - to buy/sell a specified asset on a specified future date.

American: Can be exercised on any date before expiry
European: Can only be exercised at expiry

Question 7

Clearing house functions (4)

Answer 7

-Self-contained institution whose only function is to
clear FUTURES trades and settle margin payments.
-The clearing house checks that the buy and sell orders match
-Acts as a party to every trade.
-Guarantees each side of original bargain, removes
credit risk. Uses initial and variation margins.

Question 8

Clearing house as a party to every trade

Answer 8

It simultaneously acts as if it had sold to the buyer and bought from the seller.
Following registration, each party has a contractual obligation to the clearing house.
In return, the clearing house guarantees each side of the original bargain, removing the credit risk to each of the individual parties.

Question 9

Warrant

Answer 9

-Option issued by a company.
-The holder has the right to purchase shares at a
specified price at specified times in the future.
-Similar to a call option.
-Bond warrants do exist as well

Question 10

Long position in an asset

Answer 10

Means having a positive economic exposure to that asset.

Question 11

Long party in futures contract

Answer 11

The party who has contracted to take delivery of the asset in the future.

Question 12

Short position in an asset

Answer 12

Having a negative economic exposure to that asset.

Question 13

Short party in futures contract

Answer 13

One who has contracted to deliver asset in the future.

Question 14

Credit risk

Answer 14

Risk of one of the parties to the trade defaulting on the agreement.

Question 15

Exercise price

Answer 15

price at which an underlying security can be sold to (for a put) or purchase from (for a call) the writer or issuer of an option (or option feature on a security).

Question 16

Option premium

Answer 16

Price that the option holder pays the option writer for the right to exercise (or not exercise) the option.

Question 17

Closing out position

Answer 17

Taking out an equal, but opposite contract. Applies to futures.

Question 18

Uses of equity warrants

Answer 18

• No rights that come with holding equity warrant, but protected from changes in Ordinary Share capital. i.e rights issues and scrip isuues
• Number of shares and exercise price can be adjusted later on if such an event occurs.

USUALLY AN ADDED BENEFIT TO CORPORATE BONDS:
-Added on to other benefits to attract different investment market and reduce GRY on bonds since higher yields aren’t needed to attract investors

Question 19

Futures vs Options

Answer 19

Futures:
Obligation
Exchange-traded
Standardised
No premiums paid (margins are deposits)
Margins paid by both parties

Options:
Right
OTC & Exchange
Non & Standardised
Premiums paid
Margin only paid by writer since only obligated trader