Chapter 13 Flashcards
Forward contract and where traded
Contract that means buyer agrees to buy an underlying asset from the seller at a future date for a pre specified price and they are traded OTC
Futures contract
Same as a forward contract but traded on an exchange
Characteristic of futures contact
Highly liquid
Swap?
Essentially a series of future contracts
Agreement between parties to exchange a series of cash flows in the future
Traded otc
Swap
Essentially a series of futures contracts
Agreement to exchange a series of cash flows
Exchanged OTC
Option
Is a contingent claims contract in which payoff occurs if a specific event occurs. Give one party the right to buy or sell an asset at a specified price on some future date or period
Where are otptions traded
Either otc or on the exchange
What is the most an option buyer can lose
The price they have paid for the option
What is the main organised exchange for trading futures in Uk
ICE Futures EUrope
What is the clearing house
Ensures credibility and liquidity of the exchange traded derivative market
Formal counterparty of both parties on the contract
Guarantee fulfilment of the contract and keeps parties anonymous so they not exposed to credit risk
Explain the role of credit risk for the clearing house
Ensure that parties in contract are unaware of each others identity and their credit risk
But the clearing house is exposed to the credit risk of the buyer and seller
How does clearing house minimise credit risk
Traders have to deposit money with the house to cover the maximum likely daily loss arising from futures contacts. Known as initial margin
What happens with traders at end of the trading day if there’s been adverse futures market movement
Clearing house will generally seek additional payment
What happens with traders at end of the trading day if there’s been adverse futures market movement
Clearing house will generally seek additional payment
What is variation margins
Rise in futures prices, the payment is made from contract sellers to contract holders
What is the initial margin used for
Collateral if the the loser cannot pay so clearing house doesn’t lose out
Bilateral margin requiremts
Introduced for uncleared derivatives with the intention to increase transparency and market resilience
Involves exchange of financial instruments to acts as collateral in the event obligations can’t be honored
Characteristic of OTC contracts
No clearing house involved so no margins
Exposed to credit risk of counterparty
More flexible making slightly more expensive
Riskier in term so liquidity
What cme clear port
Clearing service for the otc market in order to mitigate risk in energy market place
What cme clear port
Clearing service for the otc market in order to mitigate risk
CCP?
Clearing house
CCP?
Clearing house
What is the defence of ccp
Measuring and managing amount of capital required to protect from member default
What is the defence of ccp
Measuring and managing amount of capital required to protect from member default
What happens if collateral is not enough to pay with ccp
Ccp make up the short fall
What happens if collateral is not enough to pay with ccp
Ccp make up the short fall
What’s is the ISDA SIMM
ISDA standard initial margin model
Standard method for calculating initial margin as required by regulators around the world on non cleared derivatives
New margins rules and limitations
Under non cleared derivatives, entities need to exchange initial margin
Delays on trade can occur if margin not agreed
CCP waterfall;
Default fund from own resources and also resources from member s
Assess members
Capital of CCP
Basis formula
Spot price - futures price
Basis formula
Spot price - futures price
When futures prices is greater than spot price, what is it called
Contango
When spot price is greater than futures price, called?
Backwardation
When does backwardation occur
When the convenience yield is higher than the prevailing risk free
What is convenience yield
The benefit associated with holding the underlying product or physical good rather than derivative contract
What is the convenience yield directly related to
Cost of storage
What is the price of futures contract at expiry
Is equal to the price of the underlying due to arbitrage
How do you close out a futures position
Buyer of futures contract takes out a short futures contract (same asset and same maturity date) to cancel their obligation to the exchange
What are futures common,y used for
Short term speculation and hedging
Advantages in purchasing futures over the actual asset
Lower transaction costs
More liquid
Quicker trading
Easier to take short positions
Allow greater exposure without 100 asset outlay
Financial futures traded on ICE futures Europe fall into 3 categories
Short term interest rate
Gov bonds
Equity index
What are interest rate futures priced at
100 minus the rate of interest
If an investor believes short term interest rates will fall
In terms of futures contracts
Then they will go long on the short term sterling futures contract
What is the nominal value of each short term interest future contract
500k
Value of a basis point for a nominal short term interest contract and what I the basis point for a 3 month contract
£50
£12.5
Value of a basis point for a nominal short term interest contract and what I the basis point for a 3 month contract
£50
£12.t
What are long bond futures written on
Government bonds
What are long bond futures written on
Gov bonds in same currency as issuing gov
What happens on day of delivery for long bond futures
Take delivery of pre specified range of gov bonds
How does the price of a long bond futures contract behave
Behaves as if it were written on the cheapest to deliver bond (CTD)
What would a bond PM do if they believe long p term uk interest rates will go up
This would reduce the price of gilts they held so they would sell long gilt futures
What is the contract value of one long gilt futures contract
100,000
What is the tick value of a long gilt futures contract
0.01 x 0.01x 100,000 = £10
Formula for a gain in the long bond futures market
(Price of contracts sold - price of contracts bought) x 100 x number of contracts x tick value of contract
Feature of equity index futures
Cash settled so no delivery of shares on delivery date
What is the value of a tick
5 pounds
Why do people like equity index futures
Investor can achieve higher returns than that of the chnage in underlying cash market
What can an investor do to hedge risk of adverse market movements
Selling stock market futures
European vs American style option
European can only be action on pre specified date
American can exercise option anytime before maturity date. More expensive
Max maturity of stock option and how often created
9months
Every 3 months
Asian options
Payoff depends on the average price of the underlying over a given period of time
Bermudian options
Hybrids of European and American, only be determined on predetermined dates, ie first BD of each month
Price paid for an option is called
Option premium
What does the option premium comprise of
Intrinsic value and time value
What is intrinsic value if exercise price is £1 and current price is £0.9
Intrinsic value of stock is zero bc investor would not exercise option and just buy of the exchange as it is cheaper that way
When is call option in the money
Price of the asset is above the exercise price
When is put option in the money
When the current price below the exercise price
Blacksholes
5 variables required for it
Strike price
Current price
Time to maturity
Volatility of underlying
Risk free rate
How does maturity affect price of options
Higher charge (premiums) - higher the prob that option is in the money
How does vol affect option price
Increase price as more likely to end up in the money
What happens to call options price when I rates rise and why
Cost of borrowing to buy an investment rises so more attractive to buy the option than the actual stock, so call option premium rises
Option delta
Sensitivity to change in price of option when price of underlying changes
If share price increase by 10 and option price increases by 3, what is the delta
Delta is 3/10 = 0.3
What does theta mean
Sensitivity of option price with time
What does vega mean
Sensitivity of option price with vol of underlying
What does rho mean
Sensitivity of option price with respect to I rates
What is max loss and win for long call option, what is break even and what is motivation for call option
Max loss is premium paid
Max win is unlimited
Break even is when share price of underlying = strike price plus premium
Motivation is bullish
What is max profit, max loss, break even and motivation for short call option
Max profit is premium earned
Max loss in unlimited
Break even is when share price is strike price plus premium
Motivation is bearish
What is max profit, max loss, break even and motivation for long put option
Max loss is premium
Max gain is when underlying value at zero, so max win is strike price minus premium
Break even is strike price - break even
Motivation bearish
What is max profit, max loss, break even and motivation for short put option
Max gain is premium
Max loss is strike price minus premium (when underlying is valued at zero)
Break even is strike minus premium
Motivation for trade is bullish
What is. A long straddle and what is shape
Buy a put and call option on the same underlying with same strike price and maturity
Shape of graph is a V
What is max profit, max loss, break even and motivation for a long straddle
Max loss is premium ( call premium plus put premium)
Max gain unlimited
Break even is strike price +-premium
Motivation is volatile markets
What is max profit, max loss, break even and motivation for short straddle
Max win is premium son call plus put
Max loss is unlimited
Break even is strike plus minus premium
Motivation is static markets
Long strangle? Shape?
A long put and call option with same expiry date but different strike prices
\__/
Max profit , max loss, break even and motivation for long strangle
Max loss is value of both premium combined
Max gains unlimited
Break even is call strike plus combined premium, put strike minus combined premium
Motivation
More volatile markets than long straddle motivation (cheaper than long straddle)
Short strangle - max gain , loss break even and motivation
Max gain is the combined premiums
Max loss unlimited
Break even is call strike plus premium, put strike minus premium
Motivation - stable market with but less stable than a motivation for short straddle
Covered call strategy ?
Investor sells a call option whilst also holding the underlying
Covered call limitation
Max profit is reduced by covering
Protective put ?
Combines the long position in an asset with a long position in the put
What does protective put do
Gives full protection on the downside
How are Stock index options settled
Cash settled bc transferring all the stocks in an index would be impractical
For stock index options, how is each point on index valued
£10
How could you hedge a portfolio with a long cash position
Short futures position
Formula to for number of contracts to fully hedge
N = (face value of cash exposure/face value of futures contract) x beta
Beta from CAPM
What is a good indication for the terminal value of the fund
Fund is well diversified
Capm beta of portfolio is relevant and does not change
Hedge efficiency equation
(Absolute gain or loss from futures position/ absolute gain or loss from cash market) x 100
What does a hedge efficiency of above and below 100% mean
Over 100= hedge was very effective.
Less than 100 = would have gained more by not entering the hedge
What is the terminal of portfolio formula
Initial value of portfolio x [1+[(pf-ps)/ps]beta]
Pf is the price of futures contract
Ps is spot price of underlying
Beta is the capm beta
Credit derivatives divided into two categories
Unfunded credit derivative - settlement of contract is without recourse to other assets
Funded credit derivative - the protection seller making an initial payment that is used to settle any potential credit event
What is a CDS
They want someone else to take risk of default
So they pay premium to CDS holder, if the bond has not defaulted then the seller of CDS keeps the premiums and has nothing to pay
What happens if underlying defaults in CDS
Buyer of the CDS (who is the owner of the underlying that has defaulted) hands over the bond in return for its face value
How is premium or spread quoted on CDS
As basis points and will be related to the bond issuers yield over the risk free rate
When does the buyer of the CDS pay the seller an upfront premium
PV of protection lag is greater than PV of premium lag
How are CDs quoted
Points upfront = percentage of notional paid upfront for protection
Price = if it costs 3 points for protection, the price will be 97
Examples of unfunded credit defaults
CDs
Total return swap
Contacts maturity swap
What do CDs comprise of
Single entity -most common
Basket of entities - if any one of the entities defaults, counts as a credit event
Credit default index swaps - portfolio of single entities, if one defaults then notional reduced by amount of defaulted entity
First loss and tranche loss CDS
What are total return swaps
Way of transferring total economic exposure including credit and market risk of an underlying asset
Constant maturity defaults swaps
Premiums paid for protection are not fixed but a floating spread using a traded CDs as reference index
Examples of funded credit derivative
credit linked notes and synthetic CDOs
CDOs ?
Package it up a collection of revenue generating assets (bank loans) and issuing a bond backed by these assets
Sliced into different tranches of varying credit risk
What is a synthetic cdo
A cdo made up of credit derivatives
Credit default notes / credit linked notes
Floating or fixed rate notes where coupons/principle are referenced to a basket of credits
If credit events occurred, income streams affected/reduced
Examples of credit events
Bankruptcy of entity
Default on obligation
Failure to pay in relation to obligation
Restructuring of an obligation
Who decides what a credit event is
ISDA committee
International swaps and derivatives association
Pricing of CDS determinants
Default probability
The recovery amount
How do CDs add to financial instability
Firm increase risk as they can use CDs to hedge
Derivatives mean people take speculative positions
Increase leverage possibilities
Stock lending and what happens with them
Securities temporarily transferred from one party (the lender) to another (the borrower)
Stocks returned at the end of agreement or on demand
What happens with dividends for someone who lends stocks
In lending agreement, borrower made to pay lender the benefits
Why do people borrow
To cover short positions usually
Who stock lends
Stocks held passively so can earn additional income from them
Pensions funds
Insuanrance funds
What are the fees for lending ftse and in general
Around 200bps for ftse 100
But usually around 40 bps
All per annum
Bps per annum for gilt lending
5bps
What was a short selling rule abolished in 2007 and modified in 2010
Only short sell after an uptick in market price
Short squeeze?
When stocks has a lot of short sellers but Unexpected good news that drives stock price up
What happens when investors have to liquidate short positions
They increase the price of stock further as they all have to buy the stock back driving the price higher
Contracts for difference ?
Agreement between two parties to exchange the difference between opening price and closing price of the contract multiplied by some size of contract
What are equity index futures and what are they designed to replicate
They are a CFD (contract for difference)
Replicate economic performance of the conventional share investments
Get benefits from owning stock without owning it
Why are CFDs liked
Easily go long and short in more cost effective way
4 types of swaps CFDs
Equity, interest rate, currency, inflation
Equity swap
One party agrees to pay to another the return on some specified underlying equity over a specified period of time
Usually exchanged for a fixed rate of return
Why do investment manager who holds equity do with equity swaps
Reduce equity exposure while still holding equity
Or to increase quite exposure without the actual trading of equities, cost effective
Interest rate swaps
Involve the swapping of floating and fixed rate interest payments
Net periodic settlement between two parties of a fixed rate and floating rate
What swap would investor do if rates rise
Pay the fixed and receive the floating
What do swaps not involve
Initial outlay
Currency swap
Where foreign currency is involved in cash flows
Eg fixed rate in one country is swapped for fixed rate in another currency
What sometimes occurs with currency swaps
Principle paid at outset
Motivation of currency swap
Exploit comparative advantage - better financing rate in foreign currency
Inflation swaps and examples
Transfer inflation risk between parties
TIPS AND and UK inflation linked gilts ILG
What do inflations swaps use as swaps
Real rate coupon vs floating and also pay redemption fee at maturity
One a party pays compounded fixed rate, the other party pays actual inflation rate for the term
What are real rate swaps
Nominal interest rate swap minus the corresponding inflation swap
Convert corporate Bond
Allows investors to convert holding debt. Into pre specified amount of equity on or before a specific date
Why do firms like convertible bonds
Can issue the, at lower rate due to the potential upside of turning into equity
Conversion price formula
Par value of convertible / conversion ratio
Conversion value formula
Current share price x conversion ratio
Price of convert
Pb + (Ac / 1+q) xCR
CR is conversion ratio
Pb is current similar bond price
Ac price of call option with same price and maturity
Q is percentage change in shares when bonds are converted
Conversion premium
Price of convertible security exceeds that of the current market price of stock into which it may be converted
Equity warrants
Are call options issued by a firm on its own stock
Owner of warrant has the right to buy stock at a certain price
Typical maturity of equity warrants
5 years
Benefits of holding warrant
Voting right s
Dividend payments
Value of warrants
Not formula
Intrinsic value known as the formula value
Time value known as the premium
What is the formula value of warrant when it is out the money, and when in the money
0 = out the money
Spot price minus exercise price when in the money
Formula value equation intrinsic
(Current stock price - exercise price) x NO shares warrant creates
Premium equation for warrant
(Warrant price - formula value) / (NO new shares issued if warrant exercised x stock price)
Covered warrants
Gives the investors the rights to buy (calls ) or sell (puts ) on an asset at a pre specified price in time period
How are covered warrants differ to traded options
They are securitised derivative and listed on LSE
Defensive strategy if investor scared price may fall (warrant)
Buy a put warrant
What is the relationship between futures prices and interest rates
When interest rates fall, the prices of futures contracts generally rise
