Chapter 13 Flashcards
Derivatives
What is the role of the clearing house for exchange-traded derivatives
Exists to ensure the credibility and liquidity of the market. The clearing house becomes the formal counterparty for both the buyer and seller of the derivatives contract. Buyer and sellers of derivative contracts are therefore unaware of each other’s identity and are not exposed to the credit risk of the other individual but only to the risk of the clearing house.
To minimise this credit risk the clearing house requires that each trader deposits money with the house to cover the maximum likely daily loss arising from the future’s contract. This deposit is known as the initial margin.
Over-the-counter derivatives: bilateral margin requirements
These involve the exchange of financial instruments between counter parties of an OTC derivative transaction so as to protect each one of them from losses caused by the inability of the other accountability to honour their obligations related to the transaction.
In parallel to exchange trade distributive is initial margin is collateral collected and or posted to reduce feature exposure to a given counterparty as a result of non-cleared derivative activity . It should be exchanged by both parties without netting of amounts collected by each party i.e. on a gross basis and should be held in such a way as to ensure that:
1- the margin collected is immediately available to the collecting party in the event of the counter parties default
2- the collective margin is subject to arrangements that Philly protect the posting party to the extent possible under applicable law in the event that they’re collecting party enters bankruptcy
Note that single stock equity options and index options are temporarily exempt from these requirements until January 2026 so that the PRA and FCA can undertake future research to develop a permanent UK framework for these products
Forward VS futures contract
Forward contracts are based on the same ideas features but they are off exchange or OTC contracts. This means that one individual will seek out another individual as a counterparty rather than using the futures exchange the counterparty to the portfolio manager/investor will typically be an investment bank.
OTC forwards contract: since the contract is OTC the clearing house has no involvement. There are no margin payments and each counterparty is exposed to the credit risk of the other this together with the flexibility of the contract specifications can make forwards a little more expensive. they are also risk in terms of liquidity since they are not traded on an exchange in large volumes. If one counterparty then wants to close out their position this may be possible without suffering further cost.
This textbook description of forwards has been suspended since the 2008 global financial crisis with certain customise forward contracts specifying market to market valuation and daily margin calls.
Define the basis of a futures contract
The buyer of a future’s contract is said to have taken a long position and will make a gain if the value of the contract rises. Conversely the seller of the future‘s contract is said to have taken a short position and will gain of the future‘s contract price falls. The features price of an asset is based on the current spot price of that asset.
When the future‘s price is greater than the spot price, this is known as contango
When the sport price is greater than the futures price, this is called backwardation
What are the advantages to investors in purchasing guilt features rather than guilt or FTSE features rather than equities?
- transaction costs are considerably lower
- Features contracts are generally more liquid than the underlying security
- Transactions in future’s market can be executed more rapidly than in the relevant cash market
- By selling a future’s contract and investor can take a short position which they may not be able to take in the cash market
- The system of margins allows investors to obtain a greater degree of leverage (gaining ass exposure without 100% of the cash outlay)
In about 98% of financial future’s contract cases there is no delivery of the underlying asset
What are the three main categories of financial features contracts traded on ICE futures Europe
- Short-term interest rates.
- Government bond.
- Equity index.
There are currently no currency features contracts traded on this exchange. All the contracts have standard delivery dates in a year: March June, September and December.
What is a three month sterling short sterling ICE Futures Europe interest rate contract?
The contract guarantees to the holder the price for borrowing Stirling over a three month period commencing when the contract expires this contract is cash settled rather than settled with the delivery of the assets to the contract holder
What are long bond features contracts?
Long bond features contracts are written on government bonds (guilts for Stirling contracts at ICE futures Europe) in the currency of the issuing government. They are not cash settled and therefore on the delivery date the holder of the contract can take delivery of a government bond however a pre-specified range of government bonds are deliverable for each features contract rather than just one.
The actual bond delivered is determined by the seller subject to arterial laid down by the exchange and is known as the cheapest to deliver CTD
What are equity index futures?
Are written on a particular index of ordinary shares one of the equity index features contracts trading on ICE futures Europe is the FTSE 100 index.
The contract is cash settled and therefore a contract sellers do not have to deliver ordinary shares to contract buyers.
There is an opportunity for leverage in the futures market. The investor achieves a much higher return than that represented by the change in the underlying cash market.
Stock index futures can also be used to hedge against equity market risk for a UK equity fund manager selling stock index futures contracts on the FTSE can provide a hedge against adverse movement in the UK equity market.
Define the concept of index arbitraged
An arbitrageur is someone who exploits a pricing and normally between different markets or instruments by buying the cheaper and selling the most expensive and who therefore brings both prices back into line.
Define the concept of equity index futures
One of the equity index futures contracts traded on ICE futures Europe is the FTSE 100 index
This contract is cash settled and therefore contract sellers do not have to deliver ordinary shares to contract buyers
FTSE 100 futures priced at £10 per index point.
The minimum amount which the contract can move is 0.5 of a point .
The value of a ticket is therefore £10 divided by 2 = £5
Distinguish between American style and European style options for options contracts
- European style options can only be exercised on the options maturity date.
- American style options are allowed purchasers to exercise the option at any time prior to and including its maturity. This increases the value of the option relative to the European styles option which can only be exercised at maturity.
What is an option’s contract?
An option contract gives the holder the right to buy or sell an underlying asset. However, there is no obligation on the parts of the holder to exercise the option. The contract will specify a fixed price the exercise or strike price at which the underlying asset can be bought or sold and the date by or on which the holder can exercise the option.
A call option gives the holder the right to buy an asset while I put option gives the holder the right to sell an asset.
What is an option premium?
The price paid by investors for an auction contract is known as the option premium.
The premium will compromise the options intrinsic value and its time value.
Determine when an option is in the money out of the money or at the money for call options
To recap for call options:
Out of the money implies that the price of an asset is below the exercise price
At the money implies that the price of an asset equals the exercise price
In the money liaise that the price of the asset is above the exercise price
Determine when an option is in the money out of the money or at the money for put options
For put options:
Out of the money implies that the price of an asset is above the exercise price
At the money implies that the price of the asset equals the exercise price
In the money implies that the price of the asset is below the exercise price
What are the five input variables for pricing options in the Black-Scholes model
- The strike price of an option.
- The current stock price.
- The time to expiration.
- The risk free rate.
- The volatility of the underlying asset.
The Black-Scholes approached to calculating the premium makes assumptions about the distribution of future possible outcomes. In particular the more volatile the share price the wider the range of possible outcomes which are likely to be experienced - hence volatility of the share price is a key input in assessing the option premium. An alternative and more general approach to pricing is the Binomial model which converge is on the Black-Scholes model in many cases.
Identify and explain the factors that determine the premium of an option
Cash price relative to exercise price
- Page 318
- since the option gives the buyer the rights to buy shares at 460p and the cash price of the share is 468.9 pence the option must be worth at least 8.9p per share
- This is called the intrinsic value of the option and is given by the share price less the exercise price
- The option is actually traded at 9.75p the remaining 9.75-8.90 = 0.85p is called the time value of the option.
- note that the August 4 60 puts has zero intrinsic value since it would not be profitable to exercise at the current share price
Time to expiry
- Options with longer terms to maturity have higher premium
- The further we go into the future the higher the profitability that the option will expire in the money. ‘Time value’ reflects this profitability.
Volatility of the share price
- if the share price is very volatile then there is a higher probability that the option will expire very deeply in the money
- The potential profit from buying a call or a put on a volatile share is greater than for a less volatile share
- so the time value of the option will be higher and the premium higher. In options market we measure volatility by the annual standard deviation of return.
Discount rate
- The impact of changes in the discount rate on option premiums must be discussed separately from calls and puts
- If interest rates rise the cost of borrowing money to buy an investment rises making it more attractive to buy call options instead of the actual stock itself. Hence the call option premium rises.
Delta and the other ‘Greeks’
Theta - is the sensitivity of option price with respect to the passing time
Vega - is the sensitivity of option price with respect to a change in the volatility of the underlying asset
Rho- is the sensitivity of option price with respect to a change of interest rates
Determine the maximum profit maximum loss and the motivation behind a long and short strand option strategy.
A long put and call position with the same expiry date but different strike price is known as a long straddle
A short straddle can be formed by selling a coal and a put with the same expiry and strike price. The profits profile will look like the mirrored image of the long straddle shown in page 323.
Summary of long straddle
- Maximum profit is potentially unlimited
- Maximum loss is premiums paid
- Motivation for the trade: volatile markets more so than expected under the long straddle. Since the share price has to move further before the option strategies in the money it is cheaper than a long straddle.
What is the stock index options?
As well as being able to trade options on individual stocks investors in many countries can trade options on a stock index. One stock index option which is traded on ICE futures Europe is the FTSE 100 stock index option. Because it would be impractical to deliver or take delivery of the 100 shares which make up the FTSE 100 this contract is cash settled.
The amount transferred between the buyer and writer of the contract when it is exercised is based upon the level of the index and the strike price which is also expressed as the index itself . Each point on the index is valued at £10.
Determine the maximum profit maximum loss and the motivation behind a short straddle option strategy
A short straddle can be formed and is the opposite of the long straddle
- Page 323
- The profit/loss schedule for an investor who holds a short straddle is the mirror image of that showing from the long straddle and figure 13.7 it is a table shaped rather than a bucket
- The breaking even is the same as that of the long straddle
- The motivation for the trade is the opposite of that for the long straddle i.e. a stable market is expected
-
