Chapter 17: Futures and options

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.

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.

Question 4

Functions of the exchange

Answer 4

• 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

Question 5

Option

Answer 5

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

Question 6

Call option

Answer 6

Gives an investor the right to BUY a specified asset on a specified date in the future at a specified price.

Question 7

Put option

Answer 7

Gives an investor the right to SELL a specified asset on a specified date in the future at a specified price.

Question 8

American option

Answer 8

Can be exercised on any date before expiry

Question 9

European option

Answer 9

Can only be exercised at expiry

Question 10

Warrant

Answer 10

Option issued by a company.

The holder has the right to purchase shares at a specified price at specified times in the future.

Question 11

Long position in an asset

Answer 11

Means having a positive economic exposure to that asset.

Question 12

Long party in options contract

Answer 12

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

Question 13

Short position in an asset

Answer 13

Having a negative economic exposure to that asset.

Question 14

Short party in options contract

Answer 14

One who has contracted to deliver asset in the future.

Question 15

Clearing house

Answer 15

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, and acts as a party to every trade.

Question 16

Clearing house as a party to every trade

Answer 16

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 17

Credit risk

Answer 17

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

Question 18

Exercise price

Answer 18

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 19

Option premium

Answer 19

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