Chapter 2 & 3: Derivatives

Question 1

Derivative

Answer 1

A derivative is a financial instrument of which the value depends on the value of another underlying asset.

Question 2

Futures contract

Answer 2

A futures contract is a standardised, exchange-tradeable contract between two parties to trade a specified asset at a certain future date for a specified price.

Question 3

What is a financial future and give 4 examples.

Answer 3

A financial future is a standardised and exchange tradeable, legally binding agreement to trade a specified quantity of an underlying financial security/instrument on a specified date and at a specified price.

Examples include:

• bond futures
• currency futures
• short interest rate futures
• equity index futures

Question 4

What details does a futures contract typically specify?

Answer 4

• the unit of trading
• how the settlement rice is to be determined
• exact details of the underlying asset (i.e. type and quantity)
• delivery arrangements - date and place of delivery
• tick size

Question 5

What is a contract’s tick size?

Answer 5

The smallest price increment at which a security can trade on an exchange.

Question 6

What are the advantages of having the clearing house be the counterparty to all trades?

Answer 6

• The clearing house largely removes counterparty credit risk between the buyer and the seller.
• Each contract is indistinguishable from all the others (can close out positions more easily).

Question 7

Margin

Answer 7

The collateral each party to an exchange-traded derivative must deposit with the clearing house.
Acts as a cushion against potential losses, which the parties may suffer from future adverse price movements.

Question 8

Explain the margining process.

Answer 8

• When the transaction is first struck, initial margin is deposited with the clearing house.
• The balance in the margin account is changed on a daily basis to reflect gains and losses on the contract.
• If the balance falls below the maintenance margin the investor is required to deposit a variation margin.
• The variation margin ensures the clearing house’s exposure to counterparty risk is controlled.
• This system also makes it unlikley that an investor will default.

Question 9

Marking to market

Answer 9

• Process of daily margin requirement changes.
• Fall in value = topped up with additional payments to enable clearing house to continue giving its guarantee.

Question 10

Closing out prior to delivery

Answer 10

Closed out prior to delivery by taking opposite positions in the contract.
E.g. Buyers of a contract can later close out their positions by selling an equivalent contract.

Question 11

Open interest

Answer 11

The number of contracts outstanding at any one time.

Question 12

Price limits

Answer 12

Price limits ensure orderly markets. These protect the clearing house from excessive credit risk.
If price of contract moves up or down by more than the price limit, then the exchange will halt trading in that contract - allows variation margins to be collected.

Question 13

Role of the clearing house.

Answer 13

• counterparty to all trades
• guarantor of all deals (removing credit risk)
• registrar of deals
• holder of deposited margin
• facillitator of the marking to market process.

Question 14

Option

Answer 14

Gives an investor the right, but not the obligation, to buy/sell a specified asset on a specified future date at a set price (strike/exercise price)

Question 15

Advantages and disadvantages of OTC market compared to exchange trading.

Answer 15

Advantages:

• ability to tailor contracts to buyer’s precise requirements.

Disadvantages:

• non-standardised contracts reduce or eliminate marketability
• high dealing costs
• no quoted market values
• possibility of greater credit risk if not dealing with clearing house as guarantor. Many have CCP step in after negotiation though.

Question 16

Forward

Answer 16

A forward contract is a non-standardised and privately negotiated contract between two parties to trade a specific asset on set date in future at specified price.

May be cleared through CCP.

Question 17

Swaps

Answer 17

A swap is a contract between two parties under which they agree to exchange a series of payments according to a prearranged formula.
May be non-standardised.

Question 18

Two main types of risks associated with the use of swaps

Answer 18

• Market risk - risk that market conditions change so that the PV of net outgo in the agreement increases.
• Credit risk - risk that counterparty defaults on its payments (problem when positive value to you).
• Operational risk

Question 19

Guarateed equity products (GEPs)

Answer 19

GEPs offer a return that’s linked to an equity index, but with a minimum guaranteed return, often of zero.

Question 20

Structured notes

Answer 20

Structured notes are non-standard securities that are structured so as to meet the particular risk and return requirements of investors. Often contain embedded options and/provide payments that vary in some pre-specified way.

Question 21

Fundamental differences between forward contracts and future contracts

Answer 21

Futures contract

• exchange-traded
• standardised
• highly marketable
• delivery price determined openly by buyers and sellers in the marketplace.
• index futures readily available
• can be closed out prior to maturity and most are/

(Un-margined) Forward contract

• normally OTC
• tailored
• no or poor marketability
• delivery price negotiated privately between buyer and seller.
• contracts normally based on specific underlying security.
• difficult to close out and so usually settled at maturity.

Question 22

Payoffs from a forward contract (long and short position)

Answer 22

Long position:
ST-K
Short position
K-ST

Question 23

Difference between a traded call option and an OTC put option.

Answer 23

Traded call option

• right to buy
• traded on an exchange
• standardised
• can easily close out contract
• limited credit risk
• price quoted in market

OTC put option

• right to sell
• purchased from an investment bank
• can be ‘tailor-made’
• would need to negotiate terms to end the contract
• possibly counterparty risk if not centrally cleared
• valuation more subjective.

Question 24

Call option

Answer 24

Gives the holder the right to buy the underlying asset by a certain date and for a certain price.

Question 25

Put option

Answer 25

Gives the holder the right to sell the underlying asset by a certain date and for a certain price.

Question 27

Payoffs from call option (long and short position)

Answer 27

Long position:
= max(ST-K,0) - O
Short position:
= O - max(ST-K,0)

Question 28

Payoffs from put options (long and short position)

Answer 28

Long position:
max(K-ST,0) - O
Short position:
O - max(K-ST,0)