Chapter 2 - An introduction to forwards and options Flashcards
Define a forward contract
A forward contract is defined as setting terms today and the terms invovle buying or selling of some asset at a later point in time.
Forward contracts are obligations to both parties, and involve requirements in regards to shipping and logistics as well.
elaborate on premium in regards to forwards
No premium. They are usually traded OTC and only have commisions and the bid-ask spread to consider
Recall OTC
Skipping exchanges by negotiating a direct deal. The clearinghouse still plays its part.
Elaborate on the multiplier
Basically how many “shares” or issues of the underlying that the specific contract has to offer.
The rule is the same as for options. You have to buy in number of contracts, and if the contract specify a multiplier of 1000, you have to purchase the contract with 1000 of the underlying.
Futures and forwards can have arbitrary multipliers. However, once sat, they are fixed.
The prices of futures contracts are quoted per…?
Unit of underlying asset. NOT by contract. This is the same as for options.
elaborate on futures premium
Futures do not have an upfront premium. Instead, they require posting margin collateral.
Options are quoted as the contract price (premium) per share of the contract. how is it for futures?
For futures, since there is no premium, the quote is the future value we obligate to pay for one unit of the underlying. Therefore, this unit is the same unit as the underlying. If the underlying is S&P shares, the quote is the price we obligate to pay for one such share.
what is funded and unfunded
refer to positions.
We say a position is funded if it has been payed in full.
Likewise, the position is unfunded if it has not been payed in full.
Deferred payment, like with futures, is said to be unfunded positions, until they become funded at the expiration date.
difference between payoff and proft
payoff apparently refer to the value of a position, and is not related to differnetials in the investment.
Profit takes differnetial into account.
what is an equivalent investment to an outright long position in an index
Investing in a zero coupon bond with a face value equal to the price of the futures contract. This price is fixed (if we purchase it) so it is easy to find a bond with same face value.
The bond will trade at a discount. The differnece will be equal to the risk free interest rate, which is the time value of money.
At expiration, we have earned funds so that we are able to complete the contract, AND we have accounted for the time value of money. If we had purchased the index outright, we would have automatically accounted for the time value of money, as it would yield returns.
The argument is essentially arbitrage related.
how can we go from a payoff to profit diagram of a long position in a futures contract?
We can use a bond with FV=futures price to shift up and down vertically.
Recall that the profit and payoff diagram is basically the same, it is just that one subtract the original investment, and the other doesnt.
what is cash settlemetn
alternative procedure to the settlement. it is just a cash payment that carry the exact same value as the physical transfer would have. Then the parties can do what they want with the cash.
elaborate on the credit risk involved in futures
both parties have risk nvolved. Because of this, usually there is great emphasis placed on collateral.
OTC trades doesnt do this, and carry more risk.
elaborate on the third style of options
Bermudan. Exercise is possible only at specified periods.
