Chapter 2 and 3 Flashcards
Derivatives
Definition of a derivative contract.
It is a financial instrument whose value is dependent on or (derived from) the value of another underlying asset
State the uses of derivatives.
The specific use of a particular derivative will depend on the type of derivative it is, however, the general uses of derivatives are the following (see more on chapter 23):
- Risk management
- Control credit risk (CDS)
- Hedge market risk
- Speculation –> enhance returns
- Arbitrage
- Transition management - Switch asset allocations between different asset classes without disturbing underlying assets
Describe two distinct markets for derivatives?
- Exchange traded derivatives - standardized contracts that traded in a recognized exchange
- Over the counter derivatives
- Many financial derivatives are traded OTC by investment banks
- Swaps market and currency forward markets are two very important OTC markets
- Banks tailor wide variety of derivatives to suit needs of clients
- Less liquid and transparent than markets in exchange traded derivatives
- Possible credit risk (maybe mitigated by collateral and contract terms, e.g., as required by a central clearing party)
- Typically transacted under documentation maintained by the International Swaps and Derivatives Association (ISDA)
What is the main advantage and four disadvantages of OTC markets
Advantage:
- Provide tailor made derivatives that meet the client’s needs
Disadvantages:
- (They are less liquid)
- Credit risk, as counterparty may default
- Lack of quoted market prices (so less transparent)
- (require documentation that might be expensive and time consuming to set up)
- Expenses greater than for exchange-traded derivatives
- very difficult to close out positions
What is a future’s contract and outline process of trading future?
A standardized exchange-traded contract to trade a specified asset a specified certain future time at an agreed price.
Futures trading:
- a buyer and seller agree to deal the exchange traded derivative
- opposing contracts are created between each party and the clearing house of the exchange (who act as counterparty to both trades)
- each party deposits initial margin with the clearing house
- contract marked to market daily, which may result in variation margin being payable
- most positions in futures markets are closed out before delivery by taking an opposite position
Outline the role of the margin deposited by derivative brokers with the clearing house in the context of futures trading.
- Margin is collateral that each party to the contract must deposit with the clearing house - acts as a cushion against potential losses that parities may suffer from future adverse price movements
- When the contract is first struck, initial margin is deposited by broker with the clearing house.
- This is changed on a daily basis to ensure that clearing house’s exposure to credit risk is controlled
- Process of daily margin changes is known as marking to market
- Fall in value is topped up with additional payments of variation margin, to enable the clearing house to continue to give its guarantee.
- Increase in value of the contract may be withdrawn by the broker, also on a daily basis
What is another means by which the clearing house can protect itself against excessive credit risk?
- it can do so by means of price limits
- on any day, if the price of the futures contract moves up or down from the day opening price, by more than then price limit, then trading in that contract is halted.
- trading will continue the next day or later that day, after the traders have reflected on their position and to allow for variation margins to be collected
List the roles of the clearing house.
- Counterparty to all deals
- Guarantor of all deals
- Registrar of all deals
- Facilitator of marking to market process
- Collector and holder of margin payments
Explain what is meant by:
- Closing out a futures position
- open interest.
Closing out a position
- Most positions in futures markets are closed out before delivery by taking an opposite position
- For example, buyer of a contract can later close out his position by selling an equivalent contract. His net position is then nil.
- Only a relatively small proportion of contracts reach physical delivery.
Open interest
- Total number of long futures positions open at the exchange at any time.
Outlines the main differences between traditional futures and forward contracts
Future vs (unmargined) Forward
ET vs OTC
standardized vs tailored
Marketable vs no or poor marketable
Margins required vs no margins
Clearing house guarantee so no credit risk vs no clearing house so credit risk
Closed out vs difficult to close out
index futures available vs normally based on specific security
delivery price determined openly in market place vs delivery price negotiated privately
Let
- K be the delivery price of the forward
- S_T be the spot price of the asset at the maturity of the contract
state an expression for the payoff from:
(i) Long position in the forward
(ii) Short position in the forward
Long position:
S_T - K
Short position:
K - S_T
in each case, payoff is equal to the trader’s total gain or loss from the contract, as it costs nothing to enter into forward contract.
Explain what is meant by payoff diagram.
List factors that are ignored when drawing payoff diagrams.
Payoff diagram:
It is a diagram/plot that shows the overall profit/loss from a derivative as a function of the price underlying asset at expiry.
Factors ignored:
- Incomes from underlying asset
- tax and transactional costs payable
- time value of money/discounting impact on value of cashflows exchanged
- margin payments
Draw a payoff diagram for a long position in a forward contract.
See card 4
Outline the main differences between (traded) options and futures
Options vs futures
Holder has option, writer has obligation vs both parties obliged to trade
buyer pays premium to writer vs no money exchanged upfront
standardized strike price vs traders negotiate delivery price
writer deposits margin vs both parties deposit margin
List factors that are specified in a futures contract
- Form of quotation
- Underlying Asset
- Tick Size (minimum price movement for a contract, e.g., price agreed in $0.01 steps)
- Unit of trading (amount per index point)
- Right delivery time and date
- EDSP (Exchange Delivery settlement Price) - Final settlement price against which all outstanding cash settled futures are settled –> it is the price of the asset at T and not K
