Chapter 4: Principles of Exchange-Traded Derivatives Flashcards

1
Q

How is the price of a future derived?

A

Price of asset plus the cost of holding the position, e.g. financing

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2
Q

What is the Cost of Carry and what makes it up (4)?

A

Cost of holding the physical asset until expiry date
finance costs
security costs
storage costs
insurance

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3
Q

What is the fair value of a future?

A

cash price + cost of carry
If a future cost more than this, it would make more sense to purchase and hold the physical asset

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4
Q

How is the fair value of an equity index future calculated?

A

As other costs are negligible, only the net finance costs need to be considered

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5
Q

What is the formula for net finance costs for equity index futures?

A

interest - present value of dividends

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6
Q

How does the IASB define the fair value of a future?

A

The price at which it can be traded between two market participants at any given time

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7
Q

What is a contago?

A

A market where the net cost of carry to hold the asset to delivery are higher than cash prices

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8
Q

What is backwardation?

A

Markets where there is a net benefit to holding the asset to delivery, where futures prices are lower then cash prices

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9
Q

When is backwardation most common?

A

When long term interest rates are higher than short term rates
In commodity markets when there is high demand for immediate delivery

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10
Q

What is convergence in futures?

A

Cost of carry tends to zero as expiry approaches
This means that cash and futures prices eventually meet

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11
Q

What is basis & its formula?

A

Measure of the difference between cash and futures prices
Basis = cash price - futures price

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12
Q

What is the basis in contango markets?

A

Contango is where futures > cash
Thus negative

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13
Q

What is the basis in backwardation markets?

A

Cash > futures
Thus positive

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14
Q

How does basis differ towards expiry in contango vs backwardation markets?

A

In contango markets (eg, equity index), the basis strengthens towards
expiry.
In backwardation markets (eg, STIR and bond futures), the basis weakens towards expiry.

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15
Q

What should a trader do if they expect the basis to strengthen?

A

Buy near dated instrument
Sell far dated instrument

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16
Q

What should a trader do if they expect the basis to weaken?

A

Sell near dated instrument
Buy far dated instrument

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17
Q

How does the gap differ between contango and backwardation markets for a strengthening basis?

A

Contago - narrowing gap
Backwardation - widening gap

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18
Q

What is basis risk?

A

That a future will move differently to that of its underlying asset

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19
Q

What is the only way to eliminate basis risk?

A

Hold future till expiry, futures and cash prices will converge

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20
Q

What is a cash and carry arbitrage?

A

Where a future is trading above its fair value
Buy the underlying asset, sell the future

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21
Q

What is a reverse cash and carry arbitrage?

A

Where a future is trading below fair value
Buy future, sell underlying asset

22
Q

What is the premium made up of? (2)

A

Intrinsic Value (IV) + Time Value (TV)

23
Q

What is intrinsic value?

A

The difference between the strike price and the assets underlying price

24
Q

What is the definition of in-the-money and out-the-money options?

A

ITM - Has IV
OTM - No IV

25
Q

What is the rate at which time value decays?

A

Exponential, increases as it approaches expiry

26
Q

At what strike price does TV increase?

A

ATM
More uncertainty about whether will expire ITM or OTM

27
Q

How would TV differ for
ITM
OTM
ATM

A

TV reflects uncertainty about likelihood of exercise
ITM - High probability of exercise, low TV
OTM - High probability of being abandoned, low TV
ATM - Highest uncertainty of exercise, high TV

28
Q

How does volatility impact TV?

A

Higher volatility, higher TV

29
Q

What are the three types of volatility to be considered?

A

Historic - past
Future - no one can predict
Implied - market view on future volatility based on options pricing

30
Q

How is the Implied Volatility figure derived?

A

Options pricing models
Black-Scholes

31
Q

What is limitation of Black-Scholes?

A

Only good for European options as cannot factor in early exercise

32
Q

What is the Stochastic Alpha, Beta, Rho (SABR) pricing model?

A

Uses different levels of implied volatility to price options on the same underlying asset
It uses the volatility smile, states that IV is greater for options that are deep ITM or OTM

33
Q

Why would options pricing change based on interest rates?

A

Options are basically financing
Buyer of a call gets to keep money in bank
Seller has to own the shares
So premium would go up for example

34
Q

What is Put/Call Parity?

A

Call and put premium must be fair in relation to one another, otherwise arbitrage opportunities present themselves

35
Q

What is the put/call parity formula?

A

C - P = S - K
C = call premium
P = put premium
S = spot price
K = strike price

36
Q

When does the put/call parity formula apply?

A

All options at expiry and futures at all times

37
Q

When does the put/call parity formula need to be adjusted?

A

To take account for the cost of carry for options when the underlying asset when it is not a future or a forward, and has a possible income flow that is paid before option expires
E.g. option on a share with upcoming dividend

38
Q

What is the adjusted put/call parity formula?

A

Strike changes
K/(1+r)^t

Where
r = the annual risk-free rate
t = time to expiry in years

39
Q

What is the delta of an option?

A

Sensitivity of the options price to changes in the price of underlying

40
Q

What are the two ways to arbitrage options mispricings? (on futures)

A

If call is cheap (create synthetic long)
Buy call, sell put, sell future - called reversal
If put is cheap (create synthetic short)
Buy put, sell call, buy future - called conversion

Basically create a synthetic version of whatever asset you want, and take the opposite side on the spot - locked in profit

41
Q

What is the calculation for delta?

A

change in premium / change in price of underlying

42
Q

What is the cumulative delta?

A

Delta of a combined portfolio
Gives sensitivity and direction bias of a portfolio

43
Q

What does delta hedging hedge against? And what risks remain?

A

Price risk
Time decay, volatility and basis still remain

44
Q

What is Vega?

A

Measure of how a 1% change in implied volatility affects an options price
Greatest for ATM options
Greatest for long dated

45
Q

What is Gamma?

A

Gamma is the rate of change of delta
Small when deep ITM or OTM

46
Q

What is Theta?

A

Theta is the measure of the rate of decline of an options value due to the passage of time
Long options have negative theta, it’s working against you
Short options have positive theta

47
Q

What is Rho?

A

Measures how much an options value will change from a 1% change in interest rates
least used - this relationship is fairly stable
has minimal impact to pricing
usually around 0.02 to 0.04

48
Q

How will an increase in rates impact calls and puts?

A

Call premium goes up
Put premium goes down

49
Q

How long does it usually take for premium to be paid?

A

T+1

50
Q

Which is the only position that requires margin for equity index and stock options? And what kind of margin?

A

Short requires initial margin

51
Q

Which is the only position that does not require margin for Bond and STIR options? And what kind of margin?

A

Long, does not require initial margin

52
Q
A