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FCA Derivatives > Chapter 4: Principles of Exchange-Traded Derivatives > Flashcards

Chapter 4: Principles of Exchange-Traded Derivatives Flashcards

1
Q

What is the price of a future derived from?

A

Future price = cost of carry + current underlying market price

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2
Q

What is the price of a future derived from for equity futures?

A

Future price = net financing costs + current underlying market price

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3
Q

What does fair value represent in futures pricing?

A

Fair value indicated when a future is priced correctly based on net cost of carry and the current underlying price. This is the arbitrage free value.

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4
Q

How do you calculate net finance costs for equity index futures?

A

Net finance costs = interest - dividends

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5
Q

How does the International Accounting Standard Boards define fair value of a future? What does the IASB require from all market participants?

A

The value at which the future can be traded between 2 market participants at any given time. In other words, this is the market price. The IASB requires daily MTM evaluation of all futures.

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6
Q

What is a contango market? Where are contango markets common?

A

Contango markets are where the future price is greater than the current market price occur. These occur when cost of carry is high

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7
Q

What is a backwardation market? Where a backwardation markets common?

A

A backwardation market is a market where the current market price is greater than the future market price. Backwardation is prominent in the bond market as long term interest rates are higher than STIRs. Can also occur in commodities markets when a steep premium is offered for instant delivery.

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8
Q

What is convergence in futures pricing?

A

Convergence occurs when there is a cost of carry and therefore the current market price of an asset and the futures price differ. Convergence is the process over the futures lifetime where the 2 prices converge on eachother.

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9
Q

What is basis a measure of in the futures markets? How do you calculate basis?

A

Basis measures the difference between a cash price and future price. Basis = cash price - future price.

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10
Q

Why is it unlikely that a future price will always remain at fair value?

A

different market participants have varying costs and therefore the futures price cannot factor in every individuals relative cost of carry.

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11
Q

What affects the basis?

A

Changes in supply and demand
Changes to the cost of carry (IR movements, insurance cost changes and dividend yield movements)
Different cost bases for market participants
Changes in time remains to expiry (convergence).

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12
Q

What does it mean when basis moves in a positive or negative direction?

A

Basis = Cash price - futures price therefore when basis increase cash price strengthens and the inverse is true when basis moves in a. negative direction.

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13
Q

How does basis act in contango and backwardation markets?

A

Backwardation - basis weakens
Contango - basis strengthens

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14
Q

What should a trade do when basis is expected to strengthen in order to profit?

A

Buy the spread.

When basis is expected to increase, the cash price is expected to rise relative to futures price. Therefore to make profit, if a trade buyers the underlying and sells the future, gains from the underlying will not be netted out by owning the future.

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15
Q

What is the spread in finance?

A

The difference between 2 prices.

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16
Q

What is basis risk?

A

The risk that a futures price will move differently from the underlying security.

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17
Q

How would you remove all basis risk?

A

Hold a future until its expiration.

18
Q

What is a cash and carry arbitrage trade and why is it called a cash and carry arbitrage trade?

A

When a future trades above its fair value. Buying underlying asset and selling future will lead to a profit. this is called a cash and carry as the underlying asset is carried to satisfy the sale of a future.

19
Q

What is the arbitrage channel and why does it exist?

A

The arbitrage channel is a leeway above and below the fair value of a future created due to commissions and brokers fees. This explains the strong correlation between future and cash prices.

20
Q

How is the premium of an option priced?

A

Premium (PM) = IV - TV where IV =>0

21
Q

How is an option described when it is in profit, at break-even and at a loss?

A

In-The-Money (ITM)
At-The-Money (ATM)
Out-of-The-Money (OTM)

22
Q

What are the main contributors towards TV?

A

Time to expiry
Current profitability
Volatility

23
Q

What are the 3 types of volatility that should be considered in options premium pricing?

A

Historic or realised volatility - how volatile an asset has previously been
Future volatility - how volatile an asset will be (cannot predict)
Implied volatility - markets form a collective view on what future volatility will likely look like.

24
Q

What is the difference between implied volatility and future volatility?

A

Implied volatility is the markets view on what future volatility will look like, whereas future volatility is what volatility will actually be.

25
Q

What is the Black-Scholes model?

A

A formulas using:
volatility
strike price
underlying price
time to expiry
cost of carry to calculate a premium on an option

Through using the formula backwards, you can use the premium to calculate the implied volatility

26
Q

What is a limit of the Black Scholes model? What models can be used instead of the Black Scholes model in this instance?

A

Black Scholes model can only be used for European style options. For American style options, the binomial pricing model and finite difference model can be used

27
Q

What does SABR stand for? How is the SABR used to price premiums of options?

A

Stochastic Alpha Beta Rho
Uses different levels of implied volatility to price options on the same underlying asset. It is based on the volatility smile.

28
Q

What is the volatility smile and what does it imply?

A

The volatility smile implies that volatility is greatest for options deep ITM / OTM with the strike price furthest away from the underlying assets markets price.

29
Q

How do interest rates, dividends and coupons affect options premiums?

A

if interest rates rises, seller of an option will increase premiums as they are disadvantages by holding the underlying.

If interest rates fall, seller of options can afford to drop the prices.

30
Q

What is the put/call parity theorem?

A

Call - put = Underlying - strike

31
Q

What is the put/call parity theorem when the underlying is not a forward or future?

A

As cost of carry will not factored into the price for futures and forwards and therefore needs to be included in the formulas:

call - put = strike - underlying/(1+IR)^years

32
Q

Which option style is the put call parity theorem more applicable to?

A

European style options rather than American options.

33
Q

What should a trader buy and sell according the put-call parity theorem if:

calls are relatively cheap?
puts are relatively cheap?

A

Reversal: If calls are cheap, buy the call sell the put and sell the future.

Conversion: If put is cheap, buy the put, sell the call and buy the future.

Both creates synthetic positions that will close out with a guaranteed profit at close when buying and selling future.

34
Q

What is the delta in relation to options?

A

Delta = change in premium / change of price in underlying

Delta shows relation between change of a premium and change of at the underlying

35
Q

What value is delta usually?

A

Delta is usually between 0 and 1.
If an option is:
OTM = 0
ITM = 1
ATM = 0.5

Delta is negative for puts
Delta is positive for calls

36
Q

What is the delta of a short future?

A

-1

37
Q

How is cumulative delta calculated? What can it be used to do?

A

Through adding individual deltas across a portfolio together.

Delta can be used to hedge a portfolio and allows protection against price risk.

38
Q

What is gamma?

A

Gamma measures how quickly an options price will change based on the change of the underlying price.

It is greatest near and ATM

39
Q

What is vega?

A

Vega is the measure of how a 1% change in implied volatility will change an options price. Can be particularly useful in BSM model

40
Q

What is theta?

A

Theta is a measure of the rate of decline as time continues. Measures how much an options price changes as 1 day passes. Long calls and short calls respectively always have a negative and positive theta.

Highest for calls ATM. Theta is not constant and is more volatility as an option approaches expiry.

41
Q

What is rho?

A

Rho is the measure of an options value assuming there is a 1% change in the interest rates. This associated with the cost of carry passed onto to buyer.

42
Q

What is a futures style premium?

A

A premium paid during the life of the contract rather than at the onset.

FCA Derivatives (9 decks)

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