Chapter 5 – Derivatives

Question 1

What is a future?

What do both parties want when a future is agreed?

For futures, do either party pay an upfront payment?

Answer 1

A type of derivative

A legally binding contract to either buy or sell an asset at a specified future date, at a specified future price.

It is tradable so the owner can sell this future (and the right that comes with it) to others

Futures are exchange traded (bought on a recognised exchange) . Forwards are the same except they are Over-The-Counter

What do both parties want when a future is agreed?

• The buyer = wants the underlying to increase in price. They take a ‘long position’
• The seller = wants the underlying to fall. They take a ‘short position’

For futures, do either party pay an upfront payment?

It is important to note that there is no up-front payment made by either party for futures contracts, payment is only made on the delivery date. For this reason, futures trade on margin

Question 2

Derivatives can be:

Exchange-traded

Over-the-counter (OTC)

Answer 2

Exchange traded: bought or sold on a recognised exchange such as Ice Futures Europe, and have standard terms and conditions

Over the counter: bespoke contracts tailored to meet a customer’s specific needs and are sold directly to them by banks and other financial institutions.

So, a legally binding contract is signed between two parties, either directly or via an exchange.

Question 3

What is the underlying, in relation to derivatives?

Answer 3

It is the asset that the derivative is based on

The underlying could be a commodity or shares etc

Question 4

What is a forward?

Answer 4

A legally binding contract to either buy or sell an asset at a specified future date, at a specified future price.

They are same as futures except they are traded over-the-counter (OTC) whereas futures are exchange traded

Question 5

Futures and forwards are the same except forwards are traded OTC and futures are exchange traded

What is the benefit of forwards being OTC?

Answer 5

Benefits: get exactly what you want (bespoke)

Negatives: Having to pay a little bit more, and experiencing less liquidity than you would for an exchange-traded contract

Question 6

What are options?

How are they traded?

What are call options & what are put options?

Do buyers of options pay an upfront payment?

Whilst the option is option is still open, it can either be ‘in the money’ & ‘out of the money’

Answer 6

Type of derivative

A legally binding contract that gives the right, but not obligation, to either buy or sell an asset at a set price on or before a specified date in the future

Can be exchange traded or OTC

Options can either be a call option or a put option:

A call option gives the buyer of the option the right to buy the underlying asset.

A put option gives the buyer of the option the right to sell the underlying asset.

The option Seller must do what the buyer wants. The buyer chooses what to do, whether to exercise the option, sell it or not exercise (and let expire worthless)

Unlike futures, the option buyer WILL pay an upfront premium. This is the most that an option holder can lose (unlike futures where losses can be potentially unlimited).

An option that is ‘in the money’ & ‘out of the money’?

In the money = the underlying is more valuable than the strike price (option price) . If they exercise the option theyll make money.

Out of the money = the underlying is less valuable than the strike price. The option holder will not exercise the option in this case.

Question 7

The type of option you hold will determine when you can exercise your option.

European-style options can only be exercised at expiry i.e. on a particular date in the future.

American-style options can be exercised at any time up to expiry. Rather confusingly, most UK options are American!

Answer 7

E for european = exercise on expiry only

A for American = exercise anytime

Question 8

What is the strike price?

Answer 8

The strike price (aka the exercise price) is the price that has been agreed in advance at which the asset will be traded. So, it’s the agreed purchase price for a call option, or sale price for a put option.

In reality, most options will usually be exercised if they are ‘in-the-money’ or ITM. This happens when:

For a call option; the underlying market price is greater than the strike price

For a put option; the underlying market price is less than the strike price
In these cases, the options are said to have intrinsic value as the owner could exercise the option and get immediate profit. Others will want to buy this right if its in the money.

Question 9

A holder of an option has 3 options

Exercise it at strike price
Let it expire worthless
sell it (Selling the option is the holder trading it on the exchange rather than exercising it or letting it lapse.)

Question 10

What is time value in relation to options?

Answer 10

The longer the period of the option the higher chance it will end up ‘in the money’

Time value is an additional way people value options, along with its intrinisic value. If a call option is already in the money, but there is a chance the underlying increases further in price, the time value increases, which increases the options value

THEREFORE, THE NEARER AN OPTION GETS TO ITS EXPIREY THE CLOSER IT WILL TRADE TO ITS INTINISIC VALUE (AS TIME VALUE DECREASES)

ON EXPIRY DATE, THERE WILL BE NO TIME VALUE, ONLY INTRINIC VALUE

Question 11

An options value/price is made up of 2 elements:

Time value = Time to expiry, volatility

Intrinsic value = strike price, current underlying price

Answer 11

As we have already seen, the intrinsic value is dependent on whether the option is in or out of the money.

The intrinsic value depends on where the current price is in relation to the strike price.

The time value is dependent not only on time but how volatile the underlying is. The greater the volatility, the more likely the option will end up in the money and the higher the premium.

Question 12

5.4.3: What are Option greeks?

The main greeks that you need to know in the J12 exam are: delta, gamma, vega and theta.

T for Theta & Time to expiry

V for Vega & Volatility

READ IN MORE DETAIL

Answer 12

Delta =
measures how the option price changes as the price of the underlying changes. Delta ranges from a value of 0 to +1 for calls and 0 to -1 for puts.

Very far ‘in the money’ call option = +1

Very far ‘in the money’ put option = -1

At the money = +/- 0.5

Out of the money = 0

Gamma =
The rate of change of delta is measured by gamma

Vega =
measures how the option price changes for a 1% change in implied volatility. It is always positive when buying options (either puts or calls) as the greater the volatility, the more likely the option will be in the money and the higher the premium.

V for Vega & Volatility

theta =

This measures the change in an option’s price due to the passage of time. It is always negative when buying options (either puts or calls) as every day we get closer to expiry, we have less time.
Time value erodes to zero as we approach the expiry date.

T for Theta & Time to expiry

Question 13

5.5.1: Traditional warrants

There are 2 types of warrants: traditional warrants and covered warrants

Are warrants tradable?
Tell me the difference

WARRENT FORMULAS - It’s important to get these right as there are frequent questions on them in the J12 exam.

Answer 13

5.5.1: Traditional warrants

Similar to call options but relate solely to shares and they are dilutive/ have longer expiry dates

They give the investor the right to buy the underlying shares in a company at a set price on a pre determined date or within a range of dates

Warrants are tradable and can be bought and sold on the London Stock Exchange.

To decide whether to exercise the warrent or not, there are 2 forumulas to learn

5.5.2: Covered warrants

Covered warrants are options that are issued by financial institutions like investment banks. They are listed and trade on the London Stock Exchange and are always cash settled i.e. no physical delivery takes place.

They are available on a wide range of underlying assets such as equities, equity indices, commodities and currency exchange rates.

They are available as put or call options. The term ‘covered’ is used because they must own the underlying assets / future to ‘cover’ or hedge their position.

Don’t confuse with callable bonds!

Question 14

Someone has a warrant and has a call option (where the underlying is on company shares)

Which one is dilutive?
Which one generally has longer expiry dates

Answer 14

When warrants are exercised, new shares are issued, unlike a call option where existing shares are used.

This means that warrants are dilutive; they dilute the value of a company’s shares when exercised.

Warrants have much longer expiry dates (usually measured in years rather than months).

Question 15

What is the parity of a warrent?

Answer 15

For both covered and traditional warrants, the conversion or cover ratio tells the investor how many covered warrants are needed to buy one share. This is also known as ‘parity’ for covered warrants.

For covered warrants:
Equities usually have a parity of 1 or 10
Indices usually have a parity of 100 or 1,000

Question 16

Covered warrant = Issued by investment bank and it can be for a verity of things

Traditional warrant = Issued by single company

Question 17

5.6: What is a Contracts for Difference

Answer 17

A contract for difference or CFD is an agreement where two parties exchange the difference between the opening and closing prices of an underlying asset.

Effectively investors are speculating on the direction of the price of an asset. The main features include:

CFDs trade on margin which means that you only need put up a small fraction of the price of the shares to trade, usually 10-25%. Hence CFDs are geared investments meaning your gains / losses will be magnified.

no set expiry date and no physical exchange of the asset, rather the contract is cash settled when the contract is closed out.

Can be used for equities/ bonds/ commodities etc

If you are in a long position with a CFD, then you will benefit if the price rises; if you are in a short position with the CFD, then you will benefit if the price falls.

Question 18

5.6.1: Margin

There are 2 types of margin that will be collected: initial margin and variation margin.

Answer 18

initial margin = Amount that needs to be deposited at the outset of the trade by the buyer and seller. Act as collateral

variation margin = At close of market, Any loss will be taken from the margin account. Any gain will be added to the margin account. if a loss occurs and is higher than the initial margin, they are required to Top up margin account. If they cannot, their position will be closed and losses realised

Question 19

Contracts for Difference CFDs

CGT is payable

No stamp duty/SDRT

Losses/Gains are magnified

Owner receives dividends (known as a manufactured dividends) but they have no right to vote in AGMs

Question 20

5.6.3: What is Spread betting

WHAT IS THE MAJOR DIFFERENCE OF SPREAD BETTING TO CFD TRADING?

Answer 20

Spread betting is very similar to CFD trading. It is available on a wide range of financial indices, equities and commodities, as well as non-financial products too.

Brokers quote the price for the underlying and you either make an ‘up bet’ if you believe the price will go up or a ‘down bet’ if you believe the price will fall. You can take your profit or cut your loss by closing out your bet at any time.

As with CFDs, spread betting trades on margin, allowing for leverage to be used.

No Stamp Duty Reserve Tax

MAJOR DIFFERENCE TO CFD TRADING:
One major difference is that there is no CGT (unlike CFDs)

Question 21

5.6.4: What is Binary betting (known as binary options)?

Is it still available in UK?

Answer 21

Where a bet can pay out either zero or a fixed amount depending on where an underlying asset is.

Now banned by the Financial Conduct Authority to retail customers

For example, if the FTSE 100 index closes above 7500, the bet pays out an amount of X, but if it closes below 7500 it pays out nothing.

Question 22

5.7: Credit Default Swaps
This is our last section in our chapter on derivatives.

It is different from the subjects we have covered so far, in that a default credit swap acts as a form of insurance.

They enable an investor or organisation to buy protection against default by a company or country.

The protection buyer pays a regular premium, known as the credit spread, to the protection seller.
In return, the protection seller will compensate the protection buyer if a credit event relating to a third-party company occurs.
A credit event is typically defined as:

A default
Bankruptcy
Significant fall in the value of an asset
Debt restructuring
If a credit event occurs, then the swap terminates, and the buyer is compensated by the seller.

The more risky the third party, the higher the credit spread.

Question 23

Futures

Futures are an agreement to buy / sell a set amount of an underlying asset at a set price on a set date in the futures.
Futures are obligations.
They are traded on an exchange.
They are liquid, cheap and simple to trade.
The buyer takes a long position and will benefit if the market rises.
The seller takes a short position and will benefit if the market falls.
Gains and losses can be unlimited.
Futures can be for physical delivery or cash settled.
Options

Options give holders the right but not the obligation to buy or sell an underlying asset on or before a set date for a set price.
Calls are the right to buy.
Puts are the right to sell.
Option holders have the right, option sellers have the obligation.
They can be exchange traded or OTC.
For the option buyer, losses are limited to the premium paid.
The premium depends upon the intrinsic value and the time value.
Delta measures the sensitivity of an option’s premium to changes in the underlying price; Gamma measures how the option’s premium changes as the delta changes; Vega measures how the options’ premium changes as implied volatility changes and Theta measures how the options’ premium changes with respect to time.
Warrants

Traditional warrants are call options issued by a company alongside a share or bond issue.
They can be detached and trade separately.
They have longer maturities than regular call options.
New shares are issued by the company when exercised, so they are dilutive.
The conversion ratio describes how many warrants are needed to buy one share.
The gearing ratio shows how much exposure we get through buying warrants rather than the shares.
The conversion premium / discount tells us whether it is cheaper to buy the shares through the warrant or directly.
Covered warrants are issued by financial institutions.
They can be puts or calls, and trade on the LSE.
CFDs

CFDs are cash settled contracts that settle on the difference between the opening and closing price of an underlying asset.
They trade on margin of 10-25%, so are leveraged instruments.
A long position will profit if the market rises; a short position will profit if the market falls.
A long position will receive dividends but not the right to vote.
Initial margin and variation margin will be collected.
There is no SDRT to pay, but gains are chargeable to CGT and losses can be offset.
Spread betting is similar to CFDs. You place an up bet if you believe the market will rise and a down bet if you believe the market will fall.
There is no CGT liability on any gains with spreadbetting.
Binary bets pay out if an event occurs, and nothing if it does not. They are banned by the FCA for retail investors.
CDSs

CDSs enable market participants to hedge their credit risk.
The protection buyer pays a spread and will receive a compensation payment from the protection seller if a credit event relating to third party occurs.
If a credit event occurs, the swap terminates.
A credit event can be a default, bankruptcy, significant fall in asset value or a debt restructuring.

Question 24

A warrant has an exercise price of 175p and costs 55p. If the underlying share price is 250p, what is the warrant’s conversion premium or discount?

8% premium.

8% discount.

30% premium.

30% discount.

Answer 24

8% discount.

The premium or discount is: (((warrant price + exercise price) ÷ share price) -1) x 100, so (((175+55) ÷ 250)-1) x 100 = ((230 ÷ 250)-1) x 100 = -8%

This is negative, so it is trading at a discount. It would be cheaper to buy the warrant and exercise it to buy the shares than it would be to buy the shares directly.

Question 25

A key difference between traditional warrants and call options is:

traditional warrants are only exchange traded and call options are only traded OTC.

traditional warrants have shorter expiry dates than call options.

traditional warrants are dilutive whereas call options are not.

traditional warrants can be put as well as call options.

Answer 25

traditional warrants are dilutive whereas call options are not.

New shares are issued when warrants are exercised, which makes them dilutive.

Both traditional warrants and call options can be traded OTC or on an exchange, warrants generally have longer expiry dates than call options, and traditional warrants can only be call options.

It is covered warrants that can be put options as well as call options.

Question 26

A future is best described as:

a bespoke agreement to buy or sell an underlying asset at a set price on a set date in the future.

an exchange-traded agreement to buy or sell an underlying asset at a set price on a set date in the future.

the right to sell an underlying asset at a set price on a set date in the future.

the right to buy an underlying asset at a set price on a set date in the future.

Answer 26

an exchange-traded agreement to buy or sell an underlying asset at a set price on a set date in the future.

Futures are an exchange-traded obligation.

Options give holders the right, but not the obligation.

Question 27

A warrant is trading at a price of 35p. It has a strike price of 210p and the underlying shares are currently trading at a price of 140p. What is the gearing ratio?

1.5 x

4 x

6 x

8 x

Answer 27

4 x

Gearing ratio = share price ÷ warrant price = 140 ÷ 35 = 4 x.

Ie 4 warrants to 1 share

Question 28

A trader buys 10,000 CFDs at a price of £5 per share. If the price rises to £8 per share, what is the profit / loss?

£30,000 profit.

£30,000 loss.

£5,000 profit.

£5,000 loss.

Answer 28

£30,000 profit.

Buying 10,000 CFDs is the same as buying 10,000 shares. The price has risen by £3 so the profit is 10,000 x £3 = £30,000.

Question 29

Alix has £10,000 to buy CFDs on XYZ plc. She invests at the current price of £3.50 and her broker asks her to put up initial margin of 10%. What is her profit or loss if the share price falls to £3.25?

£714 profit.

£714 loss.

£7,143 profit.

£7,143 loss

Answer 29

£7,143 loss

Alix will use the £10,000 as margin. Her exposure to the shares will therefore be £10,000 ÷ 0.10 = £100,000.

With £100,000 she could buy £100,000 ÷ £3.50 = 28,571 shares.

The share price falls 25p and so she has made a loss of 28,571 x 0.25 = £7,143.

Question 30

Jess buys 100 covered put warrants which have a parity of 10. If the strike price is 220p and the share price is 190p, what is the total payout?

3p

30p

£3.00

£30.00

Answer 30

£3.00

The payout ratio for a put = (strike price – stock price) ÷ parity = (220-190) ÷ 10 = 3p per warrant.

Jess has bought 100 warrants so her total payout will be 3p x 100 = £3.

Question 31

An American style option can…

only be exercised on the expiry date and can only be traded in the US.

be exercised at any time and can only be traded in the US.

only be exercised on the expiry date and can be traded anywhere.

be exercised at any time and can be traded anywhere.

Answer 31

be exercised at any time and can be traded anywhere.

American style options can be traded at any time before expiry and can be traded anywhere, not just in the US. In the UK this is main type of option used

Question 32

Delta for a warrant or option is the sensitivity of an option’s price to:

a change in the underlying price.

a change in implied volatility.

a change in time.

a change in interest rates.

Answer 32

a change in the underlying price.

B is Vega, C is Theta and D is Rho (this is a measure the sensitivity of the option price to changes in interest rates. It’s not something we’ve mentioned, but an incorrect option here anyway).

Question 33

warrant or options

a change in the underlying price. = Delta

a change in implied volatility. = Vega

a change in time. = Theta

a change in interest rates. = Rho

Question 34

The following options have been quoted by an options’ trader.

Option Type Strike

X Call 150p

Y Call 175p

Z Put 200p

If the current share price is 150p, it can be said that:

Option X is at the money, Option Y is in the money and Option Z is out of the money.

Option X is at the money, Option Y is in the money and Option Z is in the money.

Option X is at the money, Option Y is out of the money and Option Z is in the money.

Option X is at the money, Option Y is out of the money and Option Z is out of the money.

Answer 34

Option X is at the money, Option Y is out of the money and Option Z is in the money.

Option X – the strike price equals the stock price, so this option is at the money.

Option Y – the strike price is higher than the share price so, for a call this option is out of the money.

Option Z – the strike price is higher than the share price, so for a put this must be in the money.