Chapter 5: Principles of OTC Derivatives Flashcards
What is a pip?
Smallest price increase in a currency, similar to a tick
What is the minimum period for a forward in FX?
Anything above T+2
What will happen to quoted spreads as a forwards contract that is further out?
They will widen, as this carries more risk for the dealer
What is the relationship between premium and change to spot?
Inversely
+ premium = -spot
How is the premium calculated?
Using the relevant STIRs of the two currencies
What is a cap?
Option product, protect the cost of a floating-rate borrowing cost
What is a floor?
Option that allows a buyer to demand a minimum rate of interest paid on a deposit
What is a collar?
Mix of a floor and a cap, allows a buyer to ensure interest is always received within a range
What is a credit derivative?
Derives its value from credit events relating to a third-party company
E.g. credit rating downgrade
What is a credit default swap?
Party pays periodic payments to another party
Receives agreed compensation if there is a credit event
What is considered a credit event? (6)
Default
Fall in price/value
Bankruptcy
Debt restructure
Merger/demerger
Gov actions
What are the three types of CDS?
Single-name or basic
Basket
Index
What is a basket CDS?
CDS based of a basket of securities, such as several airline debts
can be a range of criteria to receive payment
What is the most widely used probability of default?
Premium of an asset over a reference rate
What is a credit linked note (CLNs)?
Form of funded credit derivative
Allows issuer to transfer a credit risk to credit investors
What is a credit spread option?
Strike rate set on a spread between yield on a particular asset and agreed benchmark
Pay-off based on whether the market spread at exercise date is different
What is a credit spread?
Difference between the yield on an asset vs an agreed benchmark (e.g. USTs)
Which types of options can credit spreads options be?
American or European
What is a credit default option?
Option to buy protection or sell protection on a CDS.
What style of option are credit default options?
European
What is a collateralised debt obligation (CDO)?
Structured ABS
Value derived from a portfolio of fixed-income securities
Split into different tranches
How is a CDO created?
A corporate entity is constructed to hold assets as collateral and sell cash flows to investors
What does issuing CDOs allow originators to do?
Pass on the credit risk of the underlying assets
e.g. bank issues mortgages but passes on risk to investors
What is a collateralised bond obligation (CBO)?
Creates an investment grade bond from a pool of junk bonds, diversification decreases risk
What is a cliquet or ratchet option?
Series of ATM options with periodic settlement
Strike price resets to price level at that time
Locks in the difference between old and new strike
What is a knock-in option?
Only come into existence when underlying crosses a barrier price