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CISI: Derivatives > Chapter 5: Principles of OTC Derivatives > Flashcards

Chapter 5: Principles of OTC Derivatives Flashcards

1
Q

What is a pip?

A

Smallest price increase in a currency, similar to a tick

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2
Q

What is the minimum period for a forward in FX?

A

Anything above T+2

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3
Q

What will happen to quoted spreads as a forwards contract that is further out?

A

They will widen, as this carries more risk for the dealer

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4
Q

What is the relationship between premium and change to spot?

A

Inversely
+ premium = -spot

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5
Q

How is the premium calculated?

A

Using the relevant STIRs of the two currencies

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6
Q

What is a cap?

A

Option product, protect the cost of a floating-rate borrowing cost

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7
Q

What is a floor?

A

Option that allows a buyer to demand a minimum rate of interest paid on a deposit

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8
Q

What is a collar?

A

Mix of a floor and a cap, allows a buyer to ensure interest is always received within a range

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9
Q

What is a credit derivative?

A

Derives its value from credit events relating to a third-party company
E.g. credit rating downgrade

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10
Q

What is a credit default swap?

A

Party pays periodic payments to another party
Receives agreed compensation if there is a credit event

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11
Q

What is considered a credit event? (6)

A

Default
Fall in price/value
Bankruptcy
Debt restructure
Merger/demerger
Gov actions

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12
Q

What are the three types of CDS?

A

Single-name or basic
Basket
Index

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13
Q

What is a basket CDS?

A

CDS based of a basket of securities, such as several airline debts
can be a range of criteria to receive payment

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14
Q

What is the most widely used probability of default?

A

Premium of an asset over a reference rate

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15
Q

What is a credit linked note (CLNs)?

A

Form of funded credit derivative
Allows issuer to transfer a credit risk to credit investors

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16
Q

What is a credit spread option?

A

Strike rate set on a spread
Pay-off based on whether the market spread at exercise date is different

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17
Q

What is a credit spread?

A

Difference between the yield on an asset vs an agreed benchmark (e.g. USTs)

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18
Q

How types of options can credit spreads options be?

A

American or European

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19
Q

What is a credit default option?

A

Option to buy protection or sell protection on a CDS.

20
Q

What style of option are credit default options?

A

European

21
Q

What is a collateralised debt obligation (CDO)?

A

Structured ABS
Value derived from a portfolio of fixed-income securities
Split into different tranches

22
Q

How is a CDO created?

A

A corporate entity is constructed to hold assets as collateral and sell cash flows to investors

23
Q

What does issuing CDOs allow originators to do?

A

Pass on the credit risk of the underlying assets
e.g. bank issues mortgages but passes on risk to investors

24
Q

What is a collateralised bond obligation (CBO)?

A

Creates an investment grade bond from a pool of junk bonds, diversification decreases risk

25
Q

What is a cliquet or ratchet option?

A

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

26
Q

What is a knock-in option?

A

Only come into existence when underlying crosses a barrier price

27
Q

What is a knock-out option?

A

Exist when agreed, no longer exists when underlying crosses a barrier price

28
Q

What are the different types of barrier option? (4)

A

Down and in, is a knock-in type of option that is activated when the asset’s price falls to, or below, the pre-determined level.
* Down and out, is a knock-out type of option that is cancelled when the asset’s price falls to, or below, the pre-determined level.
* Up and in, is a knock-in type of option that is activated when the asset’s price rises to, or above, the pre-determined level.
* Up and out, is a knock-out type of option that is cancelled when the asset’s price rises to, or above, the pre-determined level.

29
Q

What is delta?

A

The ratio comparing the change in the price of asset to option value

30
Q

What is the range of Delta?

A

0-1

31
Q

What would an option that is ITM have a delta of?

A

1

32
Q

How does delta differ between calls and puts?

A

Calls: +
Puts: -

33
Q

What is Gamma?

A

Rate of change for delta with respect to asset price
First derivative of delta

34
Q

What is Gamma used to measure?

A

How deep ITM or OTM an option is
Gamma smaller for near-the-money
Gamma larger for deep ITM/OTM

35
Q

What is Vega

A

Change in options value for a 1% change in implied volatility

36
Q

What does vega differ between calls and puts?

A

It doesn’t - it is absolute

37
Q

When is Vega greatest?

A

ATM and longer options

38
Q

What is Theta?

A

The rate of decline in the value of an option due to the passage of time, AKA time decay

39
Q

What is Rho?

A

Estimate of the sensitivity of an option to changes in interest rates

40
Q

What is a major drawback to the Black-Scholes model?

A

Assumes that volatility is a constant

41
Q

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

A

Volatility model that says asset price and volatility are correlated
Used in interest rate derivative markets

42
Q

What are volatility smiles?

A

Implied volatility patters that arise in pricing options

43
Q

What is the market standard for OTC options premium settlement?

A

Next day or T+2 at the latest

44
Q

What may a broker do as a purchased option becomes closer to ITM?

A

Ask for collateral payments from client in case of exercise.

45
Q

What do FLEX options offer that OTC do not?

A

Limited credit/counterparty risk as they are centrally cleared

46
Q

What is the difference between callable and puttable bond?

A

Callable - issuer can buy back
Puttable - can be redeemed early

47
Q

5.2.4 Index-Linked Notes

A

CISI: Derivatives (6 decks)

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