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
What is a knock-out option?
Exist when agreed, no longer exists when underlying crosses a barrier price
What are the different types of barrier option? (4)
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.
What is delta?
The ratio comparing the change in the price of asset to option value
What is the range of Delta?
0-1
What would an option that is ITM have a delta of?
1
How does delta differ between calls and puts?
Calls: +
Puts: -
What is Gamma?
Rate of change for delta with respect to asset price
First derivative of delta
What is Gamma used to measure?
How deep ITM or OTM an option is
Gamma smaller for near-the-money
Gamma larger for deep ITM/OTM
What is Vega
Change in options value for a 1% change in implied volatility
What does vega differ between calls and puts?
It doesn’t - it is absolute
When is Vega greatest?
ATM and longer options
What is Theta?
The rate of decline in the value of an option due to the passage of time, AKA time decay
What is Rho?
Estimate of the sensitivity of an option to changes in interest rates
What is a major drawback to the Black-Scholes model?
Assumes that volatility is a constant
What is the Stochastic Alpha, Beta, Rho (SABR) model?
Volatility model that says asset price and volatility are correlated
Used in interest rate derivative markets
What are volatility smiles?
Implied volatility patters that arise in pricing options
What is the market standard for OTC options premium settlement?
Next day or T+2 at the latest
What may a broker do as a purchased option becomes closer to ITM?
Ask for collateral payments from client in case of exercise.
What do FLEX options offer that OTC do not?
Limited credit/counterparty risk as they are centrally cleared
What is the difference between callable and puttable bond?
Callable - issuer can buy back
Puttable - can be redeemed early
What is an index linked note?
Instrument whose return is determined by a specific index
What is a capital protected product?
Where investor borrows money to buy assets (e.g. warrants)
Assets become security for the loan
How does ISDA help in default?
Close out all transactions covered by the master agreement, rather than individually - as they can be netted
What are termination events?
In ISDA
External circumstances outside control of parties that allow deals to be terminated
What are the 3 main issues covered by the ISDA master agreement?
Termination Events
Events of default
Netting
What are the two types of netting in a master agreement?
Payment netting, netting amounts due in same currency
Close-out netting, converting all amounts to single termination currency
What are the specific terms of each deal in an agreement called?
Confirmations
What is a key attribute of collateral?
That it is easy to liquidate in a default
What is the minimum transfer amount for collateral
Agreed between CPs for min amount to be transferred in case of market value changes
What do master confirmations allow transactions to do?
Be electronically matched
Where is collateral held?
Normally held in a third party account, not companies own account
Why is collateral held in a third-party account?
Prevent the depositing counterparties assets being used to meet any liabilities
What is MarkitSERV?
DTC Gateway for OTC derivatives trade processing
What is SwapClear?
LCH Group
Clearing house function to OTC derivatives markets
Not STP
What is the matching service that DTCC provides for OTC derivatives?
Deriv/SERV
What is Omgeo OASYS
Screen affirmation platform that allows traders and front office staff to affirm trades
What is Omgeo Central Trade Manager?
Platform for the central matching o cross-border and domestic transactions
What does the NSCC National Securities Clearing Corporation do?
Act as a central counterparty, provides trade guarantees, netting and risk management services
