Chapter 5: Principles of OTC Derivatives Flashcards
What is larger the OTC market of the ETD market?
OTC markets are much larger.
What is the settlement cycle of most currencies in the FX market?
T+2
What can the longest maturity be on currency forwards?
Currencies can have maturities in 5/10 years time.
What will happen to the interest rate differential in FX markets over time?
IR differential between spot and forward rates will grow over time due to interest compounding.
What do banks use to calculate a necessary premium or discount in the forward FX market?
STIRs
What will happen to the spread in forwards market as time increases?
Spreads will continue to widen due to the interest rate differential.
What are caps in relation interest rates?
A cap is an option product. When floating rate exceeds the cap, the difference between the price and cap is paid. Can be used to protect reliance on floating rates.
What are floors in relation interest rates?
A floor is an option product. When floating rate falls beneath specified floor then the difference is paid.
What is a collar? What is a zero-cost or zero-premium collar?
When both a cap and a floor are used together. Provided a fixed worst rate level of interest. Collars can be constructed so that the 2 premiums net out to zero. This is know as a zero-cost ~(premium) collar.
What is a Credit Default Swap (CDS)? What credit events can a CDS be based on?
A CDS offers a party protection on a third party based on credit vents that could materialise. The following credit events materialise, the. purchasing party will receive an agreed compensation:
Default
Significant fall in asset price
Bankruptcy
Debt restructuring
Merger or demerger
Certain government actions
What are the 3 types of CDS?
Single name (or basic) - based on a specific asset in reference to the event
Basket - based on the default of a basket of securities. Could be first to default or a specified amount to default.
Index - based on an index movement, likely if the basket moves below a certain amount.
How are CDSs commonly priced?
Using the reduced-form pricing approach which models the probability of default (PD), which is the probability a credit event will occur, into the options pricing.
What is the default swap or asset swap spread? What is an advantage over model-driven forecasts?
Calculation of probability of default in reference to the premium being paid to investors over a reference rate such as SONIA.
This method is observable.
What is a Credit Linked Note (CLN)? What can the coupon or pice of a CLN be linked to?
Structured as a security with an embedded CDS. Issuer is not obligated to pay the debt if a credit event occurs.
Coupon and price can be determined by a reference asset. Offers investors protection and a higher yield.
What is a credit spread option?
A credit spread is the difference between a yield on an asset and agreed benchmark rate.
Pay off is determined on these options based on whether the spot is over or under the reference spread.
What is credit default option?
An option to buy protection on a CDS based on a specific reference credit with specific maturity.
What is a Collateralised Debt Obligation (CDO)?
A CDO is ABS security which groups together fixed income assets such as junk bonds and through the diversification, improved their credit rating, whilst paying a string dividend.
What are 2 types of knock-In and knock out-options?
Down and in- option starts when price fall to or below pre-determined price
Down and out - option is cancelled when price fall to or below pre-determined price
Up and in - starts when price rises to pre-determined level
Up and out- is cancelled when price rises to pre-determined level
