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CISI Introduction to Securities & Investment (L4) > Chapter 6: Derivatives > Flashcards

Chapter 6: Derivatives Flashcards

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SIE Exam flashcards
1
Q

What are Futures contracts?

A

A set price at which a stated amount of a commodity would be delivered between counterparties at a pre-specified future date.

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2
Q

What is a Commodity?

A

A raw material or agricultural product (e.g. sugar, wheat, oil, copper) that can be bought and sold. Derivatives of commodities are traded on exchanges (e.g. oil futures on ICE futures).

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3
Q

Which 4 forms can derivatives take?

A
  • Forwards
  • Futures
  • Options
  • Swaps
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4
Q

What is a Derivative?

A

A financial instrument whose price is based on the price of another asset (known as an underlying asset).

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5
Q

What could ‘the underlying’ be?

A

Could be a financial asset (e.g. bonds, shares, stock market indices and interest rates) or commodity (e.g. oil, silver, wheat).

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6
Q

What are Derivatives used for?

A
  • Hedging
  • Anticipating future cash flows
  • Asset allocation change
  • Arbitrage
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7
Q

What is Hedging?

A

Techniques employed by a portfolio manager to reduce impact of adverse price movements on a portfolio’s value; this could be achieved by selling a sufficient number of futures contracts or buying put options.

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8
Q

What is Anticipating future cash flows?

A

(Closely linked to the idea of hedging) if a portfolio manager expects to receive a large inflow of cash to be invested in a particular asset, then futures can be used to fix the price at which it will be bought and offset the risk that prices will have risen by the time the cash flow is received.

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9
Q

What is Asset allocation changes?

A

Changes to the asset allocation of a fund, whether to take advantage of anticipated short-term directional market movements or to implement a change in strategy, can be made more swiftly and less expensively using derivatives such as futures than by actually buying and selling securities within the underlying portfolio.

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10
Q

What is Arbitrage?

A

Process of deriving a risk-free profit from simultaneously buying and selling the same asset in two different markets, when a price difference between the two exists. If the price of a derivative and its underlying asset are mismatched, then the portfolio manager may be able to profit from this price anomaly.

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11
Q

What are the legally binding obligation between two parties in a futures contract?

A

Future is an agreement between the buyer and seller:
* Buyer agrees to pay prespecified amount for delivery of a particular prespecified quantity of an asset at a prespecified future date.
* Seller agrees to deliver the asset at a future date, in exchange for the prespecified amount of money.

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12
Q

What are the two distinct features of a futures contract?

A
  • Exchange traded - on derivatives exchanges such as ICE Europe (London) or Chicago Mercantile Exchange (CME) (US).
  • Dealt on standardised terms - exchange specifies the quality of the underlying asset, the quantity underlying each contract, the future date and delivery location - only the process is open to negotiation.
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13
Q

What does Long mean?

A

Position taken by the buyer of the future. The contract is committed to buying the underlying asset at the pre-agreed price on the specified future date.

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14
Q

What does Short mean?

A

Position taken by the seller of the future. Seller is committed to delivering the underlying asset in exchange for the pre-agreed price on the specified future date.

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15
Q

What does Open mean?

A

The initial trade. A market participant opens a trade when it first enters into a future. It could be buying a future (opening a long position), or selling a future (opening a short position).

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16
Q

What does Close mean?

A

Physical assets underlying most futures that are opened don’t end up being delivered:
they’re closed out instead. e.g. an opening buyer will almost invariably avoid delivery by making a closing sale before the delivery date. If the buyer doesn’t close out, they will pay the agreed sum and receive the underlying asset. This might be something the buyer is keen to avoid, e.g. because the buyer is actually a financial institution simply speculating the price of the underlying asset using futures.

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17
Q

What does Covered mean?

A

When the seller of the future has the underlying asset that will be needed if physical delivery takes place.

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18
Q

What does Naked mean?

A

When the seller of the future does not have the asset that will be needed if physical delivery of the underlying commodity is required (risk could be unlimited).

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19
Q

What is an Option?

A

Gives buyer the right (not obligation) to buy or sell a specified quantity if an underlying asset at a pre-agreed exercise price, on or before prespecified future date or between two specified dates. The seller, in exchange for the payment of a premium, grants the option to a buyer.

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20
Q

What’s a key difference between a future and an option?

A

Option gives the right to buy or sell, whereas future is legally binding obligation between counterparties.

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21
Q

Where can options be traded?

A
  • Exchanges - here will be in standardised sizes and terms.
  • OTC - not standardised terms, thus contracts spec by the parties is bespoke.
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22
Q

What are the two main classes of options?

A
  • Call option - when the buyer has right to buy asset at the exercise price, if they choose to. Seller is obliged to deliver if the buyer exercises the option.
  • Put option - when buyer has the right to sell underlying asset at the exercise price. The seller of the put is obliged to take delivery and pay the exercise price, if the buyer exercises the option.
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23
Q

What is a Holder?

A

Buyers of options are owners of options.

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24
Q

What is a Writer?

A

Seller of options. Their sale is referred to as ‘taking for the call’ or ‘taking for the put’, depending on whether they receive a premium for selling a call option or a put option.

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24
Q

For exchange-traded contracts, who do buyers and sellers settle the contract with?

A

With a clearing house that’s part of an exchange, rather than each other.

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25
Q

Why are contracts settled with a clearing house?

A

The exchange needs to be able to settle bargains if holders choose to exercise their rights to buy or sell. Since the exchange doesn’t want to be a buyer or seller of the underlying asset, it matches these transactions with deals placed by option writers who have agreed to deliver or receive the matching underlying asset, if called upon to do so.

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26
Q

Who’s the premium paid by?

A

Premium is money paid by buyer/holder to the exchange (and then by the exchange to the seller/writer) at the beginning of the option contract ; it’s not refundable.

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27
Q

What’s an Interest Rate swap?

A

Agreement to exchange one set of cash flows for another.

28
Q

What are Interest Rate swaps most commonly used for?

A

Switch financing from one currency to another or to replace floating interest with fixed interest.

29
Q

How are swaps traded?

A

OTC, negotiated between parties to meet different needs of customers, so each tends to be unique.

30
Q

What are the most common form of swaps?

A

Interest rate swaps.

31
Q

Why are swaps useful?

A

Often used to hedge exposure to interest rate changes and can be most easily appreciated by looking at an example.

32
Q

Briefly, what do Interest Rate swaps involve?

A

Involve an exchange of interest payments and are usually constructed, whereby one leg of the swap is a payment of a fixed rate of interest and the other leg is a payment of a floating rate of interest.

33
Q

What are the 2 exchanges of cash flows known as?

A

Legs of the swap. The amounts to be exchanged are calculated by reference to a notional amount.

34
Q

Why is it referred to as the notional amount?

A

Referred to as this as it’s needed in order to calculate the amounts of interests due, but is never exchanged.

35
Q

How do Interest Rate swaps work?

A

One party pays an amount based on a fixed rate to the other party, who will pay back an amount of interest that is variable and usually based on LIBOR (London Inter-Bank Offered Rate) or another benchmark rate. The variable rate will usually be set as LIBOR plus, say, 0.5% and will be reset quarterly. Variable rate is often described as the floating rate.

36
Q

What are Credit Derivatives?

A

Instruments whose value depends on agreed credit events relating to a third-party company, e.g. changes to the credit rating of that company, or an increase in that company’s cost of funds in the market, or credit events relating to it.

37
Q

What are Credit Events?

A

Includes a material default, bankruptcy, a significant fall in an asset’s value, or debt restructuring, for a specified reference asset.

38
Q

What are the purpose of Credit Derivatives?

A

Enables an organisation to protect itself against unwanted credit exposure, by passing that exposure onto someone else. Credit derivatives can also be used to increase credit exposure, in return for income.

39
Q

Why is a CDS more like an option?

A

Party buying credit protection makes periodic payment (pays an upfront fee) to a second party, the seller.
In return, the buyer receives an agreed compensation if there is a credit event relating to some third party or parties.
If credit event occurs, the seller makes a predetermined payment to the buyer, and the CDS then terminates.

40
Q

Why is CDS like a type of Insurance?

A

Holder of the bond (i.e. CDS buyer) can take out protection on the risk of the issuer of the bond (debt issuer) defaulting by paying a premium to a counterparty, the CDS seller.
An Investment fun might take out a CDS to protect its holding of a bond in case of default, while other market participants might use one to speculate on changes in credit rating.

41
Q

What are the two groups of derivatives?

A
  • OTC derivatives
  • Exchange-traded derivatives
42
Q

What are OTC derivatives?

A

Negotiated and traded privately between parties without the use of an exchange. E.g. interest rate swaps, forward rate agreements, other exotics.

43
Q

Which is the largest derivative market?

A

OTC market.

44
Q

Where does OTC trading predominantly take place?

A

Europe, mainly UK (note there’s a considerable activity taking place at the moment to move OTC trading on-exchange in response to regulatory concerns about the risks posed by OTC derivative trading).

45
Q

Where can ETDs be traded?

A

Due to having standardised features, they can be traded on organised exchanges, such as single stock or index derivatives.

46
Q

What is the role of the exchange?

A
  • Provide a marketplace for trading to take place.
  • Stand between each party to a trade to provide a guarantee that the trade will eventually be settled (done by acting as an intermediary for all trades and by requiring participants to post a margin, which is a proportion of the value of the trade, for all transactions that are entered into).
47
Q

What are some of the main commodity markets?

A
  • Agricultural markets
  • Base and precious metals
  • Energy markets
  • Power markets
  • Plastics markets
  • Emissions markets
  • Freight and shipping markets
48
Q

What are some of the main Derivatives exchanges?

A
  • ICE Futures Europe
  • Eurex
  • Intercontinental Exchange (ICE)
  • London Metal Exchange (LME)
49
Q

What derivatives products does ICE Futures Europe trade?

A

Futures and options on:
* Interest rates and bonds
* Equity indices (e.g. FTSE)
* Individual equities (e.g. BP. HSBC)

Also trades derivatives on:
* Soft commodities (e.g. sugar, wheat, cocoa)

50
Q

Where does ICE run futures and options markets?

A
  • Amsterdam
  • Brussels
  • Lisbon
  • Paris
51
Q

What is the history of life?

A

2001, Euronext purchased LIFFE (London International Financial Futures and Options Exchange) derivatives exchange - renamed to Euronext.liffe.
LIFFE established 1982.
Now part of ICE following takeover of NYSE Euronext.

52
Q

What is Eurex?

A

World’s leading international derivatives exchange based in Frankfurt.

53
Q

What are Eurex’s principal products?

A
  • German bond futures and options - most well known being contracts on the BUND (German bond).
  • Index products for a range of European markets.
54
Q

Who created Eurex?

A

Deutsche Borse AG and Swiss Exchange.

55
Q

How is trade conducted? What does it enable?

A

Traded on fully computerised Eurex platform, and members are linked to Eurex system via a dedicated wide-area communications network (WAN). Enables members across Europe and US to access Eurex outside Switzerland and Germany.

56
Q

What is Intercontinental Exchange?

A

ICE operates the electronic global futures and OTC marketplace for trading energy commodity contracts. These contracts include crude oil and refined products, natural gas, power and emissions.

57
Q

What operates under ICE Futures?

A

Company’s regulated futures and options, formerly known us International Petroleum Exchange (IPE).

58
Q

What else has ICE acquired?

A

London-based energy futures and options exchange in 2001.

59
Q

When did ICE transition to electronic trading?

A

Completed transition from open outcry to electronic trading in April 2005.

60
Q

ICE Future is leading which products?

A

ICE Futures Europe is leading energy futures and options exchange and is subsidiary of ICE.

61
Q

What products do ICE trade?

A

Derivative contracts based on key energy commodities:
* Crude oil.
* Refined oil products, such as heating oil and jet fuel.
* Other products, like natural gas and electric power.

LIFFE acquisition expanded range of tradable products to include futures and options on:
* Bonds.
* Equities.
* Indices.

62
Q

What other markets does ICE include?

A

Centred in North America, includes trading of agricultural, currency and stock index futures and options.
Took over NYSE Euronext and, as a result, by acquiring LIFFE, became the world’s largest derivatives exchange operator.

63
Q

What is the London Metal Exchange?

A
  • World’s premier non-ferrous metals market, operating for over 130 years.
  • Based in London, it’s a global market with international membership.
  • More than 95% of business comes from overseas.
64
Q

What’s traded on LME?

A

Futures and options contracts are traded on a range of metals, inc aluminum, copper, nickel, tin, zinc and lead. Also launched world’s first futures contracts for plastics.

65
Q

What 3 ways does trading on LME take place?

A
  • Open outcry trading in the ‘ring’
  • Through an inter-office telephone market
  • Through LME Select, the exchange’s electronic trading platform.
66
Q

What are the advantages of derivatives?

A
  • Enables producers and consumers of goods to agree the price of a commodity today for future delivery, which can remove the uncertainty of what price will be achieved for the producer and the risk of lack of supply for the consumer.
  • Enables investment firms to hedge the risk associated with a portfolio or an individual stock.
  • Offers the ability to speculate on a wide range of assets and markets to make large bets on price movements using geared nature of derivatives.
67
Q

What are the disadvantages of derivatives?

A
  • Some types of derivatives investment can involve the investor losing more than their initial outlay and face potentially unlimited losses.
  • Derivatives markets thrive on price volatility, meaning that professional investment skills and experience are required.
  • In OTC markets, there’s a risk that counterparty may default on their obligations, and so it requires great attention to detail in terms of counterparty risk assessment, documentation and the taking of collateral.

CISI Introduction to Securities & Investment (L4) (12 decks)

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