Chapter 6: Derivatives Flashcards
Where did derivatives come from?
Agricultural markets - farmers and merchants would enter into forward contracts. These set the price at which a stated amount of a commodity would be delivered between a farmer and a merchant at a pre specified future date.
What are commodity markets?
Where raw or primary products are exchanged or traded on regulated exchanges.
How are commodities bought?
Bought and sold in standardised contracts - where not only the amount and timing of the contract conforms to the exchanges norm but also the quality and form of the underlaying asset
What is a derivative?
Is a financial instrument whose price is based on the price of another asset, known as the underlying asset. Could be a bond, share, IR, commodity etc.
How are derivatives traded?
Directly between counterparties (OTC) or on an organised exchange (exchange trading)
What is OTC trading?
When trading takes place directly between counter parties
What is exchange trading?
When trading takes place on an exchange.
Four ways derivatives can be used to manage large portfolios:
- Hedging - reduce impact of adverse price movements on a portfolios value: e.g sell futures contracts or buying put options
- Anticipating future cash flows - 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
- Asset allocation changes - changes to the asset allocation of a fund
- Arbitrage - deriving risk free profit from simultaneously buying and selling the same asset in two different markets
Who opened worlds first derivatives exchange?
CBOT in 1848
What is a future? What is a future contract?
A future is an agreement between a buyer and seller. A contract is a legally binding obligation between two parties:
- Buyer agrees to pay a pre-specified amount for delivery of a particular pre-specified quantity of an asset at a pre-specified future date.
- Seller agrees to deliver asset at future date, in exchange for pre-specified money
Two distinct features of a futures contract:
- It’s exchange traded
- It is dealt on standardised terms
6 key terms in futures market:
- LONG - the buyer of the future. Person is committed to buying underlying asset at the pre agreed price on the specified future date
- SHORT - seller of the future. Seller is committed to delivering the underlying asset in exchange for the pre agreed price on the specified future date
- OPEN - the initial trade. Could open a long position or a short position
- CLOSE - physical assets underlying most futures that are opened do not end up being delivered; they are closed out instead
- COVERED - when seller of the future has the underlying asset that will be needed if physical delivery takes place
- NAKED - opposite of covered
Development of options
Two US academics produced an option pricing model in 1973 that allowed them to be readily priced.
What is an option?
Gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a pre-agreed exercise price, on or before a pre specified future date or between two specified dates. The seller in exchange for the payment of a premium, grants option to the buyer.
Difference between future and option
Option gives the right to buy or sell, whereas a future is a legally binding obligation between counterparties
Two main classes of options:
- CALL option - when buyer has right to buy asset at exercise price. Seller is obliged to deliver if buyer exercises option.
- PUT option - when buyer has right to sell the underlying asset at the exercise price. The seller of the put option is obliged to take delivery and pay exercise price if buyer exercises option
What are buyers and sellers referred as in options? What’s the sale known as?
Buyer - holder
Seller - writer
Sale is referred to as ‘taking for the call’ or ‘taking for the put’
What happens with exchange traded contracts?
Buyers and sellers settle with a clearing house that’s part of the exchange. The exchange matches the transactions with deals placed by option writers who have agreed to deliver or receive the matching underlying asset
What is the premium?
Money paid by buyer/holder to the exchange at the beginning of the option contract.
What is a an interest rate swap?
An agreement to exchange one set of cash flows for another. They are most commonly used to switch financing from one currency to another or to replace floating interest with fixed interest.
What does an IR swap involve? How are they used?
Exchange of interest payments and are usually constructed where 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.
They are often used to hedge exposure to interest rate changes.
What is the leg of the swap? What is notional amount?
Two exchanges of cash flow are known as the legs of the swap and the amounts to be exchanged are calculated by reference to a notional amount (notional is needed in order to calculate amount of interest due, it’s never exchanged)
How does IR swap work? What is variable rate?
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 or another benchmark rate. Variable rate is known as floating rate.
What are credit derivatives and events?
Credit derivs are instruments whose value depends on agreed credit events relating to a third party company.
Credit events are a material default, bankruptcy, a significant fall in an assets value or debt restructuring.
