Chapter 6: Derivatives

Question 1

Where did derivatives come from?

Answer 1

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.

Question 2

What are commodity markets?

Answer 2

Where raw or primary products are exchanged or traded on regulated exchanges.

Question 3

How are commodities bought?

Answer 3

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

Question 4

What is a derivative?

Answer 4

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.

Question 5

How are derivatives traded?

Answer 5

Directly between counterparties (OTC) or on an organised exchange (exchange trading)

Question 6

What is OTC trading?

Answer 6

When trading takes place directly between counter parties

Question 7

What is exchange trading?

Answer 7

When trading takes place on an exchange.

Question 8

Four ways derivatives can be used to manage large portfolios:

Answer 8

1. Hedging - reduce impact of adverse price movements on a portfolios value: e.g sell futures contracts or buying put options
2. 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
3. Asset allocation changes - changes to the asset allocation of a fund
4. Arbitrage - deriving risk free profit from simultaneously buying and selling the same asset in two different markets

Question 9

Who opened worlds first derivatives exchange?

Answer 9

CBOT in 1848

Question 10

What is a future? What is a future contract?

Answer 10

A future is an agreement between a buyer and seller. A contract is a legally binding obligation between two parties:

1. 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.
2. Seller agrees to deliver asset at future date, in exchange for pre-specified money

Question 11

Two distinct features of a futures contract:

Answer 11

1. It’s exchange traded
2. It is dealt on standardised terms

Question 12

6 key terms in futures market:

Answer 12

1. LONG - the buyer of the future. Person is committed to buying underlying asset at the pre agreed price on the specified future date
2. 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
3. OPEN - the initial trade. Could open a long position or a short position
4. CLOSE - physical assets underlying most futures that are opened do not end up being delivered; they are closed out instead
5. COVERED - when seller of the future has the underlying asset that will be needed if physical delivery takes place
6. NAKED - opposite of covered

Question 13

Development of options

Answer 13

Two US academics produced an option pricing model in 1973 that allowed them to be readily priced.

Question 14

What is an option?

Answer 14

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.

Question 15

Difference between future and option

Answer 15

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

Question 16

Two main classes of options:

Answer 16

1. CALL option - when buyer has right to buy asset at exercise price. Seller is obliged to deliver if buyer exercises option.
2. 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

Question 17

What are buyers and sellers referred as in options? What’s the sale known as?

Answer 17

Buyer - holder
Seller - writer

Sale is referred to as ‘taking for the call’ or ‘taking for the put’

Question 18

What happens with exchange traded contracts?

Answer 18

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

Question 19

What is the premium?

Answer 19

Money paid by buyer/holder to the exchange at the beginning of the option contract.

Question 20

What is a an interest rate swap?

Answer 20

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.

Question 21

What does an IR swap involve? How are they used?

Answer 21

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.

Question 22

What is the leg of the swap? What is notional amount?

Answer 22

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)

Question 23

How does IR swap work? What is variable rate?

Answer 23

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.

Question 24

What are credit derivatives and events?

Answer 24

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.

Question 25

What’s the purpose of a credit derivative?

Answer 25

Enables organisations to protect itself against unwanted credit exposure by passing that exposure on to someone else. They can also be used to increase credit exposure in return for income.

Question 26

What’s a CDS? How does it work?

Answer 26

More like an option than a swap.

The party buying credit protection makes a periodic payment to a second party (seller). In return, the buyer receives an agreed compensation if there is a credit event relating to some third party.

If a credit event occurs, the seller makes a predetermined payment to the buyer, and the CDS then terminates. So a CDS can be seen as insurance.

Question 27

Two types of derivatives: what are they?

Answer 27

1. OTC - negotiated and traded privately between parties without the use of an exchange. IR swaps, forward rate agreements and exotic derivatives are mainly traded in this way.
2. ETD - exchange traded deriv - have standardised features and can be traded on an organised exchange. Role of exchange is to provide a marketplace for trading to take place but to also guarantee trade settlement.

Question 28

Types of commodity markets:

Answer 28

• agricultural
• base and precious metals
• energy
• power
• plastics
• emissions
• freight

Question 29

Derivs exchange: ICE Futures Europe

Answer 29

LIFFE:

Main exchange for trading financial derivative products in the UK, including futures and options on: interest rates and bonds, equity indices, individual equities.

Also trades soft commodities.

Question 30

Derivs exchange: Eurex

Answer 30

Main products are German bond futures and options, bunds (German bonds).

Allows members from Europe and US outside of switz and Germany to acces eurex.

Question 31

Derivs exchange: ICE (intercontinental exchange)

Answer 31

OTC marketplace for trading energy commodity contracts. Including crude oil and refined products, natural gas, power and emissions.

Question 32

Derivs exchange: LME (London metal exchange)

Answer 32

Futures and options contracts are traded on a range of metals.

Trading takes place in 3 ways:
1. Open outcry in the ‘ring’
2. Inter-office telephone market
3. LME select (online platform)

Question 33

Advantages of investing in derivatives

Answer 33

1. Enables producers and consumers of goods to agree price of a commodity today for future delivery
2. Enables investment firms to hedge risk
3. Offers ability to speculate a wide range of assets

Question 34

Disadvantages and risks of investing in derivatives

Answer 34

1. Can face unlimited loss
2. Thrives on volatility, need a lot of experience