Chapter 6: Derivatives

Question 1

What are the main investment uses of derivatives?

Answer 1

1. Hedging - A technique used to reduce the impact of price movements.
2. Anticipating future cash flows - if a portfolio manager expects to receive cash he could buy futures to fix the price of an asset in case it rises.
3. Arbitrage- The technique used when buying and selling the same asset in different markets if the underlying assets are mismatched
4. Asset allocation changes - Changes to assets can be made more swiftly by purchasing futures rather then the actual security.

Question 2

What is the key difference between a future and an option ?

Answer 2

An option gives the buyer the right but not the obligation whilst a future has to be traded.

Question 3

What is the position of a seller of a future known as ?

Answer 3

Short

Question 4

An investor who enters into a contract for the delivery of an asset in 3 months time is said to have adopted what position ?

Answer 4

Long position

Question 5

What is the name given to a seller of an option ?

Answer 5

The writer

Question 6

What type of option gives the holder the right to sell an asset ?

Answer 6

A put option

Question 7

What is the price paid for an option known as ?

Answer 7

Premium

Question 8

What is the price paid for an option known as ?

Answer 8

Premium

Question 9

What is an interest rate swap and what is it used for ?

Answer 9

An agreement to exchange one set of cash flows for another, Most commonly used to switch financing from currency to another

Question 10

Main advantages and disadvantages of investing in derivatives ?

Answer 10

Advantages: Removes uncertainty of price changes, enables you to hedge the risk of stock, offers the ability to speculate.
Disadvantages: Can lose more then invested, very volatile, can default in OTC market.