Chapter 8: Deriratives Flashcards
What are deriratives
A derivative is an instrument whose value is determined by an underlying asset.
Derivative securities are contracts between two parties that will settle based on the price of the underlying asset and are traded over the counter (“OTC”) markets or on exchanges.
Derirative securities traded on OTC Markets are negotiated between two parties can be uniquely negotiated, while derirative securities traded on exchanges are usually standardized
What are forward contracts
They are an obligation to both parties of the contract, to buy or sell an asset at a predetermined price at a future agreed date
They are usually traded OTC
What are the differences between futures and forward contracts
Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
However, forward contracts are traded OTC while futures contracts are traded on exchanges
Forward contracts are settled on one date at the end of the contract. Futures contracts are marked-to-market daily, which means their value is determined day-by-day until the contract ends. Futures contracts can settle over a range of dates.
What is a clearinghouse. What is the purpose of it
Associated with every futures exchange is a clearing house. The main purpose of the futures clearing house is to guarantee that all trades will be honoured. The clearing house interposes itself as the buyer to every seller and the seller to every buyer.
Essentially ensures that all trades will go through by acting as an intermediary position
What are some features of future contracts
Futures contracts are marked-to-market daily, which means their value is determined day-by-day until the contract ends. Futures contracts can settle over a range of dates.
Speculators who bet on the direction of an asset’s price will move, often use futures. Futures are usually closed out prior to maturity, and delivery rarely occurs. Hedgers mainly use forwards to eliminate the volatility of an asset’s price. Asset delivery and cash settlement usually take place at settlement date.
What is the maintenance margin level
If the margin account drops below this level, he will receive a margin call from his broker
What is the initial margin
The initial margin is normally a percentage of the contract value.
In the previous example, the investor needs only 10% or $3,700 to trade on a futures contract valued at $37,000. The losses sustained by him at the end of four days amounted to $1,000 or 27% (based on a capital of $3,700). During this time, the decline in the index was 2.7%.
What are the benefits of using futures contracts
- Speculating
- Speculators are essential to the proper functioning of the futures market, absorbing the excess demand or supply generated by hedgers and assuming the risk of price fluctuations that hedgers want to avoid. They also contribute to the liquidity of the market and reduce the variability in prices over time. - Hedging
Hedgers protect themselves from price fluctuations (price risk) by buying or selling futures contracts which have opposite positions to their initial exposures or holdings. Price risk is eliminated because the profits/losses on their underlying positions will be offset by losses/profits on their futures contracts.
Why speculate on the futures market rather than the cash market
First, the transaction costs are significantly lower in the futures market than in the cash market.
Second, when dealing in futures for a physical commodity, there are no storage costs involved.
Third, the speed at which orders can be executed also gives the advantage to the futures market.
The last reason is the leverage that futures trading provides.
Why is hedging essential for a business
Hedgers protect themselves from price fluctuations (price risk) by buying or selling futures contracts which have opposite positions to their initial exposures or holdings. Price risk is eliminated because the profits/losses on their underlying positions will be offset by losses/profits on their futures contracts.
What is a short hedge and long hedge. When will you use them
Short Hedge: Protecting the value of an asset with short futures position is known as a short hedge
Consider an investor holding a quantity of silver as inventory
Since he is concerned that the price of silver is falling, to protect the value of his inventory, he sells silver futures
Long Hedge: A position that is short in the cash market and long in the futures market
A long hedge is appropriate when a company knows it will have to purchase a certain asset in the near future and wants to lock in a price now. An investor, who currently does not have any silver inventory but intends to purchase silver later, is in effect, shorting the cash market. To protect against rising silver prices, he can take a long position in the futures market.
What is the basis risk of a future contract
The basis of a futures contract is the difference between the futures price and the cash price.
That is,
Basis = Cash Price - Futures Price
Cash price refers to the point in time where the contract is redeemed
Why are there potential liquidity and leverage risks associated to futures contracts?
Liquidity risks:
Although futures contracts are exchange traded, there is no assurance that liquidity will be available at all times. This is important to keep in mind because unless an investor is willing to take delivery of the underlying asset (if the contract cannot be cash settled), the only way for an investor to close his futures position is to offset it with another futures contract.
Open interest: the number of open future contacts not yet closed off by an offsetting trade
Leverage risks:
Given that future contracts are traded using margins, a small price movement generate significant profits or losses through the leverage effect.
What are the differences between a call and put option
In general, investors buy call options if they hold a bullish view that the price of the asset will go up.
A put option gives the holder the right to sell an asset for a specified price on or before a specific date.
What is in the money / out of the money
An option is said to be in the money when its exercise would produce profits for the holder. An option is out of the money when its exercise would be unprofitable. An option is said to be at the money when its exercise would make no difference to the investor from not exercising.
