deriv mark/fwd mark/futures/options/swap/risk Flashcards
Define a deriviative and distinguish between exchange-traded and over-the-counter derivatives
A derivative has a value that is derived from the value of another asset or interest rate.
Exchange-traded derivatives, notably futures and some options, are traded in centralized locations and are standardized, regulated, and default risk free.
Forwards and swaps are customized contracts (over-the-counter derivatives) created by dealers and by financial institutions. There is very limited trading of these contracts in secondary markets and default (counterparty) risk must be considered.
Contrast forward commitments and contingent claims
A forward commitment is a binding promise to buy or sell an asset or make a payment in the future. Forward contracts, futures contracts, and swaps are all forward commitments
A contingent claim is an asset that has value only if some future event takes place (e.g. asset price is greater than a specified price). Options are contingent claims.
Define forward contracts, futures contracts, options (calls and puts), and swaps and compare their basic characteristics.
Foward contracts obligate one party to buy, and another to sell, as specific asset at a predetermined price at a specific time in the future.
Swaps contracts are equibalent to a series of forward contracts on interest rates, currencies, or equity returns.
Futures contracts are much like forward contracts, but are exchange-traded, quite liquid, and require daily settlement of any gains or losses.
A call option gives the holder the right, but not the obligations, to buy an asset at a predetermined price at some time in the future.
A put option gives the holder the right, but not the obligation to sell an asset at a predetermined price at some time in the future.
The owner of a call can “call the asset in” (i.e. buy it); the owner of a put has the right to “put the asset to” the writer of the put
Describe purposes of an controversies related to derivative markets.
Deriviative markets are criticized for their risky nautre. However, many market participants use derivatives to manage and reduce existing risk exposures.
Derivative securities play an important role in promoting efficient market prices and reducing transactions costs.
Explain arbitrage and the role it plays in determining prices and promoting market efficiency.
Riskless arbitrage refers to earning more than the risk-free rate of return with no risk, or earning an immediate gain with no possible future liability.
Arbitrage can be expected to force the prices of two securities or portfolios of securities to be equal if they have the same future cash flows regardless of future events.
Explain delivery/settlement and default risk for both long and short positions in a foward contract.
A deliverable forward contract on an asset specified that the long (the buyer) will pay a certain amount at a future date to the short, who will deliver a certain amount of an asset.
Default risk in a forward contract is the risk that the other party to the contract will not perform at settlement, because typically no money changes hands at the initiation of the contract.
Describe the procedures for settling a forward contract at expiration, and how termination prior to expiration can affect credit risk.
A forward contract with cash settlement does not require delivery of the underlying asset, but a cash payment at the settlement date from one counterparty to the other, based on the contract price and the market price of the asset at settlement.
Early termination of a forward contract can be accomplished by entering into a new forward contract with the opposite position, at the then-current expected forward price. This early termination will fix the amount of the gain or loss at the settlement date. If this new forward is with a different counterparty than the original, there is credit or default risk to consider since once of the two counterparties may fail to honor its obligation under the forward contract.
Distinguish between a dealer and an end user of a forward contract
An end user of a forward contract is most often a corporation hedging an exisiting risk.
Forward dealers, large banks, or brokerages originate forward contracts and take the long side in some contracts and the *short side *in others, with a spread in pricing to compensate them for actual costs, bearing default risk, and any unhedged price risk they must bear.
Describe the charaacterisitics of equity forward contracts and forward contracts on zero-coupon and coupon bonds.
An equity forward contract may be on a single stock, a customized portfolio, or an equity index, and is used to hedge the risk of equity prices at some future date.
- equity forward contracts can be written on a total return basis (including dividends), but are typically based solely on an index value
- index forwards settle in cash based on the notional amount and the percentage difference between the index value in the forward contract and the actual index level at settlement
Forward contracts in which bonds are the underlying asset may be quoted in terms of the discount on zero-coupon bonds (e.g. t-bills) or in terms of the yield to maturity on coupon bonds. Forwards on corportate bonds must contain special provisions to deal with the possibility of default as well as with any call or conversion features. Forward contracts may also be written on portfolios of fixed income securities or on bonds indexes.
A portfolio manager desires to generate $10 million 100 days from now from a portfolio that is quite similar in composition to the S&P 100 index. She requests a quote on a short position in a 100-day forward contract based on the index with a notional amount of $10 million and gets a quote of 525.2. If the index level at the settlement date is 535.7, calculate the amount the manager will pay or receive to settle the contract.
The actual index level is 2% above contract price, or:
535.7/525.2 - 1 = 0.02 = 2%
As the short party, the portfolio manager must pay 2% of the $10 million notional amount, $200,000, to the long.
Alternatively, if the index were 1% below the contract level, the portfolio manager would receive a payment from the long of $100,000, which would approximately offset any decrease in the portfolio value.
A forward contract covering a $10 million face value of T-bills that will have 100 days to maturity at contract settlement is priced at 1.96 on a discount yield basis. Compute the dollar amount the long must pay at settlement for the T-bills.
The 1.96% annualized discount must be “unannualized” based on the 100 days to maturity.
0.0196 * 9100/360) = 0.005444 is the actual discount
The dollar settlement price is (1-0.005444) * $10 million = $9,945,560
Please note that when market interest rates increase, discount increase, and T-bill prices fall. A long, who is obligated to purchase the bonds, will have losses on the forward contract when interest rates rise, and gains on the contract when interest rates fall. The outcomes for the short will be opposite.
Describe the characterisitcs of the Eurodollar time deposit market, and define LIBOR and Euribor
Eurodollar time deposits are USD-denominated shot-term unsecured loans to large money-center banks outside the US
The London Interbank Offered Rate (LIBOR) is an international reference rate for Eurodollar deposits and is quoted for 30-day, 60-day, 90 day, 180-day, 360-day (1 year) terms.
Euribor is the equivalent for short-term Euro denominated bank deposits (loans to banks)
For both LIBOR and Euribor, rates are expressed as annual rates and actual interest is based on the loan term as a proportion of a 360-day year.
Describe forward rate agreements (FRAs) and calculate the gain/loss on a FRA
Forward rate agreements (FRAs) serve to hedge the uncertainty about short-term rates (e.g. 30 or 90 day LIBOR) that will prevail in the future. If rates rise, the long receives a payment at settlement. The short receives a payment if the specified rate falls to a level below the contract rate.
Calculate and interpret the payoff of a FRA and explain each of the component terms of the payoff formula
The payment to the long at settlement on an FRA is:
The numerator is the difference between the rate on a loan for the specified period at the forward contract rate and the rate at settlement, it’s the interest savings in percent
and the denominator is to discount this interest differential back to the settlement date at the market rate at settlement.
Consider an FRA that:
- expires/settles in 30 days
- is based on a notional principal amount of $1 million
- is based on 90-day LIBOR
- specifies a forward rate of 5%
Assume the actual 90-day LIBOR 30-days from now (at expiration) is 6%. Compute the cash settlement payment at expiration, and identify which party makes the payment
If the long could corrow at the contract rate of 5%, rather than the market rate of 6%, the interest saved on a 90-day $1 million loan would be:
(0.06 - 0.05)(90/360) * 1 million = 0.0025 * 1 million = $2,500
The $2,500 in interest savings would not come until the end of the 90-day loan period. The value at settlement is the PV of these savings. The correct discount rate to use is the acutal rate at settlement, 6% not the contract rate of 5%.
The payment at settlement from the short to the long is:
2,500 / 1+[(0.06) * 90/360)] = $2,463.05
Describe the characterisitcs of currency foward contracts
Currency forward contracts specify that one party will deliver a certain amount of one currency at the settlement date in exchange for a certain amount of another currency.
Under cash settlement, a single cash payment is made at settlement based on the difference between the exchange rate fixed in the contract and the market exchange rate at the settlement date.
Gemco expects to receive EUR50 million three months from now and enters into a cash settlement currecny forward to exchange thes euros for US dollars at USD1.23 per euro. If the market exchange rate is USD1.25 per euro at settlement, what is the amount of the payment to be received or paid by Gemco?
Under the terms of the contract Gemco would receive:
EUR 50 million * USD/EUR 1.23 = USD61.5 million
Without the forward contract, Gemco would receive:
EUR 50 million * USD/EUR 1.25 = USD62.5 million
The counterparty would be disadvantaged by the difference between teh contract rate and the market rate in an amount equal to the advantage that would have accrued to Gemco had they not entered into the currency forward
Gemco must make a payment of USD1.0 million to the counter party.
A direct calculation of the value of the log (USD) position at settlement is:
(USD/EUR 1.23 - USD/EUR 1.25) * EUR50 million = -USD1.0 million
Describe the characteristics of futures contracts
Compare futures contracts and forward contracts
Like forward contracts, futures contracts are most commonly for delivery of commodities and financial assets at a future date and can require delivery or settlement in cash
Compared to foward contracts,futures contracts:
- are more liquid, trade on exchanges, and can be closed out by an offsetting trade
- do not have counterparty risk; the clearing house acts as coutnerparty to each side of the contract
- have lower transactions costs
- require margin deposits and are marked to market daily
- are standardized contracts as to asset quantity, quality, settlement dates, and delivery requirements
Distinguish between margin in the securities markets and margin in the futures markets, and explain the role of initial margin, maintenance margin, variation margin, and settlement in futures trading
Futures margins deposits are not loans, but deposits to ensure performance under the terms of the contract.
- Initial margin* is the deposit required to initiate a futures position
- Maintenance margin* is the minimum margin amount. When margin falls below this amount, it must be brought back up to its initial level by depositing varation margin.
Margin calculations are based on the daily settlement price, the average prices for trades during a closing period set by the exchange.
Describe price limits and the process of marking to market, and calculate and interpret the margin balance, given the previous day’s balance and the change in the futures price.
Trades cannot take place at prices that differ from the previous day’s settlement prices by more than the price limit and are said to be limit down (up) when the new equilibrium price is below (above) the minimum (maximum) price for the day.
Marketing-to-market is the process of adding gains to or subtracting losses from the margin account daily, based on the exchange in settlement prices from one day to the next.
The mark-to-market adjustment either adds the day’s gains in the contract value to the long’s margin balance and subtracts them from the short’s margin balance, or subtracts the day’s loss in contract value from the long’s margin balance and adds them to the short’s margin blaance.