Derivative Markets

Question 1

Define a derivative

Answer 1

A derivative is a financial instrument whose value is a function of another asset (the ‘underlying’, generally something immutable). So it is a contract between parties Ex: futures, forwards, options, and swaps.

Usually based on some unchangeable trait.

Question 2

What are derivatives used for

Answer 2

Derivatives are used to hedge (reduce risk), speculate (increase return), design new products for the retail market (ex: use for guarantees) and to manage a portfolio

Question 3

Define a forward

Answer 3

A forward is a contract between two parties to trade a specified asset on a specified date in the future at a specified price. Generally a non-standardised contract.

Question 4

Define a future

Answer 4

A future is an exchange tradeable contract between two parties to trade a specified asset at a specified date in the future at a specified price. It is a standardised contract and a special case of a forward.

Question 5

What does long and short mean in futures/forwards

Answer 5

One party is long the contract (buy the future) while the seller of the future is short.

Question 6

How are futures standardised - based on what

Answer 6

Details of underlying assets, units of the underlying asset of one future contract, delivery date, how the settlement price is to be determined.

Question 7

What is primary method of trading for derivatives

Answer 7

Most exchanges use electronic trading systems but some still use open outcry
Regulators encouraging to transact deals on exchanges or to centrally clear transactions to improve transparency and to reduce counterparty risk.
Exchnages are used for more standardised derivatives with high levels of demand ex: Futures
Whereas OTC derivatives trading would be used more for forwards.

Question 8

What was the open outcry process?

Answer 8

In open outcry, the dealing floor is divided into trading areas (pits) – a pit of each contract type. Traders shout out what they want to do and a trade occurs when the buyer meets the seller.
They fill out clearing slips and give to the exchange

Question 9

What is the role fo the clearing house in trading derivatives

Answer 9

The clearing house is a party to every trade – each party now has an obligation to the clearing house not one-another. It acts as the counterparty, guaranteeing delivery. Contracts are nearly always cleared centrally.

Question 10

What is a OTC derivative trade

Answer 10

An OTC derivative trade is a bilateral transaction between two counterparties, typically a bank and a client, with each party exposed to the credit risk of their counterpart
As prices move, one counterparty will typically suffer a gain while the other suffers a loss.

Question 11

What is a futures exchange structure

Answer 11

A futures exchange is usually a corporate entity with a board of directors deciding how to trade existing contracts and whether to introduce new contracts
Can have future trading systems be order driven or quote driven.

Question 12

Give an example fo derivatives markets

Answer 12

NYSE Liffe comprises the derivatives market

Question 13

How does a Clearing house manage its credit risk exposure?

Answer 13

Margin calls
If a party misses a margin call, don’t pay before market re opens, then the Clearing House closes out the position

Question 14

What is initial margin

Answer 14

Initial margin payable to clearing house at start of contract.

Question 15

What is variation margin

Answer 15

Variation margin due (or released) at the end of each trading day calculated by marking-to-market the contract at the close of each day. Ex: If you’re long and it went up in price, you’re up in price so I can release some of your margin.

Question 16

What does mark to market mean for clearing house

Answer 16

To mark-to-market, the price used is the market value of the future at the end of the day. risk management tool. Ex:If economic risk goes above a certain amount : you have to pay me x amount
Hence no big liability to one party on delivery day – it is spread smoothly.

Question 17

What could be circular issues with margin calls

Answer 17

If credit rating or liquidity decreases for a certain derivative, margin calls increase which can put further strain on these measures.

Question 18

What price limit might exist in futures markets

Answer 18

A band centring on the previous day’s close is constructed about a futures contract price so, if it moves outside the band during the day, the market closes for a cooling-off period. Market can close limit-up (price hits upper bound) or limit-down.

Question 19

What does closing out a position mean and when does this happen in reality

Answer 19

Closing out a position – take the opposite position in the same amount on the same contract.
Almost everyone closes out prior to delivery
No one goes to delivery - a totally different system, takes a few days to go through so you have days without your money.
Options for you: go short day before, go long (buy) you can roll over
If settled normally settled for cash

Question 20

What is EDSP

Answer 20

If delivery is reached then the exchange delivery settlement price which is the final settlement price on all outstanding futures is used to settle

Question 21

What quality of underlying can make it difficult to price derivatives

Answer 21

Can be difficult to price if the instrument derivative is based on isn’t traded very often.

Question 22

What are two equivalent economic exposures

Answer 22

Buy future, leaving money on deposit to gain interest OR Buy the underlying and receive whatever income the underlying gives prior to the delivery
Price must be the same to avoid arbitrage

Question 23

Give equation or fair value of a futures contract

Answer 23

Fair futures price + income from underlying = current cost of underlying + interest on deposit.

Question 24

Whats meant by cost of carry and return on carry

Answer 24

Deposit interest is sometimes called the cost of carry. While income on underlying is the return on carry.

Question 25

Whats the basis

Answer 25

Basis = Spot price of underlying – futures price

Question 26

ow is futures contract set up and why do we call it fair

Answer 26

Basically contract is agreed where futures price is fair, no one initially is exposed but with time someone gains exposure

Question 27

Whats the main cost of derivative vs holding udnerlying

Answer 27

Loss of income

Question 28

Explain the appeal of derivatives over a physical ownership of an asset

Answer 28

More liquid - can be traded with lower costs
For shorter term positions or those requiring leverage derivatives have lower costs
If held and rolled over repeatedly the costs increase
Hold physical investment more long term
May not want the physical asset ex: oil

Question 29

List the Investment & Risk Characteristics of Futures

Answer 29

Term – short term contracts
Volatility is a function of the underlying.
No income but capital flows over term- capital gains market so for tax position it might be beneficial.
Security – high with exchange-traded futures
Marketability – excellent.
Dealing costs lower than underlying.
Volatility, if related to margin payment, is extremely high because of gearing. If related to economic exposure then it is the same as underlying.
Expected returns – zero?
NO Ex: fi long on equities expected return is equity risk premium

Question 30

Define an option

Answer 30

A contract that gives one party the right but not the obligation to buy or sell the underlying at or by a future specified date at a specified price
American option: can be exercised at any time prior to expiry.
European option: can only be exercised at expiry.

Question 31

Define Long or short

Answer 31

Long means you’re buying
Short means you’re selling/writing

Question 32

Explain intrinsic value of an option

Answer 32

If option is in the money what would it be worth if you were to exercise right now.

Question 33

Explain traded options

Answer 33

Contracts that are standardised. Available on financial future ex: foreign currencies; short-term interest rates; stock market indices; commodities etc.

Question 34

What’s the purpose of a clearing house

Answer 34

Clearing house becomes a party to every trade – severing link between buyer & seller.

Question 35

Whats an OTC derivative in one sentence

Answer 35

OTC (over-the-counter) security/derivative is one not traded on an exchange.

Question 36

What are option prices theorteically

Answer 36

Actual is set by supply and demand
Theoretically: Intrinsic value of call = greater of zero or current price of underlying less exercise price
Time value is the choice that can still be exercised until expiry
The option price = Option Premium

Question 37

What does convention dictate for drawing position diagrams for options

Answer 37

You allow for premium, Ignore dealing costs and ignore interest on premium.

Question 38

List the Investment & Risk Characteristics of Options

Answer 38

Term – short-term,
Income – none but capital flows to writers via margin.
Security – as good as the clearing house.
Marketability – very good with low dealing costs.
Volatility – very high relative to premium.
Expected return – zero as a zero-sum game?

Question 39

Where are forwards and swaps traded and why

Answer 39

Forwards & swaps are OTC instruments (synthesised by investment banks). They are bespoke, less liquid, less transparent, and credit risk is a major factor.

Question 40

What is a swap

Answer 40

Swap – a contract between 2 parties under which they agree to exchange a future series of payments according to an agreed formula.
e.g. two different currencies (a ‘currency’ swap)
e.g., two different types of interest payments (an interest rate/ coupon swap)

Question 41

What does a currency swap do in terms of money changing hands

Answer 41

No liability created either side, no money changes hands but we have an income stream for the next few years. ; currency swap

Question 42

What are risks of swaps

Answer 42

market risk and credit risk

Question 43

Explain the difference in floating and fixed rate on currency swaps

Answer 43

Difference can only be risk because of arbitrage - higher premium when it’s giving fixed rather than floating.

Question 44

Whats a plain vanilla interest rate swap

Answer 44

Company B agrees to pay company A cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. At the same time, company A agrees to pay company B cash flow equal to interest at a floating rate on the same notional principal for the same period of time in the same currency

Question 45

What is the effect of a plain vanilla interest rate swap

Answer 45

Effect of transforming the nature of the liabilities or assets. In the example, company B can use the swap to transform a floating-rate loan into a fixed-rate loan.

Question 46

What is warehousing swaps

Answer 46

Unlikely that two companies will contact an intermediary to take opposite positions in exactly the same swap. For this reason, a large financial institution will be prepared to enter into a swap without having an offsetting swap with another counterparty in place.

Question 47

What is credit derivatives concept

Answer 47

Contracts where the payoff depends partly on upon the creditworthiness of one (or more) commercial (or sovereign) entities

Question 48

Explain a credit default swap and when it might be used

Answer 48

Credit default swaps — A contract that provides a payment if a event occurs. The party that buys pays a fee to the seller. If the credit event occurs within the term of the contract a payment is made from the seller to the buyer, otherwise no payment
Used by lenders who have reached their internal credit limit with a particular client, but wish to maintain their relationship

Question 49

Explain Total return swaps

Answer 49

The total return from one asset (or group of assets) is swapped for the return on another. This enables financial institutions to swap one type of exposure for another. Worth zero fair initially then exposure starts

Question 50

What is a Credit spread options

Answer 50

An option on the spread between the yields earned on two assets, which provides a payoff whenever the spread exceeds some level

Question 51

What is a credit linked note

Answer 51

Basic security plus an embedded credit default swap. They provide a useful way of stripping and repackaging credit risk.