derivative markets

Question 1

what are derivative contracts

Answer 1

financial instruments whose value is derived from the value of an underlying asset, index, rate or other reference

they allow investors and businesses to hedge risks, speculate on price movements and manage exposure to various financial variables

Question 2

what are derivative contracts

Answer 2

financial instruments whose value is derived from the value of an underlying asset, index, rate or other reference

they allow investors and businesses to hedge risks, speculate on price movements and manage exposure to various financial variables

Question 3

what are features of trading in organised exchanges

Answer 3

1. contracts on exchanges are standardised with predetermined terms - including contract size, expiration date and other specifications
2. centralised clearing
   - exchanges act as intermediaries between buyers and sellers of the contract and use clearinghouses to guarantee the performance of contracts == reducing counterparty risk
   - trading occurs on a public auction market where buyers and sellers submit orders that are matched electronically

Question 4

what are features of trading in over-the-counter markets

Answer 4

• it involves the 2 parties directly negotiating the terms of the contract
• OTC derivatives are highly customisable, allowing parties to tailor the terms to their specific needs - including the underlying asset, contract size, expiration date and other features

Question 5

what is a forward contract

Answer 5

an obligation to buy/sell a certain quantity of the underlying asset at a

1. specified price (forward price)
2. specified time (maturity or expiration date)

• they are traded OTC and are bilaterally negotiated

Question 6

what are futures contracts

Answer 6

obligations to sell/ buy a certain quantity of the underlying asset at a
1. specified price (forward price)
2. specified time (maturity or expiration date)

• traded on an exchange and hence standardised
• contracts are centrally cleared and the process involves market to market (calc. losses and gains) daily —— the clearing house manages this by requiring both parties to deposit margin with them to meet any losses

Question 7

what are long and short positions in forwards/ futures

Answer 7

the individual contracted to purchase the asset is said to have a long position

individual selling has a short position

Question 8

what is the settlement of forward/ futures contracts

Answer 8

many cases, they are cash-settled == the forward transaction does not take place.

settlement of forward contracts occurs at maturity whereas the settlement of futures contacts occurs daily (marked to market)

Question 9

what principle are forward contracts based on

Answer 9

the principle of no-arbitrage:
2 portfolios with the same cash flows must have the same market value
if not there is potential for arbitrage by selling the higher value portfolio and buying the lower value portfolio

Question 10

what is an option contract

Answer 10

an option gives its owner the right, but no obligation, to buy or sell a given quantity of a specified asset at some specified future date for a pre-determined price (strike price)

Question 11

what are the 5 things to specify with an option contract

Answer 11

1. underlying asset
2. quantity
3. maturity date = T
4. exercise price = K
5. whether the owner of the option is buying or selling

Question 12

what are the different types of options

Answer 12

call option: the right to buy the underlying asset
put option: the right to sell the underlying asset

2 versions:
european option - exercise at maturity only
american option - exercise at any time up to maturity

Question 13

what is a long call position

Answer 13

the holder has the right to purchase the stock at time T for $K.
- he will only exercise it if the stock price > K
- will not exercise if stock price < K cuz it is better to buy the stock in the market for the stock price

Question 14

what is a long call position

Answer 14

the holder has the right to purchase the stock at time T for $K.
- he will only exercise it if the stock price > K
- will not exercise if stock price < K cuz it is better to buy the stock in the market for the stock price
- payoff = St-K

Question 15

what is a short call position

Answer 15

the write of the call option will have 0 payoff if St < K cuz the option will not be exercised
- if St > K, the buyer will exerted the option and the writer will have to deliver the stock to the buyer
- payoff = -(St-K)

Question 16

what is a long put position

Answer 16

gives the right to sell an underlying stock for K at T
- holder will exercise if St < K
- payoff = k-St
- holder will not exercise if St > K

Question 17

what is a short put position

Answer 17

the writer of a put option will have 0 payoff if St > K as the option will not be exercised
- if St < K, the option will be exercised by the buyer and the writer will receive the stock from the buyer
- the payoff will be (K-St)

Question 18

when is an option said to be in the money

Answer 18

when the option has a positive payoff at maturity
- (St> K) for a call option
- (St < K) for a put option

Question 19

when is an option said to be out of money

Answer 19

when there is 0 payoff at maturity
- (St < K) for a call option
- (St > K) for a put option

Question 20

what is hedging

Answer 20

a strategy to reduce risk by holding securities or contracts whose payoffs are negatively correlated with the risk

Question 21

what is speculation

Answer 21

involves an investor taking a risky unhedged position in expectation of making a profit from expected price movements

Question 22

what is speculation

Answer 22

involves an investor taking a risky unhedged position in expectation of making a profit from expected price movements

Question 23

what is arbitrage

Answer 23

a strategy to exploit any mispricing in the market by simultaneously buying and selling equivalent assets to generate a profit

Question 24

which options are worth more in value

Answer 24

call options :
those with lower strike prices have higher market prices - the right to buy the stock at a lower price is more valuable than the right to buy it for a higher price

put options:
those with higher strike prices are more value

with same strike prices:
both call and put options are more expensive for longer time to expiration

Question 25

when is an option deep in the money/ deep out of the money

Answer 25

when the strike price and the stock price are very far apart

Question 26

what is the link between in the money and initial price and vice versa

Answer 26

the further the in-the-money the option, the higher its initial price and thus larger your potential loss

the further the out-of-money the option, the smaller its initial cost and smaller potential loss