derivative markets Flashcards
what are derivative contracts
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
what are derivative contracts
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
what are features of trading in organised exchanges
- contracts on exchanges are standardised with predetermined terms - including contract size, expiration date and other specifications
- 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
what are features of trading in over-the-counter markets
- 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
what is a forward contract
an obligation to buy/sell a certain quantity of the underlying asset at a
- specified price (forward price)
- specified time (maturity or expiration date)
- they are traded OTC and are bilaterally negotiated
what are futures contracts
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
what are long and short positions in forwards/ futures
the individual contracted to purchase the asset is said to have a long position
individual selling has a short position
what is the settlement of forward/ futures contracts
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)
what principle are forward contracts based on
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
what is an option contract
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)
what are the 5 things to specify with an option contract
- underlying asset
- quantity
- maturity date = T
- exercise price = K
- whether the owner of the option is buying or selling
what are the different types of options
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
what is a long call position
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
what is a long call position
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
what is a short call position
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)
what is a long put position
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
what is a short put position
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)
when is an option said to be in the money
when the option has a positive payoff at maturity
- (St> K) for a call option
- (St < K) for a put option
when is an option said to be out of money
when there is 0 payoff at maturity
- (St < K) for a call option
- (St > K) for a put option
what is hedging
a strategy to reduce risk by holding securities or contracts whose payoffs are negatively correlated with the risk
what is speculation
involves an investor taking a risky unhedged position in expectation of making a profit from expected price movements
what is speculation
involves an investor taking a risky unhedged position in expectation of making a profit from expected price movements
what is arbitrage
a strategy to exploit any mispricing in the market by simultaneously buying and selling equivalent assets to generate a profit
which options are worth more in value
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
when is an option deep in the money/ deep out of the money
when the strike price and the stock price are very far apart
what is the link between in the money and initial price and vice versa
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
