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