Derivatives Flashcards
Are options traded OTC or in an exchange?
Options can trade OTC or in exchange markets
Explain the difference between a broker and a dealer?
Dealer: A market participant who buys and sells securities purely on their own behalf (Principal)
Broker: A market participant who buys and sells securities on behalf of someone else (Agent)
What is the difference between an exchange traded derivative and an OTC derivative?
Exchanged traded derivatives such as futures are standardised and backed by a clearing house and require daily settlement of gains and losses.
Forwards and swaps are bespoke instruments and are traded OTC. These markets are unregulated and subject to greater counterparty risk.
What is a market maker?
Market Makers: Typically investment banks who act to ensure there is enough liquidity in the market, they buy and sell securities and set the price level through a bid-ask spread
What is the difference between a forward commitment and a contingent claim?
Forward commitment: Legally binding contract to perform some action in the future – e.g. forwards, futures, swaps
Contingent claim: Not legally binding, provides optionality e.g. options
Contingent claims that depend on a credit event occurring such as default or credit downgrade are known as…?
Credit derivatives
A legally binding contract to perform some action in the future is defined as a…?
Forward contract
What is the value of a forward and future at initiation?
Both forwards and futures have a 0 value at initiation
What is a futures contract?
Futures contract: A forward contract that is standardized and exchange-traded
What is the difference between a forward and a future
Futures are traded on a standardised exchange, are subject to greater regulation, backed by a clearinghouse and require daily settlements of gains and losses
What is an initial margin for a future?
Initial margin: The amount that must be deposited in the futures account before any trade is made to cover any losses
What is the maintainance margin for a futures contract?
Maintenance margin: The amount that must be maintained, if the margin balance falls below the maintenance margin a deposit must be made to return to the initial margin
Do futures and forwards recognise their profits at the same time every day?
No futures recognise their profits at increments intra day, forwards only recognise their profits at expiration
Forward agreements to exchange a series of payments on periodic settlement dates over a certain time period, are known as…?
Swaps
Is the notional amount exchanged in a swap?
No
What is the difference between a plain vanilla IRS and a basis swap?
Plain vanilla interest rate swap: Swap of floating and fixed rate loans
Basis swap: Swap one floating rate for another (ie swapping one basis point + L for another)
Describe the right / or obligation of a holder of a long call?
The buyer of a call option has the right to buy an underlying asset.
Describe the right / or obligation of a holder of a short put?
The writer (seller) of a put option has the obligation to buy the underlying asset.
What is the difference between American and European options?
American options may be exercised at any time up to and including the contract’s expiration date.
European options can be exercised only on the contract’s expiration date.
What type of derivative is used to manage commodity risk?
Futures
What is a credit default swap?
Credit default swap: A financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default.
What is the payoff of a call option?
The greater of the stock price minus the strike price or 0 less the option premium
What is the payoff of a put option?
The greater of the strike price minus the stock price or 0 less the option premium
Forwards and futures have linear payoffs whereas options have ___?
Non-linear payoffs
What are the benefits of using derivatives?
Reduce transaction costs Lower capital requirements Greater liquidity than spot market Reduce risk Provide price information
What are the drawbacks of using derivatives?
Risky
Investors may have limited knowledge and not know how to use them properly
What does the arbitrage law of one price state?
2 securities with the same cash flows must have the same price
What is the formula for the no-arbitrage FWD price at time t?
Ft(T) = (St - net cost of carry)*(1+Rf)^(T-t)
What is the formula for the net cost of carry?
net cost of carry (or simply carry) = PV(benefits of holding the asset) – PV(costs of holding the asset)
When interest rates and futures prices for an asset are uncorrelated what is greater futures price or fwd price?
They are equal
When interest rates and futures prices for an asset are positively correlated what is greater futures price or fwd price?
Futures prices are greater
What is the formula for the time value of an option?
Time value of an option = Value of an option minus intrinsic value of an option
How does an increase in volatility increase call option price?
Increases call option value
How does an increase in Rf impact call option value?
Increases call option value
How does an increase in strike price impact call option value?
Decreases call option value
How does an increase in stock price impact call option value?
Increases call option value
How does an increase in strike price impact put option value?
Increases put option value
How does an increase in time to maturity impact put option value?
Increases put option value
What is the put call parity equation?
( C + \frac{X}{(1+R_f)^T} = S_0 + P )
What is the forward put call parity equation?
( C + \frac{X}{(1+R_f)^T} = \frac{F}{(1+R_f)^T} + P )
When is an American put option more expensive in comparison to a European put option?
In the run up to maturity if the American put is deep in the money
Explain when a American call option will be more expensive in comparison to a European call option?
If an American call option has cash flows throughout the life of the option
