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CFA Exam Level 1 > Derivatives > Flashcards

Derivatives Flashcards

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1
Q

Are options traded OTC or in an exchange?

A

Options can trade OTC or in exchange markets

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2
Q

Explain the difference between a broker and a dealer?

A

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)

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3
Q

What is the difference between an exchange traded derivative and an OTC derivative?

A

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.

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4
Q

What is a market maker?

A

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

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5
Q

What is the difference between a forward commitment and a contingent claim?

A

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

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6
Q

Contingent claims that depend on a credit event occurring such as default or credit downgrade are known as…?

A

Credit derivatives

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7
Q

A legally binding contract to perform some action in the future is defined as a…?

A

Forward contract

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8
Q

What is the value of a forward and future at initiation?

A

Both forwards and futures have a 0 value at initiation

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9
Q

What is a futures contract?

A

Futures contract: A forward contract that is standardized and exchange-traded

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10
Q

What is the difference between a forward and a future

A

Futures are traded on a standardised exchange, are subject to greater regulation, backed by a clearinghouse and require daily settlements of gains and losses

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11
Q

What is an initial margin for a future?

A

Initial margin: The amount that must be deposited in the futures account before any trade is made to cover any losses

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12
Q

What is the maintainance margin for a futures contract?

A

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

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13
Q

Do futures and forwards recognise their profits at the same time every day?

A

No futures recognise their profits at increments intra day, forwards only recognise their profits at expiration

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14
Q

Forward agreements to exchange a series of payments on periodic settlement dates over a certain time period, are known as…?

A

Swaps

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15
Q

Is the notional amount exchanged in a swap?

A

No

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16
Q

What is the difference between a plain vanilla IRS and a basis swap?

A

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)

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17
Q

Describe the right / or obligation of a holder of a long call?

A

The buyer of a call option has the right to buy an underlying asset.

18
Q

Describe the right / or obligation of a holder of a short put?

A

The writer (seller) of a put option has the obligation to buy the underlying asset.

19
Q

What is the difference between American and European options?

A

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.

20
Q

What type of derivative is used to manage commodity risk?

A

Futures

21
Q

What is a credit default swap?

A

Credit default swap: A financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default.

22
Q

What is the payoff of a call option?

A

The greater of the stock price minus the strike price or 0 less the option premium

23
Q

What is the payoff of a put option?

A

The greater of the strike price minus the stock price or 0 less the option premium

24
Q

Forwards and futures have linear payoffs whereas options have ___?

A

Non-linear payoffs

25
Q

What are the benefits of using derivatives?

A 
Reduce transaction costs
Lower capital requirements
Greater liquidity than spot market
Reduce risk
Provide price information
26
Q

What are the drawbacks of using derivatives?

A

Risky

Investors may have limited knowledge and not know how to use them properly

27
Q

What does the arbitrage law of one price state?

A

2 securities with the same cash flows must have the same price

28
Q

What is the formula for the no-arbitrage FWD price at time t?

A

Ft(T) = (St - net cost of carry)*(1+Rf)^(T-t)

29
Q

What is the formula for the net cost of carry?

A

net cost of carry (or simply carry) = PV(benefits of holding the asset) – PV(costs of holding the asset)

30
Q

When interest rates and futures prices for an asset are uncorrelated what is greater futures price or fwd price?

A

They are equal

31
Q

When interest rates and futures prices for an asset are positively correlated what is greater futures price or fwd price?

A

Futures prices are greater

32
Q

What is the formula for the time value of an option?

A

Time value of an option = Value of an option minus intrinsic value of an option

33
Q

How does an increase in volatility increase call option price?

A

Increases call option value

34
Q

How does an increase in Rf impact call option value?

A

Increases call option value

35
Q

How does an increase in strike price impact call option value?

A

Decreases call option value

36
Q

How does an increase in stock price impact call option value?

A

Increases call option value

37
Q

How does an increase in strike price impact put option value?

A

Increases put option value

38
Q

How does an increase in time to maturity impact put option value?

A

Increases put option value

39
Q

What is the put call parity equation?

A

( C + \frac{X}{(1+R_f)^T} = S_0 + P )

40
Q

What is the forward put call parity equation?

A

( C + \frac{X}{(1+R_f)^T} = \frac{F}{(1+R_f)^T} + P )

41
Q

When is an American put option more expensive in comparison to a European put option?

A

In the run up to maturity if the American put is deep in the money

42
Q

Explain when a American call option will be more expensive in comparison to a European call option?

A

If an American call option has cash flows throughout the life of the option

CFA Exam Level 1 (10 decks)

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