Derivatives Flashcards
Derivative
mutual funds and exchange-traded funds, which would never be viewed as derivatives
Derivatives are similar to insurance in that both allow for the transfer of risk from one party to another.
any security whose value is determined by or from the value or return of another asset or security
( a contract whose value is based on something else/derives it’s value from the value of another security)
the asset from which a derivative gets a value is called an underlying asset.
most common underlying assets include commodities, stocks, bonds, interest rates, and currencies
their value depends on the value of something else, the underlying asset. so the change in the value of the derivatives underlying cause the change in the value of the derivative itself.
. Perhaps the distinction that best characterizes derivatives is that they usually transform the performance of the underlying asset before paying it out in the derivatives transaction. In contrast, with the exception of expense deductions, mutual funds and exchange-traded funds simply pass through the returns of their underlying securities. This transformation of performance is typically understood or implicit in references to derivatives but rarely makes its way into the formal definition.
As everyone knows, insurance is a financial contract that provides protection against loss. The party bearing the risk purchases an insurance policy, which transfers the risk to the other party, the insurer, for a specified period of time. The risk itself does not change, but the party bearing it does. Derivatives allow for this same type of transfer of risk. One type of derivative in particular, the put option, when combined with a position exposed to the risk, functions almost exactly like insurance, but all derivatives can be used to protect against loss. Of course, an insurance contract must specify the underlying risk, such as property, health, or life. Likewise, so do derivatives. As noted earlier, derivatives are associated with an underlying asset.
Long and Short Positions
Uses of derivatives
Derivatives are created in the form of legal contracts. They involve two parties—the buyer and the seller (sometimes known as the writer)—each of whom agrees to do something for the other, either now or later. The buyer, who purchases the derivative, is referred to as the long or the holder because he owns (holds) the derivative and holds a long position. The seller is referred to as the short because he holds a short position.
- hedging: minimizing risk in the physical market
- speculation: hope of gain but with the risk of loss.
- arbitrage: simultaneous buying and selling to take advantage of different prices for the same assets.
Exchange traded derivatives
OTC
traded org. that are standardized and highly regulated , high liquidity ,centralized trading location backed by clearinghouse, instruments: futures and options.
non standardized and more lightly regulated markets ,low liquidity, a dealer market with no central traded location , instruments: swaps , exotics and forwards.
types of derivatives
Two classes of derivatives
forwards futures options swaps credit derivatives
Forward Commitment ( futures, forwards, swaps ) Contingent Claims ( options, credit derivatives )
contingent claim
(is a claim that depends on a particular event /
a derivative in which outcome or payoff is determined by the outcome or payoff of an underlying asset ,conditional on some event occurring.)
options and credit derivatives are contingent claims.
the right but not the obligation to buy or sell the underlying at a pre-determined price. Because the choice of buying or selling versus doing nothing depends on a particular random outcome, these derivatives are called contingent claims
forward commitments
is a legally binding promise to perform some actions in future (agree today to trade something in the future)
forward commitment includes futures ,forwards ,swaps
Some provide the ability to lock in a price at which one might buy or sell the underlying. Because they force the two parties to transact in the future at a previously agreed-on price, these instruments are called forward commitments
The advantages of derivates over cash market are
Easier to go short; Relatively high degree of leverage; Lower transaction cost; High liquidity and Effective risk management
forward contract
parties are committed to buy/sell an underlying asset at some future date at a delivery price set in advance (forward price) a party seeks to enter into a forward contract to speculate on the future price of an asset but more often a party seeks to enter into a forward contract to hedge an existing exposure to the risk of asset price or interest rate changes . A forward contract can be used to reduce or eliminate uncertainty about the future price of an asset it plans to buy or sell at a later date. This contract can be used to reduce or eliminate uncertainty about the future price
neither party makes a payment at the initiation of the contract
The party to the forward contract who agrees to buy the financial or physical asset has a long forward position and is called the long . The party to the forward contract who agrees to sell or deliver the asset has a short forward position and is called the short.
if the expected future price of the asset falls below the forward price, the result is opposite and the right to sell will have a positive value and vice versa.
Failure to do so constitutes a default and the non-defaulting party can institute legal proceedings to enforce performance. It is important to recognize that although either party could default to the other, only one party at a time can default. The party owing the greater amount could default to the other, but the party owing the lesser amount cannot default because its claim on the other party is greater. The amount owed is always based on the net owed by one party to the other.
cash settled forward contracts / non deliverable forwards/ contracts for difference
one party pays cash to another when the contract expires based on the difference between the forward price and the market price of the underlying asset (i.e the spot price ) at the settlement date.
futures contract
(futures contract is a forward contract that is standardized and exchange traded.)
The primary ways in which forwards and futures differ are that futures are traded in the active secondary market, subject to greater regulation,backed by clearinghouse and require a daily cash settlement of gains and losses.
The futures contracts are similar to forward contract is that i)both can be either deliverable or cash settled contracts. ii) have contract prices set so each side of the contract has a value of zero at the initiation of the contract
A futures contract is a standardized derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.
characteristics of futures
standardization:
Recall that in forward contracts, the parties customize the contract by specifying the underlying asset, the time to expiration, the delivery and settlement conditions, and the quantity of the underlying, all according to whatever terms they agree on. These contracts are not traded on an exchange.
Backed by a Clearinghouse:
It guarantees that traders will honor their obligations.
It acts as a buyer to every seller, and as a seller to every buyer, and vice versa.
Distinguish Between Forward Contract and Future Contract
FORWARDS
Traded OTC
Private agreements-highly customized
Credit risk is high, P&L accumulates till the end
Settlement at the end of contract and on a specific date
Mostly used by hedgers that want to remove the volatility of the underlying
FUTURES
Traded on exchanges
Standardized contracts
Clearing house and daily mark-to-market reduces credit risk
Settlement can occur over a range of dates
Usually closed out before maturity, hardly any deliveries happen
futures contracts are similar to forward contracts
can be either deliverable or cash settled contracts
have contract prices set so each side of the contracts has a value of zero value at the initiation of the contract.
settlement price
is analogous (related)to closing price of the stock but is not simply the price of the final trade of the day.it is the average of the prices of the trade during the last period of trading called the closing period, which is set by the exchange. the settlement price is used to calculate the daily gain or loss at the end of each trading day. on it’s final day of trading the settlement price is equal to the spot price of the underlying asset.
marking to market
Marking-to-market involves adjusting the margin account to reflect the change in the price of the underlying security.
( each day the margin balance in a futures account is adjusted for any gains and losses in the value of the futures position based on a new settlement price)
Margin
both parties deposit a required minimum sum of money as a performance guarantee prior to entering into a futures contract. this provides protection for clearinghouse.
initial margin
the amount that must be deposited in a futures account before a trade may be made
maintenance margin
minimum amount of margin that must be maintained into a futures account. if the margin balance falls below the maintenance margin through daily settlement of gains and losses, additional funds must be deposited to bring the margin balance back up.
Variation Margin
After a margin call, the investor needs to get the account back up to the initial margin (Remember! Not the maintenance margin); the amount to be deposited is called the variation margin.
price limits
exchange imposed limits on how each day’s settlement price can change from the previous day’s settlement price . trades should be made within the price limits
limit move
limit up
limit down
locked limit
limit move due to market conditions
price goes up due to market conditions
price goes down due to market conditions
if trades cannot take place because of limit move
swaps
A swap is an over-the-counter derivative
contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either (1) a variable series determined by a different underlying asset or rate or (2) a fixed series.
a swap is more like a forward than a futures contract
Length of the swap is termed the tenure of the swap and the contract ends on the termination date
Swaps are similar to forwards in several ways:
Swaps typically require no payment by either party at initiation
Swaps are custom instruments
Swaps are not traded in any organized secondary market
Swaps are largely unregulated
Default risk is an important aspect of the contract
Most participants in the swaps market are large institutions
Individuals are rarely swap market participants
fixed-for-floating interest rate swap/“plain vanilla swap” /vanilla swap
Basis swap
Plain Vanilla Interest Rate Swap is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount
Involves trade one set of floating rate payments agrees pay fixed rate interest and has the pay fixed side of the swap
floating interest rate
A floating interest rate, also known as a variable or adjustable rate, refers to any type of debt instrument, such as a loan, bond, mortgage, or credit, that does not have a fixed rate of interest over the life of the instrument.[1]
Floating interest rates typically change based on a reference rate (a benchmark of any financial factor, such as the Consumer Price Index).[1] One of the most common reference rates to use as the basis for applying floating interest rates is the London Inter-bank Offered Rate, or LIBOR (the rates at which large banks lend to each other).
options
An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.
The owner of call option has the right to purchase the underlying asset at a specific price for a specific time period
The owner of put option has the right to sell the underlying asset at the specific price for a specific time period
four possible options positions
(The seller of the option is also called the option writer)
The price of an option is referred to as option premium
long call- buyer has the right to buy an underlying asset
short call- seller has the obligation to sell the underlying asset
long put-buyer has the right to sell the underlying asset
short put-seller has the obligation to buy the underlying asset
types of 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
exercise price /strike price/ strike / striking price
A strike price is the set price at which a derivative contract can be bought or sold when it is exercised. For call options, the strike price is where the security can be bought by the option holder; for put options, the strike price is the price at which the security can be sold.
option premium
It represents a fair price of the option, and in a well-functioning market, it would be the value of the option.
(price of a option)
credit derivatives
A credit derivative is a class of derivative contracts between two parties, a credit protection buyer and a credit protection seller, in which the latter provides protection to the former against a specific credit loss.
types of credit derivatives
Total return swap
credit spread option
credit linked note
credit default swaps
Total Return Swap
the underlying is typically a bond or loan, in contrast to, say, a stock or stock index. The credit protection buyer offers to pay the credit protection seller the total return on the underlying bond. This total return consists of all interest and principal paid by the borrower plus any changes in the bond’s market value. In return, the credit protection seller typically pays the credit protection buyer either a fixed or a floating rate of interest. Thus, if the bond defaults, the credit protection seller must continue to make its promised payments, while receiving a very small return or virtually no return from the credit protection buyer. If the bond incurs a loss, as it surely will if it defaults, the credit protection seller effectively pays the credit protection buyer.
It is defined as the total transfer of both the credit risk and market risk of the underlying asset. The assets commonly are bonds, loans and equities.
credit spread option
the credit spread is a reflection of investors’ perception of credit risk. Because a credit spread option requires a credit spread as the underlying, this type of derivative works only with a traded bond that has a quoted price. The credit protection buyer selects the strike spread it desires and pays the option premium to the credit protection seller. At expiration, the parties determine whether the option is in the money by comparing the bond’s yield spread with the strike chosen, and if it is, the credit protection seller pays the credit protection buyer the established payoff. Thus, this instrument is essentially a call option in which the underlying is the credit spread.
A credit spread, or net credit spread, involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. Investors receive a net credit for entering the position, and want the spreads to narrow or expire for profit
credit-linked note (CLN)
With this derivative, the credit protection buyer holds a bond or loan that is subject to default risk (the underlying reference security) and issues its own security (the credit-linked note) with the condition that if the bond or loan it holds defaults, the principal payoff on the credit-linked note is reduced accordingly. Thus, the buyer of the credit-linked note effectively insures the credit risk of the underlying reference security.
It is structured as a security with an embedded CDS allowing the issuer to transfer a specific credit risk to credit investors. In this case the issuer is not obligated to repay the debt if a specified event occurs. The ultimate purpose of the CLN is to pass on the risk of specific default to the investors who are willing to bear the risk in return for higher yield.
credit default swap (CDS).
A credit default swap is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the default of a third party.
collateralized mortgage obligation CMO
A security created through the securitization of a pool of mortgage-related products (mortgage pass-through securities or pools of loans).
A CMO involves pooling mortgages into a special purpose entity, from which different tranches of the securities are then sold to investors.
collateralized bond obligations
A structured asset-backed security that is collateralized by a pool of bonds.
collateralized loan obligation
A structured asset-backed security that is collateralized by a pool of loans.
collateralized debt obligations, or CDOs
Generic term used to describe a security backed by a diversified pool of one or more debt obligations.
asset-backed security
An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments made by the debt securities such that prepayments or credit losses are allocated to the most-junior tranches first and the most-senior tranches last.
Equities
Equities are one of the most popular categories of underlying’s on which derivatives are created
two types of equities on which derivatives exist
individual stocks and stock indexes
Currency Derivative
Currency risk is a major factor in global financial markets, and the currency derivatives market is extremely large. Options, forwards, futures, and swaps are widely used. Currency derivatives can be complex, sometimes combining elements of other underlying’s.
Commodity Derivatives
Commodity derivatives are widely used to speculate in and manage the risk associated with commodity price movements. The primary commodity derivatives are futures, but forwards, swaps, and options are also used. The reason that futures are in the lead in the world of commodities is simply history. The first futures markets were futures on commodities.
There has been a tendency to think of the commodities world as somewhat separate from the financial world. Commodity traders and financial traders were quite different groups. Since the creation of financial futures, however, commodity and financial traders have become relatively homogeneous. Moreover, commodities are increasingly viewed as an important asset class that should be included in investment strategies because of their ability to help diversify portfolios.
bubbles
crashes
Bubbles occur when prices rise for a long time and appear to exceed fundamental values.
Crashes occur when prices fall rapidly
Although bubbles, if they truly exist, are troublesome, crashes are even more so because nearly everyone loses substantial wealth in a crash. A crash is then typically followed by a government study commissioned to find the causes of the crash.
speculation
for hedging to work, there must be speculators. Someone must accept the risk. Derivatives markets are unquestionably attractive to speculators. All the benefits of derivatives draw speculators in large numbers, and indeed they should. The more speculators that participate in the market, the cheaper it is for hedgers to lay off risk. These speculators take the form of hedge funds and other professional traders who willingly accept risk that others need to shed. In recent years, the rapid growth of these types of investors has been alarming to some but almost surely has been beneficial for all investors.
Unfortunately, the general image of speculators is not a good one. Speculators are often thought to be short-term traders who attempt to exploit temporary inefficiencies, caring little about long-term fundamental values. The profits from short-term trading are almost always taxed more heavily than the profits from long-term trading, clearly targeting and in some sense punishing speculators. Speculators are thought to engage in price manipulation and to trade at extreme prices.15 All of this type of trading is viewed more or less as just a form of gambling.
gambling
Gambling typically benefits only a limited number of participants and does not generally help society as a whole., the benefits of derivatives are broad, whereas the benefits of gambling are narrow.
Arbitrage
Arbitrage is an imp concept in valuing derivatives securities. arbitrage opportunities arise when assets are mispriced. trading by arbitrageurs will continue until they affect supply & demand enough to bring assets prices to efficient levels.
Two types of arbitrage
- Law of one price —- two securities or portfolios that have identical cash flow in the futures regardless of future events should have the same price
if A & B have the identical future payoff & A is priced lower than B, buy A& sell B . you have an immediate profit. - requires an investment—if a portfolio of securities or assets will have a certain payoffs in the future there is no risk in investing in that portfolio
(reading 2)four main types of underlying on which derivatives are based
equities, fixed-income securities/interest rates, currencies, and commodities
holding period
The price of a financial asset is often determined using a present value of future cash flows approach. The value of the financial asset is the expected future price plus any interim payments such as dividends or coupon interest discounted at a rate appropriate for the risk assumed. Such a definition presumes a period of time over which an investor anticipates holding an asset, known as the holding period
The investor forecasts the price expected to prevail at the end of the holding period as well as any cash flows that are expected to be earned over the holding period. He then takes that predicted future price and expected cash flows and finds their current value by discounting them to the present. Thereby, the investor arrives at a fundamental value for the asset and will compare that value with its current market price. Based on any differential relative to the cost of trading and his confidence in his valuation model, he will make a decision about whether to trade.
The Formation of Expectations
Let us first assume that the underlying does not pay interest or dividends, nor does it have any other cash flows attributable to holding the asset.
Using a probability distribution, the investor forecasts the future over a holding period spanning time 0 to time T. The center of the distribution is the expected price of the asset at time T, which we denote as E(ST), and represents the investor’s prediction of the spot price at T. The investor knows there is risk, so this prediction is imperfect—hence the reason for the probability distribution. Nonetheless, at time 0 the investor makes her best prediction of the spot price at time T, which becomes the foundation for determining what she perceives to be the value of the asset.3
The Required Rate of Return on the Underlying Asset
To determine the value of the asset, this prediction must be converted into its price or present value. The specific procedure is to discount this expected future price, but that is the easy part. Determining the rate at which to discount the expected future price is the hard part. We use the symbol k to denote this currently unknown discount rate, which is often referred to as the required rate of return and sometimes the expected rate of return or just the expected return. At a minimum, that rate will include the risk-free rate of interest, which we denote as r. This rate represents the opportunity cost, or so-called time value of money, and reflects the price of giving up your money today in return for receiving more money later
The Risk Aversion of the Investor
We can generally characterize three potential types of investors by how they feel about risk: risk averse, risk neutral, or risk seeking
risk averse,
risk neutral,
risk seeking
Risk-neutral investors are willing to engage in risky investments for which they expect to earn only the risk-free rate. Thus, they do not expect to earn a premium for bearing risk. For risk-averse investors, however, risk is undesirable, so they do not consider the risk-free rate an adequate return to compensate them for the risk. Thus, risk-averse investors require a risk premium, which is an increase in the expected return that is sufficient to justify the acceptance of risk. All things being equal, an investment with a higher risk premium will have a lower price. It is very important to understand, however, that risk premiums are not automatically earned. They are merely expectations. Actual outcomes can differ. Clearly stocks that decline in value did not earn risk premiums, even though someone obviously bought them with the expectation that they would. Nonetheless, risk premiums must exist in the long run or risk-averse investors would not accept the risk.
The third type of investor is one we must mention but do not treat as realistic. Risk seekers are those who prefer risk over certainty and will pay more to invest when there is risk, implying a negative risk premium. We almost always assume that investors prefer certainty over uncertainty, so we generally treat a risk-seeking investor as just a theoretical possibility and not a practical reality.
We will assume that investors are risk averse. To justify taking risk, risk-averse investors require a risk premium. We will use the Greek symbol λ (lambda) to denote the risk premium.
The Pricing of Risky Assets
S0, by discounting the expected future price of an asset with no interim cash flows, E(ST), by r (the risk-free rate) plus λ (the risk premium) over the period from 0 to T.
S0= E(ST)/(1+r+lambda)raised to t
Other Benefits and Costs of Holding an Asset
refer curriculum slide 1
