Derivatives Flashcards
Futures
Exchange traded forward contract
Legally binding agreement to buy/sell asset at specified future date at price agreed when contract is made
Buyers take long position -expect prices to rise
Sellers take short position - expect prices to fall
The long futures position makes money in a rising market and loses money in a falling market
The short futures position hopes to make money in a falling market and loses money in a rising market
Initial margin acts as collateral
Marking to market - revalued on daily basis
Position closes when contract reaches expiry or investor ‘closes out’ position
Can be used to hedge portfolios against adverse market conditions
When the futures price is higher than the price of the underlying asset - market is in Contango.
When the futures price is lower than the price of the underlying asset, the market is-in backwardation.
Options
Gives buyer right but not obligation to
buy/sell specific asset at fixed price before or on a certain date
Call option - right to buy
Put option - right to sell
Buyer of a call option takes a long call
position - the more the price rises the more profit the buyer will make
Buyer of a put option takes a long-put
position - the more the price of the
underlying asset falls the greater the profit for the buyer
Margin payments - made by seller only
Choices are: exercise/sell/expire
Intrinsic value (value of the option)
In-the-money - strike price is below current price of asset
Out-of-the-money - strike price is above current price of asset
At-the-money - strike price is the same as the current price of asset
The more time an option has luntil expiry the greater the chance it will end up in-the- money (so higher premium)
Hedging advantages
Lower dealing costs than trading underlying physical assets
Speed of dealing
Liquidity
Traditional warrants
Traditional warrants
Long-term call option issued by companies
Holder has right but no obligation to buy shares at fixed price and date
Covered warrants
Type of option issued by financial institutions such as investment banks- traded on LSE
O
‘Covered’ because investment bank (the writer) covers or hedges its exposure by either
buying the underlying stock or takes out futures or options on an exchange
Specialised collectives
Futures and options funds (FFs), geared futures and options funds (GFOFs), capital
protected unit trusts and OEICs
Contracts for difference
Contracts for difference
O
Geared investment used for trading shares (long or short)
C
Geared so only proportion of the value of a trade is needed to fund a trade
O
Used by stock market traders
Spread and binary betting
Placing bets with a spread betting firm
Trading is done on a margin
Pure speculation
Hedge funds
Pooled investments
Hedge Fund Association recognise 14 different investment strategies offering different risk/return
Most hedge funds aim to limit downside volatility
Gearing used by some hedge funds (adds to risk)
Usually limited partnerships or offshore funds
High minimum investment
Hedge fund strategies
Long/short funds - equity and/or fixed interest
Relative value funds - no market related element in returns
Event driven funds - use price movements from anticipated corporate events to achieve returns
Tactical trading funds - trade in currencies, bonds, commodities, equities (in each asset class they may use the same long/short approach as equity hedge funds)
Hedge fund advantages and disadvantages
Advantages
Diversification
Low volatility strategy
Expertise of fund manager
Disadvantages
Lack of regulation/protection
High minimum investment
Complex
Volatile
Structure of structured products
100% capital protection
Partial capital protection
No protection
