Derivatives Flashcards
What is a derivative?
The securities whose prices are determined by or derived from the price of other securities. e.g. the price of a call option depends on the value of the underlying equity (rather than buying the specific share of a company, you buy the right to buy the share)
What is the point in derivatives?
They allow a company and investor to control the level of risk they are willing to bear
What is an Option contract?
They give the owner the right to buy or sell an asset at a fixed price on or before a given date.
This is a right, not an obligation.
What does “Exercising the Option” mean?
The act of buying or selling the underlying asset via the option contract
What is the “Strike” or “Exercise” price?
The fixed price in the option contract at which the holder can buy or sell the underlying asset
What is the expiration date?
The maturity date of the option; after this date, the option is dead
What is the difference between American and European options?
An American option may be exercised any time up to the expiration date
A European option can only be exercised on the expiration date
What is a call option?
The right to BUY an asset for a fixed price during a set period
The call option is out of the money if the share price is lower than the exercise price
The call option is in the money if the share price is higher than the exercise price
How do we draw a call option on a graph?
What is a put option?
The owner has the right to SELL an asset for a fixed price during a set period
How do we draw a put option graph?
What is writing an option?
An investor who writes (Sells) a call on equity MUST deliver shares of the equity to the holder (buyer) if the holder exercises the call
They do this because they are paid by the holder for the right of the option
What is the value of the call option BEFORE expiration?
It is the share price minus the present value of the exercise price
i.e. if the value of a share is £75, the strike/exercise price of the call option is £55, the interest rate is 5% annually. The value of the call one-year before the expiration will be £75 - (£55/1+0.05) = £22.619
What is the value of the put option BEFORE expiration?
The present value of the exercise price minus the share price
i.e. if the value of a share is £75, the strike/exercise price of the call option is £55, the interest rate is 5% annually. The value of the call one-year before the expiration will be (£55/1+0.05) - (£75) = -£22.619
Table explaining how Calls and Puts interact with certain factors?
What is the binomial (two-state) option model?
We assume that the future share price will be one of two values
By eliminating the possibility that the share price can take on other values, we are able to duplicate the option exactly.
For instance, we can determine the price of a call such that its return is identical to return of the share-with-borrowing alternative
Why do we use the Black-Scholes model?
It is an extension of the binomial model
We are at time, t, and we say at time t+1 the share price will be affected by the standard deviation
When t is negligible, there will be only two options
What are the ‘Greeks’?
What is hedging?
When a firm uses derivatives to reduce their risk.
Hedging offsets the firm’s risk, such as the risk in a project, by one or more transactions in the financial markets
What is speculating?
When derivatives are used to make profit by betting on the movement of some economic variables that underlie the derivative
What is the difference between Hedging and Speculating?
What is a forward contract?
A payment made today for delivery and payment at a future date (certain time and price)
Both the buyer and seller are obligated to perform under the terms of the contract
What is a Futures contract?
What are the differences between futures and forwards?
