Derivatives Flashcards
A forward commitment
a legally binding promise to perform some action in the future e.g. forward/future contracts, swaps
A contingent claim
a claim (to a payoff) that depends on a particular event e.g. options, credit derivatives
benefits of derivatives market
- provide price information
- risk mitigation
- reduce transaction costs
cash settlement forward contract
either the long or the short in the forward contract will make a cash payment at contract expiration and the asset is not delivered.
open interest
the number of futures contracts of a specific kind outstanding at any given time
Derivatives pricing models use the risk-free rate to discount future cash flows because these models:
are based on portfolios with certain payoffs.
Derivatives pricing models use the risk-free rate to discount future cash flows (risk-neutral pricing) because they are based on constructing arbitrage relationships that are theoretically riskless
The value of a forward or futures contract at initiation and expiration:
Initiation: typically 0
Expiration: spot price - contract price
The price of a forward or futures contract
The price specified in the contract at which the two parties agree to trade the underlying asset on a future date. This remains the same over the term of the contract.
Convenience yield
nonmonetary benefits from holding an asset e.g. an asset that is difficult to sell short when it is perceived to be overvalued
why forward and future prices differ
- futures gains and losses are settled each day and margin balance is adjusted accordingly.
- if futures prices are positively (P ↑) or negatively (P ↓) correlated with INTEREST RATES
The price of a fixed-for-floating interest rate swap
The fixed rate specified in the swap contract.
Typically a swap will be priced such that it has a value of zero at initiation and neither party pays the other to enter the swap.
Six factors that determine options prices
- price of underlying asset
- exercise price
- risk-free rate of interest (Rf ↑, call option values ↑, put option values ↓)
- volatility of underlying asset
- time to expiration
- cost/benefits of holding asset
How does the value of a long position in a forward/future differ from the value of a short position during its life?
The long and short positions in a forward or futures contract have opposite values. A gain for one is an equal-sized loss for the other.
What is the impact of increased volatility on the value of call and put options?
Volatility ↑, call option values ↑, put option values ↑
Greater volatility in the price of the underlying asset increases the values of both puts and calls because options are “one-sided.” Since an option’s value can fall no lower than zero (it expires out of the money), increased volatility increases an option’s upside potential but does not increase its downside exposure.
