Derivatives Flashcards
contract size of treasury bonds ?
Treasury bonds: $100,000
Unaholding FinServices Corporation last quarter entered into a derivative contract that has since become a relatively large position. In response to a query by the Board’s Risk Committee, the Chief Financial Officer (CFO) makes the argument that the derivate trade is a hedge, rather than a speculation or an arbitrage. Which of the following is the best support for her argument that the trade is a hedge?
a. The potential loss on the derivative contract itself is capped (aka, limited) to a 25% loss
b. The derivative’s initial value was zero and trade is considered non-directional or range-bound
c. The derivative’s value is highly correlated (negatively or positively) to an underlying exposure at the corporation
d. The net position (the derivative plus an underlying exposure) eliminates all risks; i.e., the net position is without risk
C. TRUE: The derivative’s value is highly correlated (negatively or positively) to an underlying exposure
In regard to false (A), the hedge instrument does not need to be capped; e.g., a short forward position is uncapped
In regard to false (B), most derivates have an initial value of zero to both counterparties, and range-bound trades (e.g., volatility) do not per se classify a trade as a hedge
In regard to false (D), a hedge cannot eliminate basis risk.
Which transaction is likely to governed by an ISDA agreement?
a. OTC derivative trade
b. Exchange-traded derivative instrument
c. Both OTC and exchanged-traded instrument
d. Neither OTC nor exchange-traded instrument
A. OTC derivative trade
It is a great advantage to standardize the terms of a bilateral trade under an ISDA template.
An exchange-traded derivative already has standardized specifications.
A. OTC derivative trade
It is a great advantage to standardize the terms of a bilateral trade under an ISDA template.
An exchange-traded derivative already has standardized specifications.What is the chief advantage of a derivatives trade, that intends to hedge an exposure, on the OTC market over a similar trade on an exchange?
a. Greater liquidity
b. Lower counterparty risk
c. Lower basis risk
d. Ability to trade an option instead of a futures contract
C. Lower basis risk
Lower basis risk is the key hedging advantage afforded to the CUSTOMIZATION (or “tailoring”) of the instrument to the underlying exposure; the exchange-traded instrument is standardized.
In regard to (A) and (B), please note these are decidedly false: an exchange-traded market generally offers superior liquidity and lower counterparty risk.
Which BEST summarizes Hull’s explanation for the ephemeral (short-lived) existence of arbitrage opportunities?
a. Efficient markets
b. Arbitrageurs conducting arbitrage
c. Transaction costs
d. Information technology
B. Arbitrageurs conducting arbitrage
Hull: “Arbitrage opportunities such as the one just described cannot last for long. As arbitrageurs buy the stock in New York, the forces of supply and demand will cause the dollar price to rise. Similarly, as they sell the stock in London, the sterling price will be driven down. Very quickly the two prices will become equivalent at the current exchange rate. Indeed, the existence of profit-hungry arbitrageurs makes it unlikely that a major disparity between the sterling price and the dollar price could ever exist in the first place. Generalizing from this example, we can say that the very existence of arbitrageurs means that in practice only very small arbitrage opportunities are observed in the prices that are quoted in most financial markets. In this book most of the arguments concerning futures prices, forward prices, and the values of option contracts will be based on the assumption that no arbitrage opportunities exist.”
In regard to option mechanics, each of the following is true EXCEPT which is not?
a. A margin account is required when clients write (ie, sell) options but not when they buy options
b. An American option is always worth at least as much as a European option on the same asset with the same strike price and exercise date.
c. To hedge foreign exchange risk, a long binary option on the currency provides insurance that is identical to a short foreign exchange futures contract
d. While the exercise of an exchange-traded option typically does not cause dilution of the underlying company’s equity, the exercise of an employee stock option (ESO) typically does cause dilution
C. False. A futures (forward) contract provides more complete insurance than an option, but the hedged outcome can be significantly worse than the un-hedged outcome; also, an option requires an up-front premium. A binary option provides a fixed payoff if the strike price is reached, so this answer is doubly false.
In regard to (A), (B), and (D), each is TRUE.
In regard to true (A): A margin account is required when clients write (ie, sell) options but not when they buy options. The purchase of an option does not create a potential future obligation.
In regard to true (B): An American option is always worth at least as much as a European option on the same asset with the same strike price and exercise date. This is a true statement because the American style option gives you everything you get in the equivalent European (i.e., the option to exercise at maturity) plus you get an early exercise option, so it must be worth more. We can think of an American option as its European equivalent plus an embedded option to exercise early, such that its value is greater by the value of this embedded option.
In regard to false (C): A binary option is discontinuous (it pays something or nothing), so does not match the hedge efficacy of a futures contract (with payoff that it more continuous) but, even if we ignore this fact, there is the essential difference in insurance terms between an option and a futures contract: the option requires an up-front premium which may be lost, but that is the capped profit downside, compared to a futures contract that does not require an up-front premium, yet has a symmetrical payoff with the possibility of a significant downside loss.
In regard to true (D): An exchange-traded option is a derivative contract. The counterparties and the exchange can reference the underlying stock involving the reference company. On the other hand, an ESO is granted by the company and its exercise is dilutive (e.g., a key motivation of high-tech company buybacks is to mitigate/offset the dilution created by ESO grants).
EACH of the following is NECESSARILY TRUE about the relationship between “time to expiration” (T) and option price EXCEPT:
a. An increase in time to expiration (T) implies an increase in the option price for an American call on a non-dividend-paying stock
b. An increase in time to expiration (T) implies an increase in the option price for a European call on a non-dividend-paying stock
c. An increase in time to expiration (T) implies an increase in the option price for an American put on a dividend-paying stock
d. An increase in time to expiration (T) implies an increase in the option price for a European put on a dividend-paying stock
D. Time to expiration (T) is not necessarily an increasing function for European calls/puts on dividend-paying stocks.
Time to expiration is an increasing function of (i) American calls/puts (on both dividend- or non-dividend-paying stocks) and (ii) European calls/puts on non-dividend-paying stocks.
Consider the following conditions with respect to a marketable American CALL option on a non-dividend-paying stock:
I. Risk-free rate (Rf) is increasing
II. Volatility (sigma) of underlying stock is decreasing
III. The underlying stock price (S) is increasing
IV. Investor has good reason to think stock is currently (S0) overpriced
Under which of the above condition(s) is it theoretically optimal, or increasingly advisable, to “early” exercise (i.e., prior to expiration) the marketable American CALL option on the non-dividend-paying stock?
a. III. only
b. II., III. and IV.
c. I., II., III. and IV.
d. None of the above
D. None of the above
It is never optimal to exercise an American call option on a non-dividend-paying stock before the expiration date.
In regard to (IV.), please note the option is marketable and, in Hull’s theory, if the stock is deemed overpriced, it is best to sell the option.
