Derivatives Flashcards
derivatives
a security which derives its value from the value or return on another asset or security
leverage
borrowing money in order to place a larger trade than the size of your account
initial margin
the amount of funds required in the account to initially open a trade
maintenance margin
the minimum amount of funds that must be maintained in the account to maintain the trade
if the account equity declines below maintenance margin, this triggers a
margin call, at which the investor must deposit funds to bring the account back up to the initial margin
forwards
one party agrees to buy a physical or financial asset on a specified date at a specified price
- can be used either for speculative purposes or to hedge a market risk
traded over the counter OTC
which means there is no using dealers with no central location
-largely unregulated
-each contract has a counterparty which exposes owner to default risk
futures
are the exact same as a forward with the following differences:
-futures are traded on organized exchanges
-futures are standardized
-futures have a clearinghouse which removes counterparty risk
-futures markets are regulated
types of futures/ forwards
commodity contracts
foreign exchange
indices
individual securities
commodity contracts
crude oil, corn, gold, soybean, etc
foreign exchange
EUR/USD, USD/JPY, GBP/EUR etc
indices
S&P 500, nasdaq
individual securities
apple, tesla, walmart etc
uses of the forward and futures market
hedging
speculation
hedging
using the market to reduce the volatility in a Company’s cash flows.
Example: a Company purchases aluminum, so they buy an aluminum future to lock in the price of their raw material
forward is mainly in hedging
forward is more meaningful in Company entities
speculation
an individual or firm purchases or sells a future in order to attempt to profit on price movement
most transactions in the futures market are for speculation
Arbitrage
A transaction in which an investor purchases one asset or a portfolio of assets at one price, and simultaneously sells an asset or portfolio that has the same future payoffs at a higher price. this generates risk-free gain
Risk free gain is capped at
the risk-free rate in the market. if there are arbitrage opportunities they are exploited quickly, driving the return to the market risk free rate
short:
selling an asset that you don’t actually have
future price=
spot price * (1 + RFR) ^ time
assumes no dividends or cost of storage
benefits of holding an asset
income outside of price appreciation. Dividends on stocks, coupon payments on bonds
costs of holding an asset
storage costs to hold a physical asset. Not typically associated with financial assets
net cost of carry
present value of benefits of holding an asset, minus the present value of the costs of holding an asset
futures price=
(spot price - net cost of carry) * (1+RFR)^t
options
-gives the owner the right, but not obligation, to either buy or sell an underlying asset at a given price for specified time
-the person purchasing the option will pay the seller, or “writer” of the option an up front payment, or “premium” for this right
-can be used for hedging, but primarily used for high-risk speculation
options trading
call option
put option
call option
the buyer has the right to buy an asset at a specified price, known as the strike price. a trader purchasing a call option is speculating that the price will increase above said price
put option
the buyer has the right to sell an asset at a specified price, known as a strike price. a trader purchasing a put option is speculating that the price will decrease below said price
writing an option
selling said option.
A person writing a call is speculating that the price will not increase above the strike price.
A person writing a put is speculating that the price will not decrease below the strike.
premium
the price of the option.
The buyer pays this premium to the writer
expiration
the date at which the option contract is no longer valid. If a call (put) option never rises above (declines below) the strike price, then the option expires worthless, and the writer has profited off the trade
in the money
when exercising an option would produce a profit for the buyer
out of the money
a call (put) is out of the money when the market price is below (above) the strike price
at the money
a call/put is at the money when the market price is equal to the strike price
American Option
Can be exercised on or before the expiration date
-would never be exercised, would instead be sold
European Option
Can only be exercised on the expiration date
factors which drive options pricing
price of the underlying asset
strike price
risk free rate
volatility of the underlying assets
time to expiration
costs and benefits of holding the asset
price of the underlying asset
for call options, the higher the market price the higher the value of the option. the inverse is true for put options
strike price
higher strike prices have a negative impact on the value of call options, and a positive impact on the value of put options
volatility of the underlying assets
an increase in volatility increases both the value of the put and the call options
time to expiration
the longer the time the more valuable the option
costs and benefits of holding the asset
benefits of holding the asset decreases call values and increases put values. costs of holding the asset have the inverse effect
put call parity
fiduciary call
protective put
fiduciary call
a combination of a call option with a strike price of X, and a 0 coupon treasury bond with the same expiration date as the option.
The 0-coupond bond pays the same as the strike price
protective put
(put call parity def)
a put option on a security, and the security itself
put call parity equation
call + present value of strike= put + stock
common options strategies
covered call
protective put
straddle
strangle
protective collar
long is to buy
short is always to sell
covered call
write a call, long the stock
generate income selling the call. if the price increases, you just sell the stock you own
protective put
long a put, long the stock
the put works as insurance against the stock price dealing
straddle
long a call, long a put. Each have the same strike price
you expect the price to be volatile
strangle
long a call, long a put, different strike prices. Both out of the money
-you expect significnat volatility
protective collar
long the stock, long an out of the money put, short an out of the money call
you are giving up upside in order to protect the downside
swaps
swaps are custom agreements to exchange a series of payments on periodic settlement dates over a certain period of time (ex: quarterly payments over 2 years)
-on the settlement dates, the payments are netted, so only one party makes a payment
traded OTC- largely unregulated
default risk/ counterparty risk is important- who do you trade with?
primarily comprised of institutional participants
common types of swaps
interest rate swap
currency swap
interest rate swap
one leg pays a fixed rate, the other pays a variable rate
-used by businesses to fix their borrowing costs
-used by fixed income portfolio managers to alter the duration of their portfolio
