Derivatives Flashcards
What is a long straddle
When you buy both put and call options at same exercise price
This is when you expect volatility to increase
Define short straddle
When you sell both put and call
This is when you expect volatility to decrease
Strangle
While straddle purchases at the money,
This purchases out of the money. used for more extreme volatility
Put spread
Buy OTM puts and sell puts that are further out of the money
Seagull
Spread
A put spread combined with selling a call (eg - buy a 35 delta put, sell a 25 delta put and sell a 35 delta call
Cross hedge
Hedging with an instrument that is not perfectly correlated with the exposure being hedged
Macro hedge
Addresses portfolio wide risk factors rather than the risk of individual portfolio assets
Synthetic long forward position
Long call with short put
Covered call
Long spot and sell call
When you think stock has limited upside potential
Protective put
Buying stock plus put
For investor buying stock and protecting it from going down
Collar
Buy at of the money put and sell otm call and also buy a stock (at the money put coz i did a paper)
Bull spread
Long options on the lower strike and short options on the higher strike
Bear spread
Short options on the lower strike and long options on the higher strike
Long calender spread
Buying longer dated options and selling shorter dated options
What is long risk reversal
A risk reversal strategy is an options trading strategy used to hedge or speculate on the directional movement of an asset’s price. (usually for implied volatility skew) It involves simultaneously:
Buying a call option: Gives the trader the right to buy the underlying asset at a specified price (strike price), allowing them to benefit if the asset’s price rises.
Selling a put option: Obligates the trader to buy the underlying asset at a specified price if assigned, allowing them to reduce or offset the cost of the call.
This strategy is commonly used by investors who expect the price of the underlying asset to increase.
Volatility smile
Where the further from ATM options have higher implied volatilities.
We would see a U shaped curve
Volatility skew
Implied volatility increases for more OTM puts and decreases for more OTM calls, as the strike price moves away from the current price.
Who benefits in a variance swap?
The party receiving the variable payment (the purchaser) will gain on the contract when the realised variance is greater than the implied variance and vise versa
Cash equitization/cash securitisation/cash overlay
Cash equitization is a strategy used by portfolio managers to ensure that any unintended cash holdings in a portfolio are actively contributing to returns, rather than sitting idle. It is typically done using stock index futures and interest rate futures.
Currency risk
The exposure of foreign currency denominated assets and liabilities to changes in exchange rates
Basis point value
The expected change in the value of a security or portfolio given a one basis point change in yield
Long position of fra
Will receive a payment at settlement if the market rate of interest is higher than the forward rate specified in the FRA
Payer swap
Contract to make a series of fixed rate payments and receive floating rate payments
Receiver swap
Receive fixed pay floating
Issues with developing market currencies
- low trading volume leads dealers to charge larger bid asked spreads
- for exit trade liquidity can be lower and transaction cost can be higher
- transactions between 2 emerging market currencies can be even more costly
- they are at a forward discount
- governments are highly involved in the pricing of the currency
Cross hedge/proxy hedge
Refers to hedging with an instrument that is not perfectly correlated with the exposure being hedged
Minimum variance hedge ratio
A mathematical approach to determining the hedge ratio
When to currency hedging it is a regression of the past changes in value of the portfolio to the past changes in value of the hedging instrument to minimize the value of the tracking error between these two variables
Roll yield in currency
A return from the movement of the forward price over time towards the spot price of an asset
Profit or loss on a forward or futures contract if the spot price is unchanged at contract expiration
Economic fundamentals - currency
At the heart of this approach is the assumption that, in a flexible exchange rate system, exchange rates are determined by logical economic relationships and that these relationships can be modeled.
The simple economic framework is based on the assumption that in the long run, the real exchange rate will converge to its “fair value,” but short- to medium-term factors will shape the convergence path to this equilibrium.
Currency management strategies
- Passive hedging
- Discretionary hedging
- Active currency management
- currency overlay
Bull call spread
buy the call option at a lower strike price and sell the option at a higher strike price
When to use bear spread
Investors use a bear spread strategy to profit from an expected moderate decline in the price of an underlying asset while limiting both their potential risk and reward. Bear spreads are particularly appealing for traders who have a bearish outlook but do not anticipate a large or rapid drop in price.
when to use Straddle
High Expected Volatility: You anticipate that the underlying asset will make a large move, either up or down, such as before earnings announcements or major news events.
Uncertain Direction: You believe the price will move significantly but are unsure whether it will rise or fall.
What is basis risk?
Basis risk arises when the price movements of a hedging instrument do not perfectly correlate with the price movements of the exposure being hedged. This misalignment creates a risk that the hedge will not fully offset the changes in value of the underlying exposure.
Forward rate bias
Forward rate bias in the currency market means that the forward exchange rate (the agreed-upon rate to trade currencies in the future) is not a perfect predictor of the actual exchange rate that will happen in the future. In fact, it often deviates in a way that can be somewhat predictable.
when do you use collar
Used to manage risk in an investment portfolio by limiting both potential losses and gains within a predefined range. This strategy is often employed by investors who want to protect an existing position or lock in gains while reducing the cost of downside protection.
Calendar spread
A calendar spread (or time spread) is an options trading strategy that involves buying and selling options with the same strike price but different expiration dates. Typically, the option with the longer expiration is bought, and the one with the shorter expiration is sold.
implied volatility
Expected volatility an underlying asset’s return and is derived from an option pricing model
In currency, why are forward contracts preferred over futures?
1) Futures contracts are standardized in terms of settlement dates and contract
sizes. (not much flexibility)
2) Futures contracts may not always be available in the currency pair that
the portfolio manager wants to hedge.
3) Futures contracts require up-front margin (initial margin).
Short seagull spread in currency
Buy an ATM put.
Write an OTM put.
Write an OTM call.
Long seagull spread
Write an ATM call
Buy an OTM put
Buy an OTM call
Knock in options (currency)
Becomes active only if the spot rate reaches a pre-specified barrier.
knock out options (currency)
Terminates if the spot rate reaches a pre-specified barrier.
binary options (currency)
Provides a fixed payout if the spot exchange rate is in-the-money.
Unlike vanilla options, where the payoff depends on the difference between the spot and strike price, digital options offer an all-or-nothing outcome.
transaction on cash settles equity swap
If the swap is cash settled, on the termination date of the contract the
equity swap receiver will receive (pay) the equity appreciation (depreciation) in cash.
Physically settled equity swap
If the swap is physically settled, on the termination date the equity swap receiver will receive the quantity of single stock specified in the contract and pay the notional amount.
Equity swaps (liquidity)
Illiquid, OTC, voting right do not confer to the counterparty receiving the performance of underlying
Define basis
Basis is the difference between spot price and futures price
= Spot price - futures price
if +ve basis, sell the bond and buy the future
When call volatility is higher than Put volatility
a short risk reversal strategy buying the put and writing the call
What is a bear put
It involves buying a put option at a higher strike price and selling a put option at a lower strike price, both with the same expiration date.
Currency market technical analysis
Market technicians believe that in a liquid, freely-traded market the historical price data already incorporates all relevant information on future price movements. Technicians believe that it is not necessary to look outside the market at data like the current account deficit, inflation and interest rates because current exchange rates already reflect the market consensus view on how these factors will affect future exchange rates.
Vega for call and put
When volatility increases, the price of both calls and puts goes up (because higher volatility increases the chances of moving in-the-money).
Long calls & long puts → Benefit from rising volatility (positive vega)
Short calls & short puts → Lose from rising volatility (negative vega)
Call and put for thetha
As time passes, the value of both calls and puts decreases (all else equal) because there’s less time for the option to move in-the-money.
Long calls & long puts → Lose money over time due to theta decay (negative theta)
Short calls & short puts → Gain money over time due to theta decay (positive theta)
Payer equity swap
Gain money if value of underlying decreases
Receiver equity swap
Gain money if value of underlying increases
Problem with a static currency hedge
A static hedge (i.e., an unchanging hedge) will tend to accumulate unwanted currency exposures as the value of the foreign-currency assets change. This will result in a mismatch between the market value of the foreign-currency asset portfolio and the nominal size of the forward contract used for the currency hedge (resulting in currency risk)
