Derivatives

Question 1

Define:

American-style Option

Answer 1

An option contract which can be exercised at any time up to the expiration date.

As opposed to Bermuda style and European style.

Question 2

Define:

Arbitrage-free pricing

Answer 2

Determining the price of a derivative based upon the assumption that the market is free of arbitrage opportunities.

Question 3

Define:

At the money

Answer 3

When the underlying asset price = exercise price of the option contract on that asset.

The option is “at the money”.

Question 4

Define:

Bermuda-style Option

Answer 4

Option contract that can be exercised on specified dates up to the option’s expiration date.

As opposed to American style or European style.

Question 5

Define:

Call

Answer 5

Option contract which gives the holder the right, but not the obligation, to buy an underlying asset at a fixed price over a specific period of time.

Question 6

Define:

Delta

Answer 6

Sensitivity of a derivative’s price to changes in the value of the underlying asset.

Question 7

Define:

Derivatives

Answer 7

Financial instruments, or contracts, whose value is derived from (dependent upon) the performance of an underlying asset, index, reference rate, or other financial instrument.

Question 8

Define:

Equity swap

Answer 8

A financial derivative contract between two parties that involves the exchange of cash flows or returns based on the performance of an underlying equity or equity index.

Question 9

Define:

ESG investing

Answer 9

Making investment decisions based partially upon consideration of environmental, social, and governance factors.

Question 10

Define:

European-style option

Answer 10

Option contract that can only be exercised on its expiration date.

As opposed to American style and Bermuda style options.

Question 11

Define:

Exercise

Answer 11

Utilizing the right to buy or sell the underlying (which is granted by the option contract).

Question 12

Define:

Exercise value

Answer 12

The value provided by exercising the option.

Question 13

Define:

Exercise price

aka strike price

Answer 13

The price at which the option holder has the right to buy or sell the underlying.

Question 14

Define:

Fixed-for-floating swap

aka plain vanilla swap

Answer 14

Interest rate swap with one party paying a fixed rate and the other paying a floating rate (in the same currency).

Question 15

Define:

Forward contract

Answer 15

An agreement between two parties to buy/sell an underlying asset at a later date for a price established at the start of the contract. Forwards are typically settled with delivery of the asset, and are highly customizable (as opposed to standardized futures contracts which are often not settled with delivery).

Question 16

Define:

Forward rate agreements

(FRAs)

Answer 16

Forward contracts where underlying is an interest rate. Both parties agree to apply a fixed rate to the notional value at a given point in the future. If the floating market reference rate differs at that point then a cash flow (the difference between rates) gets paid to the party that the difference favors.

The party long the FRA benefits if the floating ends above the fixed.

Different from interest rate swap, which involves a series of cash flow exchanges.

Question 17

Define:

Forward curve

Answer 17

A graphic representation of the relationship between expected future interest rates and maturities, each having the same timeframe.

“What is the one year forward rate in one year”.

Forward curve is above spot curve if spot curve is upward sloping and below if downward sloping.

Question 18

Define:

Forward rate

Answer 18

The interest rate on a fixed income security traded in a forward market (to be entered into in the future).

e.g., Agreeing to a rate on a one year bond, to be entered into in one year.

Question 19

Define:

Forward market

Answer 19

Market in which contracts for the future sale of assets, commodities, or other financial instuments are agreed upon.

Question 20

Define:

Forward price

Answer 20

The fixed price or rate which the transaction (to occur at the expiration of forward contract) will take place. Agreed on at the initiation of the contract.

Question 21

Define:

Futures contract

Answer 21

Similar to a forward contract but is more standardized and includes things like clearinghouse guarantee, daily settlement of +/-, and an organized trading facility.

Question 22

Define:

Futures price

Answer 22

The price of a futures contract, and in essence the price at which the future transaction for the underlying asset will take place.

Question 23

Define:

FX swap

Answer 23

When offsetting FX spot and forward contract transactions occur. This is done to extend, or roll, a prior FX forward position.

Only two settlement dates involved (this differs from a currency swap).

Question 24

Define:

Gamma

Answer 24

A measure of the how sensitive the option’s delta is to a change in the value of the underlying.

As the relationship that delta captures is not linear, gamma is a measure of that relationships convexity.

Question 25

# Define: Implied forward rates

Answer 25

**Break-even reinvestment rate** that links the return on a shorter-term zero-coupon bond to the return on a longer-term zero-coupon bond. ## Footnote Calculated from spot rates.

Question 26

# Define: Implied volatility

Answer 26

The volatility that option traders use to price an option, often derived using market variables and the Black Scholes formula.

Question 27

# Define: In the money | (ITM)

Answer 27

When the option has intrinsic value, and exercising the option would result in a profit for the option holder. **For a call, if the price of the underlying > the strike price. For a put, if the price of the underlying < the strike price.**

Question 28

# Define: Interest rate swap

Answer 28

A swap where underlying is an interest rate.

Question 29

# Define: Inverse floater

Answer 29

A type of leveraged structured financial instrument with **cash flows that move in the opposite direction of changes in the reference rate**.

Question 30

# Define: Moneyness ## Footnote aka intrinsic value of the option

Answer 30

Relationship between the price of the underlying and the option’s exercise price.

Question 31

# Define: Option

Answer 31

Gives a party **the right, but not the obligation**, to buy/sell an underlying asset from/to another party (at a fixed price for a specific period of time). ## Footnote Type of contingent claim.

Question 32

# Define: Protective put

Answer 32

Combining a long position in an asset with a long put position.

Question 33

# Define: Put

Answer 33

Option giving the holder **the right to sell** an underlying asset (at a fixed price for specific period of time).

Question 34

# Define: Put–call parity

Answer 34

An equation expressing the equivalence (parity) of a portfolio of a call and a bond with a portfolio of a put and the underlying, which leads to the relationship between put and call prices. ## Footnote C + PV(X) = S + P

Question 35

# Define: Put–call–forward parity

Answer 35

The relationship among puts, calls, and forward contracts. ## Footnote C + PV(F) = S + P

Question 36

# Define: Replication

Answer 36

Using another asset, portfolio, and/or derivative in order **to create/mimic characteristics of a particular asset**.

Question 37

# Define: Rho

Answer 37

A measure of the sensitivity of an option's price **to the risk-free rate**.

Question 38

# Define: Swap contract

Answer 38

An agreement between two parties to exchange a series of future cash flows.

Question 39

# Define: Time value

Answer 39

Due to the uncertainty of how the price the underlying may change over the remaining life of the option. ## Footnote Option premium = intrinsic value + time value

Question 40

# Define: Theta

Answer 40

Relationship between the time value of an option and **the passing of time**.

Question 41

# Define: Total return swap

Answer 41

A swap in which one party **agrees to pay the total return on a security** in exchange for periodic payments (usually based on fixed or floating rate).

Question 42

# Define: Vega

Answer 42

A measure of the sensitivity of an option’s price to changes **in the underlying’s volatility**.

Question 43

# Define: Volatility

Answer 43

In option pricing: **standard deviation of the continuously compounded returns** on the underlying asset.

Question 44

# Define: Basis Risk

Answer 44

Risk that expected value of a derivative is different from the value of the underlying.

Question 45

# Define: CDS credit spread

Answer 45

Difference in yield between CDS and risk free benchmark.

Question 46

# Define: Cash flow hedge

Answer 46

When a derivative is **designated as a hedge for accounting purposes** as it is used to **reduce volatility due to variable cash flows** related to things like forex, interest rates, commodities).

Question 47

# Define: Central clearing mandate

Answer 47

Requires OTC derivatives be cleared by a central counterparty. ## Footnote Came into effect following the great financial crisis of 2008.

Question 48

# Define: Convexity bias

Answer 48

Between interest rate futures and interest rate forwards there is a difference in price sensitivity to changes in yield. ## Footnote **Convex for forwards** but linear for futures.

Question 49

# Define: Fair value hedge

Answer 49

When a derivative is **designated as a hedge for accounting purposes** as it is used to **reduce fluctuation in fair value of an asset or liability** related to things like forex, interest rates.

Question 50

# Define: Central Counterparty | (CCP)

Answer 50

Intermediary which clears most derivative contracts and assumes counterparty credit risk between the parties involved.

Question 51

# Define: Futures contract basis point value | (BPV)

Answer 51

change in price of the contract per 1 basis point change in yield. ## Footnote similar to bpv with fixed income securities.

Question 52

# Define: Futures margin account

Answer 52

Money which is held by clearinghouse on behalf of involved counterparties in order to **ensure obligations are met.**

Question 53

# Define: Hedge

Answer 53

When a derivative contract is used to **mitigate exposure to adverse movements** in an underlying (asset, rate, risk).

Question 54

# Define: Hedge accounting

Answer 54

Accounting standards which allow hedging instruments to offset a transaction or balance sheet item in order to reduce volatility.

Question 55

# Define: Hedge ratio

Answer 55

Used to determine the number or amount of a hedging instrument required to hedge or offset the risk associated with a specific exposure. ## Footnote Instrument could be futures contracts, options contracts, or other derivatives.

Question 56

# Define: Net investment hedge

Answer 56

Designation when a derivative or foreign bond is used to offset **exchange rate risk.** ## Footnote for hedge accounting

Question 57

# Define: Novation process

Answer 57

Process which substitutes the initial swap execution facility (SEF) contract with identical trades facing the central counterparty (CCP), essentially **transferring rights and obligations of the contract to the CCP** which then acts as counterparty.

Question 58

# Define: Par swap rate

Answer 58

The fixed rate that makes the **value of the fixed leg equal to the value of the floating leg** on a fixed for floating interest rate swap.

Question 59

# Define: Swap

Answer 59

OTC derivative contract where **two parties agree to exchange a series of cash flows**.

Question 60

# Define: Swap execution facility | (SEF)

Answer 60

Regulated swap trading platform which multiple dealers can access and execute swaps. ## Footnote Instituted following GFC of 2008.

Question 61

# Define: Swap rate

Answer 61

**Fixed rate** paid by the fixed rate payer in a swap agreement.

Question 62

# Define: Time Value Decay ## Footnote aka theta decay

Answer 62

Related to theta sensitivity, the time value declines faster as time passes (as experiation nears). ## Footnote Theta decay is exponential not linear.