Derivatives Flashcards
Financial instrument whose value is based on the value and characteristics of another (underlying) security. Created by two investors rather than an issuer of stock and bonds
Derivative
Two parties agree to exchange cash flows based on different financial instruments
Swap Contracts
One party agrees to pay a fixed interest rate, but will receive a variable rate of interest. The other party agrees to the exact opposite. Settled on a net basis, payments will be based on the difference between the fixed and floating interest rates
Interest Rate Swap
Can be created on foreign currencies, commodities, stock prices, interest rates, or even bond defaults
Swap Contracts
In return for assuming the obligation, the writer receives the _____ from the option buyer
Premium
Name of the underlying security, expiration month, exercise price, type and premium
Components of an option
An option will only have an intrinsic value if it is
In-the-money
Amount by which an option is in-the-money
Intrinsic value
Intrinsic Value + Time Value
Option Premium
Portion of an option’s premium that exceeds its intrinsic value
Time Value
Calls are in-the-money if the stock market price is
Above the strike price
Calls are out-of-the-money if the stock market price is
Below the strike price
Puts are in-the-money if the stock market price is
Below the strike price
Puts are out-of-the-money if the stock market price is
Above the strike price of the option
Intrinsic value of an option will either be a _____ amount or _____
Positive amount or zero
Premium associated with at- or out-of-the-money options will consist only of
Time Value
Premium - Intrinsic Value
Time Value
An option’s _________ will diminish with the passage of time and, at expiration, it will have no remaining time value
Time Value
On the final day prior to a contract’s expiration, an ____________ option will be trading very close to its intrinsic value, while an _________ option will be essentially worthless
In-the-money ; Out-of-the-money
Don’t move uniformly when the underlying share price moves, move less than the underlying share price
Premiums
Estimate of the amount by which an option premium will increase or decrease for a $1.00 change in the underlying stock price
Delta
Option positions with positive deltas
Premium will rise as the stock’s price rises, but will fall as the stock’s price falls
In-the-money = Close to +1.0 or +100%
At-the-money = Close to +0.50 or +50%
Out-of-the-money = Close to 0 or 0%
Bullish (i.e., long calls and short puts)
Option positions with negative deltas
Premium will fall as the stock’s price rises, but the premium will rise when the stock’s price falls
In-the-money = Close to -1.0 or -100%
At-the-money = -0.50 or -50%
Out of the money = Close to 0 or 0%
Bearish Options (i.e., long puts and short calls)
Style of option where the option buyer may exercise the contract at any time during its life
American Style
Style of option where the option buyer may only exercise the contract on the day of expiration
European Style
Allows the investor to gain control of the stock (leverage) for a smaller amount of money than if she purchased the stock outright. If stock increases, she will profit and potential profit is almost unlimited. Risk is limited to the premium that she pays for it plus the commission costs
BULLISH ON A STOCK
Buying Calls
Believes that the price of the underlying stock will potentially decline or remain stable (BEARISH)
Selling calls
Involves selling a call against stock that an investor already owns. Allows investors to increase their portfolio’s return while also being partially protected against falling prices. Protection is limited to the premium received as a result of selling the call option
Writing covered calls
Two types of option strategies that involve selling calls
Covered call writing and uncovered (naked) call writing
Conservative option strategy
Writing covered calls
High-risk option strategy
Writing uncovered calls
Involves selling a call against stock that’s not already owned. Since the writer doesn’t own the stock, if exercised against, he will be required to buy the stock in the open market to complete delivery to the investor who exercised the call option
Writing uncovered calls
Option strategy where there is no limit as to how high the price of the stock may rise; therefore, the writer’s potential loss is unlimited
Writing uncovered calls
For bearish investors, buying a ___ may be an alternative to selling the stock short
Put
Buyer of a call
Bullish ^
Seller of a call
Bearish
Buyer of a put
Bearish
Seller of a Put
Bullish
The purchase of both a call and a put or the sale of both a call and a put. Each option will have the same underlying security, the same exercise price, and the same expiration date
Straddles
If an investor buys both options of a straddle, the position is referred to as
Long straddle
If an investor writes (sells) both options of a straddle, it’s referred to as
Short straddle
Not typically exchange-traded and their features are customized. Both the buyer and seller must come to an agreement for either party to transfer the contract to a third party
Forward contracts
Extremely liquid and can be bought and sold on exchanges such as the Chicago Board of Trade
Futures contract
