Derivatives Flashcards
What are the 3 types of investment strategies?
Hedging, speculation +arbitrage
Define derivatives
A contract/instrument where it’s value is derived from the value of an underlying asset
For what purposes do the different investment strategies engage with risk?
Arbitrage + speculation = exploit risk
Hedging = protect against risk
Define a hedge by example
If investor holds a long position (own asset, expect P to increase) for a stock, they may take short position (agree to sell at specified P in future) > betting on themselves
Define speculation
Earning a certain profit in return for accepting risk
Define arbitrage
Earning riskless, costless profit by trading
Define leverage and its purpose
Using debt or borrowed capital to undertake an investment or project
Commonly used to boost entity’s equity base
Define an option contract
Gives the RIGHT to buy/sell an asset at an agreed price (exercise/strike price) in the future
Define forward contract
Gives the OBLIGATION to trade a certain asset at a future time and place at an agreed price (forward price)
What are the two most basic types of derivative?
Options and forwards
What are the difference between american & european options?
American = trade before maturity can happen
European = trade can only be made at maturity
Difference between put & call options?
Call = holder of stock has RIGHT to BUY a security at exercise price
Put = holder of stock has RIGHT to SELL their security at exercise price
When to exercise a EU call option?
If S > X we exercise, if S <= X then we don’t exercise
How do we get the intrinsic value of the call option and a put option?
Call = S - X
Put = X - S
Put-call parity formula?
S0 + P = C + X(1+R)^-T
Where S0 = current stock price, P = P of put option, C = P of call option, X(1+R)^-T = PV of X
CASE STUDY: What happened in 2020 with the oil prices?
COVID reduced D for oil due to the lockdown’s and travel restrictions + oil price war between UAE and Russia led to a brief -ve futures contract for West Texas Intermediate (WTI)
Define a put
An options contract that gives the owner the RIGHT to SELL an underlying asset at agreed price within specific time
When does a put yield a positive return?
Only if underlying price falls below the strike price when the option is exercised
Define put-call parity
Purchasing and selling a EU call and put option of the same class (underlying asset, strike price + maturity) = buying the underlying asset at current MP
What to do if u < (1+R) when pricing a EU call option?
Short stock > buy R asset for B = S where B is a ST govt bond
End of period, cash in R and deliver stock to earn (1+R-u)B
What to do if d < (1+R) when pricing a EU call option?
Short bond > use proceeds to buy stock for S = B
End of period, sell stock for dS > pay (1+R)B > earn profit of ((d-(1+R))B)
Give some important assumptions of the Black-Scholes-Merton (BSM) model
Assets are infinitely divisible (don’t have to buy 1 full share)
Continuous trading (prices change all the time)
Stock prices follow continuous time random walk process (geometric Brownian motion)
Define the ‘greeks’
Value of option sensitive to SYSTEMatic effects from..
IR changes
Time
Volatility of + actual asset prices
The Vehicle Is Above
Define delta in the context of the BSM model
Describes what happens to C following changes to S
(Asset price effect)
Define gamma in the context of the BSM model
Gamma captures the sensitivity of delta to changes in the spot price
(non-linear price effect)
Define time decay in the context of the BSM model
Sensitivity of time to the call option premium
(time decay, value of contract declines over time)
Define vega + rho in the context of the BSM model
Sensitivity of the option to IR
Sensitivity of option to implied volatility
What are the most basic types of forward contracts?
Commodity
Forward Rate Agreement (IR)
FX (currency)
Disadvantages of forward contracts?
Not protected against default!
Can’t be easily closed by one party
Not liquid (FRAs + FX contracts are)
Characteristics of futures contract?
pretty much opposite to forward contract
Issued by an exchange thus guaranteed by ER (no default risk)
Highly liquid
Define cost-of-carry
The cost incurred by holding asset until period T
Define basis
Difference between forward price of contract and spot price
Define forward price
Expectation of the price in the future
What are the different types of credit risk shifting derivatives?
CDOs
CDS
NCDS
SCDO
What’s the value of the hedge (riskless) portfolio?
V = hS - C, where h = shares/call
