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Corporate Finance + Derivatives > Derivatives > Flashcards

Derivatives Flashcards

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1
Q

What are the 3 types of investment strategies?

A

Hedging, speculation +arbitrage

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2
Q

Define derivatives

A

A contract/instrument where it’s value is derived from the value of an underlying asset

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3
Q

For what purposes do the different investment strategies engage with risk?

A

Arbitrage + speculation = exploit risk
Hedging = protect against risk

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4
Q

Define a hedge by example

A

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

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5
Q

Define speculation

A

Earning a certain profit in return for accepting risk

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6
Q

Define arbitrage

A

Earning riskless, costless profit by trading

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7
Q

Define leverage and its purpose

A

Using debt or borrowed capital to undertake an investment or project

Commonly used to boost entity’s equity base

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8
Q

Define an option contract

A

Gives the RIGHT to buy/sell an asset at an agreed price (exercise/strike price) in the future

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9
Q

Define forward contract

A

Gives the OBLIGATION to trade a certain asset at a future time and place at an agreed price (forward price)

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10
Q

What are the two most basic types of derivative?

A

Options and forwards

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11
Q

What are the difference between american & european options?

A

American = trade before maturity can happen

European = trade can only be made at maturity

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12
Q

Difference between put & call options?

A

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

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13
Q

When to exercise a EU call option?

A

If S > X we exercise, if S <= X then we don’t exercise

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14
Q

How do we get the intrinsic value of the call option and a put option?

A

Call = S - X
Put = X - S

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15
Q

Put-call parity formula?

A

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

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16
Q

CASE STUDY: What happened in 2020 with the oil prices?

A

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)

17
Q

Define a put

A

An options contract that gives the owner the RIGHT to SELL an underlying asset at agreed price within specific time

18
Q

When does a put yield a positive return?

A

Only if underlying price falls below the strike price when the option is exercised

19
Q

Define put-call parity

A

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

20
Q

What to do if u < (1+R) when pricing a EU call option?

A

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

21
Q

What to do if d < (1+R) when pricing a EU call option?

A

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)

22
Q

Give some important assumptions of the Black-Scholes-Merton (BSM) model

A

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)

23
Q

Define the ‘greeks’

A

Value of option sensitive to SYSTEMatic effects from..

IR changes
Time
Volatility of + actual asset prices

The Vehicle Is Above

24
Q

Define delta in the context of the BSM model

A

Describes what happens to C following changes to S

(Asset price effect)

25
Q

Define gamma in the context of the BSM model

A

Gamma captures the sensitivity of delta to changes in the spot price

(non-linear price effect)

26
Q

Define time decay in the context of the BSM model

A

Sensitivity of time to the call option premium

(time decay, value of contract declines over time)

27
Q

Define vega + rho in the context of the BSM model

A

Sensitivity of the option to IR
Sensitivity of option to implied volatility

28
Q

What are the most basic types of forward contracts?

A

Commodity
Forward Rate Agreement (IR)
FX (currency)

29
Q

Disadvantages of forward contracts?

A

Not protected against default!

Can’t be easily closed by one party

Not liquid (FRAs + FX contracts are)

30
Q

Characteristics of futures contract?

A

pretty much opposite to forward contract

Issued by an exchange thus guaranteed by ER (no default risk)

Highly liquid

31
Q

Define cost-of-carry

A

The cost incurred by holding asset until period T

32
Q

Define basis

A

Difference between forward price of contract and spot price

33
Q

Define forward price

A

Expectation of the price in the future

34
Q

What are the different types of credit risk shifting derivatives?

A

CDOs
CDS
NCDS
SCDO

35
Q

What’s the value of the hedge (riskless) portfolio?

A

V = hS - C, where h = shares/call

Corporate Finance + Derivatives (2 decks)

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