Derivatives

Question 1

When does either party make payment on a futures contract?

Answer 1

At the delivery date

Question 2

What does the buyer and seller hope happens to the market price of the underlying asset in a futures contract?

Answer 2

Buyer - hopes price rises
Seller - hopes price falls

Question 3

What’s the difference between a cash settled and physical delivery future?

Answer 3

Physical delivery - seller delivers set quantity of good on delivery date
Cash-settled - set amount of money exchanged per contract

Question 4

What obligations do the buyer and seller have on delivery date of a future?

Answer 4

Both have obligation to deliver or take delivery

Question 5

What is the main risk of a futures contract?

Answer 5

If either party can’t fulfil their obligation

Question 6

What is the main difference between a future and a forward?

Answer 6

Forwards are traded OTC, whereas futures are exchange-traded.

Question 7

Is an option exchange-traded, OTC or both?

Answer 7

Both

Question 8

State the difference between a call and a put option.

Answer 8

Call - buyer has right to buy the underlying asset
Put - buyer has the right to sell the underlying asset

Question 9

What is the most an option holder can lose?

Answer 9

The upfront premium

Question 10

State the difference between European and American style options.

Answer 10

European style - can only be exercised at expiry
American style - can be exercised at any time up to expiry

Question 11

When would a call option be ‘in the money’?

Answer 11

When the underlying market price is more than the strike price

Question 12

What does Delta measure?

Answer 12

How option price changes as the underlying’s price changes

Question 13

What does Gamma measure?

Answer 13

The rate of change of delta

Question 14

What does Vega measure?

Answer 14

How the option price changes for a 1% change in implied volatility.

Question 15

What does Theta measure?

Answer 15

The change in an option’s price due to the passage of time.

Question 16

Name the two different types of warrants.

Answer 16

Traditional
Covered

Question 17

Describe how a traditional warrant works.

Answer 17

-Gives investor right to buy shares at a set price on pre-determined dates
-Price is fraction of the share’s price
-Movements in the warrant’s price magnify changes in the underlying share price.

Question 18

What does the conversion ratio show?

Answer 18

How many warrants equal one share

Question 19

If the warrant price = 150p, the exercise price = 170p and the ordinary share price = 750p, what is the conversion premium/discount?

Answer 19

[(150+170)/750]-1= -57.33%

Question 20

If the share price is 175p, gearing is 8 and the investment amount is £12,600, how many shares/warrants can be bought?

Answer 20

7,200 shares or 57,600 warrants

Question 21

What is the initial margin on a contract for difference?

Answer 21

Amount deposited at outset by buyer and seller which acts as collateral

Question 22

How much margin has to be put up if:
12,000 CFDs bought
£1.70 share price
15% margin

Answer 22

12,000 x 1.7 x 0.15 = £3,060

Question 23

What is the profit if:
£20,000 to invest in CFDs
Margin is 12.5%
Share price rises from £2 to £2.75

Answer 23

£20,000 / 0.125 = £160,000 worth of shares
Which is £160,000 / 2 = 80,000 shares
Profit = 80,000 x (2.75-2) = £60,000

Question 24

State the benefits and drawbacks of contracts for difference.

Answer 24

Benefits:
-Magnified gains
-No Stamp Duty/SDRT
-Can go long or short

Drawbacks:
-Magnified losses
-CGT on gains
-Broker commission due

Question 25

What does a higher credit spread indicate about a third party?

Answer 25

Higher credit risk

Question 26

What are the two potential outcomes in binary betting?

Answer 26

Nothing
OR
Fixed Amount