Derivatives Flashcards
1
Q
What is a futures contract?
A
- A future is simply an agreement (a contract) between two parties where one party agrees to buy something in the future and the other party agrees to sell.
- There is no premium paid when buying a futures contract.
- There is an obligation to deliver.
- The terms and conditions of a futures contract are agreed today.
2
Q
What is the long position?
A
- The long position with a future is the BUYER of the underlying asset; this is a binding contract.
- The long hopes that the price of the underlying asset will rise compared to the price they agreed to buy at.
- Longs make money in a rising market.
3
Q
What is the short position?
A
- The short position with a future is the SELLER of the underlying asset.
- In a falling market, short positions make money as they can buy from the market at a price lower than the agreed price for delivery.
- Remember, futures are binding. There is an obligation.
4
Q
Forwards
A
- Direct deal between two parties; sold OTC i.e. not on an exchange.
- Otherwise, exactly the same as futures.
- The main disadvantage with forwards contracts is that there is a direct counter-party risk with the opposite side of the trade.
- Creditworthiness of both parties extremely important. .
5
Q
What are the three main uses when looking to hedge or speculate via derivatives?
A
- Tactical - Shorter term exploitation of market opportunities, eg flattening yield curve
- Strategic - Duration management of a bond portfolio using futures and interest rate swaps, eg, short five-year UK swaps
- Downside protection - Manage overall risk profile using indicies and options, eg a long equity put option and short (risk) five-year iTraxx credit derivatives.
6
Q
What is a swap contract?
A
- Swap is a forward contract (that is, it’s very much like a future), but where the exchange is one of a series of future cash flows (interest payments or index movements) for another.
- Swaps are customized contracts traded in the over-the-counter (OTC) market privately, versus options and futures traded on a public exchange.
- I.e. Credit Default Swaps (CDS)
- An individual client could, for example, decide to make a swap to exchange the variable payments on a mortgage, which are linked to the Euribor (Euro Interbank Offered Rate), for payments at a fixed interest rate. In this way, the risk of unexpected increases in monthly payments would be averted.
7
Q
Hedging with Futures - key points:
A
- Futures such as the FTSE 100 future, can be used to hedge portfolios of UK equities against adverse market movements.
- I.e. fund manager has £200m stock in FTSE100 shares and is concerned prices may fall.
- He takes a short future position fo the following month by trading on the exchange.
- Contract size for a FTSE 100 future is £5 pre half tick (£10 per point).
- If the FTSE100 is at 6800. £10 x £6,800 = £68,000 .
- £2000m/ 68,000 = 2942 whole future contracts for a full hedge.
- If the market falls to 6500, 300 points lost.
- 300 x 2942 x £10 = £8,826,000 gain
- This should cancel out the loss in his UK stocks portfolio.
8
Q
What are options?
A
- Options give the buyer the right, but not the obligation, to buy or sell an underlying asset at a fixed price (strike price) on, or before a given date in the future.
- Call Option - Give holder the right to BUY the underlying asset. The writer (seller) of the option is on the short side - buyer on the long side.
- Put Option - Gives holder the rights to SELL the underlying asset.
9
Q
What are the four option positions that can be taken?
A
- Holders of options:
- Long call option - right to BUY
- Long put option - right to SELL
- Sellers of options
- Short call option - potential obligation to SELL (to the buyer of the option contract)
- Short put option - potential obligation to BUY (from the holder)
10
Q
What is a covered call?
Why is it used?
Maximum potential profit?
Maximum potential loss?
A
- A covered call refers to a financial transaction in which the investor selling call options owns an equivalent amount of the underlying security.
- To execute this an investor holding a long position in an asset then writes (sells) call options on that same asset to generate an income stream.
- The investor’s long position in the asset is the “cover” because it means the seller can deliver the shares if the buyer of the call option chooses to exercise.
- If the investor simultaneously buys stock and writes call options against that stock position, it is known as a “buy-write” transaction.
- When the call is first sold, potential profit is limited to the strike price minus the current stock price plus the premium received for selling the call.
- You receive a premium for selling the option, but most downside risk comes from owning the stock, which may potentially lose its value. However, selling the option does create an “opportunity risk.” That is, if the stock price skyrockets, the calls might be assigned and you’ll miss out on those gains.
11
Q
What is a long call option?
Maximum potential profit?
Maximum potential loss?
A
- If you are buying a long call option, it means you want the price of the stock (or other security) to go up so that you can generate profit from your contract by exercising your right to buy that stock (and usually immediately sell them to rake in the profit).
- Allows use of leverage over a greater number of shares than could be bought outright.
- Profit if the stock rises, without taking on all of the downside risk that would result from owning the stock.
- There’s a theoretically unlimited profit potential, if the stock goes to infinity.
- Risk is limited to the premium paid for the call option.
12
Q
What is a long put option?
Maximum potential profit?
Maximum potential loss?
A
- Investors go long put options if they think a security’s price will fall.Investors may go long put options to speculate or hedge a portfolio.
- A long put has a strike price, which is the price at which the put buyer has the right to sell the underlying asset.
- Assume the underlying asset is a stock and the option’s strike price is $50. That means the put option entitles that trader to sell the stock at $50, even if the stock drops to $20.There’s a substantial profit potential.
- If the stock goes to zero you make the entire strike price minus the cost of the put contract. Keep in mind, however, stocks usually don’t go to zero.Risk is limited to the premium paid for the put.
13
Q
What is a short put option?
Maximum potential profit?
Maximum potential loss?
A
- The buyer of the option to sell, pays a premium to the option writer. They are then granted the right to sell the underlying asset on expiry if they wish.
- They can sell at the agreed strike price, in the future, to the writer who has an obligation to BUY.
- The writer of the option makes a premium on sale.
- The maximum loss for the buyer is the premium.
- The lower the price of the underlying, the more the profit the buyer (holder) will make, but the more losses the writer will make.
14
Q
Structure periods - how do they work and features?
A
- Combination of a security (typically zero coupon bond or similar providing guaranteed capital return) and a derivative (typically an option of some description to participate in a price increase).
- Main features:
- Fixed term
- Return of capital with growth and/or income
- Minimum and maximum returns specified at outset
- Retruns linked to an underlying investment index
- Risk
- Counterparty risk
- Transparency
- Lack of liquidity
- Costs
- Underlying investment risk
15
Q
The XYZ investment trust is issuing one free warrant for every five new-issue shares sold. Explain what a warrant is and the options a client may have available (6):
A
- Warrants are offered by investment trusts as incentives to buy shares in the trust.
- They are long-term call options
- They give a purchaser the right, but not the obligation, to purchase a fixed amount of shares, for a fixed price, at a fixed date in the future.
- Or within a specified period
- Client can either sell warrants on the market, let them expire, or exercise them according to the terms of the warrant.
