Derivatives Flashcards

1
Q

What are derivatives?

A

Securities whose prices are based on an underlying asset

Don’t hold asset directly

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2
Q

What does exchanged traded mean in terms of derivatives?

A

Available for purchase/sale each business day on recognised exchange

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3
Q

What does over the counter (OTC) mean in terms of derivatives?

A

Individual arrangement created by financial institution for a client

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4
Q

What are the features of a derivative?

A

No income

CGT regime applies

No voting rights

Higher risk than holding underlying asset but greater potential returns - element of gearing due to premium

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5
Q

How can derivatives help to hedge portfolio?

A

Transaction that will make a gain if original investment falls.

Protects existing position

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6
Q

What is a Future?

A

Creates an obligation on both parties to undertake a transaction at pre-determined (strike/exercise) price on an agreed future (strike/exercise) date

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7
Q

What obligations do the parties in a futures contract have?

A

1 party obliged to deliver underlying asset on strike date

1 party obliged to pay strike price

1 party = profit
1 party = Loss

Equal profit and loss

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8
Q

What does the seller of a futures contract expect?

A

Expects prices to fall - short position

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9
Q

What does the buyer of a futures contract expect?

A

Expects prices to rise - long position

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10
Q

Explain the Margin in a futures contract?

A

Both parties pay a deposit (known as margin) with 3rd party.

Margin adjusted daily - increases for one party and decrease for other - in line with underlying asset

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11
Q

How is futures contract delivered?

A

Can be completed by physical delivery

usually by settlement of difference in positions for cash

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12
Q

What do FTSE 100 futures trade at?

A

£10 per point

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13
Q

What are the risks of commodity futures?

A

Can lose more than original investment

Physical delivery maybe required

Alternative is an ETC which would only lose original investment

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14
Q

What is an option?

A

Put together by writer who sells for a price to investor known as premium

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15
Q

Explain who buyer and seller are in an option contract?

A

Writer = seller = obligation

Investor = Buyer = A right not an obligation

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16
Q

What rights does an investor/buyer have with regards to an option contract?

A

Can exercise option before strike/exercise date

Sell on market

Allow to expire - worthless

17
Q

What is a Call Option?

A

Right to investor to buy at asset at predetermined price before/on strike date.

18
Q

What is Put Option?

A

Right to investor to sell an asset at a pre-determined price before/on strike date

19
Q

If an investor buys a Call Option for premium of 20p to buy shares at 220p what does she hope for?

A

Price will rise above 240p to cover price and premium

20
Q

If an investor buys a Put Option for premium of 30p to sell shares at 300p what does she hope for?

A

Price will fall below 270p so can be sold for 300p and purchase for less than 270p = gain above premium

21
Q

What is intrinsic value in terms of an Option?

A

amount of premium recovered at todays price

22
Q

What is time value mean in terms of an Option?

A

Rest of premium from intrinsic value

Minimum amount that an investor hopes share price will increase before option contract expires

23
Q

What is In the Money mean in terms of an Option?

A

Ignores premium - indicates share price moving in right direction for investor

24
Q

What is At the Money mean in terms of an Option?

A

Same price

25
What is out of the Money mean in terms of an Option?
Share price moving in wrong direction for investor
26
What should an investor do if expects price to go up (Option)
Buy call option
27
What should an investor do if expects price to go down (Option)
Buy a put option
28
What should an writer do if expects price to go up (Option)
Write a put option
29
What should an writer do if expects price to go down (Option)
Write a call option
30
How can options be used to rebalance a portfolio and why?
If overweight = purchase put option If underweight = purchase a call option Less time consuming and costly than selling/buying part of a holding
31
What are hedge funds?
Pooled investments Often based offshore Recognised 14 different investment strategies Aim to limit downside - seeking absolute returns High min investment Gearing
32
Name 4 Investment strategies for hedge funds?
Long/Short funds - Buying equities/bonds offering good long term returns and selling those believed overvalued Relative Value funds - use arbitrage to take advantage of short term price anomalies before price normalises Event driven funds - price movements from anticipated corporate actions - mergers etc Tactical trading funds - long and short in range of asset classes - currencies, bonds, commodities, equities
33
What are the advantages and disadvantages of hedge funds?
Diversification Low volatility strategy Expertise of fund manager Lack of regulation/protection High min investment Complex/opaque Volatile
34
Disadvantages of hedge funds
High charges Non-transparent investment strategy High gearing risk Lower regulatory standards Liquidity risk Reliance on fund manager ability