Derivatives

Question 1

What are derivatives?

Answer 1

Securities whose prices are based on an underlying asset

Don’t hold asset directly

Question 2

What does exchanged traded mean in terms of derivatives?

Answer 2

Available for purchase/sale each business day on recognised exchange

Question 3

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

Answer 3

Individual arrangement created by financial institution for a client

Question 4

What are the features of a derivative?

Answer 4

No income

CGT regime applies

No voting rights

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

Question 5

How can derivatives help to hedge portfolio?

Answer 5

Transaction that will make a gain if original investment falls.

Protects existing position

Question 6

What is a Future?

Answer 6

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

Question 7

What obligations do the parties in a futures contract have?

Answer 7

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

Question 8

What does the seller of a futures contract expect?

Answer 8

Expects prices to fall - short position

Question 9

What does the buyer of a futures contract expect?

Answer 9

Expects prices to rise - long position

Question 10

Explain the Margin in a futures contract?

Answer 10

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

Question 11

How is futures contract delivered?

Answer 11

Can be completed by physical delivery

usually by settlement of difference in positions for cash

Question 12

What do FTSE 100 futures trade at?

Answer 12

£10 per point

Question 13

What are the risks of commodity futures?

Answer 13

Can lose more than original investment

Physical delivery maybe required

Alternative is an ETC which would only lose original investment

Question 14

What is an option?

Answer 14

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

Question 15

Explain who buyer and seller are in an option contract?

Answer 15

Writer = seller = obligation

Investor = Buyer = A right not an obligation

Question 16

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

Answer 16

Can exercise option before strike/exercise date

Sell on market

Allow to expire - worthless

Question 17

What is a Call Option?

Answer 17

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

Question 18

What is Put Option?

Answer 18

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

Question 19

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

Answer 19

Price will rise above 240p to cover price and premium

Question 20

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

Answer 20

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

Question 21

What is intrinsic value in terms of an Option?

Answer 21

amount of premium recovered at todays price

Question 22

What is time value mean in terms of an Option?

Answer 22

Rest of premium from intrinsic value

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

Question 23

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

Answer 23

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

Question 24

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

Answer 24

Same price

Question 25

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

Answer 25

Share price moving in wrong direction for investor

Question 26

What should an investor do if expects price to go up (Option)

Answer 26

Buy call option

Question 27

What should an investor do if expects price to go down (Option)

Answer 27

Buy a put option

Question 28

What should an writer do if expects price to go up (Option)

Answer 28

Write a put option

Question 29

What should an writer do if expects price to go down (Option)

Answer 29

Write a call option

Question 30

How can options be used to rebalance a portfolio and why?

Answer 30

If overweight = purchase put option

If underweight = purchase a call option

Less time consuming and costly than selling/buying part of a holding

Question 31

What are hedge funds?

Answer 31

Pooled investments

Often based offshore

Recognised 14 different investment strategies

Aim to limit downside - seeking absolute returns

High min investment

Gearing

Question 32

Name 4 Investment strategies for hedge funds?

Answer 32

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

Question 33

What are the advantages and disadvantages of hedge funds?

Answer 33

Diversification
Low volatility strategy
Expertise of fund manager

Lack of regulation/protection
High min investment
Complex/opaque
Volatile

Question 34

Disadvantages of hedge funds

Answer 34

High charges

Non-transparent investment strategy

High gearing risk

Lower regulatory standards

Liquidity risk

Reliance on fund manager ability