Derivatives Flashcards
What are derivatives?
Securities whose prices are based on an underlying asset
Don’t hold asset directly
What does exchanged traded mean in terms of derivatives?
Available for purchase/sale each business day on recognised exchange
What does over the counter (OTC) mean in terms of derivatives?
Individual arrangement created by financial institution for a client
What are the features of a derivative?
No income
CGT regime applies
No voting rights
Higher risk than holding underlying asset but greater potential returns - element of gearing due to premium
How can derivatives help to hedge portfolio?
Transaction that will make a gain if original investment falls.
Protects existing position
What is a Future?
Creates an obligation on both parties to undertake a transaction at pre-determined (strike/exercise) price on an agreed future (strike/exercise) date
What obligations do the parties in a futures contract have?
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
What does the seller of a futures contract expect?
Expects prices to fall - short position
What does the buyer of a futures contract expect?
Expects prices to rise - long position
Explain the Margin in a futures contract?
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
How is futures contract delivered?
Can be completed by physical delivery
usually by settlement of difference in positions for cash
What do FTSE 100 futures trade at?
£10 per point
What are the risks of commodity futures?
Can lose more than original investment
Physical delivery maybe required
Alternative is an ETC which would only lose original investment
What is an option?
Put together by writer who sells for a price to investor known as premium
Explain who buyer and seller are in an option contract?
Writer = seller = obligation
Investor = Buyer = A right not an obligation
What rights does an investor/buyer have with regards to an option contract?
Can exercise option before strike/exercise date
Sell on market
Allow to expire - worthless
What is a Call Option?
Right to investor to buy at asset at predetermined price before/on strike date.
What is Put Option?
Right to investor to sell an asset at a pre-determined price before/on strike date
If an investor buys a Call Option for premium of 20p to buy shares at 220p what does she hope for?
Price will rise above 240p to cover price and premium
If an investor buys a Put Option for premium of 30p to sell shares at 300p what does she hope for?
Price will fall below 270p so can be sold for 300p and purchase for less than 270p = gain above premium
What is intrinsic value in terms of an Option?
amount of premium recovered at todays price
What is time value mean in terms of an Option?
Rest of premium from intrinsic value
Minimum amount that an investor hopes share price will increase before option contract expires
What is In the Money mean in terms of an Option?
Ignores premium - indicates share price moving in right direction for investor
What is At the Money mean in terms of an Option?
Same price
What is out of the Money mean in terms of an Option?
Share price moving in wrong direction for investor
What should an investor do if expects price to go up (Option)
Buy call option
What should an investor do if expects price to go down (Option)
Buy a put option
What should an writer do if expects price to go up (Option)
Write a put option
What should an writer do if expects price to go down (Option)
Write a call option
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
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
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
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
Disadvantages of hedge funds
High charges
Non-transparent investment strategy
High gearing risk
Lower regulatory standards
Liquidity risk
Reliance on fund manager ability
