Derivatives

Question 1

What is a futures contract?

Answer 1

Legally binding agreement to buy/sell asset at specified future date at price agreed when contract is made

Futures contracts are used for speculation and hedging in various markets.

Question 2

What position do buyers take in a futures contract?

Answer 2

Long position - expect prices to rise

Buyers profit when the market price increases.

Question 3

What position do sellers take in a futures contract?

Answer 3

Short position - expect prices to fall

Sellers profit when the market price decreases.

Question 4

How does the long futures position perform in a rising market?

Answer 4

Makes money

Long positions benefit from price increases.

Question 5

How does the long futures position perform in a falling market?

Answer 5

Loses money

Long positions incur losses when prices drop.

Question 6

How does the short futures position perform in a falling market?

Answer 6

Makes money

Short positions benefit from price decreases.

Question 7

How does the short futures position perform in a rising market?

Answer 7

Loses money

Short positions incur losses when prices rise.

Question 8

What is the purpose of the initial margin in futures contracts?

Answer 8

Acts as collateral

Initial margins are required to ensure that parties can fulfill their contractual obligations.

Question 9

What does ‘market to market’ refer to in futures trading?

Answer 9

Revalued on daily basis

This process ensures that gains and losses are realized each day.

Question 10

When does a futures position close?

Answer 10

When contract reaches expiry or investor closes out position

Closing a position can be done before the contract expires.

Question 11

How can futures contracts be used in investment strategies?

Answer 11

To hedge portfolios against adverse market conditions

Hedging helps mitigate potential losses in the market.

Question 12

What is contango in futures markets?

Answer 12

When the futures price is higher than the price of the underlying asset

Contango can indicate expectations of rising prices.

Question 13

What is backwardation in futures markets?

Answer 13

When the futures price is lower than the price of the underlying asset

Backwardation can suggest expectations of falling prices.

Question 14

What does an options contract provide to the buyer?

Answer 14

Right but not obligation to buy/sell specific asset at fixed price before or on a certain date

This flexibility is a key feature of options.

Question 15

What is a call option?

Answer 15

Right to buy

Call options are beneficial if the price of the underlying asset rises.

Question 16

What is a put option?

Answer 16

Right to sell

Put options are beneficial if the price of the underlying asset falls.

Question 17

What position does the buyer of a call option take?

Answer 17

Long call position

Buyers of call options profit from increases in the underlying asset’s price.

Question 18

What position does the buyer of a put option take?

Answer 18

Long put position

Buyers of put options profit from decreases in the underlying asset’s price.

Question 19

Who makes margin payments in options trading?

Answer 19

Seller only

Margin requirements can differ between futures and options.

Question 20

What are the choices available for an option?

Answer 20

Exercise, sell, expire

These choices determine how and when an option can be utilized.

Question 21

What is intrinsic value in options?

Answer 21

Value of the option

Intrinsic value reflects the profitability of exercising the option.

Question 22

What does ‘in-the-money’ mean for options?

Answer 22

Strike price is below current price of asset

In-the-money options have intrinsic value.

Question 23

What does ‘out-of-the-money’ mean for options?

Answer 23

Strike price is above current price of asset

Out-of-the-money options have no intrinsic value.

Question 24

What does ‘at-the-money’ mean for options?

Answer 24

Strike price is the same as the current price of asset

At-the-money options are often considered for potential exercise.

Question 25

How does the time until expiry affect an option’s premium?

Answer 25

The more time an option has until expiry, the greater the chance it will end up in-the-money (so higher premium)

Time value is a significant component of an option’s price.

Question 26

What are Derivatives?

Answer 26

Financial contracts were the value is derived from value of underlying investment
Allows investors to take exposer in relation to underlying asset without ownership
Cost of buying derivative is fraction of the cost of buying actual asset
Traded on exchange or over the counter

Question 27

Use of Derivatives

Answer 27

Hedging - protect a fund manager against future adverse price movements
Advantages - lower dealing costs, speed of dealing and liquidity

Speculation - try to profit by correctly forecasting future price movements
Risk is limited to premium paid
Reward is unlimited
Largest risk is in writing options over shares/assets the writer doesn’t own (uncovered calls)

Question 28

What are Traditional Warrants?

Answer 28

Long term call option issued by companies
Holder has right but no obligation to buy shares at fixed price and date

Question 29

What are Covered warrants?

Answer 29

Type of option issued by investment banks on the stock exchange
‘Covered’ because bank (writer) covers or hedges it’s exposure by either buying the underlying stock or takes out futures or options on an exchange

Question 30

What are Specialised collectives (derivatives)

Answer 30

Futures and options funds (FOFs)
Geared futures and options funds (GFOFs)
Capital protected unit trusts and OEICs

Question 31

What are Contracts for difference (derivatives)

Answer 31

Geared investment used for trading shares (long or short)
Geared so only proportion of the value of a trade is needed to fund a trade
Used by stockmarket traders

Question 32

What is Spread and Binary betting? (Derivatives)

Answer 32

Placing bets with a spread betting firm
Trading is done on a margin
Pure speculation

Question 33

What are Absolute return funds used for?

Answer 33

Aim to produce positive returns in all market conditions

Focus on Alpha of manager

Question 34

What is a structured product?

Answer 34

Designed to offer tailored combination of risk and return
Many offer capital guarantees
Really just a wrapper for specific investment objectives with specific risk/reward profile
Made up of a zero coupon bond and a call option
Usually fixed term of 5 or 6 yrs
Max and min returns are pre-specified
Returns based on performance of index
Taxed as income in year they mature or capital gain depending on produce structure
Offers either 100% capital protection, partial capital protection or no protection

Question 35

What should be considered before investing in a structured product?

Answer 35

Return - how is it calculated?
Risk profile - what assets form the structured product, what are the risks to original capital, any protection under FSCS?
Costs - costs and fees, tax implications
Encashment - any early penalties, costs, liquidity in secondary mkt
Credit Risks - creditworthiness of issuer and any counterparties

Question 36

Options

Answer 36

Option (not obligation) to buy or sell an asset within a set timescale at a set ‘strike price’
European options have a set strike date, US options can be exercised anytime up to their strike date
A call option = right to buy
Put option = right to sell
If purchaser expects markets to rise they buy call options, if expect markets to fall they buy put options

Question 37

Futures

Answer 37

An obligation rather than an option, often used in the trading of commodities

Question 38

Contracts for difference (CFDs)

Answer 38

opportunity to benefit from movements in the price of an asset
a bit like spread betting

Question 39

Swaps

Answer 39

Written agreement to swap assets or income in the future