Derivatives Flashcards
What is a futures contract?
Legally binding agreement to buy/sell asset at specified future date at price agreed when contract is made
Buyer has long position (commit to buy) and seller has short position (s for short/seller)
Futures contracts are used for speculation and hedging in various markets.
What position do buyers take in a futures contract?
Long position - expect prices to rise
Buyers profit when the market price increases.
What position do sellers take in a futures contract?
Short position - expect prices to fall
Sellers profit when the market price decreases.
How does the long futures position perform in a rising market?
Makes money
Long positions benefit from price increases.
How does the long futures position perform in a falling market?
Loses money
Long positions incur losses when prices drop.
How does the short futures position perform in a falling market?
Makes money
Short positions benefit from price decreases.
How does the short futures position perform in a rising market?
Loses money
Short positions incur losses when prices rise.
What is the purpose of the initial margin in futures contracts?
Acts as collateral
Initial margins are required to ensure that parties can fulfill their contractual obligations.
What does ‘market to market’ refer to in futures trading?
Revalued on daily basis
This process ensures that gains and losses are realized each day.
When does a futures position close?
When contract reaches expiry or investor closes out position
Closing a position can be done before the contract expires.
How can futures contracts be used in investment strategies?
To hedge portfolios against adverse market conditions
Hedging helps mitigate potential losses in the market.
What is contango in futures markets?
When the futures price is higher than the price of the underlying asset
Contango can indicate expectations of rising prices.
What is backwardation in futures markets?
When the futures price is lower than the price of the underlying asset
Backwardation can suggest expectations of falling prices.
What does an options contract provide to the buyer?
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.
What is a call option?
Right to buy
Call options are beneficial if the price of the underlying asset rises.
What is a put option?
Right to sell
Put options are beneficial if the price of the underlying asset falls.
What position does the buyer of a call option take?
Long call position
Buyers of call options profit from increases in the underlying asset’s price.
What position does the buyer of a put option take?
Long put position
Buyers of put options profit from decreases in the underlying asset’s price.
Who makes margin payments in options trading?
Seller only
Margin requirements can differ between futures and options.
What are the choices available for an option?
Exercise, sell, expire
These choices determine how and when an option can be utilized.
What is intrinsic value in options?
Value of the option
Intrinsic value reflects the profitability of exercising the option.
What does ‘in-the-money’ mean for options?
Strike price is below current price of asset
In-the-money options have intrinsic value.
What does ‘out-of-the-money’ mean for options?
Strike price is above current price of asset
Out-of-the-money options have no intrinsic value.
What does ‘at-the-money’ mean for options?
Strike price is the same as the current price of asset
At-the-money options are often considered for potential exercise.
How does the time until expiry affect an option’s premium?
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.
What are Derivatives?
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
Use of Derivatives
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)
What are Traditional Warrants?
Long term call option issued by companies
Holder has right but no obligation to buy shares at fixed price and date
What are Covered warrants?
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
What are Specialised collectives (derivatives)
Futures and options funds (FOFs)
Geared futures and options funds (GFOFs)
Capital protected unit trusts and OEICs
What are Contracts for difference (derivatives)
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
What is Spread and Binary betting? (Derivatives)
Placing bets with a spread betting firm
Trading is done on a margin
Pure speculation
What are Absolute return funds used for?
Aim to produce positive returns in all market conditions
Focus on Alpha of manager
What is a structured product?
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
What should be considered before investing in a structured product?
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
Options
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
Futures
An obligation rather than an option, often used in the trading of commodities
Contracts for difference (CFDs)
opportunity to benefit from movements in the price of an asset
a bit like spread betting
Swaps
Written agreement to swap assets or income in the future
