Derivatives Flashcards
What is a forward contract on a bond?
A forward contract is an agreement to buy or sell a bond at a specified future date for a predetermined price (forward price).
How is the forward price of a bond calculated?
Price of a bond today * EXP(r*T)
Or Price of a bond today / discount rate
How does an increase in interest rates affect an existing forward contract?
The forward price decreases, causing a long position in the forward contract to lose value.
How does the value of a forward contract change over time?
It fluctuates based on interest rate movements and changes in the present value of the underlying asset.
How does a forward contract relate to a zero-coupon bond?
A forward contract can be decomposed into a long position in the bond and a short position in a zero-coupon bond.
Why do forward contracts have zero value at initiation?
The forward price is set such that neither party gains or loses at the start.
What is an interest rate swap?
A derivative where one party exchanges fixed interest payments for floating interest payments or vice versa.
What are the two main types of interest rate swaps?
Payer swap (pays fixed, receives floated)
Receiver swap (receives fixed, pays floated)
How are interest rate swaps used for risk management?
Companies and institutions use swaps to hedge against interest rate fluctuations affecting their liabilities or assets.
What is the swap rate and how is it determined?
The fixed rate in a swap that makes the present value of fixed and floating payments equal at initiation.
What is the difference between a swap and an FRA?
An FRA is a one-time agreement on a future interest rate, whereas a swap is an ongoing series of payments.
How do banks uses swaps when issuing floating-rate loans?
They often sell swaps to transform floating-rate debt into fixed-rate obligations.
What is a swap spread?
The difference between the swap rate and the yield of a risk-free Treasury bond with the same maturity.
How do interest rate futures differ from forwards?
Futures are standardized, exchange-traded, and settled daily, while forwards are customized and settled at expiration.
What happens to Eurodollar futures when interest rates rise?
Their prices fall, as they reflect the market’s expectation of lower future interest rates.
How are interest rate futures used for hedging?
Investors use them to lock in future borrowing or lending rates.
What is the difference between an interest rate future and a bond future?
An interest rate future is based on short-term rates (LIBOR, SOFR) while a bond future is based on the price of a long-term bond.
What is a bond option?
A financial derivative that gives the holder the right, but not the obligation, to buy or sell a bond at a specified price.
How does a call option on a bond work?
It gives the right to buy the bond at a fixed price, benefiting from rising bond prices (falling rates)
How does a put option on a bond work?
It gives the right to sell the bond at a fixed price, benefiting from falling bond prices (rising rates)
What role does volatility play in bond option pricing?
Higher volatility increases the option’s value, as there is a greater chance of the bond price moving in-the-money.
What is a put-call parity for bond options?
A pricing relationship ensuring that the difference between call and put prices equals the present value of the bond’s forward price minus the strike price.
What is an interest rate cap?
A series of call options on an interest rate, ensuring that rates do not exceed a predefined level.
What is an interest rate floor?
A series of put options on an interest rate, ensuring that rates do not fall below a predefined level.
Why are caps and floors used in risk management?
They provide protection against extreme interest rate movements for floating-rate borrowers or lenders.
What is cap-floor parity?
The relationship stating that a cap is equivalent to a floor plus a swap.
What factors influence the pricing of a caplet or floorlet?
Forward interest rates, discount factors, strike rate and implied volatility.
What is a swaption?
An option that gives the holder the right to enter into an interest rate swap at a future date.
What are the two types of swaptions?
Payer swaption - right to enter a pay fixed, receive floating swap.
Receiver swaption - right to enter a receive fixed, pay floating swap.
Why are swaptions widely used in the financial industry?
They allow investors to hedge against future interest rate changes or to speculate on rate movements.
How is swaption pricing related to volatility?
Higher implied volatility increases the swaption’s price, as larger rate movements are more likely.
How does a swaption’s payoff depend on the market swap rate?
A payer swaption is exercised if the market swap exceeds the strike rate.
A receiver swaption is exercised if the market swap rate is below the strike rate.
What is the swaption volatility surface?
A 3D graph showing implied volatilities for swaptions across different maturities and tenors.
Why do implied volatilities vary across strikes?
Due to demand, market expectations, and risk management considerations, creating volatility skews and smiles.
What happens to the volatility surface in times of financial stress?
Volatility tends to spike, especially for short-term options, reflecting greater uncertainty in rate movements.
How do traders use the volatility surface?
They interpolate/extrapolate volatilities to price custom swaptions that do not have directly quoted prices.
What is tricky about the Black formula to calculate caps and floors in terms of volatility?
They use implied volatility which is the same for all caplets, which is called flat volatility, however, that is an oversimplification because volatility changes over time.
