Derivatives

Question 1

What is a Derivative instrument?

Answer 1

A derivative instrument is an investment transaction in which the parties’ gain or loss is derived from some other economic event (i.e. the price of a given stock, foreign currency exchange rate or the price of a certain commodity)

One party enters into the transaction to speculate (incur risk) and the other enters into it to hedge (avoid risk)

Derivatives are a type of financial instrument, along with cash, accounts receivable, notes receivable, bonds, preferred shares, common shares, etc.

Derivatives are not claims on business assets (i.e. those represented by equity securities)

Question 2

What is a Covered option?

Answer 2

A covered option is one in which the seller (writer) already has possession of the underlying

Question 3

What is Naked (uncovered) option?

Answer 3

A naked (uncovered) option is a speculative instrument; since the writer does not hold the underlying, they may have to acquire it at an unknown price in the future to satisfy their obligations under the option contract

Question 4

What is an Index option?

Answer 4

An index option is an option whose underlying asset is a market index. If exercised, settlement is made by cash since delivery of the underlying is impossible

Question 5

What are Long-term equity anticipation securities (LEAPS)?

Answer 5

Long-term equity anticipation securities (LEAPS) are examples of long-term stock option or index options (with expiration dates up to 3 years away)

Question 6

What are Foreign currency options?

Answer 6

Foreign currency options give the holder the right to buy a specific foreign currency at a designated exchange rate

Question 7

What is a Call option?

Answer 7

A call option gives the buyer (holder) the right to purchase (i.e. the right to “call” for) the underlying asset (stock, currency, commodity, etc.) at a fixed price

A call option represents a long position to the holder because the holder benefits from a price increase

The seller (writer) of a call option obviously hopes the price of the underlying will remain below the exercise price since they must make the underlying available to the holder at the stick price, regardless of how much the seller must pay to obtain it. The seller of a call option is thus taking a short position

Question 8

What does it mean when a call option is “in-the-money”?

Answer 8

If the price of the underlying rises above the exercise price, the option is said to be “in-the-money”

The holder can exercise their option and buy the underlying at a bargain price

Question 9

What does it mean when a call option is “out-of-the-money”?

Answer 9

If the value of the underlying is less than the exercise price of the option, the option is “out-of-the-money” or NOT worth exercising

Question 10

What does it mean when a call option is “at-the-money”?

Answer 10

If the value of the underlying is equal to the exercise price of the option, the option is said to be “at-the-money”

Question 11

How do you calculate the buyer (holder) gain/loss on a call option?

(Long position)

Answer 11

The buyer’s gain (loss) necessarily mirrors the seller’s loss (gain). The amount of gain and loss on a call option can be calculated as follows:

= Units of underlying x (Excess of market price over exercise price - Option price)

Question 12

How do you calculate the seller (writer) gain/loss on a call option?

(Short position)

Answer 12

The buyer’s gain (loss) necessarily mirrors the seller’s loss (gain). The amount of gain and loss on a call option can be calculated as follows:

= Units of underlying x (Option price - Excess of market price over exercise price)

Question 13

What is a Put option?

Answer 13

A put option gives the buyer (holder) the right to sell (i.e. the right to “put” onto the market) the underlying asset (stock, currency, commodity, etc.) at a fixed price

A put option represents a short position to the holder because the holder benefits from a price decrease

The seller (writer) of a put option obviously hopes the price of the underlying will remain above the exercise price, since they must buy from the holder at the strike price, regardless of the fact that the same underlying can be obtained for less than the open market. The seller of a put option is thus taking a long position

Question 14

What does it mean when a put option is “in-the-money”?

Answer 14

If the price of the underlying falls below the exercise price, the option is said to be “in-the-money”

The holder can exercise their option and compel the counterparty to buy the underlying at a price higher than that prevailing in the market

Question 15

What does it mean when a put option is “out-of-the-money”?

Answer 15

If the value of the underlying is higher than the exercise price of the option, the option is “out-of-the-money” or NOT worth exercising

Question 16

What does it mean when a put option is “at-the-money”?

Answer 16

If the value of the underlying is equal to the exercise price of the option, the option is said to be “at-the-money”

Question 17

How do you calculate the buyer (holder) gain/loss on a put option?

(Short position)

Answer 17

The buyer’s gain (loss) necessarily mirrors the seller’s loss (gain). The amount of gain and loss on a put option can be calculated as follows:

= Units of underlying x (Excess of exercise price over market price - Option price)

Question 18

How do you calculate the seller (writer) gain/loss on a put option?

(Long position)

Answer 18

The buyer’s gain (loss) necessarily mirrors the seller’s loss (gain). The amount of gain and loss on a put option can be calculated as follows:

= Units of underlying x (Option price - Excess of exercise price over market price)

Question 19

What is the Put-call parity theorem?

Answer 19

The put-call parity theorem mathematically depicts the combinations of investment strategies that can be devised using European options (i.e. those with a single exercise date). The 2 sides of this equation represent combinations with identical outcomes (given identical exercise prices for the put and the call and identical expiration dates)

= Value of call + PV of exercise price (discounted at the risk-free rate) = Value of put + Value of underling

Question 20

What does the left side of the Put-call parity theorem entail?

Answer 20

Left side of the put-call parity theorem formula:

= Value of call + PV of exercise price (discounted at the risk-free rate)

The buyer of a call may wish to hedge against the loss that they will incur if the market price of the underlying fails to rise sufficiently

The buyer can do this by investing the present value of the exercise price in a safe investment. If the option is out-of-the-money on the expiration date, the option holder has the return from this safe investment to make up for the loss

Question 21

What does the right side of the Put-call parity theorem entail?

Answer 21

Right side of the put-call parity theorem formula:

= Value of put + Value of underling

The buyer of a put may wish to hedge against the loss that they will incur if the market price of the underlying fails to fall sufficiently

The buyer can do this by buying the underlying at the same time as the option. If the option is out-of-the-money on the expiration date, the option holder can simply sell the underlying at the going market price to make up for the loss

Question 22

How can the Put-call theorem formula be restated to depict the investment strategy that provides a risk-free return?

Answer 22

The basic formula can be restated to depict the investment strategy that provides a risk-free return:

PV of exercise price = Value of put + Value of underlying - Value of call

In other words, the combination of buying a put option, buying the underlying and selling a call option provides the same return as investing the present value of the exercise price at the risk-free rate. Knowledge of these relationships can help investors devise appropriate option strategies

Note: the put-call theorem formula is:

= Value of call + PV of exercise price (discounted at the risk-free rate) = Value of put + Value of underling

Question 23

What are the 2 most well-known models for valuing options?

Answer 23

The 2 well-known models for valuing options are the Black-Scholes formula for call options and the binomial method. Although the equations are complicated and beyond the scope of the CMA, the formulas contain the following inputs:

1. Exercise price
2. Price of underlying
3. Interest rates
4. Time until expiration
5. Volatility of price underlying

Question 24

What is exercise price input in an option valuation model?

Answer 24

Exercise price - in general, the buyer of a call option benefits from a low exercise price. Likewise, the buyer of a put option generally benefits from a high exercise price

An increase in the exercise price of an option results in a decrease in the value of a call option and an increase in the value of a put option

Question 25

What is price of an underlying input in an option valuation model?

Answer 25

Price of underlying - as the price of the underlying increases, the value of a call option also will increase; the exercise price is more and more of a bargain with each additional dollar in the price of the underlying

By the same token, the value of a put option will decrease as the price of the underlying increases since there is no advantage in selling at a lower-than-market price

Question 26

What are interest rates inputs in an option valuation model?

Answer 26

Interest rates - buying a call option is like buying the underlying on credit. The purchase of the option is a form of down payment. If the option is exercised in a period of rising interest rates, the exercise price is paid in inflated dollars, making it more attractive for the option holder

A rise in interest rates will therefore result in a rise in the value of a call option and fall in the value of a put option

Question 27

What is time until expiration input in an option valuation model?

Answer 27

Time until expiration - the more time that passes, the riskier any investment is

Thus, an increase in the term of an option (both calls and puts) will result in an increase in the value of the option

Question 28

What is volatility of price of underlying input in an option valuation model?

Answer 28

Volatility of price of underlying - the price of an asset can drop no lower than zero. Thus, there is a natural limit to the potential downside loss for either party to an option transaction

On the upside, however, there is much greater flexibility. Thus, parties to an option transaction will prefer volatility

An increase in the volatility of the price of the underlying will result in an increase in the value of the option (both calls and puts)

Question 29

If the exercise price of an option increases, the value of call option will?

(Effects of valuing an option)

Answer 29

Increase in exercise price of option = DECREASE in value of call option

Question 30

If the exercise price of an option increases, the value of put option will?

(Effects of valuing an option)

Answer 30

Increase in exercise price of option = INCREASE in value of put option

Question 31

If the price of underlying increases, the value of call option will?

(Effects of valuing an option)

Answer 31

Increase in price of underlying = INCREASE in value of call option

Question 32

If the price of underlying increases, the value of put option will?

(Effects of valuing an option)

Answer 32

Increase in price of underlying = DECREASE in value of put option

Question 33

If interest rates increase, the value of call option will?

Effects of valuing an option

Answer 33

Increase in interest rates = INCREASE in value of call option

Question 34

If interest rates increase, the value of put option will?

Effects of valuing an option

Answer 34

Increase in interest rates = DECREASE in value of put option

Question 35

If the time until expiration increase, the value of call option will?

(Effects of valuing an option)

Answer 35

Increase in the time until expiration = INCREASE in value of call option

Question 36

If the time until expiration increase, the value of put option will?

(Effects of valuing an option)

Answer 36

Increase in the time until expiration = INCREASE in value of put option

Question 37

If the volatility of price of underlying increase, the value of call option will?

(Effects of valuing an option)

Answer 37

Increase in the volatility of price of underlying = INCREASE in value of call option

Question 38

If the volatility of price of underlying increase, the value of put option will?

(Effects of valuing an option)

Answer 38

Increase in the volatility of price of underlying = INCREASE in value of put option

Question 39

What are Forward contracts?

Answer 39

One method of mitigating risk is the simple forward contract. The two parties agree that (at a set future date) one of them will perform and the other will pay a specified amount for the performance

A common example is that a retailer and a wholesaler who agree in September on the prices and quantities of merchandise that will be shipped to the retailer’s stores in time for the winter holiday season. The retailer has locked in a price and a source of supply and the wholesaler has locked in a price and a customer

The party that has contracted to buy the underlying at a future date has taken a long position

The party that has contracted to deliver the underlying has taken a short position

Question 40

What does it mean when the market price of an underlying on delivery date > contractual price for a forward contract?

Answer 40

The payoff structure is similar to that for options

If the market price of the underlying on the delivery date is higher than the contractual price, the party that has taken the long position benefits (since they locked in a lower price)

Question 41

What does it mean when the market price of an underlying on delivery date < contractual price for a forward contract?

Answer 41

The payoff structure is similar to that for options

If the market price of the underlying on the delivery date is lower than the contractual price, the party that has taken the short position benefits (since they are entitled to receive higher payment for the underlying than the amount currently prevailing in the market)

Question 42

What is difference between a forward contract and an option?

Answer 42

In a contract, both parties must meet their contractual obligations (i.e. to deliver merchandise and to pay)

Neither has the option of nonperformance (like with an option)

Question 43

What are Futures contracts?

Answer 43

A Futures contract is a commitment to buy or sell an asset at a fixed price during a specific future month; unlike with a forward contract, the counterparty is unknown. Future contracts are actively traded on futures exchanges

Since futures contracts are for delivery during a given month (not a specific day), they are more flexible arrangements

The clearinghouse randomly matches sellers who will deliver during a given month with buyers who are seeking delivery during the same month

Question 44

When is it more appropriate to use a forward contract vs. a futures contract?

Answer 44

A forward contract where the parties are exchanging very specific merchandise and can take the time to address all the facets of the contract would use a forward contract vs. a futures contract

Question 45

When is it more appropriate to use a futures contract vs. a forward contract?

Answer 45

Traders in undifferentiated commodities (such as grains, metals, fossil fuels and foreign currencies) often do not have the luxury of taking the time to address all facets of the contract. The trading process of these products is eased by the use of futures contracts

Question 46

What are some distinguishing feature of future contracts (as opposed to forward contracts)?

Answer 46

Since future contracts are actively traded, the result is a liquid market in futures that permits buyers and sellers to net out their positions (as opposed to forward contracts, which aren’t as liquid)

Future contract prices are marked-to-market every day at the close of the day to each person’s account. Thus, the market price is posted at the close of business each day

A party to a forward contract typically expects actual delivery. Futures contracts are generally used as financial tools to offset the risks of changing economic conditions. Thus, the two parties simply exchange the difference between the contracted price and the market price prior to the expiration date

Question 47

How does a mark-to-market provision minimize a future contract’s chance of default?

Answer 47

A mark-to-market provision minimizes a futures contract’s chance of default because profits and losses on the contracts must be received or paid each day through a clearinghouse

This requirement of daily settlement minimizes default and is necessary because futures contracts are sold on margin (i.e. they are highly leveraged)

Question 48

What are Swaps?

Answer 48

Swaps are contracts by which the parties exchange cash flows. The 3 type of common swaps are:

1. Interest rate swaps
2. Currency swaps
3. Credit default swaps

Question 49

What are Interest rate swaps?

Answer 49

Interest rate swaps are agreements to exchange interest payments based on one interest structure for payments based on another structure

For example, a firm that has fixed debt service charges may enter into a swap with a counterparty that agrees to supply the first party with interest payments based on a floating rate that more closely tracks the first party’s revenues

These agreements are highly customized

Question 50

What are Currency swaps?

Answer 50

Currency swaps are agreements to exchange cash flows denominated in one currency for cash flows denominated in another

For example, a U.S. firm with revenues in euros has to pay suppliers and workers in dollars (not euros). To minimize exchange-rate risk, it might agree to exchange euros for dollars held by a firm that needs euros

The exchange rate will be an average of the rates expected over the life of the agreement

Question 51

What are Credit default swaps?

Answer 51

Credit default swaps are agreements whereby one of the parties indemnifies the other against default by a third party

For example, a large bank may agree to pay a constant stream of cash to another bank as long as one of the first bank’s major debtors remains current on its loans. If the customer defaults, the second bank covers the first bank’s loss. One of the parties is (in effect) providing loan default insurance to the other party

Unlike interest rate swaps, these agreements are usually bundled into large portfolios

Question 52

What is Swap spread?

Answer 52

The swap spread is the market-determined additional yield that compensates counterparties who receive fixed payments in a swap for the credit risk involved in the swap. The swap spread will differ with the creditworthiness of the counterparty

Most swaps are priced to be at-the-money at inception, meaning that the value of the two sets of cash flows being exchanged is the same. Naturally, as interest rates, currency exchange rates, and credit risks change, the values of swaps will change