Derivatives

Question 1

What is a derivative?

Answer 1

A bilateral contract or payments exchange agreement whose value derives from the value of an underlying asset or reference rate or index.

Question 2

What are derivatives used for?

Answer 2

To provide a means for shifting risk from one party to a counterparty that is more willing or better able to assume that risk.

Question 3

What are four objectives that can be achieved through the use of derivatives?

Answer 3

1) Hedge against market risk, 2) Management of assets and liabilities, 3) Lowering of funding costs and 4) Speculation for profit.

Question 4

What are the four types of derivatives contracts?

Answer 4

Forwards, futures, swaps and options.

Question 5

How do derivatives manage risk?

Answer 5

They enable a user to isolate, trade, and transfer one or more distinct risks. They are highly leveraged as they require little or no good faith deposit to secure the counterparties’ obligations. Some parties are now requiring stricter margin requirements.

Question 6

What is counterparty credit risk?

Answer 6

The risk of economic loss from the failure of an obligor to perform according to the terms and conditions of a contract or agreement. If a counterparty fails, the derivative contract is meaningless.

Question 7

What happened with LTCM?

Answer 7

Long Term Capital Management (LTCM) was a hedge fund that received a private sector recapitalization facilitated by the Fed (bailout).

Question 8

Why did the Fed choose to bailout LTCM?

Answer 8

They were concerned that rapid liquidation of LTCM’s very large trading positions would cause a “fire sale” and destabilize the financial markets.

Question 9

What are the two categories of derivatives according to the U.S. Treasury?

Answer 9

1) Privately negotiated and traded agreements, called over-the-counter (OTC) and 2) standardized agreements, called “exchange- traded derivatives”, which are traded through an organized exchange.

Question 10

How do exchange-traded derivatives eliminate counterparty risk?

Answer 10

An organized exchange addresses the counterparty credit risk inherent in bilateral contracting by standardizing derivatives contracts to create a liquid market in the contracts themselves. They impose margin requirements.

Question 11

How do exchanges eliminate their own counterparty risk?

Answer 11

By regulating its market participants to ensure their financial integrity. The clearinghouse guarantees each contract, and the members are jointly responsible for a failure of one of the members. There are also exchange-imposed margin and mark-to-market requirements.

Question 12

What are the characteristics of an exchange-traded derivative?

Answer 12

1) Centralized marketplace, 2) Standardized terms, 3) Daily mark-to-market, 4) Constant maturity.

Question 13

What are the characteristics of an over-the-counter derivative?

Answer 13

1) Bilaterally negotiated, 2) Flexible terms, 3) Collateral agreements, 4) Mature over time.

Question 14

What are the reasons for using derivatives instead of direct spot transactions?

Answer 14

1) No need for immediate transaction in underlying, 2) Want to lock in price of underlying today, 3) Do not want to expend the entire cost of notional value of the underlying.

Question 15

What is leverage?

Answer 15

The concept of making an investment with a small upfront monetary commitment using borrowed funds.

Question 16

What is basis risk?

Answer 16

The risk arising from possible changes in the difference between the spot and futures price of a particular underlying. Any time a derivative is bade on an underlying that is not the exact risk a firm is trying to hedge, basis risk exists.

Question 17

What is market risk?

Answer 17

The potential for changes in the market price for an item.

Question 18

What are the four most common market risk factors?

Answer 18

Interest rates, foreign exchange rates, equity prices and commodity prices.

Question 19

What are forwards?

Answer 19

Financial contracts in which two counterparties agree to exchange a specified amount of a designated product for a specified price on a specified future date or dates. Biggest drawback is counterparty credit risk. Terms are customizable (not standard) and they trade OTC. Parties are usually expected to make actual delivery. In re Borden Chemicals.

Question 20

What is the primary purpose of a forward?

Answer 20

To facilitate the sale and delivery of a physical commodity and to assure the commodity’s availability at a date in the future when it will be needed.

Question 21

What is are futures?

Answer 21

Exchange-traded forward contracts with standardized terms.

Question 22

What is the primary purpose of futures?

Answer 22

To transfer price risk rather than ownership of the underlying commodity.

Question 23

How does delivery work for futures contracts?

Answer 23

Although terms for delivery are usually included in the contract, actual delivery of the underlying is uncommon. Mechanisms are usually involved that permit the parties to avoid delivery, either by cash settlement or an offsetting transaction.

Question 24

Can futures contracts be traded OTC?

Answer 24

No. They are required by law to trade on federally licensed contract markets that are regulated by the CFTC.

Question 25

What are 3 features of futures contracts that reduce counterparty risk?

Answer 25

1) They require a performance bond, aka “good faith”” margin deposit as collateral. 2) Marked to markt on a daily basis with exchange of cash flow reflecting the net market movement. 3) Futures exchanges recognize only exchange members as counterparties to individual transactions.

Question 26

What features of futures make them more suitable for hedging than for mechandising?

Answer 26

1) Standardization of contract terms creates liquidity, 2) Participants can offset their positions without delivery requirements, 3) Instead of full value, can enter into contract with margin.

Question 27

What is legal risk?

Answer 27

The potential for ambiguity in regulation to impede the smooth operation of a transaction.

Question 28

What are foreign exchange futures?

Answer 28

Derivative contracts traded on exchange where the delivery of underlying currency is the subject matter of the contract.

Question 29

What is an option?

Answer 29

A contract that transfers the right but not the obligation to buy or sell an underlying asset, instrument, or index on (European) or before (American) the option’s exercise date at a specified price (the strike price).

Question 30

What is a call option?

Answer 30

It gives the option purchaser the right but not the obligation to buy a specific quantity of the underlying on or before the option’s exercise date at the strike price.

Question 31

What is put option?

Answer 31

It gives the option purchaser the right but not the obligation to sell a specific quantity of the underlying on or before the option’s exercise date at the strike price.

Question 32

How are options contracts settled?

Answer 32

Although options contemplate future transaction in the underlying, the settlement is generally done by cash payment representing the difference between the market price and the strike price.

Question 33

What is a premium?

Answer 33

The price paid by the buyer of an option.

Question 34

What formula is used for pricing options?

Answer 34

Black-Scholes formula.

Question 35

Who regulates options?

Answer 35

The SEC regulates the public trading of put and call options for securities and indexes. Board of Trade of the City of Chicago v. SEC.

Question 36

What is a swap?

Answer 36

An OTC derivatives contract in which 2 parties agree to exchange “cash flows” on a “notional amount” over a period of time in the future.

Question 37

How are cashflows for a swap calculated?

Answer 37

By applying the agreed-upon formula for each party’s respective “leg” (set of payments) of the swap to a “notional amount” (an underlying sum of capital that does not itself change hands).

Question 38

What are the characteristics of a swap?

Answer 38

1) Credit risk exposure similar to forwards, 2) A beginning valuation date, intermediate swap interest exchange dates, and a final termination date, 3) Customizable terms.

Question 39

What are credit derivatives?

Answer 39

Off-balance sheet arrangements that allow one party (the beneficiary) to transfer credit risk of a reference asset—which the beneficiary may or may not own—to another party (the guarantor).

Question 40

What are the 2 major categories of credit derivatives?

Answer 40

Credit default swaps and collateralized debt obligations.

Question 41

What is a credit default swap?

Answer 41

A private contract in which private parties bet on the probability of a debt issuer defaulting.

Question 42

What is a collateralized debt obligation?

Answer 42

An asset pool consisting of numeroud debt obligations held by a special purpose entity whose interests are divided and resold into different tranches based on differences in credit quality of the assets in the pool.

Question 43

What contracts are required to use a central clearing facility by Dodd-Frank?

Answer 43

Swaps and credit derivatives.