Derivatives

Question 1

What are the 3 types of markets for Forwards and Futures?

Answer 1

• Spot markets
• Forward markets
• Futures markets

Question 2

What are the 2 types of Options?

Answer 2

• Call Options

- Put Options

Question 3

What are the 2 types of Swaps?

Answer 3

• Interest rate swaps

- Currency swaps

Question 4

How are Derivatives defined?

Answer 4

Derivatives are financial instruments whose value is linked to and derived from somewhere else.

Question 5

What could derivatives be linked to?

Answer 5

Derivatives could be linked to almost anything;

• Commodities
• Interest Rates
• Equities and Equity Indices
• Bonds
• Currencies
• Weather

Question 6

What can Derivatives be used for?

Answer 6

Derivatives can be used for both ‘hedging’ (reducing existing exposures) and ‘speculation’ (deliberately taking new exposures).

D markets can also be thought of as reallocating risk from those who do not wish to bear it to those who do.

Question 7

How are Derivatives financed?

Answer 7

Many derivatives involve significant amounts of leverage, which can make them a very effective financial tool.

It also helps explain why derivatives have been involved in many of the largest financial disasters.

Question 8

Which institutions are involved in Derivatives?

Answer 8

Banks and Hedge Funds = Major players

Most large international corporations dabble in derivatives to hedge their risks. Otherwise, Derivatives is open to all investors.

Question 9

How are Derivatives traded?

Answer 9

Derivatives are traded on both open outcry and electronic exchanges, though electronic trading is gaining.

SOme of the largest exchanges are CBOT/CME and LIFFE.
These exchanges compete for trading volume.

Question 10

What is a Spot contract?

Answer 10

An agreement between two parties for immediate delivery of an Asset (by Seller) and immediate payment of funds in return (by Buyer)

Question 11

What is a Forward contract?

Answer 11

An agreement between two parties at time t=0 to exchange a non-standardised asset for cash at some future date. The details of the asset, price to be paid, and future date are all set at t=0.

Question 12

What is a Futures contract?

Answer 12

Similar to a Forward, but agreement at time t=0 is to exchange a ‘standardised’ asset for cash at some ‘standardised’ future date.

The transactions occur in a centralised market.

Question 13

What is the difference between Forwards and Futures?

Answer 13

Forwards are more personal compared to Futures, whereas Futures are much more market-oriented instruments, in that they are more standardised.

Question 14

What is an FRA?

Answer 14

Forward Rate Agreement
Forward contract for loans that today fixes the interest rate on a loan that will be made in the future.

Others Fs are agreements to deliver particular commodities in the future, at a price specified now.

Question 15

How does one make profit from a Long Forward position?

Answer 15

If the position is Long, the f(x) slants upward. This position causes the owner to profit if the price increases.

Question 16

How does one make a profit from a Short Forward position?

Answer 16

If the position is Short, this means the f(x) will slant downwards. Thus the owner of this position will profit when the price of the underlying asset decrease.

‘The Big Short’ is a famous book about how bankers used the crisis to profit, despite falls in stock values.

Question 17

What position (on Forwards) do Buyers and Sellers take, respectively?

Answer 17

Buyers:
Usually take long position, in order to counterbalance any increase in the price of the underlying asset, that would otherwise cause a loss to the Buyer.

Sellers:
Usually take short position, in order to counterbalance any decrease in the price of the underlying asset, that would otherwise cause a loss to the Seller.

Question 18

What are the axis for the Derivatives diagram?

Answer 18

y axis:
Profit positive/negative

x axis:
Price of Underlying asset at Maturity (S[T])

Question 19

A Cocoa grower wants to remove uncertainty about the price he will receive when the crop is harvested. How should he hedge?

Answer 19

Take Short Forward position on Cocoa prices.

Question 20

What is the logic behind Derivatives?

Answer 20

When there is a possibility of something bad (harmful to business) happening, the investor bets on it (as if to say he believes it WILL happen).
He does so by setting prices at the current/agreed level and taking a long/short position (dependant on wether he buys or sells underlying asset) in which case he will make profit if the bad possibility happens, making up for the losses.
This is the logic.

Question 21

A producer of electronic goods needs to buy a 100 tonnes of copper in six months time. How should she hedge?

Answer 21

Long Forward position on Copper prices

Question 22

A UK investor holds $110m of US equities. She is bullish on the performance of the equities, but fears that a fall in the dollar might still lead to losses. How should she hedge?

Answer 22

Take a Short Forward position on the Dollar.

Question 23

What are the reasons that one may consider trading in Forwards?

Answer 23

• Hedging
• Speculation
• Arbitrage

Question 24

What does the Futures Contract Exchange guarantee?

Answer 24

The Exchange guarantees payment for both parties so that counter-party default risk is not a concern. Principles will not normally know the opposing party in the contract unless delivery is arranged.

Question 25

What are the measure imposed on exchanges to protect both parties?

Answer 25

Exchanges impose;

• Margin requirements
• Position limits
• Daily marking to market

Question 26

What is the Initial margin, and how does it work?

Answer 26

Buyers/Sellers of Futures contracts must post Initial Margin, usually about 1-5% of the face value of the contract.

Losses are deducted from investors’ margin accounts. If future prices move against them, they will be asked to top up their margin to its original level. This is also known as the margin call).

Question 27

What is the purpose of the Initial margin and how does it contrastto the Forwards system?

Answer 27

This system is put in place to make sure that investors cannot walk away from a deal if prices move against them.

By contrast, on a Forwards contract, no cash is paid or received until contract maturity.

Question 28

What are the differences between Forward and Futures Contracts?

Answer 28

• Forwards consist of private contract between 2 parties, whereas a simple Exchange is traded in Futures.
• Forwards are non-standardised, while Futures are standardised
• Forwards usually have 1 specified delivery date, while futures have a range of delivery dates.
• A Forward is settled at the end of a contract, while Futures are settled daily.
• While Forwards may have credit risk, Futures have no credit risk.

5, CSDSeR Contract Standardisation Delivery Settlement Risk

Question 29

How are Options defined?

Answer 29

An Option is a derivative instrument that provides the holder (long position) with the right, but not the obligation, to complete a transaction on the underlying asset at a specific price (STRIKE PRICE) during or at a specific period of time (EXPIRATION DATE).

If holder of Option chooses to exercise his right, the writer (Short position) is obliged to act on it.

Question 30

What is a Call Option?

Answer 30

This gives the holder the right (not obligation) to purchase the underlying security at the agreed strike price. For this right he/she pays the writer an up-front fee known as the ‘Call Premium’.

BUY

Question 31

What is a Put Option?

Answer 31

This gives the holder the right (not obligation) to sell the underlying security at the agreed strike price. For this right, he/she pays the writer an up-front fee known as the ‘Put Premium’

SELL

Question 32

What are the 4 types of Option Positions?

Answer 32

• Long Call _/
• Long Put _
  (For Holders)
  These are positions that investors will take to protect themselves from price fluctuation. Assuming similarity to Forwards, Buyers would tend to buy Calls and Sellers would tend to buy Puts.
• Short Call -\
• Short Put /-
  (For Writers)
  The Horizontal area represents profit from premiums

Question 33

What are the defining factors of Options?

Answer 33

They give you an Option ===

Draw Long/Short on eBay
(Option price $5, Strike price $100, Option life: 2 months)

Draw Long/Short on IBM
(Option price $7, Strike price $70, Option life: ???)

Question 34

Why would somebody Short on Options?

Answer 34

If they are the ‘Writer’ of the Option.

Question 35

What is the Black-Scholes model?

Answer 35

The Black-Scholes Option pricing model is used to calculate the value of standard (vanilla) options based on certain assumptions: in particular about future volatility of the underlying asset. Increased volatility makes options more valuable.

‘Exotic’ options may need more complex valuation models.

Question 36

What is a Swap?

Answer 36

A Swap is an agreement between 2 parties to exchange assets and/or a series of Cash flows in the future.

Can also be thought of as a series of individual forward agreements stretching into the future.

Question 37

What are Swaps typically used for?

Answer 37

They are typically used for hedging rather than speculation. They are generally used to hedge interest rate (fixed vs. floating) and foreign exchange exposures.

Question 38

What kind of Derivative is a Swap?

Answer 38

Swaps are OTC derivatives, and are highly customised to users’ needs. Many different types exist, including Credit-Default Swaps.

Question 39

What do Derivatives acheive?

Answer 39

Derivatives allow firms to hedge their risks cheaply and efficiently. They are also a very effective tool for speculation.

Question 40

Why has the use of Derivatives often been seen as controversial?

Answer 40

The high gearing and complexity of some derivatives, sometimes coupled with outright fraud, has led to some massive losses. Nick Leeson is just one example.

They are a powerful tool if used correctly, but dangerous if used badly.