Derivatives

Question 1

Define derivative

Answer 1

A derivative is a financial instrument, derives its performance from the performance of an underlying asset

Question 2

What is: underlying asset

Answer 2

Also called underlying

underlying asset - trades in the spot or cash market, its price is called cash or spot price

Question 3

What are the two classes of derivatives?

Answer 3

forwards commitment & contingent claims

Question 4

How can derivative be created?

Answer 4

as a standardized instrument on derivative exchanges, or as a customized instrument in the over the counter market

Question 5

extange traded

Answer 5

standardized, highly regulated, transparent transactions, guaranteed against default - thanks to the clearinghouse

Question 6

Over the counter

Answer 6

customized, flexible, more private, and less regulated than exchange-traded, greater risk of default

Question 7

Forward contract

Answer 7

Over the counter derivative
2 parties agree that one party, the buyer, purchase an underlying asset from the other party, the seller, at a later date and at a fixed price they agreed upon on the day they signed the contract

Question 8

Future contract

Answer 8

similar to forward contract, but future contract is a standardized derivatives contract created and traded on the futures exchange.

2 parties agree that one party, the buyer, will purchase an underlying asset from another party, the seller, at a later date and at a price agreed on by the two parties when the contract was initiated.

there are daily settling gains and losses and a credit guarantee by the future exchange through its clearinghouse

Question 9

Call option

Answer 9

buy the underlying asset

Question 10

Put option

Answer 10

sell the underlying asset

Question 11

SWAP

Answer 11

over the counter derivavite

2 parties agree to exchange a series of cash flows, one party pays a variable series (that will be determined by an underlying asset or rate), and the other party pays either a fixes series, or a variable series (determined by a different underlying asset or rate).

Question 12

Option

Answer 12

is a derivative contract
1 party the buyer - pay a sum of money to the other party - the seller or writer, and receive the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.

Question 13

other name for seller in the option market is?

Answer 13

writter

Question 14

Credit derivatives are

Answer 14

class of derivatives contract between two parties, the credit protection (buyer and seller),

where the second (latter), provide protection to the first (former) against a specific credit loss

Question 15

credit default swap

Answer 15

widely used credit derivatives
contract between 2 parties, credit protection (buyer and seller)

where the buyer makes a series of payments to the seller and receives a promise of compensation for credit losses resulting from the default of a 3rd party

Question 16

Derivative combination to other derivatives

Answer 16

derivatives can be combined with other derivatives or underlying assets to form hybrids

Question 17

Asset backed securities

Answer 17

Derivative contract - where a portfolio of debt is created and claims are issued not he portfolio in forms of tranches - which have different priorities.

prepayment or credit losses are allocated to the most junior tranches first and the most senior tranche last.

Question 18

Where are derivatives issued on?

Answer 18

Equities, fixed-income securities, credit, commodities, interest rate, currency, underlying weather, disaster claims, electricity

Question 19

Derivatives and gambling

Answer 19

criticized for being a form of gambling

Question 20

Transfer of risk with derivatives

Answer 20

Transfer of risk is facilitated,
creation go strategy and payoff
provide information about the spot market
offer lower transaction costs,
reduce the amount of capital required
easier to go short,
improve the efficiency of the sport market

Question 21

Derivatives and priced forming

Answer 21

priced by forming a hedge involving the underlying asset and a derivative,
the combination must pay the risk free rate and do so for only one derivative price

Question 22

Pricing - storage - derivatives

Answer 22

Pricing relies heavily on the principle of storage

storage can incur costs, but can also generate cash - like dividends and interest

Question 23

Arbitage condition

Answer 23

2 parties equivalent assets or derivatives or combination of assets and derivatives sell for different prices,

opportunity to buy at a lower price and sell at the higher price,

earning a risk-free-rate profit without committing any capital

Question 24

Combined action of arbitrageurs

Answer 24

Bring about a convergence of prices, arbitrage leads to the law of one price: Transactions that produce equivalent results must sell for equivalent prices

Question 25

Law of one price

Answer 25

Transactions that produces equivalent results must sell for equivalent prices.