Derivatives and Currency Management Flashcards
What is a synthetic long forward position?
The combination of a long call and short put that have identical strike prices and expirations.
What motivates the creation of a synthetic long forward position?
The motivation to create a synthetic long forward position could be to exploit an arbitrage opportunity or if an investor needs an alternative to the outright purchase of a long forward position.
What investment objectives are possible for using a covered call?
The possible investment objectives for using a covered call include:
* Yield enhancement
* Reducing a position at a favorable price
* Target price realization
What is the value of a covered call position at option expiration?
At option expiration, the value of a covered call position is the stock price minus the exercise value of the call. Any price increases beyond the strike price of the covered call belong only to the buyer of the call.
What risk is there to a covered call strategy?
A covered call strategy is stock price depreciation. Covered calls do not protect against downside, although the receipt of the call premium offsets losses.
If a stock rises beyond the strike price. If this occurs, the investor has lost the opportunity to profit from price appreciation (opportunity loss).
What are the similarities between the profit and loss diagram for protective puts and holding a long call?
The profit and loss diagram for protective puts is similar to holding a long call.
This similarity is the result of put–call parity—being long the asset and long the put is equivalent to being long a call plus long a risk-free bond.
What are the risks to protective puts?
The real risk to protective puts is that they have a finite term and must be rolled over periodically to maintain the insurance (expensive over time).
Another minor risk is that purchasing a put before a stock rises will reduce total return.
What is delta (Δ)?
Delta (Δ) ≈ Change in value of option/Change in value of underlying security.
Because a long call/put increases/decreases in value as the underlying security price rises:
* call deltas are always positive (0 to 1)
* put deltas are always negative (0 to –1)
What is a straddle, including long and short straddles?
The objective of a straddle is to profit from a directional play on volatility.
Long Straddle: seeks to profit from above-consensus volatility and involves a long put and call with the same strike price and expiration.
Short Straddle: seeks to profit from below-consensus volatility.
What is a call bear spread.
A call bear spread seeks to profit from falling prices, but offsets the price of a long call at a high exercise price with a short call at a low exercise price, generating negative options cost (credit spread).
What is implied volatility?
Implied volatility not observed directly, but is derived by using the sigma value.
In a Black–Scholes–Merton (BSM) model’s cumulative distribution function that equates the theoretical price to the market price.
What are the uses of calendar spreads?
A long calendar spread is long the far option, which has slowly declining time decay and vega, and short the near option. It will profit from stable or increasing volatility.
The opposite applies to short.
What is volatility skew, smirk, and smile?
Volatility Skew: results from the price impact of increasing put and decreasing call volatility as the strike price diverges from the current price.
Smirk: occurs when volatility increases more for OTM puts than OTM calls reflecting greater demand for protective puts than calls.
Smile: results from increasing volatility for both puts and calls.
What are some common strategies for options?
Common strategies for options include:
* A long call can be used to increase risk exposure to implement a bullish outlook.
* A protective put can be used to reduce equity risk exposure in that it serves as insurance against falling prices.
* Investors can hedge against increasing or decreasing market volatility through the use of call and put options on the the VIX.
What are some option strategies for implementing a market view or investment objective?
- Bearish investors use collars on a long position to hedge risk and smooth volatility.
- Investors will buy/sell a call/put if implied volatility is expected to increase/decrease.
- Investors wanting to buy stock when implied volatility is high sell puts to offset the price of the stock.
- A bullish or bearish investor can use a bull or bear spread if markets are not clearly trending.
What is a hedge ratio (HR)?
The hedge ratio (HR) is the number of futures contracts required to fully or partially hedge the portfolio.
HR = (ΔP/ΔCTD) × CF
What are cross-currency basis swaps?
Cross-currency basis swaps: exchange notional principal, which allows firms to use a local currency loan to create a foreign currency loan without bearing any foreign exchange risk.
What are currency forwards and futures?
Currency forwards and futures: are used to manage currency risk, as these instruments can hedge against exchange rate risk by periodically buying/selling foreign currency at a fixed price agreed upon at contract initiation.
What is cash equitization/securitization/overlay of unintended cash holdings?
Cash equitization/securitization/overlay: of unintended cash holdings is when futures are purchased to replicate underlying market returns where cash holdings would have otherwise been invested; puts and calls with the same strike price and expiration can also be used.
What is variance swap payoff?
Variance swap payoff is convex and the profit/loss for changes in realized volatility is not linear.
What is a mark-to-market valuation of a variance swap?
The mark-to-market valuation for a variance swap at time t (VarSwap_t) depends on realized volatility from initiation to t (RealizedVol (0,t)) and implied volatility at time t (ImpliedVol (t,T)) for the remaining life of the swap (T − t).
How does a payment at settlement of variance swaps settle?
Variance swaps only exchange cash at expiration, not inception or periodically in between, and payment at settlement.
What aree the implications of flat backwardation and contango volatility.
A flat shape shows that volatility is expected to remain stable over the near to long term.
A downward slope (backwardation): shows decreasing volatility expectations over time; prices are higher for short-term contracts.
An upward slope (contango): shows increasing volatility expectations over time; prices are lower for short-term contracts.
What is the VIX correlation and the appeal to investors of VIX call options and VIX put options?
Increases in VIX are negatively correlated with equity prices.
Investors would purchase VIX call options if they expect increasing volatility due to a sell-off.
Investors would purchase VIX put options if they expect decreasing volatility due to stable markets.