Derivatives And Other Instruments Flashcards
What is a derivative? (1)
- An asset where the underlying value derives from another products e.g. future and options
What is a future? (5)
- A contract between two parties where one party agrees to buy something in the future and the other party agrees the opposite side of the trade
- The terms of the contract are agreed now e.g. price, quantity
- By fixing the price, the instrument provides certainty about future pricing
- Longing = buying. Shorting = selling. Long knows how much they will pay and short knows how much they will receive
- Contract is binding - price of delivery is set.
What is an underlying asset? (5)
- Derives the value of a future - underlying or cash asset (gilts/currencies/commodities)
- Conditions of futures are specified/standardised because futures are traded on exchanges around the world
- Standardising opens markets and therefore provides liquidity
- Standardised Teresa re known as contract specifications
- Price is never standardised - price does however form part of the total agreement so is a feature of future contracts
What are the features of a long position? (6)
- The future buyer of the underlying asset
- Thinks the price of the asset will rise
- If long position says they will buy £300 of copper in June 2026, they have to stick to this, regardless of price changes of the underlying asset
- The long position makes money in a rising market but loses money in a falling market
- Max gain: unlimited
- Max loss: limited to the price of the future
What are the features of a short position? (7)
- The future seller of the underlying asset
- Short position thinks that the price of the asset will fall
- If an investor shorts copper future at £300, they have agreed to sell copped in June 2026 at that price
- Once agreed, short position must sell
- Short position makes money in a falling market and loses money in a rising market
- Max gain: limited to the price of the future
- Max loss: unlimited
What is the delivery date? (2)
- Date on which the agreed transaction takes place
- Represents the end of the futures life
What is fair value? (4)
- A theoretical arbitrage-free value of the future
- Based on the theory that a long future position, there is always another alternative. The alternative to buying wheat in the future is buying wheat today and holding it in a warehouse for 3 months
- However, buying wheat today incurs extra costs above the price of the asset - this is known as cost of carry e.g. interest rates, storage, insurance
- Fair value of future = cash price of underlying asset + cost of carry
What is the cost of carry vs cash price of underlying asset? (2)
- Cost of carry: what it would cost to hold the asset until the delivery date e.g. finance charge, storage, insurance
- Cash price of underlying asset: what it would cost to buy the asset today (spot price)
What is basis? (2)
- Quantifies the difference between the cash price of the underlying asset and the futures price
- Basis = cash price - future price
What is contango? (3)
- Means the basis is negative e.g. cash price is less than the future price
- Future price indicates the cost of carry, basis is usually negative and the market is described as contango
- Neative basis is the norm where there is adequate supply e.g. ‘far’ (future) prices are higher than ‘near’ (spot) prices
What is backwardation (back)? (4)
- Means the basis is positive
- Cash price is greater than the price of the future price
- Would occur if there was a temporary shortage of the underlying which would push up the cash/spot price today and produce a back market
- Can occur when there is an overall benefit of carry rather than cost of carry e.g. div yield on an equity or equity index is above interest rates
What is contingent liability? (2)
- A transaction that describes a position where the investor faces a potential liability which is uncertain at the present time
- All futures transactions are contingent liability transactions
What are the features of forwards? (6)
- Similar to futures - agreed conditions for the future transaction is set today.
- Key difference: futures are exchange tranced why forwards are OTC
- Advantage of forwards over futures: they offer a high degree of flexibility to the parties involved - no exchange to standardise in the terms of the contract
- Disadvantage: forwards are a direct counterparty risk with the opposite side of the trade - no central counterpart or formalised collateral payments system - credit worthiness of both parties is important.
- No central marketplace - difficult to value forwards and price information is not always available
- Examples are currency forwards, currency swaps
What are the features of CFDs? (5)
- Term describes a cash settled derivative
- No physical delivery actually takes place - contract is settled for difference between the agreed price and the settlement price
- E.g. interest rate futures and futures in equities indices
- Many futures are physically settled meaning that at expiry the underlying asset is delivered (to the long position)
- Physically delivered derivatives include ICE Futures Europe long gilt
What is arbitrage? (5)
- Process whereby investors make risk free profit by exploiting anomalies and inconsistencies in the prices between 2 related but different markets
- E.g. buying a cheaper car in Europe, paying additional import fees and selling it in the UK for a higher price for profit
- By exploiting inconsistencies between motor car prices in different markets, a quick profit can be made
- The same principle is use when arbitraging between an index and its derivative - if an investor can buy an asset and pay the cost of carry for less than the price on the future contract, there is an inconsistency in pricing
- Investor can spot this arbitrage opportunity and buy the asset and hold (cheap) and short the future (agree to sell as a higher price)
What is closing out? (4)
The buyer of the future contract has 2 options
- Hold the future to expiry and then take delivery of the underlying (if physically deliverable)
- Sell the future before the expiry (known as closing out of the position)
- Closing out is achieved by entering in to a second equal buy opposite contract in order to offset the terms and conditions of the first
- Opening sale is closed out by a closing purchase
What are roll contracts? (4)
Motivation
- Specifically linked to commodity contracts that proceed to the physical delivery of an asset on the delivery date of the contract
- Where the manager gains exposure to commodities through the use of futures, they do not want to take delivery (long) or make delivery (short). They do want to retain the exposure to the underlying commodity the contract gives. This is called rolling on the contract
- Rolling contracts involve 2 trades - one to close out the current contract that is approaching delivery and one to open a new position in a longer dated contract
- As the longer dated contract approaches delivery, it is rolled again - ad infinitude
What is a roll yield? (3)
- Near dated contract being closed out and far dated contract being opened will not be priced the same.
- In a contango market, the far dated contract will be priced higher
- Where the manager is closing out of a long passions by going short and rolling the contract on by going long, this will incur a costs (roll yield). This is negative
What is a roll yield? (3)
- Near dated contract being closed out and far dated contract being opened will not be priced the same.
- In a contango market, the far dated contract will be priced higher
- Where the manager is closing out of a long passions by going short and rolling the contract on by going long, this will incur a costs (roll yield). This is negative
What is basic hedging? (6)
- Futures can be used to provide defensiveness in portfolio against adverse market conditions e.g. FTSE 100 future
- The number of contracts required is known as heading ratio
- In order to gain protection, a short hedge is constructed by selling
- The most liquid month is the nearest delivery date e.g if the hedge was created in Nov, Dec future would be used
- The size of the contract for FTSE 100 future is £5/0.5 bps
- Assumes that the portfolio will move the same way as the market
What is beta hedging? (4)
- To incorporate any disproportionate changes in the portfolio relative to the market, a number called ‘Beta’ is used
- Beta = how much more or less volatile the index is against a portfolio
- E.g. A beta of 1.2 is 20% more volatile than the index it is measured against. A beta of 0.7 is 30% less volatile than the index it is measured against
- Beta value = number of contracts equirectangular for a basic hedge x beta of the portfolio
What is an option? (1)
- Gives the buyer the right (not obligation) to buy or sell an underlying asset at a fixed price on or before a given date in the future
What is the main difference between a future and an option? (4)
- Only the seller has an obligation while the buyer has a choice in putting or calling options
- Both the buyer and seller have obligations in futures
- Buyer of an option pays a premium to the seller to have the right to choice
- There is no premium paid when buying futures
What is the term for buying/selling options? (2)
- Selling: put option
- Buying: call option