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CWM Financial Markets > Derivatives Basics > Flashcards

Derivatives Basics Flashcards

1
Q

What is a derivative?

A

An asset whose value is derived from the value of some other asset.

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2
Q

What is the underlying?

A

The security from which the value of the derivative is derived from

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3
Q

What are the 3 main risks of derivatives?

A

1) Counterparty Risk
2) Leverage
3) Complexity / Lack of transparency

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4
Q

What are the two ways derivatives are traded?

A

1) OTC
2) Exchanges

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5
Q

What is unique about OTC derivatives compared to exchange traded?

A

Far more bespoke

Limitless variations

Can be included into vanilla assets to create structured products

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6
Q

What change are OTC derivatives seeing in the way they are traded?

A

Often traded through a central counterparty now

This is to reduce overall credit risk

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7
Q

In simple terms what is a forward?

A

A contractual obligation made between two parties - to agree to exchange a specific quantity of an asset or commodity on a fixed date in the future.

1) It is legally binding
2) Terms can be customized

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8
Q

What is the primary risk of a forward?

A

One party could default (counterparty risk)

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9
Q

What is a future?

A

Effectively the same as a forward but traded over an organized and regulated exchange

(Two parties agree to buy / sell a fixed quantity of an asset or commodity, on a fixed date or between two dates)

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10
Q

What are the 3 key differences between a future and a forward?

A

A future is
1) Guarenteed against default
2) Standardized to promote active trading
3) Settled on a daily basis

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11
Q

What is a swap?

A

An agreement between two parties to exchange payments on regular future dates - where the legs are calculated on a different basis.

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12
Q

Where are swaps traded?

A

OTC - therefore has counterparty risk

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13
Q

What risks can swaps be used to manage?

A

1) FX Rate Risk
2) Interest Rate Risk (e.g. borrow variable can swap to fix)
3) Commodity Price
4) Share Price

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14
Q

What can swaps effectively be thought as being?

A

A series of forwards

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15
Q

What are the two types of options?
What right do they conver to the holder?

A

1) Call - The right to buy at a fixed price before a set date (bullish)
2) Put - The right to sell at a fixed price before a set date (bearish)

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16
Q

Why does the buyer of an option pay a premium?

A

For the flexibility

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17
Q

Where can options trade?

A

1) OTC
2) Standardized on exchanges

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18
Q

Give an example of a situation where a derivative has a greater liquidity than its underlying:

A

An index of assets

Individual liquidity is less than that of an index derivative

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19
Q

What are the 4 primary users of derivatives?

A

1) Speculation
2) Hedging
3) Arbitrage
4) Margin Traders

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20
Q

Why are derivatives used for speculation?

A

Buying derivatives contracts of the underlying is generally much cheaper - therefore the profit is greater
(although the risk can potentially be higher e.g. leverage)

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21
Q

What is an example of a derivative being used to speculate?

A

Think commodity price will rise
Buy exchange traded future
Sell contract if price rises

By doing so you have avoided the expensive delivery / storage costs but still profitted from underlying

22
Q

What is hedging using derivatives?

A

Guarding against market variables using swaps, futures, forwards and optoins

23
Q

What market variables can be guarded against?

A

1) Rates
2) Share prices
3) Commodity prices
4) FX Rates
5) Bond Prices

24
Q

How does a company receiving a payment in foreign FX hedge?

A

Enter into a forward with a bank to receive a fixed amount of domestic currency when they get paid

25
Q

How does a fund manager hedge against share price risk

A

Take the opposite position in the derivatives market

26
Q

How does a farmer hedge?

A

Agree price for produce in advance via a future

The buyer could be a speculator or another hedger, e.g. a supermarket

27
Q

What is arbitrage?

A

Exploiting a mispricing in two different markets in order to generate a risk free profit

28
Q

What is the fourth use of derivatives the book gives?

A

Quickly / cost effectively rebalanace asset allocation of a portfolio

29
Q

What is an example of using derivatives to rebalance a portfolio?

A

Want to reduce equity exposure and buy bonds

Sell FTSE futures and buy long gilt futures

Same exposure but get to keep underlying ownership benefits

30
Q

What 3 things facilitate derivative trading?

A

1) Brokers
2) Clearing Houses
3) Exchanges

31
Q

What kind of firms are clearing houses usally, and what do they do?

A

Typically large investment banks - used to settle transactions

32
Q

What do exchanges do?

A

Define terms of derivative contracts

Help offer liquidity & price discovery - helps to transfer risk amongst agents

33
Q

What are the 3 ways in which derivatives can settle?

A

1) Exchange Traded
2) OTC
3) Cash Settled (swaps)

34
Q

What is a cash settled derivative?

A

A contract which settles at maturity where the out of the money party makes payment to the in the money party

35
Q

What two categories can derivatives be seperated into?

A

1) Vanilla Derivatives - most simple form
2) Exotic Derivatives

36
Q

Which of these are OTC?

1) Swaps
2) Futures
3) Forwards
4) Options

A

1) Swaps
2) Forwards

Futures and options are exchange traded

CFDs are also OTC

37
Q

What is clearing?

A

Clearing is the process by which derivatives trades are confirmed and registered

It is done by a central counter party (novation)

38
Q

What is the structure of the clearing house?

A
39
Q

What is the purpose of variation margin?

A

Made from one party to another if the contract suffers an adverse price movement

40
Q

Points about variation margin

A
  • Collected by the clearing house on the party’s behalf.
  • Member must pay the amount called for by wire transfer within one hour.
  • Applied to settlement, does not go into standing or initial margin account.
  • Must be paid in cash
41
Q

What is maintenance margin?

A

Maintenance margin is an additional agreement between the member and client to post more than just the initial margin. This provides a safety cushion for the member firm

For example a member may require that a client deposits an additional 25% of the initial margin as maintenance margin.

42
Q

What are 4 forms of acceptable collateral?

A

1) Cash in major currencies
2) Bank guarentees from approved banks
3) Certificates of Deposit
4) Govt Debt Securities

Should be “high quality and easy to liquidate”

43
Q

What is an uncommon practice that some members of an exchange do to allow margin to be met?

A

Extend a line of credit to their clients

44
Q

What bonds / bond characteristics are not accepted as collateral?

A

1) Swiss Bonds
2) Not denominated in currency of issuing country
3) Custodians and depositories must be acceptable to the clearing house

Haircut also applied to the value of collateral

45
Q

What is the “tick size” of a contract

A

The smallest permitted movement allowed on one contract

46
Q

What is tick value?

A

The value of change in a contract given a tick value

47
Q

What is a “unit of trade”

A

Contract value - Price * £10 = Unit of trade

48
Q

If an index is priced at 7200, what is the unit of trade?

A

£72,000

7200 * 10

49
Q

If you beleive a market is about to fall, how can you minimise your loss?

A

Short Hedge

50
Q

How does a short hedge minimise a loss?

A

By taking (as close to) an equal and opposite position, the loss from the cash position is offset by the short.

51
Q

E.g. £36,000,000 portfolio
7200 point index
How many contracts are needed to completely hedge?

A

36,000,000 / 72000 = 500

£72,000 because index is 7200 and unit of trade is 10 -> 7200 * £10 = 72,000

CWM Financial Markets (58 decks)

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