Derivatives Market (11)

Question 1

What are DERIVATIVES INSTRUMENTS?

Answer 1

Those whose value derives from others, “the underlying instrument”. Derivatives are traded in organised, zero-sum markets and are ST (< 1 year).

Greater risk than underlying instrument due to…

• multiplier effect
• leverage effect

Underlying instruments can be FINANCIAL // NON-FINANCIAL

• means of pricing of underlying instrument is key
• high levels of standardisation (settlement dates, measuring variations…)
• standardisation provides liquidity

Question 2

Why is the standardisation of contracts evident?

Answer 2

• Small number of maturities with specific dates (limited amount of maturity dates per year)
• Standard amounts per contract (amounts are quoted, known, min P fluctuations)
• Market opening times and rules for trading (organised market)
• The possibility of closing a position before maturity
• The existence of security deposits and settlement of Profit/Loss (The Clearing House)

Question 3

Why do OTC arise?

Answer 3

Standardisation…

• reduction in trading, settlement and compensation costs
• WORKS AGAINST SPECIALIZATION

products like OTC (over the counter) appear, these contracts are designed by express agreement between the parties

• traded outside organised market
• no Clearing House

Question 4

OPTIONS

Answer 4

An option gives the holder the RIGHT to buy/sell a certain quantity on a set date (perhaps before), at P agreed today.

CALL OPTION - BUY (when exercised “call in”)
PUT OPTION - SELL (when exercised “put”)

Question 5

FUTURES

Answer 5

A future gives the holder the OBLIGATION to sell/buy a certain quantity on a set date (perhaps before), at P agreed today.

“forward traded contract with no premium”
F = S x e^rt

Question 6

Valuing Options

Answer 6

option premium = P paid by the purchaser

comparison between the exercise P and the market value of the underlying asset allow us to determine the state of the option:

1. ITM (in the money)
2. OTM (out of the money)
3. ATM (at the money)

variables that have an influence on the valuation of options:
(KNOWN) P of underlying asset, exercise P, interest rate, remaining maturity
(UNKNOWN) dividends to be paid, future volatility

Question 7

What to consider when Valuing Options…

Answer 7

option premium = P paid by the purchaser

comparison between the exercise P and the market value of the underlying asset allow us to determine the state of the option:

1. ITM (in the money)
2. OTM (out of the money)
3. ATM (at the money)

variables that have an influence on the valuation of options:
(KNOWN) P of underlying asset, exercise P, interest rate, remaining maturity
(UNKNOWN) dividends to be paid, future volatility

Question 8

Option Valuation Methods

Answer 8

BINOMIAL VALUATION - replicating portfolio intuition
“put-call parity”: payoffs = cost
“delta hedging”: valuing derivatives by valuing primitive securities when they have the same payoffs (riskless hedge)

RISK-NEUTRAL VALUATION - expected pay off in risk-neutral hypothesis, and discount by the rate of interest

BLACK-SCHOLE formula

Question 9

Why is the DERIVATIVES MARKET different from other financial markets?

Answer 9

main ≠ –> type of contracts traded and their characteristics

• Clearing and Settlement House (manages risk, parties fulfilment of obligations)
• Guarantees + Daily profit and loss settlement
  Investors in future contracts do not have to wait until maturity to collect their profits, but rather are paid daily (process known as “mark to market”)