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Financial institutions and markets > derivatives market > Flashcards

derivatives market Flashcards

1
Q

explain the first economic purpose of the futures market?

A

Price discovery: provides information to public about future spot prices. Increases competitiveness of markets

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2
Q

explain the 2nd economic purpose of a futures market?

A

Risk transference: Enables investors & borrowers to protect
assets & liabilities against risks e.g. changes in interest rates,
exchange rates & security prices

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3
Q

explain the 3rd economic purpose of a futures market?

A

Lower transaction costs.
But markets are zero sum games. i.e. one person’s loss is
another’s gain

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4
Q

Name the 4 types of derivative markets

A
  1. Futures markets (organised exchange market)
  2. Forward markets (OTC markets)
  3. Options contracts (many organised markets)
  4. Swap markets (OTC markets)
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5
Q

What are the 2 types of Options?

A
  • Call Options

- Put Options

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6
Q

What are the 2 types of Swaps?

A
  • Interest rate swaps

- Currency swaps

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7
Q

How are Derivatives defined?

A

Derivatives are financial instruments whose value is linked to and derived from somewhere else.

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8
Q

What could derivatives be linked to?

A

Derivatives could be linked to almost anything;

  • Commodities
  • Interest Rates
  • Equities and Equity Indices
  • Bonds
  • Currencies
  • Weather
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9
Q

what is a futures contract?

A

Legally binding agreement to buy or sell a specified quantity of a
specified commodity/financial instrument for a specified delivery date in the future at a price agreed upon at setting up of contract

• A futures contract = highly standardised contract in terms of amounts,
prices & conditions

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10
Q

what is hedging?

A
  • transferring the risk of unanticipated changes in

prices, interest rates or exchange rates to another party.

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11
Q

long position on a futures contract

A
  • Agreement to buy in the future
  • Will have money to invest in future
  • believes (will profit if) market will go up
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12
Q

short position on futures contract

A
  • Agreement to sell in the future
  • Has shares to sell in future.
  • Believes (will profit if) market will fall
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13
Q

what is an initial margin?

A

• Funds put up as security for guarantee of
contract fulfilment at time futures position is established.

• Paid by both buyer & seller to clearing house

• Set by futures exchange for its members who then set margin
for client

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14
Q

what is a maintenance margin call?

A

Any adverse price movement in the market must be covered

daily by further deposit of funds

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15
Q

What does a clearing house do?

A
  • guarantees contract performance to both parties by becoming opposite party in all transactions
  • records transactions, handles margin processes, helps
    settlement & transfer
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16
Q

final settlement of futures contract may be ____ or _____?

A

standard delivery or cash settlement.

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17
Q

why are Majority of financial futures closed out before expiry
date?

A
  • they Reverse trade by taking a position in market equal &
    opposite to that already held

• Example: Company currently holds a 6-month futures
contract to “sell one five-year govt bond” so goes into futures
market & buys a contract to “buy one five-year govt bond”
with same delivery date

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18
Q

what is a arbitrageur?

A

• someone taking advantage of price differentials between two markets & making riskless profits.

Example: differentials between futures contract price & physical
spot price of the underlying commodity

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19
Q

Explain the 4 types of risk involved with hedging

A
  1. Standard Contract Size – 90-day bank bill —$1,000,000 Face Value
    – 3 year Govt. bond —$100,000 Face Value
    – Listed Company Share —1,000 shares
  2. Margin Risk -
    • Initial margin- buyers & sellers need to pay initial margin (2-10% of futures contract)
  3. Basis Risk
    • A perfect hedge requires there to be zero initial & final basis risk between the physical and futures markets
  4. Cross-commodity Hedging
20
Q

what is a forward contract?

A

• Are similar to futures in that they are agreements to buy or
sell an asset at a certain time in the future for a certain price
but NOT traded on a futures exchange

• They are private agreements between 2 FIs or between FI &
client i.e. OTC products

21
Q

What is an FRA?

A

Forward Rate Agreement

Forward contract for loans that today fixes the interest rate on a loan that will be made in the future.

22
Q

what is an option?

A

• An option gives the buyer the right, but not the obligation to
buy or sell ‘commodities’ at a specified price (exercise price
or strike price), on or before a specified date (expiration date)

23
Q

what is a call option?

A

gives the buyer the right to buy the ‘commodity’ at

the exercise price

24
Q

what is a put option?

A 
gives the buyer the right to sell the ‘commodity’ at the
exercise price (or strike price)
25
Q

when can options be exercised?

A

– Exercisable at any time up to maturity (American)

– or Exercisable only at maturity (European)

26
Q

How does a buyer of a call make profit?

A

– when price of underlying physical price greater than strike price

27
Q

how does the buyer of a put make profit?

A

– when price of underlying physical price less than strike price

28
Q

option sellers are known as what?

A

-writer

e.g. a writer of a call option must sell underlying shares to
holder of the call if they exercise option.

29
Q

what type of markets are options sold in?

A

• Exchange-traded options have options clearinghouse
– Novation, Margin requirements
– Administration such as exercise notices sent to writer
– Most holders & writers close out before exercise date

• Over-the-counter options offered by banks are a major part
especially for interest-rate-related options

30
Q

what relationship do interest rates and calls have?

A

– Positive relationship between interest rates & the price of a call

31
Q

what relationship do interest rates and puts have?

A

– Negative relationship between interest rates & the price of a
put

32
Q

call option in the money

A

S greater than X

33
Q

put option in the money

A

S less than X

34
Q

call & put option at the money

A

S = X

35
Q

call option out of the money

A

S less than X

36
Q

put option out of the money

A

S greater than X

37
Q

Options vs Futures

A

Futures
• Buyers and sellers of futures contracts gain & lose
symmetrically, & without limit (margin required)

Options
• Buyers loss limited to premium paid (no margin)
• Sellers (writers) loss unlimited (margin required)

38
Q

What are the 2 types of Swaps?

A
  • Interest rate swaps

- Currency swaps

39
Q

what is a interest rate swap?

A
  • It works like a forward as it guarantees the exchange of 2 items at some future point

• The two parties swap their interest payments during the
swap’s lifetime based on notional principal

• No transfer of principal amount- only net transfer of interest

40
Q

what is a direct swap?

A

= a swap when the two parties deal with each

other to manage their risk exposure

41
Q

what is a intermediated swap?

A

one where one of the parties is a

bank. Most swaps are intermediated.

42
Q

what is a basis swap?

A

• A swap where floating for floating interest payments are

swapped

43
Q

what are the main reasons for growth in interest rate swaps?

A
  • lower net cost of funds
  • Restructuring of firms’ existing debt
  • Lock in profit margins on business transactions
  • Gain access to otherwise inaccessible markets
44
Q

what is a currency swap?

A
  • Two parties exchange debt denominated in different currencies
  • Interest payments are exchanged at fixed periods over lifetime

• Principals are exchanged at beginning of agreement & then reexchanged
at maturity of agreement

45
Q

Advantages of currency swaps

A

• Allows firms to
– Obtain a lower cost of funds
– Hedge their foreign exchange risk

46
Q

Hedging purposes of Currency Swaps

A

• Exporters could use a swap to convert a series of
debt payments into the currency that they will be
paid in to create a natural hedge.
• Banks can hedge their international debt borrowings

Financial institutions and markets (12 decks)

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