derivatives market Flashcards
explain the first economic purpose of the futures market?
Price discovery: provides information to public about future spot prices. Increases competitiveness of markets
explain the 2nd economic purpose of a futures market?
Risk transference: Enables investors & borrowers to protect
assets & liabilities against risks e.g. changes in interest rates,
exchange rates & security prices
explain the 3rd economic purpose of a futures market?
Lower transaction costs.
But markets are zero sum games. i.e. one person’s loss is
another’s gain
Name the 4 types of derivative markets
- Futures markets (organised exchange market)
- Forward markets (OTC markets)
- Options contracts (many organised markets)
- Swap markets (OTC markets)
What are the 2 types of Options?
- Call Options
- Put Options
What are the 2 types of Swaps?
- Interest rate swaps
- Currency swaps
How are Derivatives defined?
Derivatives are financial instruments whose value is linked to and derived from somewhere else.
What could derivatives be linked to?
Derivatives could be linked to almost anything;
- Commodities
- Interest Rates
- Equities and Equity Indices
- Bonds
- Currencies
- Weather
what is a futures contract?
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
what is hedging?
- transferring the risk of unanticipated changes in
prices, interest rates or exchange rates to another party.
long position on a futures contract
- Agreement to buy in the future
- Will have money to invest in future
- believes (will profit if) market will go up
short position on futures contract
- Agreement to sell in the future
- Has shares to sell in future.
- Believes (will profit if) market will fall
what is an initial margin?
• 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
what is a maintenance margin call?
Any adverse price movement in the market must be covered
daily by further deposit of funds
What does a clearing house do?
- guarantees contract performance to both parties by becoming opposite party in all transactions
- records transactions, handles margin processes, helps
settlement & transfer
final settlement of futures contract may be ____ or _____?
standard delivery or cash settlement.
why are Majority of financial futures closed out before expiry
date?
- 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
what is a arbitrageur?
• 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
Explain the 4 types of risk involved with hedging
- 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 - Margin Risk -
• Initial margin- buyers & sellers need to pay initial margin (2-10% of futures contract) - Basis Risk
• A perfect hedge requires there to be zero initial & final basis risk between the physical and futures markets - Cross-commodity Hedging
what is a forward contract?
• 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
What is an FRA?
Forward Rate Agreement
Forward contract for loans that today fixes the interest rate on a loan that will be made in the future.
what is an option?
• 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)
what is a call option?
gives the buyer the right to buy the ‘commodity’ at
the exercise price
what is a put option?
gives the buyer the right to sell the ‘commodity’ at the exercise price (or strike price)
when can options be exercised?
– Exercisable at any time up to maturity (American)
– or Exercisable only at maturity (European)
How does a buyer of a call make profit?
– when price of underlying physical price greater than strike price
how does the buyer of a put make profit?
– when price of underlying physical price less than strike price
option sellers are known as what?
-writer
e.g. a writer of a call option must sell underlying shares to
holder of the call if they exercise option.
what type of markets are options sold in?
• 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
what relationship do interest rates and calls have?
– Positive relationship between interest rates & the price of a call
what relationship do interest rates and puts have?
– Negative relationship between interest rates & the price of a
put
call option in the money
S greater than X
put option in the money
S less than X
call & put option at the money
S = X
call option out of the money
S less than X
put option out of the money
S greater than X
Options vs Futures
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)
What are the 2 types of Swaps?
- Interest rate swaps
- Currency swaps
what is a interest rate swap?
- 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
what is a direct swap?
= a swap when the two parties deal with each
other to manage their risk exposure
what is a intermediated swap?
one where one of the parties is a
bank. Most swaps are intermediated.
what is a basis swap?
• A swap where floating for floating interest payments are
swapped
what are the main reasons for growth in interest rate swaps?
- lower net cost of funds
- Restructuring of firms’ existing debt
- Lock in profit margins on business transactions
- Gain access to otherwise inaccessible markets
what is a currency swap?
- 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
Advantages of currency swaps
• Allows firms to
– Obtain a lower cost of funds
– Hedge their foreign exchange risk
Hedging purposes of Currency Swaps
• 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
