Derivatives Markets Flashcards
Define a derivative
Derivatives are contracts whose value is derived from
the price of other asset(s) or another contract(s).
Explain the idea of a forward contract
Forwards contracts, roughly speaking, involve buying
something in the future rather than today, but with details
agreed today
Explain the difference between Fowards & Futures contracts
Agreement to buy or sell an asset on a specific date in the future.
-Futures contracts are traded on exchanges with standarised terms.
-Fowards are traded OTC
Explain swap contracts
A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments.
What is one well known use of interest rate swaps - often how they are defined?
Its said interest rate swaps are traded between one party having a competitive advanatge in fixed interest with another who had an advanatge in floating.
Party A: Agrees to pay a fixed 5% interest rate on a notional amount of $10 million.
Party B: Agrees to pay a floating interest rate of LIBOR + 1% on the same notional amount.
Why do banks use interest rate swaps
banks use them to hedge interest rate exposures from business conducted and the risks arising from them. Interest rate swaps produce a similar cash flow to normal bank lending - synthetic lending by banks. Banks typically lend for long terms receiving a fixed rate while funding itself short term with lower floating rates
Explain swaptions
Swaptions are options on swaps, i.e., the option to enter
into a swap at some point in future on pre-specified
terms
Where did derivative markets originate?
Modern derivatives markets are considered to have
begun in Chicago in the mid-1800s. For grain prices when harvest was greater than expected the prices were lower and vice versa creating problems for farmers and purchasers of grain. This prompted the idea of the “to arrive contract”
Explain the “to arrive contract” in terms of the history of derivative markets
The price of grain was agreed in advance for delivery to arrive at a specified date. This type of contract enabled both parties (farmer and purchaser) to reduce (hedge) their risks.
Explain the history of derivative markets when financial derivatives caught on.
Financial derivatives began to catch on in the 1970s and
have grown exponentially, chicago is the location of the biggest derivatives exchange with the chicago mercantile exchange and the chicago board options exchange.
Why is it hard to measure the size of derivative markets?
Not as easy as OTC markets because derivatives are private transactions so the data is not collected
What is ISDA?
ISDA (International, swaps and derivatives association) fosters safe and efficient derivatives markets to facilitate effective risk management for all users of derivative products
Why do investors use derivatives?
Efficient Portfolio Management: Quickly adjust portfolio exposures using derivatives with lower costs and higher liquidity than physical assets.
Asset Transitions: Use futures to gain temporary market exposure while building a physical portfolio, selling futures as assets are purchased.
Currency Hedging: Hedge foreign currency risks, especially for low-risk assets like bonds, using currency forwards.
Leveraged Investments: Create leveraged exposures (e.g., 2-3x an index) using swaps, without traditional financing costs
Explain the appeal of derivatives over a physcial ownership of an asset
More liquid and can be traded with lower costs for most asset classes. For shorter term positions or those requiring leverage derivatives have sigificantly lower cost where liquid and standard contracts are used. If derivatives are held for a long time or rolled over repeatedly the costs increase as its an expensive contract renewal. May be better to hold physical investment more long term particularly if turnover is low.
Explain asset transitions as a reason why investors use derivatives
Asset transitions – for example, a target equity market exposure could be created quickly using futures whilst a
physical equity portfolio is being built up in parallel by a manager. The futures are sold down as equities are purchased
Explain currency hedging programmes as a reason why investors use derivatives
Lock In exchange rate in the future
An overseas investor will want to generate returns in their local currency rather than gain unintended currency exposure. Currency forwards allow unintended currency exposures to be hedged
Explain Leveraged investment as a reason why investors use derivatives
Possible to create a leveraged exposure without entering
into financing agreements and hence with lower costs.
Explain leveraged investing
Leveraged investing is a technique that seeks higher investment profits by using borrowed money. These profits come from the difference between the investment returns on the borrowed capital and the cost of the associated interest.
Explain a margin call
A margin call is a demand from your brokerage firm to increase the amount of equity in your account.
What does a long position when holding an investment mean?
With a long-position investment, the investor purchases an asset and owns it with the expectation that the price is going to rise.
Explain a short position investment
Short selling occurs when an investor borrows a security, sells it on the open market, and expects to buy it back later for less money.
Explain long/short portfolios as a reason why investors use derivatives
Long/short portfolios use derivatives to take both long (buying) and short (selling) positions on assets.
Long position: Bet on price increases.
Short position: Bet on price decreases.
Derivatives like futures or options allow investors to leverage these positions with less capital and flexibility. They can hedge risks and profit from both rising and falling markets, without directly buying or selling asse
Explain nonlinear/ options based strategy as a reason why investors use derivatives
Options are good for protection strategies. EX: Tail hedge are one way to potentially limit losses in adverse markets.
What is a key resource/funds to have when investing in derivatives?
Specialist derivative advice is needed - need suitably skilled personnel. Additionally a fund that uses derivatives will need to maintain sufficient collateral to meet margin calls so this will create additional operational requirements that need to be managed
What is a key resource/funds to have when investing in derivatives?
Specialist derivative advice is needed - need suitably skilled personnel. Additionally a fund that uses derivatives will need to maintain sufficient collateral to meet margin calls so this will create additional operational requirements that need to be managed
What are the two marketplaces in derivatives markets
Exchange traded derivatives and OTC derivatives
What have regulators been encouraging in derivatives markets in recent years
Regulators have been encouraging derivative market participants
either to transact deals on exchanges or to centrally
clear transactions to improve transparancy and to reduce counterparty risk. Also banks are required to hold additional capital inr espect of OTC derivative transactions to ensure financial system soundness
What derivatives are traded on exchanges
Exchanges generally focus on standardised derivatives where there are high levels of demand and supply and hence high levels of liquidity
What is the OTC derivatives markets like?
An OTC derivative trade is a bilateral transaction between two counterparties, typically a bank and a client, with each party exposed to the credit risk of their counterpart to the trade. As prices move, one counterparty will typically suffer a gain while the other suffers a loss. Contracts can be cleared through a clearing house
How can counterparty risk in OTC derivative markets be reduced?
This counterparty risk is generally mitigated through collateralisation, i.e. the party who has suffered a loss is required to provide collateral to cover their loss-making position with their counterpart.
What type of derivative market are forward contracts traded?
OTC instruments. Trades take place directly for a specific amount and specific delivery date as negotiated between the two parties
What type of derivative market are swaps contracts traded?
Also negotiated over the counter. Intermediaries in a swap transaction re usually banks and with ISDA these agreement shave some standardisation applied to them
What does ISDA stand for?
International Swaps and Derivatives Association
What is the ISDA Master agreement?
Global standard legal document for derivative trades
Explain the Master agreements enforceability of netting provisions
Ensuring the enforceability of the netting provisions in the Master Agreement has been an important part of ISDA’s activity. Netting allows bought and sold exposure transacted between the same
counterparties to be offset in the event of default, such that only the remaining net exposure is considered as a claim against the defaulter. ISDA have got a series of laws being passed in many countries that give legal certainty for netting in the event of default.
Explain the Master agreements and ISDA’s activity in obtaining legal opinions on netting
Regarding netting, the ISDA Master Agreement allows for netting of obligations, meaning that if one party owes money to the other under multiple contracts, they can offset those amounts to reduce the overall exposure.
This helps minimize the number of transactions and simplifies the settlement process, reducing counterparty risk
Explain how futures contracts are traded
Futures contracts trades take place in an organised exchange and the contracts are revalued daily. In recent years move has been towards electronic trading between market makers. EX: NYSE Liffe oeprates Exchange- traded derivative markets in a number of cities, including
Amsterdam, Brussels, London and Paris
How is a future exchange structured?
A futures exchange is usually a corporate entity with a board of directors deciding how to trade existing contracts and whether to introduce new contracts (which the regulator has to approve). Can have future trading systems be order driven or quote driven.
What details of contracts does a future exchange set?
The futures exchange sets the size of each contract, the units of price quotation, minimum price fluctuations, the grade’ and place for delivery, any daily price limits and margin requirements as well as opening hours for trading
Explain relationship between future and options exchnages
Also future exchanges can also operate an option exchanges sometimes but there are large option exchanges which do not trade in futures ex: CBOE
What are options traded on and what types of derivative markets do they oeprate in.
Options are traded on individual stocks, stock indices, foreign currencies, futures contracts and, to a much lesser extent, on Treasury notes and Treasury bonds. OTC options market is very large as can tailor the option contract to the buyers specification
What does CfD stnad for
Contract for Difference
Why might small investors use financial spread betting or CfDs
May find it diffcult to invest through derivatives markets because of minimum contract sizes - way to gain exposure to assets in these markets as pricing is based on the pricing of assets, but in smaller amounts
How is spread betting taxed
Classified as gambling and taxed like this. Some countries have it as illegal. Gains are often tax free except for the betting duty paid by the spread betting company. Invetsing in the underlying assets means tax on income and capital gains having said with spread betting that losses cannot be offset agaisnt future profits.
Explain the bid offer spread in financial spread betting and CfDs
Narrower than in underlying cash markets - reducing buying and selling costs but additional costs are present with rollover costs
What is an important factor when considering if you should invest via spread betting or cash markets
Time - if you want to invest long term cheaper to invest directly
Short term investing - financial spread betting or CfDs could be a good option
What does CDS stand for and what is it
Credit default swap
(CDS) is a contract between two parties in which one party purchases protection from another party against losses from the default of a borrower for a defined period of time.
Advantages of selling CDS vs buying a corporate bond
Greater range of durations is often available in CDS market
Liquidity is greater in CDS markets
CDS are unfunded enabling gearing positions
CDS market is more standardised
Disadvantages of selling CDS vs buying a corporate bond
Liquidity depends on market makers making good market - doesn’t work when the market is stressed
The correlation of prices of CDS and bond are not stable in times of stress
Collateral arrangements need to be made
Counterparty risk introduced
How does a bank use derivatives to increase off-balance sheet lending
Banks profits are limited by the size of their balance sheet aka the funds it has to lend
Derivatives enable banks to create further leverage beyond what’s suggested
Explain a synthetic position
Synthetic positions allow traders to take a position without laying the capital to actually buy or sell the asset
What are structured investment products
Collective investment vehicles offering investors a target return profile, typically linked to a combination of standard indices and often with variable leverage or protection feature ex: Equity linked return but with a minimum guaranteed payment of 90% of inital investment after x years
Advantages of structured investment products
Principal protection - often hidden fees aren’t advertised though
Can obtain a very tailored investment return
More tax-efficient tin some cases than the underlying asset
Typically have lower volatility than the asset but with scope to participate in the rising equity markets
