Derivatives security markets Flashcards
What are spot markets?
Immediate agreement of exchange of funds and assets
What are derivative markets?
Future payment and delivery
What are the characteristics of forward contracts?
- Customized contracts
- Not regulated
- High counter party risk
- OTC market
What are the characteristics of future contracts?
- Standardized contracts
- Regulated
- Default risk is diminished
- Occurs in a market
- Price is marked to market daily –> initial margin and then additional according to price fluctuations
What is a position liquidation?
When one of the parties on a futures contract liquidates their position by buying the other side of the contract as well
What is short and long position?
Short = sell Long = buy
What is the difference between an american and european option?
American = can be exercised at any given moment European = only at maturity
What is a call option?
Right to BUY
What is a put option?
Right to SELL
What is the call premium?
Upfront fee to participate in an option
What does it mean an option is IN the money? (call option)
The stock price is greater than the strike price of the option
What does it mean an option is OUT of the money? (call option)
The stock price is lower than the strike price on that option (no option exercise)
The Black-Scholes option pricing model is a function of
- The spot price of the asset
- The exercise price on the option
- The date
- The price volatility
- Risk-free rate of interest
What is the intrinsic value of an option?
Intrinsic value = stock price (mkt) - strike price
At expiration date, an option’s value is = to its intrinsic value
What is the time value of an option?
The value associated with the probability that the intrinsic value (the price) could increase between the option’s purchase and expiration date. As the option approaches maturity, its time value goes to zero
What was the first exchange devoted to the trade of stock options?
The Chicago board of options exchange
What is the extrinsic value/time value of an option?
The potential for price changes, the closer it gets to maturity, the lower it is. At maturity date we are only left with the intrinsic value
What is the contract price of an option?
Contract price = intrinsic + extrinsic value
Collar
Buy a put and sell a call. Buy a floor and sell a cap to protect your investment from downfalls but you also have to give up all potential gains above the cap
What are swaps?
An agreement between two parties to exchange a series of cashflows for a specific amount of time and interval associated with an asset
What is the plain vanilla swap?
When one party receives a fixed amount of cash and pays a fluctuating amount. It hedges from interest rate risk
Buyer = fixed payment
Seller = floating payments
What is a currency swap?
Two parties exchange cash flows supply of similar amounts in different currencies in order to avoid foreign exchange risk. It is a fixed-fixed agreement regardless of the market rate or a variable, that depends on the market rate
What is a credit default swap (CD)?
Hedge credit risk of mortgages. You pass the credit risk to another party. (toy video)
What is a total return swap?
Something that doesn’t make sense. You pay someone to invest in an instrument and YOU get the return ???
Hedge the party from credit risk, but contains i risk
What is a pure credit swap?
The FI pays a fixed amount to the other party, but if the FI’s lender doesn’t default, it will receive nothing from the counterparty (like mortgage)
What are the characteristics of the swap market?
- No standardized contract
- Swap dealers - matchmakers
- Little regulation
- International Swaps and Derivatives association (ISDA) sets some codes for swaps documentation
By convention, a swap buyer on an interest rate swap agrees to
Pay a fixed interest and receive a floating rate
By convention, a swap seller on an interest rate swap agrees to
Pay a floating rate and receive a fixed interest
In order to accept a project, should the rate of return be smaller or higher than the cost of capital?
Higher, because you could invest in another project
