Derivatives Tutorial Flashcards
What are derivatives?
Definition: Financial contracts whose value derives from an underlying asset, index, rate, or another financial instrument.
Purpose: Used for speculation, hedging, or arbitrage in financial markets.
Key points about derivatives:
Types: Common types include futures, options, swaps, and forward contracts.
Underlying Assets: Can be based on stocks, bonds, commodities, currencies, interest rates, or market indices.
Risk Management: Used for managing financial risks by providing exposure to price movements without owning the underlying asset.
Leverage: Allows investors to control a larger position with a smaller amount of capital, amplifying both gains and losses.
Market Liquidity: Derivatives often contribute to market liquidity and price discovery.
How are derivatives used in risk management?
They allow investors to hedge against price fluctuations by minimizing potential losses on investments.
Define leverage in the context of derivatives.
Leverage refers to using borrowed funds to amplify potential returns (or losses) from an investment.
What is the purpose of using derivatives for speculation?
Speculators use derivatives to profit from anticipated price movements without owning the underlying asset.
What is a contrived instrument?
A contrived instrument refers to a financial or investment product that is artificially created or structured using complex arrangements to serve specific purposes or meet particular needs.
Why are contrived instruments created?
They are designed to address specific market conditions, offer unique investment opportunities, or cater to the specific needs or goals of investors or institutions.
What characterizes a contrived instrument?
Complexity and non-standard structure are typical features of contrived instruments, often combining different financial elements or derivatives in their design.
What are some potential risks associated with contrived instruments?
Complexity can make it challenging to understand the risks involved, leading to increased exposure to unexpected market movements or difficulties in accurately assessing potential returns.
Give an example of a contrived instrument.
A collateralized debt obligation (CDO) that combines various debt securities into a new investment product, often with different risk tranches, is an example of a contrived instrument.
What is “mark to market”?
“Mark to market” is an accounting method that values assets or liabilities at their current market price.
When is “mark to market” commonly used?
It’s often used for financial instruments like stocks, bonds, derivatives, and other assets that frequently change in value.
What are the benefits and drawbacks of “mark to market” accounting?
Benefits include transparency and a more accurate representation of current values, but drawbacks involve potential volatility in reported values, especially in unstable markets.
What is a notional amount?
The notional amount is the nominal or face value of a financial instrument, often used to calculate payments but not necessarily exchanged.
How is the notional amount different from the actual value?
The notional amount represents the amount used to calculate payments or returns in financial contracts, while the actual value exchanged might be based on factors such as interest rates, asset prices, or other variables.
In what financial instruments is the notional amount commonly used?
It’s commonly used in derivatives contracts, such as options, swaps, and futures, to calculate payments or obligations without necessarily exchanging the entire notional amount.
Why is the notional amount important in derivatives?
It determines the size of the contract and helps in calculating cash flows or payments, but the parties typically settle the difference in values rather than exchanging the full notional amount.
Does the notional amount represent actual money exchanged?
No, the notional amount doesn’t necessarily change hands; it’s used as a reference for calculating contractual payments or obligations based on market movements.
What does “off-balance-sheet” refer to in finance?
“Off-balance-sheet” items are assets, liabilities, or financing activities not recorded on a company’s balance sheet.
What are linear derivatives?
Linear derivatives have a linear relationship between the underlying asset’s price and the derivative’s value. The payoff structure is directly proportional to the changes in the underlying asset’s price.
Can you provide examples of linear derivatives?
Futures and forwards contracts are examples of linear derivatives because their values move in a linear fashion concerning the changes in the underlying asset’s price.
What characterizes nonlinear derivatives?
Nonlinear derivatives have a payoff structure that does not correspond directly or proportionally to changes in the underlying asset’s price. Their value can exhibit complex or nonlinear relationships with the underlying asset.
What are examples of nonlinear derivatives?
Options contracts, such as vanilla options, exhibit nonlinear behavior. The relationship between the value of an option and the underlying asset’s price is nonlinear due to factors like volatility, time decay, and strike price.
How do linear and nonlinear derivatives differ in terms of payoff structures?
Linear derivatives have a straightforward relationship between the derivative’s value and the underlying asset’s price, whereas nonlinear derivatives have more complex and nonlinear relationships that are influenced by various factors.
What is Delta in the context of derivatives?
Delta measures the rate of change in the derivative’s price concerning changes in the price of the underlying asset.
How does Delta relate to nonlinear derivatives?
In nonlinear derivatives, Delta represents the rate of change of the derivative’s price concerning changes in the underlying asset’s price, but this relationship is not constant and can vary across different price levels and times.
What does a Delta value of 0.5 mean for an option?
A Delta of 0.5 for an option implies that for every $1 increase in the underlying asset’s price, the option’s price would theoretically increase by $0.50, assuming other factors remain constant.
How does Delta change in nonlinear derivatives like options?
In nonlinear derivatives such as options, Delta is not constant and varies based on factors like the option’s strike price, time to expiration, and changes in volatility.
Why is understanding Delta important for traders dealing with nonlinear derivatives?
Delta helps traders assess the sensitivity of options or other nonlinear derivatives to changes in the underlying asset’s price, aiding in risk management and strategy development.
Does Delta apply to linear derivatives like futures or forwards?
No, Delta isn’t applicable to linear derivatives like futures or forwards because these contracts have a linear payoff structure. Their value moves in a direct, proportional manner with changes in the underlying asset’s price.
How do linear derivatives behave concerning changes in the underlying asset’s price?
Linear derivatives have a constant exposure or sensitivity to the underlying asset’s price movements. For instance, a one-unit change in the underlying asset’s price leads to an equal and linear change in the derivative’s value.
What measures the sensitivity or exposure of linear derivatives to underlying asset price changes?
Instead of Delta, linear derivatives use other metrics like the contract’s size or quantity to determine their sensitivity to changes in the underlying asset’s price.
Why is Delta not relevant for linear derivatives?
Delta measures the non-linear relationship between the option price and the underlying asset’s price, a feature that linear derivatives like futures or forwards do not possess.
What is volatility in derivatives?
Volatility represents the degree of variation or fluctuation in the price of the underlying asset, and it’s a crucial factor influencing the value of nonlinear derivatives.
How does volatility affect non-linear derivatives like options?
In non-linear derivatives such as options, higher volatility generally leads to an increase in the option’s price. This is due to the increased likelihood of the underlying asset’s price reaching the option’s strike price.
Why is volatility important in non-linear derivatives?
Volatility impacts the option’s price, as it affects the probability of the underlying asset reaching certain price levels within a specific time frame, influencing the option’s potential profitability.
How do traders and investors manage volatility in non-linear derivatives?
Traders use strategies like buying or selling options to hedge against or speculate on changes in volatility. They might also use complex option strategies designed to profit from volatility changes.
Can volatility impact linear derivatives like futures or forwards?
While linear derivatives’ values are directly linked to the underlying asset’s price and not influenced by volatility in the same manner as options, extreme volatility can still impact market conditions and the underlying asset’s pricing.
How does volatility affect linear derivatives like futures or forwards?
Volatility itself doesn’t impact the value of linear derivatives directly. Instead, their value is directly linked to the price movement of the underlying asset.
Why is volatility less relevant for linear derivatives?
Linear derivatives have a straightforward relationship with the underlying asset’s price. They are not sensitive to changes in market volatility because their value is determined by the direct movement of the underlying asset’s price.
Do changes in volatility influence trading behavior in linear derivatives markets?
While volatility might not directly impact the value of linear derivatives, extreme volatility can impact market sentiment and behavior, potentially influencing trading volume and liquidity in the underlying asset’s market.
How are strategies involving volatility different in linear derivatives compared to non-linear derivatives?
In linear derivatives, strategies involving volatility focus more on the overall market conditions and sentiment, as volatility itself doesn’t directly affect their value. In contrast, non-linear derivatives like options are directly influenced by changes in volatility.
What are credit derivatives?
Credit derivatives are financial instruments that allow investors to manage credit risk by transferring the risk of default on loans, bonds, or other credit assets.
How do credit derivatives work?
They involve transferring credit risk from one party (the seller or issuer of the derivative) to another (the buyer), typically through contracts like credit default swaps (CDS).
What is a common type of credit derivative?
Credit default swaps (CDS) are widely used credit derivatives. In a CDS, the buyer makes periodic payments to the seller in exchange for protection against potential default on a specific underlying asset.
What’s the purpose of using credit derivatives?
Credit derivatives enable investors to manage and hedge against credit risk, providing insurance-like protection against defaults or credit events.
How can credit derivatives impact financial markets?
While they can mitigate risk for investors, misuse or improper valuation of credit derivatives played a role in the 2008 financial crisis, highlighting their potential to amplify systemic risks if not managed properly.
What are the risks associated with credit default swaps?
While they can provide risk mitigation, improper valuation or misuse of CDS can amplify systemic risks and contribute to market volatility if not managed properly.
What is a yield spread?
A yield spread refers to the difference in yield between different financial instruments or securities, often used to compare the risk or return between them.
How is yield spread calculated?
Yield spread is calculated by subtracting the yield of one security or asset from another with a similar maturity but different risk profile or credit quality.
What does a wider yield spread indicate?
A wider yield spread usually indicates higher perceived risk or uncertainty in the market. It might suggest that investors demand a higher return for holding riskier assets compared to safer ones.
What is the formula to calculate delta for a call option?
For a call option:
What is the formula to calculate delta for a put option?
For a put option:
How is d1 calculated ?
What is the formula for the Black-Scholes model for a call option?
