Derivatives Tutorial Terms 1. Flashcards
What is convexity in finance?
Convexity is a measure that evaluates the curvature of the relationship between a bond’s price and changes in interest rates. It reflects how the bond’s price reacts to interest rate movements.
How does convexity differ from duration?
While duration measures the bond’s price sensitivity to interest rate changes, convexity accounts for the curvature or non-linear relationship between bond prices and interest rates.
Why is convexity important for bond investors?
Convexity helps investors refine their understanding of how bond prices change in response to interest rate movements, providing more accurate estimates beyond what duration alone offers.
What does positive or negative convexity imply?
A positive convexity indicates that the bond’s price increases at an increasing rate as interest rates fall, while negative convexity suggests that the bond’s price rises at a decreasing rate as interest rates decline.
How is convexity calculated?
Convexity is calculated as the second derivative of the price-yield curve with respect to yield, or it can be estimated using mathematical formulas to measure a bond’s sensitivity to interest rate changes.
What is correlation in finance?
Correlation measures the degree to which the movements of two variables, such as asset prices or returns, are related or move together. It ranges between -1 (perfect negative correlation) and +1 (perfect positive correlation).
How is correlation used in finance?
Correlation helps investors understand the relationship between different assets within a portfolio. It aids in diversification by identifying assets that may not move in tandem, reducing overall portfolio risk.
What does a correlation coefficient of 0 mean?
A correlation coefficient of 0 indicates no linear relationship between the variables, suggesting that changes in one variable do not predict or influence changes in the other.
How does correlation impact portfolio management?
Positive correlation implies that assets move together, potentially increasing portfolio risk. Negative correlation suggests diversification benefits, as assets may move inversely, mitigating overall risk.
What are the limitations of correlation?
Correlation measures only linear relationships and may not capture nonlinear associations or causal relationships between variables, posing limitations in risk assessment.
What is covered call option writing?
Covered call option writing is an options strategy where an investor holds a long position in an underlying asset and sells call options on that asset to generate income.
How does covered call writing work?
The investor, who owns the underlying stock, sells call options, giving the buyer the right to purchase the stock at a specified price (strike price) within a set time frame. In return, the seller receives a premium.
What is the goal of covered call writing?
The primary objective is to generate income from the premiums received by selling call options while still benefiting from potential stock appreciation up to the strike price.
What happens if the stock price rises in covered call writing?
If the stock price exceeds the call option’s strike price, the stock may get called away (assigned) from the seller, who then sells the stock at the agreed-upon price.
What if the stock price doesn’t reach the strike price in covered call writing?
If the stock price remains below the strike price, the seller keeps the premium received for selling the call option and retains ownership of the stock.
What is documentation risk?
Documentation risk refers to the possibility of financial losses or legal disputes arising from errors, omissions, or inadequacies in financial or legal documentation.
What causes documentation risk?
Documentation risk can arise from inaccurate or incomplete information in contracts, agreements, financial statements, or legal documents, leading to misunderstandings or disputes.
What are the consequences of documentation risk?
Documentation risk can lead to litigation, financial penalties, delays in transactions, failed deals, or disputes between parties due to discrepancies in the terms or conditions outlined in the documents.
How can organizations mitigate documentation risk?
To mitigate documentation risk, organizations employ rigorous review processes, use standardized templates, ensure accuracy in financial reporting, conduct thorough due diligence, and involve legal expertise in document preparation.
Why is documentation risk important in finance?
Documentation risk can significantly impact financial transactions, contracts, or legal agreements, potentially resulting in financial losses, reputational damage, or legal liabilities for individuals or organizations.
What is duration in finance?
Duration is a measure of the weighted average time it takes to receive the cash flows from a bond, considering both coupon payments and the bond’s final repayment.
How is duration calculated?
Duration is calculated as the weighted average of the present values of a bond’s cash flows, where the weights are the proportion of each cash flow’s present value to the bond’s total present value.
What does duration indicate about bond price and interest rates?
Duration measures the bond’s price sensitivity to interest rate changes. Higher duration implies higher sensitivity, meaning the bond’s price will change more for a given change in interest rates.
How does duration relate to maturity?
Generally, the longer the maturity of a bond, the higher its duration. However, duration also depends on the bond’s coupon rate, yield, and other factors.
Why is duration important for bond investors?
Duration helps investors assess the risk associated with interest rate changes and make informed investment decisions by understanding how bond prices may fluctuate with changes in interest rates.
What are embedded derivatives?
Embedded derivatives are components within financial contracts (such as bonds, insurance policies, or leases) that have characteristics of standalone derivatives but are part of a larger financial instrument.
What are some examples of embedded derivatives?
Convertible bonds, equity warrants, certain types of options or swaptions embedded within bonds, or commodity price guarantees in supply contracts are examples of embedded derivatives.
How are embedded derivatives different from standalone derivatives?
Standalone derivatives, such as options or swaps, are independent contracts traded on exchanges or OTC markets. In contrast, embedded derivatives are part of other financial instruments and cannot be separately traded.
Why are embedded derivatives important?
Embedded derivatives can affect the overall risk profile and value of the host contract. Recognizing and valuing these embedded derivatives is crucial for proper accounting and financial reporting.
How are embedded derivatives accounted for?
Accounting standards often require the separation and individual valuation of embedded derivatives from the host contract to accurately reflect their impact on financial statements.
What is an equity swap?
An equity swap is a financial contract where two parties agree to exchange future cash flows based on the performance of a stock or equity-related benchmark.
How do equity swaps work?
In an equity swap, one party may agree to pay the return on a stock or index to the other party in exchange for a predetermined payment, such as a fixed or floating interest rate.
What are the purposes of equity swaps?
Equity swaps can be used for various purposes, including gaining exposure to the returns of a specific stock or index, hedging against equity-related risks, or achieving portfolio diversification.
Who typically uses equity swaps?
Hedge funds, institutional investors, and financial institutions commonly use equity swaps to manage risks, speculate on stock prices, or tailor their exposure to specific equity markets.
What are the variations of equity swaps?
Variations include total return swaps (TRS), where one party pays the total return of an asset, including dividends, and variance swaps, which pay based on the variance of an underlying asset’s price.
What is a currency swap?
A currency swap is a financial contract in which two parties agree to exchange principal and interest payments in different currencies for a specified period.
How does a currency swap work?
In a currency swap, the parties exchange notional amounts in different currencies and make periodic interest payments based on the agreed-upon terms, helping to manage exposure to exchange rate fluctuations.
What are the purposes of currency swaps?
Currency swaps are used to hedge against exchange rate risk, obtain lower interest rates in different currencies, secure funding in foreign currencies, or manage currency-related cash flows.
Who utilizes currency swaps?
Multinational corporations, financial institutions, and governments often use currency swaps to hedge against currency risk, finance international operations, or obtain favorable borrowing rates.
How do currency swaps differ from other types of swaps?
Currency swaps specifically involve the exchange of cash flows in different currencies, distinguishing them from interest rate swaps or equity swaps.
What are European-style options?
European-style options are financial contracts that permit the holder to exercise their buying or selling rights on the underlying asset only at the expiration date, not before.
How do European-style options differ from American-style options?
European-style options differ from American-style options in that they can only be exercised at the expiration date, while American-style options allow exercise at any time before expiry.
What is the significance of the exercise date in European options?
In European options, the holder cannot exercise the option before the expiration date. They can only exercise it on the specific expiration date itself.
How are European-style options used?
European options are used for various purposes, including speculation, hedging, and portfolio management, providing investors with strategic tools for risk management and profit potential.
Where are European-style options commonly traded?
They are frequently traded on organized exchanges, allowing investors to participate in various markets while managing risk exposure within defined timeframes.
What is a floor in finance?
A floor is a derivative contract that acts as a financial safeguard, establishing a minimum or “floor” for the interest rate on an underlying financial instrument, such as a loan or investment.
