FMP4 - Introduction to Derivatives

Question 1

Define derivatives, describe features and uses of derivatives, and compare linear and non-linear derivatives

Answer 1

• Derivatives are contracts whose value depends on underlying financial variables
• Linear / non-linear contracts have profits linearly / non-linearly related with assets underlying price

Question 2

Describe specifics of exchange-traded and over-the-counter markets and evaluate the advantages and disadvantages of each

Answer 2

Exchange-traded markets trade standardised contracts defined by the exchange

Over-the-counter markets can trade any contract participants agree on

Question 3

Differentiate among options, forwards, and futures contracts

Answer 3

Forwards are OTC contracts where one party agrees to buy an asset and one party agrees to sell an asset for a predetermined price at a future time

Futures are the same but on exchange traded market, where exchange specifies asset and maturity date

Options give the owner the right to buy or sell at a specific price in the future

Question 4

Identify and calculate option and forward contract payoffs

Answer 4

• Payoff on long forward = Y(St - K)
• Payoff on short forward = Y(K - St)
• Payoff long call = max(St - K, 0)
• Payoff short call = -max(St - K, 0)
• Payoff long put = max (K - St, 0)
• Payoff short put = -max(K - St, 0)

Question 5

Differentiate among the broad categories of traders: hedgers, speculators, and arbitrageurs

Answer 5

• Hedgers use derivatives to reduce / eliminate exposure to risk
• Speculators allow risk to be taken with small upfront payment
• Arbitrageurs take advantage of inconsistent pricing across different markets

Question 6

Describe some of the risks that can arise from the use of derivatives

Answer 6

Leverage speculators can obtain makes it very easy for traders to take significant risks