Forward Commitment and Contingent Claim Features & Instruments

Question 1

What is a “Forward Price”?

Answer 1

A forward price represents an agreed upon forward contract to be exchanged upon at the contract’s maturity date, T.

Denoted as: F0(T)

Question 2

What is a “Linear Derivative”?

Answer 2

Firm commitment derivative contracts in which the payoff/profit function is linear with respect to the price of the underlying.

Question 3

What is a “Breakeven Point”?

Answer 3

Represents the price of the underlying in a derivative contract in which the profit to both counterparties would be zero.

Question 4

What are “Futures Contracts”?

Answer 4

Forward contracts with standardized sizes, dates, and underlying’s that trade on futures exchanges.

Question 5

What is a “Futures Price”?

Answer 5

The pre-agreed price at which a future contract buyer (seller) agrees to pay (receive) for the underlying at the maturity date of the futures contract.

Question 6

What does “Mark to Market” (MTM) mean?

Answer 6

The practice in which a central clearing party assigns profits and losses to to counterparties to derivative contracts.

In exchange-traded markets, this practice often takes place daily and is often referred to as daily settlement.

Question 7

What is “Daily Settlement”?

Answer 7

A specific process of mark-to-market by a central clearing party in which the profits and losses of all counterparties to derivatives contracts are determined using settlement prices for each contract.

Question 8

What is the “Settlement Price”?

Answer 8

The price determined by an exchange’s clearinghouse in the daily settlement of the mark-to-market process.

The price reflects an average of the final futures trades of the day.

Question 9

What is a future’s margin account?

Answer 9

An account held by an exchange clearinghouse for each derivatives counterparty.

The funds in such an account are used to ensure that counterparties do not default on their contract obligation.

Question 10

What are “Price Limits”?

Answer 10

Establish a band relative to the previous day’s settlement price within which all trades must occur.

Question 11

What is a “Circuit Breaker”?

Answer 11

A pause in intraday trading for a brief period if price limit is reached.

Question 12

What is “Open Interest”?

Answer 12

The number of outstanding contracts.

Question 13

What is a “Floating-Rate Payer”?

Answer 13

The counterparty paying the variable cash flows in a swap contract.

May also be referred to as the fixed-rate receiver.

Question 14

What is the “Fixed Rate Payer”?

Answer 14

The counterparty paying fixed cash flows in a swap contract.

Question 15

What is a “Swap Rate”?

Answer 15

The fixed rate to be paid by the fixed-rate payer specified in a swap contract.

Question 16

What does “Exercise” mean?

Answer 16

The decision to transact the underlying by an option holder.

Question 17

What is the “Exercise Price”?

Answer 17

The pre-agreed execution price specified in an option contract.

Sometimes this price is referred to as the “Strike Price”

Question 18

What is an “Option Premium”?

Answer 18

The amount that is paid upfront from the option buyer to the option seller.

Reflects the value of the option buyers right to exercise in the future.

Question 19

What are “European Options”?

Answer 19

Options that may be exercised only at contract maturity.

Question 20

What are “American Options”?

Answer 20

Options that may be exercised at any time from contract inception until maturity.

Question 21

What is a “Put Option”?

Answer 21

A right to sell the underlying.

Question 22

What does “In-the-money” mean?

Answer 22

Describes when an option has positive intrinsic value.

Question 23

What is “Out-of-the-Money”?

Answer 23

Describes an option with zero intrinsic value because the option buyer would not rationally exercise the option.

Question 24

What is “At-the-money”?

Answer 24

Describes a situation in which the price of the underlying is equal to an option’s exercise price.

Like an out-of-the-money option, the intrinsic value is zero.

Question 25

What are “Non-linear derivatives”?

Answer 25

Derivatives, such as options, or other contingent claims, where payoff/profit are asymmetrical.

Question 26

What does “Time Value” represent?

Answer 26

The difference between an option’s premium and its intrinsic value.

Question 27

What is a “CDS credit spread”?

Answer 27

Reflects the credit spread of a credit default swap (CDS) derivative contract.

As with cash bonds, CDS credit spreads depend on the probability of default (POD) and loss given default (LGD)

Question 28

What is a “Credit Event”?

Answer 28

An event that defines a payout in a credit derivative.

Events are usually defined as:

(1) Bankruptcy
(2) Failure to Pay an Obligation
(3) Involuntary Debt Restructuring