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FCA Paper 2: Derivatives > Introduction to Derivatives > Flashcards

Introduction to Derivatives Flashcards

6/100 Questions

1
Q

Long and short meanings

A

Long = Agreed to buy an asset at a specified future date
Short = Agreed to sell an asset at a future date.

Logically, for every long, the counterparty on the other side will be short

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2
Q

3 main uses of derivatives

A
  • specullation = people guess what the market will do and buy derivative products to try and realise a profit from this. AS DRVTs are highly geared, you can get high market exposure for a low initial inv.
  • Hedging = protect investors from price movements. The basis is how much the risk is offset dependant on how closely a portfolio is linked to an index or mkt
  • arbitrage = exploitation of price anomalies in 2 markets.Buy low in 1 mkt and sell high in another.offers risk free profit.
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3
Q

3 common forms of arbitrage

A
  • Intertemporal - prices between 1 month and 6 month zinc contracts are ‘out of line’
  • Geographic - when the same contract is priced differently accross 2 countries
  • Value chain - difference in prices of the main assets, e.g. crude oil and refined oil products like petrol.
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4
Q

Forward contracts

A
  • OTC - customisable
    *
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5
Q

Futures contracts

A
  • Exchange traded - standardised terms
  • 2 parties agree to exchange a specific quantity of an asset at a specified future date at a specified future price
  • Traded on ICE futures (eu), CME Group (US) and Shanghai futures exchange (CHN).
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6
Q

futures - what are contract specifications

A

Terms are specified in a contract specification - allows participants to take generic positions in price movements in any market. Also promote transparency as all the details are laid out

Standardises the product, delivery date and makes the contract fungible (identical to and subsitituable with the same contract on another exchange).

makes contracts easy to trade due to set terms and the concentration of activity provides liquidity

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7
Q

Pricing and timing of futures - what is negotiable, tick sizes

A
  • ONLY THE PRICE IS NEGOTIABLE - but minimum prices and how they are quited are set by exchanges.
  • Wheat futures are quoted ‘per bushel’ with a minimum pprice movment of 0.25% per bushel AKA tick size which can be used to work out the tick value which is the min price movement for the whole contract.
  • Exchange specifies delievry date
  • The oblligation to take delivery can be offset by buying an opposing futures contact to sell for example
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8
Q

How futures work

A
  • Can be long or short - either will expose the trader to price movements = profit/loss
  • Holding the contract until the end will oblige the trader to take/make delivery of the underlying asset
  • Long position - if prices rises = profit
  • Short = price falls = profit
  • P+L of opposing parties will not be the same (ie long makes £10 short loses £10) due to differing charges
  • The risk to the seller of a future is unlimited as the price can thoetretically keep climbing.
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9
Q

Advantges of futures

A
  • Fungibility - standardisation of contracts draws liquidty as the same product is being traded by all participants
  • Counterparty risk - Novation in the central clearing house reduces counterparty risk (Novation=the clearing house becomes the counterparty for all trades)
  • Cost - low brokerage fees due to all of the above
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10
Q

FORWARDS

A
  • Typically OTC contracts
  • Contract to take/make delivery of an underlying asset for an agreed time, price and quantity.
  • Customisable which attracts investors with specific needs
  • Not marked-to-marked daily which means less margin tops ups etc and makes for a more ‘hands off’ hedge.
    *
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11
Q

Advantages of Forwards

A
  • Flexibility
  • Bettter margin/collateral terms
  • wide range of underlying assets
  • Available from most commercial banks
    *
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12
Q

Disadvantages of forwards

A
  • counterparty risk - espcially when they are not cleared, as they are OTC.
  • Liquidity risk as they can be very specialised and reduces fungibility and the number of people willing to trade
  • Higher fees compared to futures for the above reasons
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13
Q

Forwards are common in…markets

A
  • FX markets - used to manage FX transaction risk if they are exporting.importing goods in different currencies for example
  • Markets where delivery of the asset is common - e.g. an airline might use forwards to lock in AvGas prices to take delivery later.
  • Price is agreed based on the spot price
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14
Q

Contracts for difference (CFDs) - tax benefits, OTC or ETD, bought from who

A
  • Give investors access to the returns of an underlying asset without having to physically own it or pay full price for it.
  • Purchased from a CFD provider (stock borker) who settles the price between when the contract is purchased and when it is sold/ended.
  • Profit and loss is dependant on how far the price moves from the purchase prices.
  • OTC contract
  • Stamp duty and broker fee exempt
    *
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15
Q

CFD margin trading

A
  • CFDs are traded on margin - so investors can leverage their position. Brokers typically require a 10-30% initial margin on CFDs.
  • THis allows investors access to the products at a low price and allows them to easily increase their market exposure with leverage.
  • Most contracts have stop losses built in to stop investors getting fucked
  • CFDs don’t have an expiry dateand are rolled over at the close of each trading day if desired.
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16
Q

Spread betting and differences to CFDs

A

Different to CFDs as spread bets have an expiry date and spread betting is considered as gambling so have different tax rules.
* CFDs may charge a commsion whereas spread bet firms earn moeny through their bid/offer spread

  • Both are primarily used by retail investors
  • Spread betting is illegal in a umber of EU countries due to the high leveraged risk.
  • Short term interest rate (STIR) contracts are common spread betting trades.
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17
Q

OPTIONS terminology

A
  • Long - buyer of the contract
  • Short - seller of the contract
  • Call option - R but not O to buy the underlying asset for the strrike price on a specified date
  • Put option - R but not O to sell the underlying asset for the strrike price on a specified date
  • Strike price - price at which the option can be exercised AKA exercise price
  • Settlement price - price determining payoff when the option expires
  • Premium - cost of the option to the buyer - buyers pay their broker who passes the cash to the clearing house on their behalf.
  • In/out of the money - How much you are in profit/loss - difference between the strike price and the current UA price
  • At the moeny - break even
  • Intrinsic value - ONLY options that are in the money have intrinsic value
  • Extrinsic value- value derived from other factors (like IRs, time value, etc) which causes there to be a discrepancy between intrinsic value and price of the UA
  • Time value- market assigned value increasing probability of an increase in intrinsic value. Long dated options tend to have a higher time value as they have more time to be in the money.
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18
Q

How options can be exercised (exercise styles)

A
  • European style - an option that can be exercised on its expiry day ONLY
  • American style - option can be exercised at any day in its life.
  • Asian style - price at maturity is based on the average underlying price over the length of/specified time period of the contract. 2 common types:
    1. strike price set at the beginning and settlement price = avergae price over the life of the option
    2. strike price is the average traded price over the length of the option.
  • Bermudan style - early exercise is possible but restricted to certain dates within the option’s life that are spaced at regular intervals. Pricing sits between EU and US style. gets the name from the fact is has characteristics of both an bermuda is geopraphically between US and UK.
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19
Q

Types of exotic options

A

Asian and Bermudan style exercise options are considered exotic. the others are vanilla.
* Lookback option - path dependant - holder can buy/sell depending on the highest or lowest price of the option over a specified period
* Barrier option - path dependant - payoff is based on whether the UA has reached a certain price. 2 types:
1. knock in option - option is activated/starts to exist after the UA price hits a certain level
2. knock out option - cease to exist if the UA hits a certain price
* binary option (digital option AKA) - pays a fixed amount or nothin at all depending on the option price at expiry/a specified time
* Chooser option - option that allows the holder to chose if it is a put or a call at a specified time in it’s life
* compound option - gives the holder the right to purchase another option at pre determined times in it’s life. Can get puts on calls, puts on puts, calls on calls and calls on puts.
* Rainbow option - option with multiple underlying assets AKA multi-asset options

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20
Q

Buying a call option (long call)

A

Buyer of the option pays the premium quoted in pence (i.e 30p) and recieves the right but not hte obligation to take ownership of the underlying asset for 700p.

At expiry:
* if the price at maturity is below 700p, the investor sacrifices the 30p and faces no further loss. They let the option expire and do not exercise.
* If the price is above 700p the buyer will exercise and resell the UA into the market for a profit.
* Break even price = strike price + premium

  • Maximum loss to buyer = Premium paid.
  • profit is made if the profit at exercisee is greater than the premium (e.g. 35p=5p profit)
  • break even as above
  • Unlimited potential profit.
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21
Q

Selling a call. (short call)

A
  • The seller of the option receives a premium from the buyer which is due per share the seller is now on the obligation to deliver the shares if the buyer wishes to exercise.
  • At expiry if the price is below what the buyer paid for the option they will abandon it and the seller will make it profit. The seller no longer has delivery obligations.
  • If the share price is above the exercise price - The buyer exercises the option and the seller is obliged to deliver the UA. This will cause a loss for the seller if the loss when selling the option to the buyer exceeds the premium paid by the buyer.

Summary
* Unlimited potential losses
* Net loss will be made if The loss exceeds the premium paid by the buyer
* Break even point = strike price plus premium
* Sellers maximum potential profits is limited to the premium received

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22
Q

Buying a put (long put)

A
  • the buyer of the option pays the seller a premium giving them the rights to cell one share for specified price.
  • The share price is above the exercise price the holder will abandoned the option as it is worthless.
  • If the share price is below the exercise price the holder will exercise the option as they can sell the share for a higher price than in the market.
  • The maximum loss is limited to premium
  • A net profit will be made by the buyer if the profit exceeds the premium paid
  • The break even points is a strike price subtract the premium
  • The buyers maximum profits will arise if the share price falls to 0
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23
Q

Selling a put (short put)

A
  • The seller receives a premium from the buyer and the seller is under the obligation to buy the shares if the buyer decides to exercise.
  • If the share price is above the exercise price the buyer will abandoned the option and the seller keeps the premium received therefore making a profit
  • At the share prices below the exercise price the buyer will exercise the option. The seller will be obliged to buy the shares for the exercise price and sell it on the market for a lower price taking a loss
  • The seller’s maximum profit is limited to the premium received
  • Net loss will be made if the loss exceeds the premium
  • Break even points is strike price minus the premium
  • The maximum potential loss is a strike price minus the premium and arises if the share price falls to 0
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24
Q

Options profits and losses summary

A
  • Long call - Max loss limited premium - Max profit unlimited.
  • Short call - Max loss unlimited - Max profits limited to premium
  • long put - Max loss limited to premium – max profit strike price-premium (if asset falls to $0)
  • Short puts – max loss strike price-premium, asset price falls to 0 - Max profit limited to premium

Counterparty risk is eliminated when an option is out of the money as no one will exercise it and when the seller recieves the premium.

It arsises when an option it out of the money and a seller has to sell the option to the buyer (or source if from the market first and then sell to the buyer).

25
Q

Calculations for profit and loss

A

Format = option type - when strike price exceeds expiry price - when expriy price exceeds strike price.

  • Long call - loss=premium - gain=(expiry price-strike)-premium
  • Short call - gain=premium - loss = (strike - expiry price) + premium
  • Long put - gain= (strike - expiry price) - premium - loss=premium
  • Short put - loss = expiry price-strike) + premium - gain=premium
26
Q

FLEX options

A

Launched in 1993 by CBOE. Hybrid products.
* Are exchanged traded but have OTC features - provides increased flexibility by minxing OTC and ExT.
* Exercise price, style and expiry date are customisable
* Reduced credit risk as they are exchange traded and use a clearing house
*

27
Q

2 aspects of FLEX options trading facilities - EFS, EFP

A
  • Exchange for Physical (EFP) - off market transaction that swaps an OTC derivative for a future. the future and OTC must be very similiar in price, etc for it to work.
  • Exchange for swap (EFS) - swaps an OTC SWAP with a number fo futures contracts. the OTC swap and futures have price correlations, etc to be a suitable instrument. Price correlation=price movement in the OTC and futures are similar if not identical.
28
Q

Benefits and disadvantages of exchange for physical

A

+
* Counterparty credit exposure is reducing when an OTC is changed for a future as counterparties can release credit which clears their credit limits and allows for more OTC trading
* Reduced balance sheet and margin requirements by netting OTC and future position
* 24 hour trading but can only be registered within market hours.

-
* Increase Operational risk when dealing in futures contracts
* Firms might not be considered sophisticated enough to deal in futures contracts as they are market to market constantly requiring margin monitoring etc. Also annoying if you’re using it as a hedge.

29
Q

Warrants

A

Similar to an option - gives the right but not the obligation to buy an asset for a set pric. Often attached to/part of a bond and can be seperated from the bond and traded seperately.

30
Q

Gearing

A

Using borrowed money to magnify returns as a small initial investment that is highly geared can have huge returns with a very small change in price.

31
Q

Gearing Options - smaller premium means…?, why can price movements between options and the UA be different

A

As the option premium is a small fraction of the value of an asset, changes to the price of the UA can produce disproportinate changes in the price of the option.

Typically, the smaller the premium, the higher the gearing.

32
Q

Futures gearing - what system allows them to be geared

A

Futures are geared using the margin system.

Investors are required to pay an initial margin up front and don’t have to pay for the full value of the contract, leading to leverage. They can gain or lose the full amount however depending on price movements

33
Q

Liquidity and measures of liquidity

A
  • ease of converting assets into cash and how easily it can be traded without affecting the mkt price.

Measures of liquidity:
* Bid offer spread - (tighter=more liquid)
* Immediacy - time needed to trade a specified amount of an asset at a given price.
* Resillience - speed at which prices return to former levels after large transactions in the market. Determined over a time period
* Market depth - The number of orders above and below the current market price. Allows for orders to keep being filled if hte price changes. Slippage occurs when the avrg price of a security moves quickly (gaps).

Derivatives exchanges aim to give liquidity and in turn ocnfidence to the dervatives market

34
Q

5 main features of a liquid market

A
  1. Many buyers and sellers
  2. Small bid/offer spreads
  3. Low commissions.
  4. Larrge volumes can be traded without affecting the market price

Open interest refers to the volume traded in a given period by looking at the cumulativee open positions.

35
Q

Margin schedules - OTC or ETD, administered by who, developed by who

A

Have become standard for OTC and exchange traded derivatives and margin is administered by central counterparties (CCP).

BCBS and IOSCO have developed standardised margin schedules for most OTC derivs.

Margin reqs have been about since 2016 for large contracts.
Smaller contracts with month end notional values greater than $8billion require initial and variation margin.

36
Q

Significant factors of exchnage traded derivatives

A
  • Contract terms - Standard
  • Delivery - standardised by the exchange with fixed dates
  • Liquidity - very liquid on major contracts
  • Financial integrity - CCP reduces credit risk, marked to market daily (set variation margins)
  • Margin - Initial (required to open the contract) and variations margins (required to cover profit+loss at EOD) always required
  • Documentation - standard and concise
  • Regulation - significant regulation
  • Pricing quotes - highly transparent, public
  • transaction costs, standardised and lower
37
Q

Significant factors of OTC derivatives

A
  • Contract terms - fullly customisable, flexible and confidential
  • Delivery - negotiable
  • Liquidity - limited but depends on UA. Slower execution
  • financial integrity - counterparty risk, needs a credit rating. Can use prime brokers to reduce the risk.
  • Margin - formal margin not usually required but some contracts require additional collateral. Not regullar payments like margins but can demand more collateral in times of high volatility
  • Documentation - bespoke and more complex however some standard contracts exists such as ISDA agreements.
  • Regulations - EMIR and Dodd Frank Act since 2008 - require CCP and to report trades to a trade repository.
  • Price quotes - Limited and need to shop around
  • Transaction costs - priced individually and more expensive than exchange traded contracts.
38
Q

Swaps

A
  • OTC derivative
  • 2 counterparties exchange cashflows or liabilities from 2 different financial instruments
  • Usually cahs flows from notional principal amounts such as loans or bonds (although the instrument can be anything)
  • Largest derivative market due to the hgih number of underlying assets that can be traded
  • Interest rate swaps are the most common.
39
Q

Interest rate swaps

A

Counterpaties exchange 1 set of future interest payments for another for a set period.

Variety of swap
1. Fixed/floating swap - vanilla swap AKA a coupon swap where parties excahnge fixed or floating rate loans. (ie I have floating, I swap for fixed)
2. Floating/floating - basis swap - both income streams are floating
3. Fixed/Fixed - FX swap where both parties exchange a fixed IR on the principal amount.

At each payment date a net payment will be made based on the difference in return on the 2 swaps.

Swap payment date = date where cash flows exchanges must take place.
If terminated, an agreed price is paid by the party leaving the contract and accured interest is taken from the termination date

40
Q

Swaption

A

Buyer pays an upfront sum for the right to enter into a swap contract by a pre agreed future date. )i.e has the right but not the obligation to enter a swap contract - an option on a swap)

Wholesale market and is often used to manage risk and take advantage of less risky/cheaper cash flows.

41
Q

Inflation linked swaps - what is it, maturity times

A

Exchange of cash flows with one or both legs being linked to an inflation index.

Protects investors from inflation’s impact on an underlying asset in the future. Usually investors pay a fixed amount for the privilege.

Benchmarks are retail price index (RPI) UK, Harmonised Index of consumer prices (HICP) EU and US Consumer Price Index (CPI) US.

MATURITIES = 5-30 YEARS

42
Q

Zero coupon inflation products

A
  • Standard derivative based on inflation rates with the UA being a measure of inflation.
  • 1 cash flow with no intermediate coupon (swap date) and no fixed/floating amount at maturity.
  • Essentially allows for speculation on inflation rates

Benefits:
* Hedge/speculate on inflation rates fluctuations
* Evaluate inflation linked securities including TIPS (US inflation linked bonds) and other inf linked securities
* Hedge against central bank credit tightenting policies

43
Q

Currency Swaps

A

Swaps the principal and interest of one currency for the same in another currency for a certain period of time.

Allows investors to get a better IR on foreign currency loans than they would get in the debt market. Can also hedge transacttion risk on exisiting foreign currency loans.

Started in 1981, one of the earliest forms of swap

44
Q

Types of currency swap cash flow exchanges

A
  • Fixed interest in one currency and floating in another
  • Fixed interest in one currency and fixed in the other
  • Floating interest in both currencies.

Basically swaps one currency for another and the parties sacrifice any benefits of holding the currency like strengthening exchange rates etc.

Reduces the cost of borrowing other currencies, replaces unpredicatbale cash flows (with respect to exchange rates compared to other currencies) with predictable ones.

Typically come at an initial cost, usually a bit below the exchange rate quoted at market.

45
Q

Equity swaps - bullet swaps

A

Swaps where payments on one or both sides of the swap are linked to the performance of an equity/equity index.

Used to avoid witholding taxes, obtain leverage, gain access to equities with restricted foreign ownership.

Can create synthetic portfolios of shares where the holder doesn’t actually own the shares in the portfolio.

Most common type=bullet swap - all payments are made at maturtiy.

46
Q

Equity basket swaps - ETD or OTC

A

Where one or both of the UAs are a non index basket of shares.

Similar characteristics to exchange traded Equity swaps but are ALWAYS OTC as the equities being traded aren’t standard.

Used for correlation trading and hence are OTC as the basket of shares must be specific to what the buyer requires.

47
Q

Equity forwards

A
  • OTC contract
  • 2 parties buy/sell and individual equity/basket of equities at a specified future time and price.
48
Q

Variance swaps

A
  • Allows the buyer to speculate or hedge the price movement of a specific UA.
  • The cash flow for one side of the agreement will be the variance (price movements) of the specific UA selected over the life of the swap.
  • Prices recorded daily, usually at the UA’s close price.
  • The other side of the swap pays a fixed amount agreed upfront.
  • Provides the purest exposure of a UA’s price volatility.
  • Profit/loss based on implied vs actual volatility
49
Q

Dividend Swaps

A
  • Swaps a fixed cashflow for the dividends of a company. ONLY considers dividends, no actual share price movement.
  • Fixed cashflow leg pays the other party the fixed amount and the floating leg (dividend) pays the full dividend to the counterparty.
  • The signing value of the contract is usually $0 as teh fixed leg is calculated to be an average of the expected dividend payments.
    *
50
Q

Asset swaps

A
  • Used to change the IR exposure or currency exposure of an investment
  • Used to create synthetic fixed rate investments. I.e. buys a floating rate bond and swaps it for a SONIA fixed rate note.
  • The investor can choose the UA based on different criteria like liquidity, credit quality, pricing, etc.
  • It seperates choosing an asset and choosing what type of cash flow (Fixed or Floating) you want
  • The negative is the counterparty needs to hedge their exposure to teh UA chosen by the opposing investor, limiting numbers of willing counterparties. If they find a counterparty, the charges or spread are usually very high to cover the counterparties hedging costs/risk of price movement of the UA
51
Q

Total return swaps -
Leg 1 receives
Leg 2 receives

A
  • One leg pays the full return of a particular asset including dividends, interest, capital appreciation.
  • The other leg typically is a floating IR.
  • Duplicates borrowing short term funds and investing in another asset.
  • Gives investors access to inaccessible securities and helps them maintain liquidity as they don’t need to hold the actual asset.
  • Negatives are both counterparties can find it hard to be liquid, increasing costs.
52
Q

Mark-to-Market swaps

A
  • Swaps where amounts due are calculated after the UA is marked to market and the difference in loss or gain since the last M-T-M is paid or recieved by the coutnerparty.
  • It removes any credit risk that has built up at each settlement date as payments are made regularly.
  • Effectively settles the exisiting swap, pays the correct counterparty and opening a new swap. Repeat until the swap expires.
  • FX resettable swap - FX swap and a MTM swap. all settlement dates must be days where both currencies trade

Partcially, most swaps are marked to market at least quarterly to reduce counterparty risk.

53
Q

Commodity swaps - fixed for floating swap

A
  • Swap based on the underlying returns of a commodity.
  • Used by firms who like to lock in commodity prices (airlines for AvGas, farmers for crops etc)
  • Fixed for floating commodity swap - One party pays the other the return of a commod multiplied by a fixed price and the other pays the return multiplied by a floating rate.
  • LOOK AT BOOK EXAMPLE PAGE 40
  • Common commod swaps are
    1. Bullion swaps
    2. Other industrial outputs (fertiliser - CME offer clearing house)
    3. Energy swaps like crude oil, natural gas
54
Q

Amortising, accreting and rollercoster swaps

A

The returns of the swap are matched to a specific feature of the UA

  • The returns of the swap reduce at the same rate as the asset amortises.
  • notional principal increases - accreting
  • The returns rise and fall in line with seasonal trends - rollercoser
55
Q

Forward start swaps

A

A swap with terms that are agreed today but the intial funds are transacted at a future date.

For example a 3 year note and a 5 year note with a 2 year delay so they expire at the same time

56
Q

Gloabal regulators

A

UK d
* PRA
* FCA d
EU
* ECB
* EU banking Authority EBA
* ESMA
* France - AMF
* Ireland - cnetral banl of ireland
* Germany BaFin
US
* SEC
* CFTC
* FDIC
Japan
* FSA
* SESC
India
* RBI
* SEBI
China
* CSRC
* CIRC
* CBRC

57
Q

Derivatives market participants

A
  • Regulators
  • Central banks
  • Sovereign wealth funds
  • Global corps, inv banks etc
  • Exchanges - cna be floor trading (CME Group, CBOE, LME) or electronic trading platforms (ICE)
  • Market makers
  • Sell and buy side firms
58
Q

Roles of different market participants

A
  • Prime brokers
  • Clearing brokers - broker-dealer acting as a clearing agent to other brooker dealers.
  • Introducing broker - broker-dealer that facillitates transactions via a clearing broker. DOESN’T hold customer securities/funds
  • Executing broker - broker that executes orders on behalf of clients
  • Inter dealer brokers - acts as an intermediary between 2 dealers and act as a wholesale execution house
  • Futures commission merchant - person or firm registered with the CFTC facillitating execution of listed commodity derivatives. Able to extend credit
59
Q

3 main risks associated with derivative contracts

A
  • Counterparty risk - one side of the contract cannot honour their obligations. OTCs have higher counterparty risk than exchange traded as ex tr use CCPs.
  • Liquidity risk
  • Operational risk - failure in a firm’s processing activites on transcations for example. (loss from failure internal processes, people, systems and external events)

FCA Paper 2: Derivatives (9 decks)

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