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FCA 2: Derivatives > Introduction to Derivatives > Flashcards

Introduction to Derivatives Flashcards

1
Q

what is the difference between forwards and futures?

A

futures are traded on an exchange with standardised contracts whereas forwards are traded OTC with customisable terms

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2
Q

what are the three uses of derivatives?

A
  • speculation
  • hedging
  • arbitrage
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3
Q

how can derivatives be used in speculation?

A

speculators can take a view on the markets direction and seek to make a profit from price movements by buying and selling futures contracts

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4
Q

how can derivatives be seen as more attractive than the underlying?

A

they can be highly geared meaning that a small expenditure in an initial investment can give the holder big exposure to a market (they also have to allow for margin requirements)

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5
Q

how can derivatives be used in hedging?

A

they can be used to protect a position or an anticipated position in the underlying market by taking an opposite position in the futures market

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6
Q

How can derivatives be used in arbitraging?

A

contracts can be used to exploit price anomalies between markets (‘mispricing’)

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7
Q

what are the three most common forms of arbitrage?

A

intertemporal: prices between contracts of different time periods
geographic: two identical contracts across multiple exchanges
value-chain: as between prices at different stages of the production chain (e.g., crude oil vs refined)

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8
Q

what is a future contract in derivatives?

A

a legal agreement between two parties to make or take delivery of a specific quantity and quality of a specified asset on a fixed future date at a price agreed today.

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9
Q

where are futures traded?

A

traded on organised exchanges e.g., ICE Futures, CME Group

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10
Q

how are the terms of each contract figured out in a futures trade?

A

standardised in a legal document called the contract specification, which details precisely which allows participants to take positions on general price movements in any given market and promotes transparency. Also set out the future date, set a day within the month

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11
Q

what is the sole element of a futures contract that is open to negotiation?

A

the price, the exchange doesn’t specify by how much they can alter it but it has to be above the minimum permitted movement which is a full tick value

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12
Q

what does it mean when a futures contract is fungible?

A

it is identical to and substitutable with others traded on the same exchange

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13
Q

how is a future position opened?

A

by going long (buying) or short (selling). the trader then becomes exposed to the changes in the futures price and the position will incur profits or losses depending on the price movements

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14
Q

how do price movements affect the profit/loss a trader makes from a futures position?

A

if the price of the asset rises, the buyer (in the long position) will make a profit as they will be able to take delivery at the lower contract price and sell at the higher market price, the seller (in the short position) will make a loss. or vice versa if the price falls

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15
Q

what are the benefits of forwards contracts?

A

as they are generally traded OTC, they have a degree of customisability that make them attractive to participants requiring a more tailored product

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16
Q

what are the main advantages of futures?

A

fungibility: standardisation of contract specifications means all counterparties will be trading the same product

counterparty risk: reduced considerably by novation through a CCP

Cost: brokerage fees associated tend to be low

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17
Q

what are the main advantages of forwards compared with futures?

A
  • flexibility
  • better margining and collateral terms
  • range of underlying assets
  • available from most commercial banks
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18
Q

what are the main disadvantages of forwards compared with futures?

A
  • potential counterparty risk
  • credit/default risk
  • liquidity on forwards can be low
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19
Q

where can forwards be used?

A

by those in the commercial industry to manage their FX risk by protecting against adverse currency movements or to lock in the price of physical commodities

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20
Q

what are CFDs?

A

contracts for difference, allow investors to benefit from the capital gains of an underlying asset without actually owning or paying for it

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21
Q

how is a profit/loss accrued with a CFD?

A

The investor enters into an agreement with the CFD provider to settle the difference between the opening price of the asset when the agreement is made and the price when the agreement ends

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22
Q

what is the key feature of CFDS?

A

they don’t have a set maturity and the contract specification ranges depending on buyer and seller

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23
Q

what are the benefits of CFD?

A

cost efficient, investor doesn’t have to pay stamp duty nor the brokers fee, allow investors who are bearish on a share to profit from a fall in the share price rather than going short

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24
Q

how are CFDs traded?

A

based on margin trading, investor can leverage their position- require a margin deposit of 10-30% of the contracts value, allows investors to increase their risk based on the size of their initial investment

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25
Q

what do many CFD contracts include?

A

include an automatic stop-loss order as part of the contract, which minimises the risk of a large loss

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26
Q

what is the difference between a CFD and a spread-bet?

A

spread betting in the UK is considered gambling and is treated differently as far as tax. CFDs may charge a commission whilst brokers are compensated by spread bets through the price spread they quote

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27
Q

what is an option?

A

an option is a contract that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a particular asset at a particular price, on or before a specified future date.

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28
Q

how are options derivatives of a derivative?

A

options on futures give the holder the right but not the obligation to call or put a specified futures contract, offered by all major derivatives exchanges

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29
Q

what is the strike price price in relation to an option?

A

price at which the option can be exercised

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30
Q

what is the settlement price in relation to an option?

A

the price that determines the pay-off when the option expires

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31
Q

what is the premium in relation to an option?

A

the cost of the option to the buyer, non-returnable and are paid by the option holder to the option writer

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32
Q

what is in/out/at the money in relation to an option?

A

the extent to which the options contract is in profit or loss, quoted as a difference between the strike price of the contract and the current price of the underlying

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33
Q

what is the intrinsic value of an option?

A

when an option is in the money

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34
Q

what is the extrinsic value of an option?

A

where option premiums differ from the option’s intrinsic value, the option has value that is being derived from factors other than just the price of the underlying asset

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35
Q

what is the time value of an option?

A

the extrinsic value that the market assigns to an option, given the probability that there may be an increase in the intrinsic value of the option.

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36
Q

what are the different styles of exercising an option?

A

European-style: option can only be exercised on its expiry date

American: an option that the holder can exercise on any day of its life

Asian: pay-off is not determined by the underlying price at
maturity, but by the average underlying price over the entire length or a specified part of the contract.

Bermudan: early exercise is restricted to certain dates during its life, usually a series of dates over the contract’s life that are spaced in regular intervals.

37
Q

what are the two common versions of Asian options?

A
  • The strike price is set at the beginning and the settlement price is the average asset price over the life of the option.
  • The strike price is the average traded price over the life of the option (also sometimes called an ‘average strike option’).
38
Q

how are the different styles of exercising an option categorised?

A

EU/ USA style are plain vanilla, Asian and Bermudan are described as exotics

39
Q

what is a lookback option (exotics)?

A

strike price is dependent on the historical price of the underlying market and where the option owner has the right to buy (or sell) the underlying instrument at its lowest (or highest) price over a preceding period.

40
Q

what is a barrier option and the different types (exotics)?

A

path-dependent option, pay-off depends on where the underlying asset has reached a predetermined price.

knock-on: activates or starts once the underlying asset has reached the predetermined price
knock out: opposite of knock-in, option ceases to exist if the underlying asset reaches the predetermined price

41
Q

what is a binary option (exotics)?

A

pays a fixed amount or nothing at all, depending on
the price of the underlying instrument at maturity or at stated times prior to maturity

42
Q

what is a chooser option (exotics)?

A

allows the option to the holder to decide whether they want to put or call at a predetermined time

43
Q

what is a compound option (exotics)?

A

option that gives the owner the right to purchase another option, with specific strike prices at pre-determined dates, during the option’s life (4 types based on an amalgamation of put and call)

44
Q

what is a rainbow option?

A

option on multiple underlying assets (eg, a group or basket of commodities, securities or currencies)

45
Q

what can an options diagram show when buying a call?

A

The potential for gain or loss, with profit or loss shown on the
Y-axis (vertical axis) and the price of the underlying at expiry on the X-axis (horizontal axis)

  • The maximum cost to the buyer is limited to the premium paid, which is paid regardless of the outcome at expiry.
  • A net profit will be made by the buyer if the profit on exercise exceeds the premium paid.
  • The break-even point is the strike price plus the premium.
  • The maximum potential profit for the buyer is unlimited as the long call option will become increasingly valuable to them as the share price rises above the exercise price
46
Q

what does an options diagram show when selling a call?

A

The potential for gain or loss, with profit or loss shown on the
Y-axis (vertical axis) and the price of the underlying at expiry on the X-axis (horizontal axis)

  • The maximum loss for the seller is potentially unlimited.
  • A net loss will be made by the seller if the loss on exercise exceeds the premium already received.
  • The seller’s break-even point is the strike price plus the premium.
  • The seller’s maximum potential profit is limited to the premium received.
47
Q

what does an options diagram show when buying a put?

A
  • The maximum loss to the buyer is limited to the premium paid.
  • A net profit will be made by the buyer if the profit on exercise exceeds the premium paid.
  • The break-even point is the strike price less the premium.
  • The buyer’s maximum potential profit will arise if the share price falls to zero, and is the strike price less the premium
48
Q

what does an options diagram show when selling a put?

A
  • The seller’s maximum profit is limited to the premium received.
  • A net loss will be made by the seller if the loss on exercise exceeds the premium received.
  • The seller’s break-even point is the strike price less the premium.
  • The seller’s maximum potential loss is the strike price less the premium, and will arise if the share price falls to zero.
49
Q

what does counterparty risk with options reflect?

A

that when an option is OUT (of the money) there is no risk it will be exercised as once the seller has received the premium, they don’t have any counterparty risk

50
Q

what is the counterparty risk to a buyer in an options trade?

A

they have counterparty risk as the seller will have to either buy the underlying asset if its a put or sell the underlying asset in a call option

51
Q

what are the profit/loss profiles for the party going long on a call option?

A
  • the person going long on the call is the buyer as they have the right but not the obligation to buy the underlying at a given price, their loss if the expiry price is lower than the strike price will be the premium that they paid to exercise that option and
  • profit if the expiry price is greater than the strike price will be the (expiry price (the price traded on the market at the close of the contract)- the strike price (the amount they can buy the underlying for))- the premium paid (to exercise that option)
52
Q

what are the profit/loss profiles for the party going short on a call option?

A
  • the person going short on a call option is the seller. their gain if the strike price is greater than the expiry price will be the premium as the buyer (long call) will not exercise the option.
  • and their loss if the expiry price is greater than the strike price will be the (strike-the expiry price)+ the premium. This is because the seller will be obligated to go and source the underlying at the market price which could be anything, they then take away from the price they paid to source the strike price which is what they receive from the buyer (long) and add the premium which they get to keep anyways.
53
Q

what are the profit/loss profiles for the party going long on a put option?

A
  • the person going long on a put will be the seller as they have the right but not the obligation to sell the underlying at a given price. their gain will be the (strike price-expiry price)-premium. this is because the strike price will be higher than the expiry price so they can sell the underlying at a higher price than what they have to pay to the market to purchase it and they lose the premium as that’s what they paid to exercise the option.
  • their loss will simply be the premium as that’s non-refundable (entitles you to the option) but they haven’t chosen to exercise it
54
Q

what are the profit/loss profiles for a party going short on a put option?

A
  • the person going short on a put option is the buyer of the underlying. their loss is the (expiry price- the strike price)+ the premium. This is because they receive payment for the underlying at the higher strike price and have to sell it to the market at the lower expiry price, they will however receive the premium as they are giving the long party the option to sell the underlying at the strike price.
  • the gain for the party going short on a put is the premium. this is because the expiry price will be greater than the strike price, so the seller will choose not to exercise the option and will sell to the market straight off the bat. they still receive the premium though
55
Q

what is the maximum profit/loss for the party that is going long on a call option?

A

buyer;
max profit: unlimited
max loss: limited to premium

56
Q

what is the maximum profit/loss for the party going long on a call option?

A

seller
max profit: limited to premium
max loss: unlimited

57
Q

what is the maximum profit/loss for the party going long on a put option?

A

buyer:
max profit: strike price minus premium
max loss: limited to premium

58
Q

what is the maximum profit/loss for the party going short on a put option?

A

seller:
max profit: limited to premium
max loss: strike price minus the premium

59
Q

what are FLEX options?

A

hybrid E-T products which also introduce OTC features, provide an exchange traded product which offers greater flexibility by mixing the strengths of those products with OTC options

60
Q

what can traders customise with FLEX options?

A

key contract terms e.g., price, exercise style and expiry date

61
Q

what are the two aspects of wholesale trading facilities?

A

Exchange for physical: swapping an OTC position for a futures position- must be similar in value/quantity

Exchange for swap: swapping of an OTC swap with a series of futures contracts- must have price correlation

62
Q

what are the benefits and risks of EFP transactions?

A
  • credit exposure reduced
  • reduced balance sheet and margin requirements
  • 24 hr trading
  • operational risk
63
Q

what is a warrant?

A

similar to an option as it gives the owner the right to buy an asset at a set price, often attached to or form part of a bond

64
Q

what is gearing?

A

the measure of the amount of cash or initial investment spent on establishing a position in a derivatives contract compared to the value of the underlying. the proportion of the change of the underlying compared to the initial investment

65
Q

how can gearing be explained in terms of options?

A

option premium is usually only a small fraction of the value of the asset, changes in the price of the underlying can produce disproportionate changes in the price of an option, smaller the premium the higher the potential gearing

66
Q

how can gearing be explained in terms of futures?

A

buyers or sellers only pay a small proportion of the market price of the underlying asset as initial margin, yet have the potential to gain or lose the full amount of any subsequent change in the price of the underlying asset.

67
Q

what are the three measures of liquidity?

A
  • immediacy
  • market depth
  • resilience
68
Q

what are the two ways derivatives contracts can be entered into?

A
  • through standardised contracts via an exchange
  • through negotiation away from an exchnage
69
Q

what is a swap?

A

an OTC derivative where two counterparties exchange the cashflows or liabilities from two different financial instruments e.g., loan or bond

70
Q

what is an interest rate swap?

A

where two counterparties exchange one stream of future interest payments against another, based on a specified principal over a set period.

71
Q

what are the different forms of interest rate swaps?

A
  • Fixed/floating
  • floating/floating
  • fixed/fixed
72
Q

how does payment work in a swap transaction?

A

at each payment date, a net payment is made based on the underlying interest rates and who has the higher rate

73
Q

what is a swaption?

A

an arrangement where a buyer pays an upfront sum for the right to enter into a swap agreement by a pre-agreed date in the future

74
Q

what is an inflation swap?

A

exchange of cashflows, calculated with reference to an inflation index, provides protection against rising prices

75
Q

what are zero coupon inflation products?

A

standard derivative product based on an inflation rate, underlying asset is a single price asset- only one financial flow at the end without any intermediate coupon

76
Q

what is a currency swap?

A

FX transaction that involves trading the principal and interest in one currency for the same in another currency for an agreed period of time- guarantees a predictable cash flow without having to worry about FX fluctuations

77
Q

what are the different exchanges between currencies that traders can enter into with a swap?

A

*fixed interest in one currency for floating interest in another currency
* fixed interest in one currency for fixed interest in another currency, or
* floating interest in one currency for floating interest in another currency.

78
Q

what are equity swaps?

A

swaps where the payments on one or both sides are linked to the performance of equities or an equity index - enable the creation of synthetic portfolio of shares without needing to buy all of the individual underlying shares, can gain the benefits of ownership without actually owning shares.

79
Q

what is an equity basket swap?

A

one or both of the underlying assets is a non-index basket of shares, always traded OTC

80
Q

what is an equity forward?

A

OTC contract between two parties to buy or sell an individual share/basket at a specified future time at a price agreed upon today

81
Q

what is a variance swap and how does it work?

A

allows investors to hedge or speculate on future price movements of an underlying asset, one sides payment will be linked to realised variance, over the swaps life and the other side will be a fixed amount which has been agreed

82
Q

what is a dividend swap?

A

allows one to swap fixed payments with dividend payments from a security/ basket of

83
Q

what is an asset swap?

A

swap that can be used to change the interest rate exposure or currency exposure of an investment, can create a fixed/floating interest rate for an asset that has been purchased (the underlying)

84
Q

what is a total return swap?

A

one leg will pay the total return on a particular financial asset, other leg will typically be a floating rate interest rate

85
Q

what is an MTM swap?

A

mark-to-market. one where settlements are calculated by revaluing the swap regularly and paying/receiving the MTM loss/gain since the previous settlement- essentially regularly closing the swap at its current value and settling based on that

86
Q

what is a commodity swap?

A

paying or receiving a cash flow that is determined by the price or returns of a specific commodity.

87
Q

what is a forward start swap?

A

one that is agreed today, but the exchange of funds takes place at a future date.

88
Q

what is a price taker?

A

market participant who either requests the price or deals via an intermediary on another participant’s price.

89
Q
A

FCA 2: Derivatives (9 decks)

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