L2 Financial markets - derivatives

Question 1

whats a forward contract

Answer 1

A forward contract is indeed an agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. This contrasts with a spot contract, where the asset is exchanged immediately.

In a forward contract, one party takes a long position (agrees to buy) while the other takes a short position (agrees to sell) the underlying asset at the specified future date and price. Forward contracts are commonly used by large banks for both spot and forward trading.

A forward-forward contract, on the other hand, involves a cash borrowing or deposit that begins on one forward date and ends on another forward date. This arrangement allows parties to fix the terms, amount, and interest rate in advance, thereby removing interest rate risk.

In your specific scenario, if you need to borrow for a 3-month period starting in 2 months’ time and anticipate that interest rates will rise, you could enter into a forward-forward contract. You would borrow for 5 months at a fixed rate of 5.4% and then deposit the entire borrowed amount for 2 months at a fixed rate of 5.6%.

Forward-forwards are commonly referred to by the beginning and end dates of the forward period. For example, “2x5”, “2/5”, “2v5”, or “two against five” all indicate that the forward period begins 2 months from the current date and ends 5 months from the current date.

Question 2

whats forward interest rates

Answer 2

A forward-forward contract, on the other hand, involves a cash borrowing or deposit that begins on one forward date and ends on another forward date. This arrangement allows parties to fix the terms, amount, and interest rate in advance, thereby removing interest rate risk.

In your specific scenario, if you need to borrow for a 3-month period starting in 2 months’ time and anticipate that interest rates will rise, you could enter into a forward-forward contract. You would borrow for 5 months at a fixed rate of 5.4% and then deposit the entire borrowed amount for 2 months at a fixed rate of 5.6%.

Forward-forwards are commonly referred to by the beginning and end dates of the forward period. For example, “2x5”, “2/5”, “2v5”, or “two against five” all indicate that the forward period begins 2 months from the current date and ends 5 months from the current date.

Question 3

more info on forward contracts

Answer 3

Certainly! Here are some additional key points about forward contracts:

1. Customization: Forward contracts are highly customizable, allowing parties to tailor the terms to their specific needs, including the underlying asset, contract size, expiration date, and price.
2. Private Agreements: Forward contracts are typically traded over-the-counter (OTC), meaning they are privately negotiated between two parties rather than on a centralized exchange. This allows for flexibility in contract terms and confidentiality.
3. Non-Standardized: Unlike futures contracts, which are standardized and traded on organized exchanges, forward contracts are non-standardized. Each forward contract is unique and negotiated directly between the parties involved.
4. Delivery vs. Settlement: In forward contracts, delivery of the underlying asset typically occurs at the end of the contract period. However, in many cases, parties choose to settle the contract financially rather than physically delivering the asset. This is known as cash settlement.
5. No Initial Payment: Unlike futures contracts, which require an initial margin payment, forward contracts typically do not require any upfront payment. Instead, payment and delivery of the asset occur at the expiration of the contract.
6. Counterparty Risk: One of the main risks associated with forward contracts is counterparty risk, which refers to the risk that one party may default on its obligations under the contract. To mitigate this risk, parties may require collateral or use credit derivatives such as credit default swaps.
7. Hedging: Forward contracts are commonly used for hedging purposes to manage or mitigate risks associated with price fluctuations in the underlying asset. For example, a farmer may enter into a forward contract to lock in the price of a crop before harvest to protect against price volatility.
8. Speculation: In addition to hedging, forward contracts can also be used for speculative purposes to profit from anticipated changes in the price of the underlying asset. Speculators may enter into forward contracts with the expectation that the future price will differ from the current price.

Overall, forward contracts are versatile financial instruments used for a variety of purposes, including risk management, speculation, and investment. They offer flexibility and customization but also carry risks, particularly related to counterparty default and price movements in the underlying asset.

Question 4

what are options

Answer 4

Absolutely, options are indeed versatile financial contracts offering the right, but not the obligation, to buy (call option) or sell (put option) a specified amount of an underlying asset at a predetermined price (strike price) on or before a specified date (expiration date).

Here’s a breakdown of the different types of interest rate options:

1. Floating Rate Options: These options give the holder the right to enter into a transaction involving a floating interest rate. The payoff of a floating rate option depends on the level of a reference rate, such as LIBOR (London Interbank Offered Rate), at the expiration date.
2. Fixed Rate Options: Fixed rate options provide the holder with the right to enter into a transaction involving a fixed interest rate. The payoff of a fixed rate option is determined by comparing the fixed rate specified in the option contract with the prevailing market interest rate at the expiration date.
3. Spread Options: Spread options involve the difference between two interest rates, such as the difference between two different fixed rates or the difference between a fixed rate and a floating rate. The payoff of a spread option is based on the spread between the two rates at the expiration date.

Options on interest rates and interest rate products, including government bonds, are actively traded in both over-the-counter (OTC) markets and on organized exchanges. Exchange-traded options are standardized contracts traded on regulated exchanges, offering liquidity and transparency. OTC options, on the other hand, are customized contracts negotiated directly between counterparties, offering flexibility but may entail counterparty risk.

Overall, interest rate options provide investors and institutions with valuable tools for managing interest rate risk, hedging exposure to fluctuations in interest rates, and speculating on future interest rate movements. They play a crucial role in the financial markets, offering opportunities for risk management and profit potential.

Question 5

what are option contracts

Answer 5

Your summary of option contracts is accurate. Here’s a breakdown of the key points:

1. Definition: An option contract provides the holder with the right, but not the obligation, to buy (call option) or sell (put option) an underlying security at a specified price (strike price) on or before a specified date (expiration date).
2. Premium: The buyer of an option pays a premium to the seller of the option for the right to exercise the option. The premium represents the cost of obtaining the option contract.
3. Call and Put Options: A call option gives the holder the right to buy the underlying security at the strike price, while a put option gives the holder the right to sell the underlying security at the strike price.
4. American vs. European Options: American options can be exercised at any time before or on the expiration date, while European options can only be exercised at the expiration date. Most exchange-traded options are American-style, while many OTC options are European-style.
5. Types of Options: Options can be used for various purposes beyond buying or selling stocks. For example:
   • Interest Rate Options: These options give the holder the right to borrow or lend funds at a specified rate of interest for an agreed period at a future date.
   • Currency Options: These options give the holder the right to buy or sell currencies at agreed exchange rates at future dates, providing a tool for managing currency risk in international transactions.

Overall, options are versatile financial instruments that offer investors flexibility in managing risk, hedging against price fluctuations, and speculating on market movements. They are widely used in financial markets by investors, traders, and institutions for a variety of purposes.

Question 6

Option contracts: payoff profiles

Answer 6

payoff profiles Most common options have shares as underlying assets
Consider a call option

Scenario 1: If at the expiration date the Barclays stock sells at £55, the option holder can exercise the option to buy it for £50 and then sell it in the spot market for £55, making a profit of (£55 - £50 - £2) = £3.

Scenario 2: If at the expiration date the Barclays stock sells at £45 or below, the option holder would not exercise the option, as it would be more economical to buy the stock directly from the market rather than exercising the option at the higher strike price.

Question 7

Option contracts: payoff profiles

Answer 7

Put Option:

Scenario 1: If at the expiration date the Barclays stock sells at £30 or below, the option holder can exercise the option to sell it for £50 and then buy it in the spot market at £30, making a profit of (£50 - £30 - £2) = £18.

Scenario 2: If at the expiration date the Barclays stock sells at or above £50, the option holder would not exercise the option, as it would be more economical to sell the stock directly in the market rather than exercising the option at the lower strike price.

These examples illustrate how call options provide the right to buy the underlying asset at the strike price, while put options provide the right to sell the underlying asset at the strike price. Option holders benefit from favorable price movements in the underlying asset, while they may choose not to exercise the option if the market price is unfavorable.

Question 8

currency option

Answer 8

Your summary of currency options is accurate. Here’s a breakdown of the key points:

1. Definition: Currency options are financial derivatives that give the holder the right, but not the obligation, to buy (call option) or sell (put option) a specific amount of one currency in exchange for another currency at a predetermined exchange rate (strike price) on or before the expiration date.
2. Call and Put Options: Every currency option can be viewed as both a call option and a put option. A call option gives the holder the right to buy the base currency (e.g., EUR) and sell the quote currency (e.g., USD) at the strike price. Conversely, a put option gives the holder the right to sell the base currency and buy the quote currency at the strike price.
3. EUR Call/USD Put Option: In the case of a EUR call/USD put option, the holder has the right to buy a specified amount of euros in exchange for US dollars at the strike price. Alternatively, it can be seen as the right to sell US dollars for euros at the strike price.
4. Settlement: Currency options are typically settled in the underlying currency pair. This means that if the option is exercised, the holder will receive or deliver the specified amount of currency at the agreed-upon exchange rate.
5. Flexibility and Risk Management: Currency options provide flexibility to market participants in managing currency risk. They can be used to hedge against adverse movements in exchange rates or to speculate on future currency movements.

Overall, currency options are valuable instruments in the foreign exchange market, providing participants with opportunities to hedge exposure to currency fluctuations and to capitalize on market opportunities. They offer flexibility and versatility in managing currency risk and are widely used by corporations, financial institutions, and investors.