L9 - Derivatives

Question 1

What are derivatives?

Answer 1

• A derivative instrument is an asset whose performanceis based on the behaviour of the value of an underlying asset ( just referred to as the underlying)
• It is the legal right that becomes an asset, with its own value, and it is the right that is purchased orsold
• If employed properly they can be remarkably effective at limiting risk

Question 2

What is an option?

Answer 2

An option is a contract giving one party the right, but not the obligation, to buy or sell a financial instrument, commodity or some other underlying asset at a given price, at or before a specified date

• the seller of the option who recieves the premium is referred to as the writer

Question 3

What are share options?

Answer 3

gives the purchaser a right but not the obligation to buy a fixed number of shares at a specified price at some time in the future

Question 4

what are american-style options?

Answer 4

An American option is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration

Question 5

What are European-Style options?

Answer 5

A European option is a version of an options contract that limits execution to its expiration date. In other words, if the underlying security such as a stock has moved in price an investor would not be able to exercise the option early and take delivery of or sell the shares. Instead, the call or put action will only take place on the date of option maturity.

• On ICE Futures Europe, one option contract relates to a quantity of 1000 shares

Question 6

What is the difference between call and put options?

Answer 6

A Call Option gives the buyer the right, but not the obligation to buy the underlying security at the exercise price, at or within a specified time.

A Put Option gives the buyer the right, but not the obligation to sell the underlying security at the exercise price, at or within a specified time.

Question 7

Why does premium increase when buying an option later in the future?

Answer 7

• Time value arises because of the potential for the market price of the underlying to change in a way that creates intrinsic value.
• The intrinsic value of an option is the pay-off that would be received if the underlying were at its current level when the optionexpires

Question 8

What is the exercise price?

Answer 8

The exercise price is the price at which an underlying security can be purchased or sold when trading a call or put option, respectively. The exercise price is the same as the strike price of an option, which is known when an investor takes a trade. An option gets its value from the difference between the fixed exercise price and the market price of the underlying security.

Question 9

What are In-the-money options?

Answer 9

In the money (ITM) is a term that refers to an option that possesses intrinsic value. ITM thus indicates that an option has value in a strike price that is favorable in comparison to the prevailing market price of the underlying asset:

• An in the money call option means the option holder has the opportunity to buy the security below its current market price.
• An in the money put option means the option holder can sell the security above its current market price.

An option that is ITM does not necessarily mean the trader is making a profit on the trade. The expense of buying the option and any commission fees must also be considered.

Question 10

What is an Out-of-the-money option?

Answer 10

Out of the money (OTM) is a term used to describe an option contract that only contains intrinsic value. These options will have a delta less than 50.0.

An OTM call option will have a strike price that is higher than the market price of the underlying asset. Alternatively an OTM put option has a strike price that is lower than the market price of the underlying asset.

Question 11

What is an At-the-money option?

Answer 11

At the money (ATM) is a situation where an option’s strike price is identical to the price of the underlying security. Both call and put options can be simultaneously ATM. For example, if XYZ stock is trading at $75, then the XYZ 75 call option is at the money and so is the XYZ 75 put option. An ATM option has no intrinsic value, but it may still have time value prior to expiration. Options trading activity tends to be high when options are ATM.

Question 12

Where would the break even point be on a call option?

Answer 12

• at the strike price + the premium cost

Question 13

What does the call option look like for the writer?

Answer 13

You want the price of the shares to stay constant or fall, as you keep the premium

Question 14

What is a covered and uncovered call option?

Answer 14

A naked call is an options strategy in which an investor writes (sells) call options on the open market without owning the underlying security. This stands in contrast to a covered call strategy, where the investor owns the underlying security on which the call options are written. This strategy is sometimes referred to as an “uncovered call” or a “short call.”ncovered call option?

Question 15

What is a put option?

Answer 15

A put option gives the holder the right, but not the obligation, to sell a specific quantity of shares on or before a specified date at afixed exerciseprice.

Question 16

What does a put option look like for the buyer?

Answer 16

• there is a cap on profits cause a company share price can only really go to zero

Question 17

What does a put option look like for the writer?

Answer 17

Question 18

How are share options used for hedging?

Answer 18

-Options can give protection against unfavourable movements in the underlying while permitting the possibility of benefiting from favourable movements

Question 19

What are forwards?

Answer 19

• A forward contract is an agreement between two partiesto undertake an exchange at an agreed future date at a price agreed now

• Forward contracts are tailor-made
• ‘Over-the-counter instruments’
• Risk of default
• Difficult to cancel

Question 20

What are Futures?

Answer 20

• Futures contracts are agreements between two parties to undertake a transaction at an agreed price on a specified future date

• Exchange-based instruments
• The exchange provides standardised legal agreements traded in highly liquid markets
• Clearing house becomes the formal counterparty to every transaction
• With futures you are committed and are unable to back away
• have margin accounts where money if moved between the buyer and seller when there is only small changes in the price in which the transaction of the good would be pointless –> but if the price flutuates to more thats in either margin account, there will be a margin call and you will have to top the account up

Question 21

What is the role of a clearing house in futures?

Answer 21

• the clearing house operates a margining system
• Initial margin: likely to be in the region of 0.1 per centto 15 per cent of the value of the underlying –> depends on the volatility of the underlying
• Daily marketing to market - exchange of funds between buyers and sellers margin accounts based on current market prices
• Mainenance margin - A maintenance margin is the minimum amount of equity that must be maintained in a margin account. –> 70/80% of intial margin
• Variation margin -Variation Margin, also known as Mark To Market Margin, is additional amount of cash you are required to deposit to your futures trading account after your futures position have taken sufficient losses to bring it below the “Maintenance Margin”. (credit and debits on the margin account)
• the price of the future will be equal to the price of the underlying on the day of settlement

Question 22

How do you close a futures position?

Answer 22

To close or cancel out a futures contract position, a trader simply enters the opposite type of trade and the contract will be removed from the trader’s account. For example, if a trader is long on a contract, a sell order will close the trade and the trader will no longer have a position in the contract.

Question 23

What do you need to do to the settlement price when finding the value of a equity index future?

Answer 23

multiply by £10

Question 24

What are short-term interest rate futures?

Answer 24

• An interest rate future is a futures contract with an underlying instrument that pays interest. An interest rate future is a contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset.
• The interest rate future allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.
• Notional fixed-term deposits usually for three month periods starting at a specific time in the future
• The buyer of one contract is buting the right to deposit money at a particular rate of interest for three months
• Unit of trading for a three-month sterling time deposit is £500,000
• Cash delivery by closing out the future position is the means of settlement
• Short-term interest contracts are quoted on an index basis rather than on the basis of the interest rate itself
  
  • the price is defined as P=100-i
    
    • where P = price index
    • i - the future interest rate in percentage terms

Question 25

What are the advantages of Options?

Answer 25

• Downside risk is limited but the buyer is able to participate in favourable movements in the underlying
• Avaiable on or off exchanges.
• Exchange regulation and clearing house reduce counterparty default risk for thsoe options traded on exchanges
• For many options there are highly liquid market resulting in keen option rpemium pricing and ability to revser a position quickly at low cost
• for others trading is thin and so premium payables may become distorted and oddsetting transaction costly and difficult

Question 26

What are the disadvantages of Options?

Answer 26

• Premium payable reduces returns when market movements are advantagous
• Margin required when writing options

Question 27

What are the advantages of Futures?

Answer 27

• Can create certainty: specific rates are locked in
• Exchange trading only
• Exchange regulation and clearing house reduce counterparty default risk
• No premium is payable (However margin payments are required)
• Very liquid markets, Able to reverse transacitons quickly and cheaply

Question 28

What are the disadvantages of futures?

Answer 28

• No right to let the contract lapse. Benefits from favourable movements in underlying are foregone
• IN a hedge position if the underlying transaction does not materialise the fduture posiution power can experience a switch from a covered to an uncovered position: the potential loss is unlimited
• Many exchange restrictions - on size of contrtact, duration(e.g. certain months of the year), trading times (e.g. ICE Futures Europe is open)
• Margin calls require faily work for ‘back office’

Question 29

What are the advantages of Forwards and FRAs?

Answer 29

• Can create certianty: specific rates are locked in
• Tailor-made, off exchange, not standardised as to size, duration and terms, Good for companies with non-standard risk exposures
• No margin or premium payables (Occasionally a good faith performance margin is required by one or more parties in a forward (also credit limits may be imposed)

Question 30

What are the disadvantages of Forwards and FRAs?

Answer 30

• No right to let the contract lapse, Benefit from favouravle movements in underlying are forgone
• In a hedge position if the underlying transaction does not materialisethe forward/FRA position owners can experience a switch from covered to an uncovered position: potential for loss is unlimited
• Greater risk of counterparty default - not exchanged traded therefore counterparty is not the clearing house
• However this may change for many OTC derivatives as they move to exchanges
• Generally the minimum contract size is for millions rather than few thousands (as on the futures or option markets)
• More difficult to liquidate position (than with exchange-traded instruments) by creating an offsetting transactions that cancel positions