Lecture 1: Review Session

Question 1

Derivatives derive its value ( “are written on”) an [..].

Common underlying assets: [.], bonds, precious metals, [.], commodities, indexes & even [.].

3 purposes of derivatives: [., ., .]

3 basic types of derivative contracts: [./. , . , .]

Answer 1

Derivatives derive its value ( “are written on”) an UNDERLYING ASSET.
Common underlying assets: SHARES, bonds, precious metals, CURRENCY, commodities, indexes & even DERIVATIVES themselves.

3 purposes of derivatives: HEDGING, SPECULATION& ARBITRAGE.

3 basic types of derivative contracts: FORWARD/FUTURE, OPTIONS, SWAPS.

Question 2

Prime purpose of derivatives: [.] (i.e. Risk reduction):
- traditionally unsystematic risks are reduced by diversification.
However, because underlying assets are normally [.] correlated or at best [.] correlated, some unsystematic risks can’t be removed by diversification.
–> Derivatives help investors to introduce [.] correlations & reduce [.] risks.

Answer 2

Prime purpose of derivatives: HEDGING:
i.e. Risk reduction
- traditionally unsystematic risks are reduced by diversification.
However, because underlying assets are normally POSITIVELY correlated or at best ZERO correlated, some unsystematic risks can’t be removed by diversification.
–> Derivatives help investors to introduce NEGATIVE correlations & reduce more risks.

Question 3

Second purpose of derivatives: [.]:
- taking [.]:
[.] markets are attractive to speculators because they require at most a small upfront payment –> provide investors with [.] –> magnify [.].
- [.] positions:
[.] markets allow investors to take a short position easily.
e.g. instead of going short on all 500 stocks of S&P 500, investors can easily take a short position in S&P 500 Futures contract.

Answer 3

Second purpose of derivatives: SPECULATION:
- taking RISKs:
FUTURES markets are attractive to speculators because they require at most a small upfront payment –> provide investors with LEVERAGE–> magnify RETURNS.
- SHORT positions:
Futures markets allow investors to take a short position easily.
e.g. instead of going short on all 500 stocks of S&P 500, investors can easily take a short position in S&P 500 Futures contract.

Question 4

3rd purpose of derivatives: [.] (free money)
–> [.] profit & help [.] securities:
2 assets same return –> [.] priced.
If not, arbitragers trade on the basis of [.] until market price returns to [.] .
- No arbitrage pricing relationship:
e.g. F = Se^(r-q)T

Answer 4

3rd purpose of derivatives: ARBITRAGE (free money)
–> RISKLESS profit & help PRICE securities:
2 assets same return –> EQUALLY priced.
If not, arbitragers trade on the basis of MISPRICING until market price returns to EQUILIBRIUM.
- No arbitrage pricing relationship:
e.g. F = Se^(r-q)T

Question 5

Forward vs Future contract:
- Similarity: both are an [.] to buy/sell sth
- Differences: 
Customised / [.] 
[...] market / Exchange traded
[.] settled/ [...]
No counterparty/ [..]

Answer 5

FORWARD vs FUTURE contract:
- Similarity: both are an OBLIGATION to buy/sell sth
- Differences:
Customised / Standardised
Over-the-counter market / Exchange traded
Maturity settled/ Marked to market
No counterparty/ Clearing house

Question 6

Options: [.] but not obligation to buy ( [.] ) or sell ( [.] ) an underlying asset for an agreed ([.] or [.]) price at some point (exercise date) in the future ([.] style) or up to & including the exercise date ([.] style).

Answer 6

OPTIONS:
RIGHT but not obligation to buy (CALL) or sell (PUT) an underlying asset for an agreed (STRIKE or EXERCISE) price at some point (exercise date) in the future (EUROPEAN style) or up to & including the exercise date (AMERICAN style).

Question 7

SWAPS:

• facilitate an exchange of [.] (e.g. interests, foreign currency)
• Most simple type: [.] for [.] plain vanilla interest rate swap.
• [.] swap: [..]: allow both parties to benefit from cheaper funding & changes in risk exposure.
• [..] swaps: popular to protect against default risks.

Answer 7

SWAPS:

• facilitate an exchange of CASHFLOWS (e.g. interests, foreign currency)
• Most simple type: fixed for floating plain vanilla interest rate swap.
• Currency swap: mutually beneficial: allow both parties to benefit from cheaper funding & changes in risk exposure.
• Credit default swaps: popular to protect against default risks.

Question 8

Draw Options Diagram:

1. Call Options
2. Put Options

Answer 8

https://optionposts.com/option-profit-loss-diagrams/

or my notes

Question 9

Illustrate a fixed for floating plain vanilla swap

Answer 9

http://jkowens.com/Main/PCBS-17/Day%20Three/InterestRateSwaps.pdf
or my notes