Lecture 16 - Derivatives: Optios Fututres And Swaps

Question 1

Derivatives markets

Answer 1

Financial derivatives can be defined as instruments whose price is derived from some underlying security
The price of the derivative is linked to the price of the underlying asset and Arbitrage maintains this link

Question 2

Main uses of derivatives

Answer 2

Hedging - purchase of financial instrument in order to ensure against a possible reduction in wealth caused by unforeseen economic fluctuations or to the process of transferring the risk to a party who is less risk averse than the ledger
Speculation implies profiting from any intervening price changes
Arbitrage takes advantage of price or yield differentials in different markets in a riskless transaction
Criticism: blamed for an increase in complexity and risk in financial markets

Question 3

A variety of derivatives exists

Answer 3

Options 
Financial future 
Swaps 
Forward contracts 
Credit default swaps 
Contracts for difference

Question 4

Derivatives on many underlying instruments

Answer 4

Stocks 
Bonds 
Currencies 
Market index 
Commodities 
Interest rates

Question 5

Trading derivatives

Answer 5

Instruments: financial futures and traded options
Pros and con:
- liquidity, competition and good price, implicit protection against default through the clearing house, standardised products = lack of flexibility

Question 6

OTC derivatives

Answer 6

Instruments bought directly from a banks or other financial institutions
Instruments: swaps, forward contracts and OTC options
Pros and cons
Flexibility, lack of liquidity and competition and risk of counterparty default

Question 7

Clearing house

Answer 7

Derivative exchanges provide a clearing service which acts as a central counterpart for all trades
Initial/original margin - a clearing house requires both parties to deposit cash against the transaction
The each contract is marked to market daily to take into account movements in the price underlying security
Variation and maintenance margin is the difference between mark to market price and the purchase price

Question 8

If the mark to market price < the purchase price

Answer 8

A holder of a future has to top up the margin account to the level it was before

Question 9

If the mark to market price > the purchase price

Answer 9

The margin account will be credited

Question 10

Options

Answer 10

Confer the right, but not the obligation to the purchaser to buy a call option or the right to sell an underlying instrument at a standard price and at a specified time in the future

Question 11

Traded options

Answer 11

Can be bought from and sold to parties other than original writer of the option, this is not possible for the OTC options
Over the counter options

Question 12

A financial contract

Answer 12

An agreement to sell or buy a quantity of a financial security on an organised market or exchange at a fixed future date and at a pprice specified at the time of making a contract
Security = bond, bill, currency or stock

Question 13

Swap

Answer 13

An exchange of financial instruments between two parties

Question 14

Traded options

Answer 14

Standardised exchange-traded options that grant the buyer the right, but not the obligation to buy or sell financial instruments at standard prices and dates in the future

Question 15

Exercise/strike price

Answer 15

The price at which an option holder has the right to sell or buy an underlying security

Question 16

Option writer

Answer 16

The person who sells a call or put option

Question 17

Option premium

Answer 17

A fee that is paid by an option holder to the option writer in return for the right to buy or sell an underlying security at a given exercise price

Question 18

Call options

Answer 18

Bought when one wishes to gain from an increase in price later. Buying a call option - long call; selling a call option - short call

Question 19

Put option

Answer 19

Bought when one wishes to gain from a fall in price later.

Buying a put option-long put and selling a put option - short put

Question 20

American options

Answer 20

Exercised at any time prior to the expiring date

Question 21

European options

Answer 21

Only exercised at expiration date

Question 22

Forward contract

Answer 22

Agreement between two parties to buy and sell an underlying asset for actual delivery at an agreed price at some time in the future
OTC instruments
Usually at least $5m
Currencies over fifth
Profit or loss realised at maturity
Contract is completed by actual delivery of the underlying asset

Question 23

A future contract

Answer 23

A standardised notional agreement to buy or sell a given quantity of an underlying product by a given date in the future at a price agreed now
Exchange traded derivatives
Contract usually 50-100k
Currencies only major
Profit or loss can be realised prior to maturity

Question 24

Futures vs options

Answer 24

Future market enable traders to take speculative positions
Enable traders to take short positions, that is sell something they don’t own
Futures contract types: bonds, interest rates and currencies

Options 
Not a commitment 
No premium to pay
Futures gives the user protection from an adverse price movement but they cannot benefit from a favourable movement 
Risk is unlimited

Question 25

Interest rate swaps

Answer 25

A contract to exchange fixed payments for floating payments linked to an interest rate, and is generally used to manage exposure to fluctuations in interest rates
Over the counter derivatives

Elements in the swap
Fixed rate 
Variable rate 
Settlement period 
Total maturity 
Underlying national principal

Question 26

Banks hedging strategies in swaps

Answer 26

Bank may not have interest rate risk, but does have counterparts risk
In providing a market in swaps, banks are exposed to risk until they find someone who wants to do a swap in the opposite directions

Question 27

Hedging strategies in the risk events

Answer 27

A fall interest rate as it has lent floating and borrowed fixed
A rise in interest rate because it has borrowed floating and lent fixed

Question 28

Misuse of derivatives

Answer 28

Can create leverage and give rise to contingent liabilities

The pricing and nature of some derivatives is complex

There have been some spectacular trading derivative disasters