Lecture 2 Part 1: The Markets and Derivatives

Question 1

Trading can occur via organized exchanges or over-the-counter (OTC). Which of the following statement(s) are TRUE about exchanges? (Select 1-5)

A) Assets traded are standardized and regulated
B) Markets and information are transparent (bid and ask prices of assets are available)
C) Clearing houses clear all trades, implying virtually no credit risk
D) Trades are partly cleared by clearing houses, whilst others are not
E) Enables high degree of freedom to set up trade arrangements

Answer 1

A) Assets traded are standardized and regulated
B) Markets and information are transparent (bid and ask prices of assets are available)
C) Clearing houses clear all trades, implying virtually no credit risk

Question 2

Trading can occur via organized exchanges or over-the-counter (OTC). Which of the following statement(s) are TRUE about OTC? (Select 1-5)
A) OTC trading takes place between a network of dealers of financial institutions or fund managers trading directly with each other
B) Trades are less standardized and less regulated than organized exchange trades
C) Lower transparency than organized exchange trades
D) Some trades are cleared through clearing-houses, which reduces credit risk, but some credit risk remains (in particular those trades not cleared by clearing houses)

Answer 2

All options are true

Question 3

Organized exchanges organize trades such that contract defaults are avoided. This is where clearing houses and margins come into play. Which statements are true about clearing houses? (Select 1-4)
A) Clearing houses stand between the traders
B) Clearing houses require traders with potential future liabilities from a trade to post margin
C) Clearing house members contribute to a guarantee fund
D) The margin requirement and the guaranty fund means that traders are subject to virtually no credit risk

Answer 3

All options are true

Question 4

Clearing houses require traders with potential future liabilities from a trade to post margin. Which of the following statements are true about margins? Select (1-3)
A) The margin helps guarantee future payments from the liable trader
B) When a position suffers a loss, a margin call takes place
C) A margin call is an order from a broker to an investor, that demands that the investor place more money into their margin account
D) If margin calls are not met, the trader’s position is closed out

Answer 4

All options are true

Question 5

Which are the tree types of margins?

Answer 5

Initial margin
Maintenance margin
Variation margin

Question 6

Initial margin: The margin that has to be posted at the time of the trade, giving us the initial margin reserve. It is typically ~50% of the total value of the investment

TRUE/ FALSE

Answer 6

TRUE

Question 7

Maintenance margin is the lower limit on margin reserve amount, which is typically ~25%-40% of the total value of the asset.

E.g., if the value of the position drops to an extent where the margin reserve gets below a certain limit (maintenance margin), a margin call is issued

TRUE/ FALSE

Answer 7

TRUE

Question 8

Variation margin is the additional margin required if the market has moved against the trader, and he is not fulfilling his maintenance margin. I.e., the amount to be added to the margin account is the variation margin

TRUE/ FALSE

Answer 8

TRUE

Question 9

Margins can be either in the form of cash or liquid securities with haircut. Which is most common?

Answer 9

Cash margins are most common, with interest paid by the investor

Question 10

Margins can take form of liquid securities with haircut. What does haircut mean?

Answer 10

A haircut is a percentage by which the market value of a security is REDUCED

Example: treasury bills may be marginable at 90% of their market value, which implies a haircut of 10%. Meanwhile, stocks (higher risk) may be marginable at 70% of market value, implying a haircut of 30%

Question 11

When buying on margin (or in the event of short-selling), the margin is the amount the investor contributes (equity), whereas the remainder is borrowed from a broker.

TRUE/ FALSE

Answer 11

TRUE

Question 12

Buying on margin means:

A) You borrow money from your broker to buy financial assets
B) You are gearing or leveraging up
C) You invest for more than you can directly afford

Select all correct options

Answer 12

All options are correct

Question 13

If the return on the stock exceeds the interest paid for the loan, then, the investor makes an overall HIGHER /LOWER return if buying on a margin compared to only investing equity capital with no debt.

Answer 13

HIGHER

Question 14

The percentage margin is calculated as?

Answer 14

Percentage margin = own investment / total value of position = E/V

Question 15

Leverage magnifies the potential positive returns, but simultaneously also imply a larger loss in the event of a negative stock return (the investor risks losing more than 100% of the investment due to debt).

TRUE/ FALSE

Answer 15

TRUE

Question 16

Margins are often used in short-sales, where the initial margin is typically 200%

TRUE/ FALSE

Answer 16

FALSE –> The typical initial margin requirement in short sale is 150%

Question 17

Margins are often used in short-sales, where the maintenance margin is typically 50%

TRUE/ FALSE

Answer 17

FALSE –> The typical maintenance margin requirement in short sale is 125%

Question 18

Most trading of derivatives take place on ______

A) On the OTC market
B) Through organized exchanges

Answer 18

Most trading of derivatives take place on the OTC-market, and trades occurring here are typically significantly larger than those taking place through an exchange.

Question 19

Which of the following statement is not true about a forward contract?
A) It is customized and traded OTC
B) It is a binding agreement to buy or sell an asset at a pre-determined price at a certain future point in time
C) It is standardized and traded on organized exchanges
D) Popular forward contracts concern currencies and interest rates

Answer 19

C) It is standardized and traded on organized exchanges
This is a futures contract

Question 20

If you hold a LONG position on a forward contract, given that the market price on the underlying asset is ABOVE the delivery price, the payoff is _____
positive/ negative?

Answer 20

If you hold a LONG position on a forward contract, given that the market price on the underlying asset is ABOVE the delivery price, the payoff is POSITIVE.

Note, you earn money if you are allowed to buy the underlying asset at a lower price than the market price

Question 21

If you hold a SHORT position on a forward contract, given that the market price on the underlying asset is ABOVE the delivery price, the payoff is _____
positive/ negative?

Answer 21

If you hold a SHORT position on a forward contract, given that the market price on the underlying asset is ABOVE the delivery price, the payoff is NEGATIVE

Note, you have agreed to sell the asset at a pre-determined price. I.e., if the market price is ABOVE the delivery price, you need to pay more than the market price for the asset –> NEGATIVE payoff

Question 22

Define forward price (F)

Answer 22

The forward price (F) is defined as the delivery price (K) which makes the value of the forward contract equal to zero today.

Question 23

The value of the forward contract (NOT FORWARD PRICE) is equal to the PV of the difference between the forward price and the delivery price

TRUE/ FALSE

Answer 23

TRUE

Question 24

Forwards are traded _____ while futures are traded _____.
Fill in the blanks

A) On exchanges
B) OTC

Answer 24

Forwards are traded OTC while futures are traded on exchanges

Question 25

Which of the following statements are NOT true about futures contracts?

A) they are standardized contracts: quality, quantity, and delivery are standardized
B) contracts are settled daily by the clearing central
C) to buy a futures contract, the investor must have a margin account at his broker, needed for the daily settlement to take place
D) it is more difficult to get out of a futures agreement than a forward
E) most futures are closed out before maturity by entering the opposite contract –> no delivery actually takes place

Answer 25

D) It is more difficult to get out of a futures agreement than a forward

ANSWER: One can easily get out of a futures agreement, relative to a forward, where one party of a forward cannot be sure that there is demand for the contract in the OTC-market. This implies that it is not necessarily easy to get out of a forward

Question 26

A swap is an agreement to exchange two well-defined (with respect to time and amounts) cash flows. Swaps are traded/ agreed upon in the OTC-markets.

TRUE/ FALSE

Answer 26

TRUE

Question 27

Which of the following is NOT a type of swap?

A) Plain vanilla interest rate swap
B) Currency swap
C) Commodity swap
D) Risk swap
E) Volatility swap
F) Equity swap

Answer 27

D) Risk swap

Question 28

The exchange of a cash flow based on a predetermined fixed interest rate with a cash flow based on a given floating interest rate is termed _______ swap

Answer 28

Plain vanilla interest rate swap

Question 29

Exchange a cash flow in one currency with a cash flow in another currency is a _____ swap

Answer 29

Currency swap

Question 30

What happens to the value of the options (put and call) if the stock volatility increases? Select 1-4
A) The put value will increase
B) The put value will decrease
C) The call value will increase
D) The call value will decrease

Answer 30

A) The put value will increase
C) The call value will increase

If the stock volatility increase (σ), both the price of the put and call will increase. This is due to the fact a higher volatility implies a higher risk that the stock will either perform very poorly or well due to the higher fluctuation.
In essence, flexibility becomes more valuable when risk increases.

Question 31

What happens to the value of the options (put and call) if the time to maturity increases? Select 1-4
A) The put value will increase
B) The put value will decrease
C) The call value will increase
D) The call value will decrease

Answer 31

A) The put value will increase
C) The call value will increase

The longer the period until maturity, the higher the risk of fluctuation in the price of underlying, increasing risk (sigma). Again, the value of flexibility increases.

Question 32

Which of the following factors increase the value of a call option? (EU=American)?

A) current stock price increase
B) exercise price increase
C) time to maturity increase
D) volatility increase
E) risk-free rate increase
F) amount of future dividends increase

Answer 32

A) current stock price increase
C) time to maturity increase
D) volatility increase
E) risk-free rate increase

The following factors affect the call value negatively:
B) exercise price increase
F) amount of future dividends increase

Question 33

Which of the following factors increase the value of a put option? (EU=American)?

A) current stock price increase
B) exercise price increase
C) time to maturity increase
D) volatility increase
E) risk-free rate increase
F) amount of future dividends increase

Answer 33

B) exercise price increase
C) time to maturity increase
D) volatility increase
F) amount of future dividends increase

The following factors affect the put value negatively:
A) current stock price increase
E) risk-free rate increase

Question 34

What can financial instruments be used for?
Hint: 3 activities

Answer 34

• Hedging: reducing risk
• Speculation: taking risk by betting on given outcome
• Arbitrage: attempting to lock in a profit by simultaneously trading in two or more markets