Lecture 8

Question 1

What is a derivative?

Answer 1

An instrument whose value is linked to / derived from something else

Question 2

What are derivatives used for?

Answer 2

Hedging & speculation

Question 3

What is hedging?

Answer 3

Reducing existing exposures

Question 4

What is speculation?

Answer 4

Taking on new exposures

Question 5

What are major types of derivates?

Answer 5

• Forwards / futures
• Options
• Swaps

Question 6

What is a spot contract?

Answer 6

Immediate delivery, immediate payment

Question 7

What is a forward contract?

Answer 7

Exchange given asset for given price at given date

Question 8

What is a futures contract?

Answer 8

Like a forward, but standardised, with liquid secondary market

Question 9

What does FRA stand for?

Answer 9

Forward Rate Agreement

Question 10

How does a FRA work?

Answer 10

Fixes the interest rate on a loan to be made in the future

Question 11

How does a margin call work?

Answer 11

Exchange calls losing side on futures contract & demands margin in excess of losses

Question 12

What is a margin call for?

Answer 12

Limits default risk on futures contracts

Question 13

What is a key difference between forwards & futures?

Answer 13

Futures are settled daily, forwards are settled at end of contract

Question 14

Is a call option holder long or short?

Answer 14

Long

Question 15

Is a put option holder long or short?

Answer 15

Short

Question 16

What is the cost of buying an option called?

Answer 16

The premium

Question 17

What can make options more valuable?

Answer 17

Underlying asset with high volatility

Question 18

What is one way of valuing standard options?

Answer 18

Black-Scholes option pricing model

Question 19

What is a swap?

Answer 19

Agreement to exchange a series of cash flows in the future

Question 20

Swaps can be thought of as…

Answer 20

A series of individual forward agreements

Question 21

How are swaps generally used?

Answer 21

Hedging interest rate / foreign exchange exposure

Question 22

What do derivatives achieve?

Answer 22

• Cheap & efficient hedging / speculation
• Take very specific exposures

Question 23

What is the danger of derivatives?

Answer 23

Huge exposures with little cash up front

Question 24

What is ‘reading the markets’?

Answer 24

Inferring people’s expectations from prices

Question 25

When are call options ‘in the money’?

Answer 25

When the current price > the strike price

Question 26

When are call options ‘out of the money’?

Answer 26

When the current price < the strike price