LM 2: Forward Commitment & Contingent Claim Features & Investments

Question 1

What does zero sum game mean?

Answer 1

gain of one is equal to the loss of another party, combined they equal 0.

Question 2

What is a forward contract?

Answer 2

agreement to a make a trade at future date

Question 3

What is the formula for ending value of profit for the long party?

Answer 3

sT - f0 (T)

spot price - forward price

Question 4

What is the formula for ending value of profit for the short party?

Answer 4

f0 (T) - sT

forward price - spot price

Question 5

What is spot price?

Answer 5

the current market value of an asset

Question 6

What is the difference between forward contract and future contract?

Answer 6

forward contract is a private and customizable agreement that settles at the end of the agreement and is traded over the counter (OTC)

futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.

Question 7

What is counterparty risk?

Answer 7

risk that other party will not fulfill their obligation

Question 8

What is the initial margin?

Answer 8

the initial deposit you must make per contract.

Question 9

What is maintenance margin?

Answer 9

the lowest amount of value a contract can fall too before you’re required to deposit more.

Question 10

What is the variance margin?

Answer 10

difference between the maintenance margin and initial margin

aka the amount required to bring an account back up to the initial margin

Question 11

What is margin call and purpose?

Answer 11

request from exchange to deposit additional funds

purpose to ensure each party can always cover future potential losses

Question 12

If a party gets a margin call how much money do they need to deposit?

Answer 12

enough to match the initial margin not just the maintenance margin

Question 13

What is price limit for derivatives?

Answer 13

maximum range that future contract is allowed to move up or down within a single day

Question 14

What is circuit breakers?

Answer 14

trigger a pause in trading if the price moves out of the price limit

Question 15

What position do long stock holders take to close position?

Answer 15

short stock position

Question 16

What is open interest?

Answer 16

number of outstanding contracts

Question 17

What is a swap?

Answer 17

two parties exchange a series of cash flows, one with a floating rate and one with a fixed rate. fixed rate party benefits when rates rise above their fixed rate, and floating rate party benefits when floating rate drops below fixed rate since they get the difference

Question 18

What is marked to market?

Answer 18

method of measuring the fair value of an asset at the end of the day, which allows traders to realize gains or losses.

Question 19

What are the 3 types of forward commitments?

Answer 19

1. OTC forward contracts
2. OTC swaps
3. exchange traded futures contract

Question 20

What is the difference between call option and put option?

Answer 20

call option grants right to buy underlying asset

put option grants right to sell

Question 21

Whats the difference between european style option & american style option?

Answer 21

european style option can only be exercised at maturity

american style can be exercised anytime before maturity

Question 22

How much loss potential to buyers of calls & puts have?

Answer 22

limited loss potential, only equivalent to premium

Question 23

How much loss potential to sells of calls and puts have?

Answer 23

unlimited loss potential

Question 24

What are 2 types of contingent claims?

Answer 24

1. options
2. credit derivatives

Question 25

What is the payoff and profit formula for long call options?

Answer 25

payoff = maximum of (0, st (value of underlying security at expiration) - x (exercise price))
profit = cT (value at maturity) - c0 (premium paid)

Question 26

What is the payoff and profit formula for long put options?

Answer 26

payoff = maximum of (0, x (exercise price) - sT (value of underlying security at expiration)
profit = pT (value at maturity) - p0 (premium paid)

Question 27

What are credit default swaps?

Answer 27

insurance if a company where to go bankrupt or fail to make payments (aka default)

Question 28

What is a credit spread (CDS spread)?

Answer 28

spread the reflects the probability of issuer defaulting and expected loss if a default occurs