LM 2: Forward Commitment & Contingent Claim Features & Investments Flashcards
What does zero sum game mean?
gain of one is equal to the loss of another party, combined they equal 0.
What is a forward contract?
agreement to a make a trade at future date
What is the formula for ending value of profit for the long party?
sT - f0 (T)
spot price - forward price
What is the formula for ending value of profit for the short party?
f0 (T) - sT
forward price - spot price
What is spot price?
the current market value of an asset
What is the difference between forward contract and future contract?
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.
What is counterparty risk?
risk that other party will not fulfill their obligation
What is the initial margin?
the initial deposit you must make per contract.
What is maintenance margin?
the lowest amount of value a contract can fall too before you’re required to deposit more.
What is the variance margin?
difference between the maintenance margin and initial margin
aka the amount required to bring an account back up to the initial margin
What is margin call and purpose?
request from exchange to deposit additional funds
purpose to ensure each party can always cover future potential losses
If a party gets a margin call how much money do they need to deposit?
enough to match the initial margin not just the maintenance margin
What is price limit for derivatives?
maximum range that future contract is allowed to move up or down within a single day
What is circuit breakers?
trigger a pause in trading if the price moves out of the price limit
What position do long stock holders take to close position?
short stock position
What is open interest?
number of outstanding contracts
What is a swap?
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
What is marked to market?
method of measuring the fair value of an asset at the end of the day, which allows traders to realize gains or losses.
What are the 3 types of forward commitments?
- OTC forward contracts
- OTC swaps
- exchange traded futures contract
What is the difference between call option and put option?
call option grants right to buy underlying asset
put option grants right to sell
Whats the difference between european style option & american style option?
european style option can only be exercised at maturity
american style can be exercised anytime before maturity
How much loss potential to buyers of calls & puts have?
limited loss potential, only equivalent to premium
How much loss potential to sells of calls and puts have?
unlimited loss potential
What are 2 types of contingent claims?
- options
- credit derivatives
What is the payoff and profit formula for long call options?
payoff = maximum of (0, st (value of underlying security at expiration) - x (exercise price))
profit = cT (value at maturity) - c0 (premium paid)
What is the payoff and profit formula for long put options?
payoff = maximum of (0, x (exercise price) - sT (value of underlying security at expiration)
profit = pT (value at maturity) - p0 (premium paid)
What are credit default swaps?
insurance if a company where to go bankrupt or fail to make payments (aka default)
What is a credit spread (CDS spread)?
spread the reflects the probability of issuer defaulting and expected loss if a default occurs
