Mid Sem Flashcards
Forwards
OTC agreement between 2 parties: buyer/ sell at future date, with the price agreed upon today (t=0).
Futures
traded on an exchange and settled daily. Protects against default risk.
open and close. position
open = enter contract via broker or online exchange + referred to delivery month
close = enter in opposite trade (if not at expiry cash is settled)
relationship b/w future p and spot p
converge when approaching expiry (if not = arbitrage)
margins
invest cash to broker, minimise default risk
marking to market
balance adjusted to reflect daily settlement
settlement change
diff bw yesterday and today settlement price
regulation
regulation = protect the public interest
regulators = prevent questionable trading practices on the floor os exchange or outside groups
forward vs future
priv contract vs exchange
not stand vs stand
specific date vs range
maturity vs daily
close date on delivery vs before
credit risk vs none
forward at maturity
At maturity (t=T), the long buys the asset at the agreed price.
futures Long position
profit when the underlying asset’s price at maturity exceeds the agreed price. |–/–
futures short position
profit when the underlying asset’s price at maturity is below the agreed price. |–--
open interest stock
total no. of contracts that haven’t been liquidating by an offsetting transaction or physical delivery.
no. long position = no. short postions
open interest change
no. of net new positions
volume (flow)
during a specified period is
no. of purchases = no. of sales
price limits
2/3 of exchange - commodities
based on the volatility of underlying
partial substitute for margins
short hedges
sell asset in future, lock in price, asset owned
spot long : |–/– future short : |–--
long hedges
purchase asset in future , want to lock in price
spot short : |–-- future long : |–/–
should companies hedge?
for:
use futures to minimise risk, focus on the main business
against:
well diversified - own hedging decisions
gain on underlying is difficult
basis risk
imperfect hedge - risky when don’t know date closed out before expiry
cross hedging
asset to be hedged is not same as underlying
use of stock index futures (fund managers perspective)
cheaper way to get out of the market for a short period of time
hedge systematic risk
no. contracts shorted + CAPM
hedge ratio
mvhr = size of future position/size of spot exposure
3 approaches to short/long hedges
- transactions actually occur
- offsetting payoffs assist hedge ratio
- basis risk
basis risk formula
basis(t) = spot price of hedge asset - future of contract
arbitragee
price difference bw markets - risk free profit
investment assets
invest - help for investment purposes –> can price forward + futures off spot via arbitrage
short selling
IMPORTANT!
sell securities you don’t own , broker borrows and sells on spot , you buy back and return
price falls = sell high , buy low
pay dividends
short sale constraint
not needed for the forward price equation, only some people hold asset only for investment purposes
Invest asset: known yield - stock index futures, currentcy futures
q = avg yield over life of contract
consumption assets
not able to pirce forwards+futures off spot via arb
valuation
the value of futures contract is zero - value in margin account
ESG
environmental social governance - less exposed to tail risks
e.g,. EUREX, NASDAQ
future + expected spot prices
F= E –> unbiased estimate of S
F< E –> normal backwardation
F>E –> contango
option types
call - buy
put - sell
euro - only at maturity
American - any time
option positions
long call, long. put, short call , short put –> learn diagrams
moneyness
in money = S>K for call
out money = S< K for call
at. money S=K for call/ put
euro exercise when in money on expiry date.
intrinsic value
max of zero , value of option if exercised immediately.
Max(S-K, 0). call
Max (K-S,0) put
time value
option may in crease in value due to volatility in underlying
factors affecting option prices
look at table
stock p increase : call increase
strike p decrease: call increase
div reduce stock p
increase in risk free rate - decrease PV of K
upper bound
call never worth more than stock
American put never. more. than exercise price
lower bound
c>_ max (S-Ke-rt, 0)
violation. of lower bound = arbitrage profit
put - call parity
price of a call option and a put option with the same strike price and expiration date should have a specific relationship to the price of the underlying asset.
early exercise
American exercise early - exception is American call on non div paying stock
no income sacrificed, delay paying strike , call provide insurance against stock price falling below strike.
the effect of dividends
when paid, optimal to exercise American call prior to ex date
final expiry close to T, div is large, multiple div better to exercise before last
option value
intrinsic + time value
