Midterm #1 Flashcards
What is Trading Volume
The amount of individual product that was traded daily, monthly, etc…
What is Notional Value
(Units in contract x Spot Price)
What is Open Interest
The total number of contracts for which counter parties have a future obligation to perform
3 Groups of Investment
- Equity (stock/shares)
- Debt (bonds/banknotes)
- Derivatives (forwards/futures/options)
How is Market Value determined
Determined by the market value of a firms total assets minus its debt
Properties of Dividends
- not guaranteed
- not always reflective of the profitability of the firm
Dividend Yield
Annual Dividend / Market Value
Bond Price > Par Value
Sell at Premium
Bond Price = Par Value
Sell at Par
Bond Price < Par Value
Sell at Discount
4 Uses for Derivatives
- Risk Management
- Speculation
- Reduce Transaction Costs
- Regulate Arbitrage
Describe derivatives and risk management
Used for companies to reduce risk
- reinsurance companies
- a company doing business in multiple countries to hedge currency risk
Derivatives and Speculation
- buying a call/put
- bet on the price
How can derivatives reduce transaction costs
- instead of buying a commodity with transaction cost and storage fee, you can hold cash and buy future contract
- make money on the fluctuation of gold without owning gold
What is a Market Maker
Typically large banks that are in place to ensure trades are done seamlessly. Without market makers, there would likely be little liquidity. In other words, investors who want to sell securities would be unable to unwind their positions due to a lack of buyers in the market.
What is “offer/ask price”
Cost of purchasing a security from market maker
Must pay HIGH end
What is “bid price”
Price you can get for selling a security to a market maker
Must accept LOW end
Why are there 2 prices for buying and selling
There are 2 prices because the Market Makers need to make money.
Ex.) Ask: 102/104, this means the market maker would pay you $102 for the security then would sell it for $104
Advantages/Disadvantages of Market Orders
+: the trade will be executed as soon as possible
-: could have got better price if you were patient
Advantage/Disadvantage of Limit Orders
+: can obtain a better price
-: possibility that the order is never filled
What is a Stop-Loss Order
- Always a sell
- Creates market order that will sell asset if its price falls below specified price (stop the loss by selling)
What is Short Selling
- Selling an asset that you don’t own
- Borrow asset from someone and sell it immediately then buy assets back at a later date and return to owner
- Short-Sell a stock if you see it is overvalued
(Shon said to short Tesla right before it crashed)
What does “Short Squeezed” mean
Short Squeezed is if the short-seller has difficulty buying back the asset and returning it to the owner
What is “long position”
Long Position = Buying something
What is “short position”
Short Position = Selling something
Haircut
Requiring a haircut means that the size of the position taken by the short seller is limited by the amount of capital they can provide
What is payoff
Cashflow
What is profit
Cashflow - AV(cost of initial investment)
What is Stock Index
Average price of a group of stock
What is payoff for long forward
Spot Price @ expiration - Forward Price
What is payoff for short forward
Forward Price - Spot Price @ expiration
What is a call option
- Non-binding agreement to buy asset in future at a price set today
- At expiration buyer can decide to exercise or stop on the
What do you buy and sell in Arbitrage
Sell expensive, buy cheap
Advantage and Disadvantage to Call Option
+: preserves upside potential while eliminating the the downside for buyer
-: comes at a premium
What is Strike Price
The amount paid by the option buyer if he/she decides to exercise the call option at expiration
What are the 3 exercise options
- European Style: exercise only at expiration
- American Style: exercise any time before expiration
- Bermudan Style: exercise during specified period
Call Option Payoff
Max[0, St - K]
St = Spot Price
K = Strike Price
Call Option Profit
Max[0, St - K] - FV(premium)
Option Writer
The seller who receives the premium but has the obligation to sell at the strike price if the buyer chooses to exercise the option
Written Call Payoff
Max[0, St - K]
Written Call Profit
Max[0, St - K] + FV(premium)
What is a Put Option
- opposite of call option
- seller has the right to sell at strike price but not obligated
- seller can choose to sell at the strike price or choose to keep the asset
Put Option Payoff
Max[0, K - St]
Put Option Profit
Max[0, K - St] - FV(premium)
Call/Put Profitability
Call: more profitable when the asset increases in value
Put: more profitable when the asset decreases in value
In-The-Money Option
Call: Strike < St
Put: Strike > St
Out-The-Money Option
Call: Strike > St
Put: Strike < St
Written Call
obligation to sell asset at strike price if option exercised
Written Put
obligation to buy asset at strike price if option exercised
What does it mean to Hedge an Investment
Hedging is like insurance against something bad happening to minimize loss.
Ex. buying house insurance is like hedging against fires, floods, break-ins
What is Put Call Parity
C(k) - P(k) = PV(F) - PV(k)
or
C(k) - P(k) = So - ke^(-rt)
Call Premium - Put Premium = Stock - Bond
What is Synthetic Forward
This is when you buy a call and sell a put or vice-versa. This in return creates a forward when combined because no matter what you will end up buying an asset at the strike price.
Differences between forward and synthetic forward
- ) Forwards do not have premiums however with Synthetic Forward you must pay the net option premium
- ) Forward contract you pay Forward price, Synthetic Forward you pay the strike price
Synthetic Call
C = P + S - ke^(-rt)
Long Put
Long Stock
Short Bond
Synthetic Put
P = C - S + ke^(-rt)
Long Call
Short Stock
Long Bond
Synthetic Stock
S = C - P + ke^(-rt)
Long Call
Short Put
Long Bond
Synthetic Bond
ke^(-rt) = P + S - C
Long Put
Long Stock
Short Call
What is a Floor
The purchase of a put on a long forward means you’re insuring the long position in an asset. It guarantee’s a minimum sale price.
What is a Cap
The purchase of a call on a short forward is called a cap. This is you insuring the short position. It caps the amount lost.
What is covered writing
writing an option when there is a corresponding long position in the asset
What is naked writing
the writer of the option has no position in the asset
What is covered call writing
This is when you take the long position in an asset and write a call
What is covered put
Achieved by writing a put against a short position on the index. Same as writing a call.
What is a spread
Position consisting of only call and put, some are purchased and some are written
What is Bull Spread
Long Forward with upside limit and downside protection
Buy: C(k1) or P(k1)
Sell: C(k2) or P(k2)
k1 < k2
What is Bear Spread
Short Forward with upside limit and downside protection Buy: C(k1) or P(k1) Sell: C(k2) or P(k2) k1 > k2 **OPPOSITE BULL SPREAD**
What is Box Spread
This is combination of bull spread and bear spread, resulting in a risk free bond
Buy: +C(k) and -C(x)
Sell: +P(x) and -P(k)
HORIZONTAL LINE ON AXIS
What is Ratio Spread
Buy: nC(k1) or nP(k1)
Sell: mC(k2) or mP(k2)
n < m, k1 < k2
AS ‘m’ INCREASES, SLOPE INCREASES
What are Collars
Resembles a short forward contract as the benefit is if the asset price decreases
Buy: P(k1) or C(k1)
Sell: C(k2) or P(k2)
k1 < k2
What is a Collared Stock
This looks like a bull spread and a written collared stock looks like a bear spread
What is a Straddle
This is buying a call and put with same strike and expiration date. Make money off volatility!
- stock rises, profit on call
- stock falls, profit on put
- high premiums
- if stock nears strike price, loss on both ends
- *V-SHAPE**
What is a written straddle
This you are betting on minimal volatility hoping the price doesn’t change much. SELLING STRADDLE
What is a Strangle
Cheaper version of a straddle but still trying to make money off volatility. Buy: P(k1) Sell: C(k2) k1 > k2 **U-SHAPE**
What is a Butterfly Spread
Combination of a short straddle and a long strangle. Used for speculating little volatility hedge a written straddle.
- limits downside loss
