Module 9

Question 1

what is a derivative?

Answer 1

a financial instrument whose value/return is based on the value of some underlying asset

Question 2

what is hedging?

Answer 2

• mitigating economic risk by locking the price today (protection from price changes)
• reduces the exposure to a possible loss

Question 3

what is speculating

Answer 3

• betting on future price movements
• not worried about the risk bc you take additional risk in expectation of a gain
• no interest in dealing with the commodity, use derivatives to profit from future spot price movements

Question 4

hedgers vs speculators

Answer 4

hedgers deal with the commodity in some way (own it / want to own it). speculators don’t.

Question 5

exchange markets for derivatives

Answer 5

controlled by the stock exchange (Safex) and has standardized terms

Question 6

over-the-counter markets for derivatives

Answer 6

informal market and has customized terms

Question 7

what is a forward contract

Answer 7

an agreement between two parties to buy and sell an asset to be delivered at a future date for a price agreed upon today (F0)
eg.) spot contract

Question 8

concern with a forward contract

Answer 8

other party may fail to fulfil their obligation

= counter-party default risk

Question 9

what is the spot contract

Answer 9

agreement to buy/sell an asset today

Question 10

what is the spot price

Answer 10

the market price now

Question 11

what happens on the expiration date?

Answer 11

the contract has to be settled by asset delivery and cash payment

Question 12

where are spot contracts traded

Answer 12

outside of exchange markets between private individuals, otc markets = not regulated

Question 13

seller of a forward contract

Answer 13

take a short forward position. is a hedger. risks a price decrease.

Question 14

buyer of a forward contract

Answer 14

takes a long forward position. require the assets for certain purposes. commit to buying the underlying asset at a future date. risk an increase in forward price.

Question 15

limitations to forward markets

Answer 15

• lack of centralized trading
• illiquid
• counterparty default risk

Question 16

what is a futures contract?

Answer 16

a legally binding agreement between two parties to buy/sell an asset at a certain price in the future

Question 17

how is a futures contract different from forward?

Answer 17

• contracts are made with a clearinghouse and not directly between buyer and seller
• they have to pay a goodwill deposit

Question 18

what is a clearinghouse?

Answer 18

a financial institution formed to facilitate the exchange of payments, securities or derivatives transaction. Oversees delivery and there is cash settlement on a daily basis (marking to market)

Question 19

benefits of a clearinghouse

Answer 19

• conditions and terms standardized and public – regulated and more transparent
• reduce counterparty default risk by using margins and daily settlement of accounts (marking)

Question 20

futures markets examples

Answer 20

SAFEX
COMEX
CME

Question 21

forwards vs futures contracts

Answer 21

• large trades not comm vs trades are immediately known to other market participants
• one delivery date vs a range
• no cash paid till expiry vs cash into/out of margin accounts daily

Question 22

when do long futures generate profits?

Answer 22

when the spot price increases above F0 which offsets higher purchase value of the asset

Question 23

when do short futures generate profits?

Answer 23

when the spot price decreases below F0 which offsets lower sales value of the asset

Question 24

P/L on a long contract

Answer 24

spot price @ maturity (ST) - F0

Question 25

P/L on a short contract

Answer 25

F0 - ST

Question 26

what is the initial margin

Answer 26

the initial amount put into a margin account by a trader to establish a futures position

Question 27

what is the maintenance margin?

Answer 27

minimum amount that a trader must keep in a margin account to maintain a futures position

Question 28

what is the variation margin?

Answer 28

the extra funds deposited to top up the margin account to initial level

Question 29

how margin accs work?

Answer 29

marked to market daily for daily net gains or losses realized. at the end of the day the b/s’s account is inc/dec by the loss amount

Question 30

purpose of margining system?

Answer 30

to reduce the credit risk (the probability of market participants sustaining losses bc of defaults)

Question 31

what is a call option?

Answer 31

gives the holder the right (not obligation) to buy the underlying asset by a certain date for a predetermined price (strike/exercise price) until it expires

Question 32

positions of call option?

Answer 32

buyer = long
seller = short

Question 33

when will the buyer buy the call option?

Answer 33

when it is profitable to them

Spot price > strike price

Question 34

buyer vs seller of call option

Answer 34

• pays a premium (max loss) vs receives (max profit)

- worried about price increase vs decrease

Question 35

payoff on a call option

Answer 35

= spot/share price - strike price

Question 36

profit/loss on a call option

Answer 36

= payoff - premium

Question 37

ITM call option

Answer 37

spot price > strike price

Question 38

OTM call option

Answer 38

spot price < strike price (buyer will not exercise)

Question 39

ATM call option

Answer 39

spot price = strike price

Question 40

what is a put option?

Answer 40

gives the holder the right but not obligation to sell the underlying asset for a certain price at a certain date

Question 41

advantages of a put option

Answer 41

protect the buyer by establishing a minimum price the option buyer will receive when selling the asset = exercise price

Question 42

buyers vs sellers of a put option

Answer 42

pays a premium (max loss) vs receives (max prof)

Question 43

what is a swap contract?

Answer 43

arrangements in which one party trades something with one another. they are exposed to different risks and by swapping the CF they are able to hedge their positions.

Question 44

ITM put option

Answer 44

spot price < strike price

Question 45

OTM put option

Answer 45

spot price > strike price

Question 46

ATM put option

Answer 46

strike price < asset price

reflects if it would be profitable for the buyer to exercise the option

Question 47

what is an interest rate swap?

Answer 47

an agreement between two parties to exchange periodic int rate pmts over some future period based on an agreed upon principal amount (notional principal). allows parties to alter the stream of pmts it makes/receives

Question 48

what is a foreign currency swap?

Answer 48

two firms initially trade one currency for another. subsequently the exchange int pmts (based on foreign int rates) and finally they exchange the currencies.