Module 9 Flashcards
what is a derivative?
a financial instrument whose value/return is based on the value of some underlying asset
what is hedging?
- mitigating economic risk by locking the price today (protection from price changes)
- reduces the exposure to a possible loss
what is speculating
- 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
hedgers vs speculators
hedgers deal with the commodity in some way (own it / want to own it). speculators don’t.
exchange markets for derivatives
controlled by the stock exchange (Safex) and has standardized terms
over-the-counter markets for derivatives
informal market and has customized terms
what is a forward contract
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
concern with a forward contract
other party may fail to fulfil their obligation
= counter-party default risk
what is the spot contract
agreement to buy/sell an asset today
what is the spot price
the market price now
what happens on the expiration date?
the contract has to be settled by asset delivery and cash payment
where are spot contracts traded
outside of exchange markets between private individuals, otc markets = not regulated
seller of a forward contract
take a short forward position. is a hedger. risks a price decrease.
buyer of a forward contract
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.
limitations to forward markets
- lack of centralized trading
- illiquid
- counterparty default risk
what is a futures contract?
a legally binding agreement between two parties to buy/sell an asset at a certain price in the future
how is a futures contract different from forward?
- contracts are made with a clearinghouse and not directly between buyer and seller
- they have to pay a goodwill deposit
what is a clearinghouse?
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)
benefits of a clearinghouse
- conditions and terms standardized and public – regulated and more transparent
- reduce counterparty default risk by using margins and daily settlement of accounts (marking)
futures markets examples
SAFEX
COMEX
CME
forwards vs futures contracts
- 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
when do long futures generate profits?
when the spot price increases above F0 which offsets higher purchase value of the asset
when do short futures generate profits?
when the spot price decreases below F0 which offsets lower sales value of the asset
P/L on a long contract
spot price @ maturity (ST) - F0
P/L on a short contract
F0 - ST
what is the initial margin
the initial amount put into a margin account by a trader to establish a futures position
what is the maintenance margin?
minimum amount that a trader must keep in a margin account to maintain a futures position
what is the variation margin?
the extra funds deposited to top up the margin account to initial level
how margin accs work?
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
purpose of margining system?
to reduce the credit risk (the probability of market participants sustaining losses bc of defaults)
what is a call option?
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
positions of call option?
buyer = long seller = short
when will the buyer buy the call option?
when it is profitable to them
Spot price > strike price
buyer vs seller of call option
- pays a premium (max loss) vs receives (max profit)
- worried about price increase vs decrease
payoff on a call option
= spot/share price - strike price
profit/loss on a call option
= payoff - premium
ITM call option
spot price > strike price
OTM call option
spot price < strike price (buyer will not exercise)
ATM call option
spot price = strike price
what is a put option?
gives the holder the right but not obligation to sell the underlying asset for a certain price at a certain date
advantages of a put option
protect the buyer by establishing a minimum price the option buyer will receive when selling the asset = exercise price
buyers vs sellers of a put option
pays a premium (max loss) vs receives (max prof)
what is a swap contract?
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.
ITM put option
spot price < strike price
OTM put option
spot price > strike price
ATM put option
strike price < asset price
reflects if it would be profitable for the buyer to exercise the option
what is an interest rate swap?
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
what is a foreign currency swap?
two firms initially trade one currency for another. subsequently the exchange int pmts (based on foreign int rates) and finally they exchange the currencies.
