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Options and Futures > MT1 > Flashcards

MT1 Flashcards

1
Q

What is a derivative?

A

A contract whose value depends on and changes when the underlying asset value changes.

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2
Q

Types of derivatives:

A

Futures
Forwards
Options
Swaps

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3
Q

What is the difference between forwards and futures contracts?

A

Forward contracts are customizable and are exchanged OTC.
Futures contracts are not customizable and are tradedin organized exchanges.

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4
Q

What are the 4 steps involved in trading financial assets?

A

1) Buy and seller agree on price
2) Obligations of each party are specified (cleared)
3) Trade must be settled (everyone pays their part)
4) Ownership records are updated

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5
Q

What type of derivative is exchange traded and what type of risk is there?

A

Options and Futures
No Credit Risk

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6
Q

What type of derivative is traded OTC and why type of risk is there?

A

Fowards, Swaps, and Exotic Options
Small amount of credit risk

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7
Q

What are the four different measures of a market and its activity?

A

Trading Volume
Market Value
Notional Value
Open Interest

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8
Q

What does trading volume measure? What does a high trading volume represent?

A

Counts the number of financial claims that change hands.
High TV = High Liquidity (for stocks)

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9
Q

What does market value measure?

A

Sum of the market value of the claims that could be traded, without regard to whether they have been traded

MV = # shares outstanding * spot price per share

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10
Q

What does notional value measure?

A

Measure the scales of a position

NV = contract size * asset price per unit

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11
Q

What does open interest measure? What does a high open interest mean?

A

The total number of contracts for which counterparties have a future obligation to perform.
Shows how liquid a derivative is, count to see who hasn’t closed their interest (always count pairs! There should be an equivalent number of open buyers and open sellers)

High OI = High Liquidity (for options)

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12
Q

How are derivatives used?

A

Risk Management (Must be in the equity market to be a hedger)
Speculation
Reduce Transaction Costs
Regulatory Arbitrage

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13
Q

What are the two aspects of the long position?

A

Price goes up, you win
You pay cash in, when you close out, you get cash back; sort of like lending money

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14
Q

What are the two aspects of the short position?

A

Price goes down, you win
You get cash when you take the position, when you close out, you pay cash; it is like borrowing money

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15
Q

How do you establish a short selling position in a stock? How do you close out a short selling position in stocks?

A

1) Find a broker who has the stock to lend to you
2) Borrow the certificates, promising to return them at a later date
3) Sell them immediately
4) Buy the shares back (hopefully at a lower price)
5) Return them to the broker

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16
Q

What is a forward/futures contract?

A

A binding agreement to buy/sell an underlying asset in the future at a price set today.

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17
Q

What are the forward/futures contract specifics?

A

1) Features and quantity of the asset to be delivered
2) Delivery logistics, such as time, date, and place
3) The price the buyer will pay at the time of delivery

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18
Q

What types of expiration dates are there?

A

Monthly, Quarterly, Seasonal

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19
Q

What is a settlement? What are the types of settlements, their perks, and their costs?

A

Fulfillment of the legal delivery obligations associated with the original contract

Cash - less costly and more practical : most common - equity index and interest rate futures
Physical Delivery - often avoided due to significant costs (when illiquid choose this option)

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20
Q

If the market for the underlying asset is liquid with an established price, will you choose cash or physical delivery?

A

Financial results are the same!

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21
Q

What is an options contract?

A

A non-binding agreement to buy/sell an asset in the future, at a price set today.
Preserves the upside potential while eliminating the downside potential (for the buyer)

Seller of an option contract is obligated to deliver if asked

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22
Q

What are the types of options? Describe them.

A

Call - right to buy the underlying asset (long - no obligation, short - obligation)
Put - right to sell the underlying asset (long - no obligation, short - obligation)

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23
Q

What is the strike (exercise) price?

A

Price set for calling/putting asset (K)

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24
Q

What does it mean to exercise?

A

The act of paying/receiving the strike price to buy/sell the underlying asset by which the option must be exercised or become worthless.

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25
Q

When are American options equal to European options?

A

When there is a call on non-dividend paying stock because it will never be optimal to call it early.

26
Q

What are the benefits of an options contract?

A

Hedging
Speculation
Requires smaller investment than buying underlying security outright
Provides leverage
Zero-Sum Game

27
Q

What is the put seller (short put) obligated to do?

A

Obligated to buy underlying asset at a specified price

28
Q

What is the put buyer (long put) able to do?

A

Has the right to sell the asset at a specific price

29
Q

What are the basic insurance strategies for options?

A

Used to insure long positions (floors)
Used to insure short positions (caps)
Written against asset positions (selling insurance)

30
Q

What is covered writing?

A

Writing an option when there is a corresponding long/short position in the underlying asset (you take a position in the opposite of what the asset you have is)

31
Q

What is naked writing?

A

Writing an option when the writer does not have a position in the underlying asset

32
Q

When do you use a protective put vs a protective call? What makes up each of these?

A

A protective put is used when you are afraid of downside risk (long put, long stock)
A protective call is used when you are afraid of upside risk (long call, short stock)

33
Q

What is the difference between covered and protected?

A

Protective is from the buyer side, covered is from the seller side (so covered is the opposite of protective)

34
Q

What is a synthetic forward?

A

Buying a call and selling a put on the same underlying asset, with each option having the same strike price and time to expiration

35
Q

What is the difference between a synthetic long forward contract and an actual forward?

A

Forward has zero premium
Forward you pay the forward price, synthetic forward you pay the strike price

36
Q

What is Put-Call Parity?

A

The net cost of buying the index using options must equal the net cost of buying the index using a forward contract?

37
Q

When L<R in PC Parity…

A

S is overvalued, so you will short the stock and close the position by creating a synthetic long. R - L = arbitrage profit.

38
Q

What do the left and right sides of the PC Parity equation represent?

A

Left Side = Synthetic Forward
Right Side = Forward

39
Q

What is an option spread? What are the types of spreads?

A

Position consisting of only calls or only puts
Ex. Bull (expect prices to increase) and Bear (expect prices to decrease) Spread

40
Q

What is a collar? What is a type of collar?

A

The purchase of a put option and the sale of a call option with a higher strike price, both having the same underlying asset and expiration date. A bet that the underlying asset will decrease in price.
Ex. Zero-Cost Collar

41
Q

What is a bull spread made of?

A

Buy a call and sell an identical call with a higher strike price.
Can also be made with puts (same position with puts as calls).

Long Call (lower strike price)
Short Call (higher strike price)

Looks like:
_
_ /

42
Q

What is a bear spread made of?

A

Sell a call and buy an otherwise identical call with a higher strike price.
Can also be made using puts. (Opposite of bull)

Long Call (higher strike price)
Short Call (lower strike price)

Looks like:
_
_

43
Q

What is a collar made of?

A

Purchase of a put option and the sale of a call option with a higher strike price
Zero-Cost Collar - premiums of call and put offset each other

Long Put (lower strike price)
Short Call (higher strike price)

_
\

44
Q

How do you speculate on volatility?

A

Straddles, Strangles, and Butterflies

45
Q

What is a straddle, how is it constructed, and what does it bet the volatility will be?

A

Buying a call and a put with the same strike price and time to expiration

** ALWAYS ATM STRIKE PRICES **

Long Straddle (high volatility):
Long Put
Long Call

Short Straddle (low volatility):
Short Put
Short Call

46
Q

What is a strangle, how is it constructed, and what does it bet the volatility will be?

A

The same as a straddle, just with the options having different strike prices.

Strangles are flat, straddles are pointy

** ONE OR BOTH OTM **

47
Q

What is a butterfly, how is it constructed, and what does it bet the volatility will be?

A

Insured, short straddle position (same position with puts)

Long Butterfly (Low volatility):
Lambda Long Call (lowest K)
1 Short Call (medium K)
1-Lambda Long Call (highest K)

Middle strike price is always the highest profit

48
Q

What is the producer’s perspective when it comes to risk management? What are their strategies?

A

Selling a risky commodity, so they have an inherent long position

Strategies:
Short Forward
Long Put
Short Call
Long Collar

49
Q

What is the buyer’s perspective when it comes to risk management? What are their strategies?

A

Buying a risky commodity, so they have an inherent short position

Strategies:
Long Forward
Short Put
Long Call
Short Collar

50
Q

What is cross hedging?

A

Hedging when the asset you want is slightly different from the asset in the market. Example: Want jet fuel, so we take out a heating oil contract instead

51
Q

What is a hedge ratio?

A

The ratio of the size of the position take in the futures contract to the size of the exposure.

Using a hedge ratio of 1 is not always optimal. The hedger should choose a value for the hedge ratio that minimizes the variance in the hedged position?

52
Q

What is delta S?

A

Change in spot price

53
Q

What is delta F?

A

Change in futures price

54
Q

What is sigma s?

A

Standard deviation of delta S

55
Q

What is sigma f?

A

Standard deviation of delta F

56
Q

What is rho?

A

Coefficient of correlation between delta s and delta f

Want this to be close to 1

57
Q

What is h*?

A

Hedge ratio, that minimizes the variance of the hedger’s position

58
Q

What is Na?

A

Size of the position hedged

59
Q

What is Qf?

A

Size of one futures contract or collar or put etc.

60
Q

What is N*?

A

Optimal number of futures contracts for hedging

Options and Futures (2 decks)

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