options and otc intro

Question 1

Option term

Answer 1

As with futures, 
options are usually short-term 
(usually the maximum term to expiry is 
less than a year 
for a traded option).

Question 2

four basic option positions an investor could hold

Answer 2

1. buying a call option 

2. buying a put option 

3. “writing” (ie selling) a call option 

4. “writing” (ie selling) a put option

Question 3

A call option gives

Answer 3

gives its holder the right, but not the obligation,
to buy a specified asset
on a set date in the future
for a specified price. 


Question 4

A put option gives

Answer 4

its holder the right, but not the obligation,
to sell a specified asset
on a set date in the future
for a specified price. 


Question 5

The exercise price is

Answer 5

the price at which an underlying security 
can be sold to (for a put) or 
purchased from (for a call) 
the writer or issuer of an option (
or option feature on a security). 
Also known as the strike price.

Question 6

The writer of an option is

Answer 6

the seller of that option.

Question 7

To buy either a call or a put option

Answer 7

you pay a small amount of money up front
to the writer of the option.
This money, the option premium,
is non-returnable.

Question 8

if you exercise a call option you

Answer 8

then have to pay the writer the exercise price. 
So 
in total you will have paid 
the option premium 
plus the exercise price 
to buy the asset.

Question 9

If you exercise a put option

Answer 9

the writer pays you 
the exercise price for the specified asset. 
So 
in total you will have received 
the exercise price 
less the premium 
in return for the asset.

Question 10

If you choose not to exercise an option,

Answer 10

there are no further cash flows,
so only the premium
will have changed hands.

Question 11

when options are traded

Answer 11

margin only required from

only one of the parties to an options contract.

Question 12

Writers are required

Answer 12

to pay initial margin, and
will be required to pay variation margin
if the underlying asset price moves against them

up for a call writer,
down for a put writer.

Question 13

most options contracts are

Answer 13

typically closed out
with an opposite transaction,
rather than being exercised.

Question 14

Why aren’t the buyers of options required to deposit margin?

Answer 14

Buyers of options are not obliged to trade,
unlike the sellers of such contracts.
Buyers do not face any loss, beyond that of the initial costs (such as commission) and
thus do not pose any default risk to the clearing house.
As there is no credit risk,
no margin is required to protect the clearing house.

Question 15

Over-the-counter markets consist of

Answer 15

Forwards
Swaps
Some options
Other Structured Products

Question 16

OTC markets are characterised by contracts that are:

Answer 16

individually arranged 
on a non-standardised basis 
over the telephone 
with banks 
rather than 
being traded 
on a recognised exchange.

Question 17

two very important OTC markets:

Answer 17

1. interest rate swaps

2. forward currency contracts

Question 18

many transactions are now

Answer 18

taking place on exchanges or
are migrated to a clearing house (“cleared”)
immediately after the transaction has taken place.

Question 19

Generally, a CCP will require

Answer 19

the parties with obligations under an OTC contract
to deposit margin.,

if a forward or a swap is centrally cleared through a CCP
it becomes more similar in nature
to a standardised contract.

Question 20

Investment banks are able to tailor

Answer 20

a wide variety of derivatives
to suit the needs of corporate clients
and investors.

Question 21

OTC markets generally

Answer 21

less
liquid and
transparent

than markets in exchange-traded derivatives and

counterparty credit risk is greater.

Question 22

OTC derivatives are typically transacted under documentation:

Answer 22

maintained by
the International Swaps and Derivatives Association (ISDA).

ISDA documents often
bespoke,
can contain provisions for collateralisation and other legal terms
that can be used to manage counterparty risk.

Question 23

Tailored derivatives that are available OTC include:

Answer 23

 Bermudian options, which
⁃ are exercisable only on specified days, and 


 Asian options,
⁃ where the payoff is based on the average value of the underlying asset over a period rather than the value at the point it is exercised.

Question 24

What are the main advantages and disadvantages of the OTC market compared to exchange trading?

Answer 24

The main advantage of the OTC market is
⁃ ability to tailor contracts to
⁃ buyer’s precise requirements eg
⁃ with a delivery date which is different
⁃ to that of the similar exchange tradable contract.
⁃

 main disadvantages of the OTC market are: 
	⁃	 non-standard contracts 
	⁃	reduce or eliminate marketability 

	⁃	 high dealing costs 

	⁃	 no quoted market values 

	⁃	 greater credit risk 
	⁃	if you are not dealing with 
	⁃	a clearing house as guarantor. 


Question 25

 What are the two types of risk associated with the use of swaps?

Answer 25

Market risk
is the risk that market conditions will change
so that the present value of the net outgo
under the agreement increases.
market maker will often attempt to
hedge market risk by
entering into an offsetting agreement.

Credit risk
is the risk that the other counterparty
will default on its payments.
will only occur if the swap has a negative value
to the defaulting party
so the risk is not the same as
the risk that the counterparty would default on a loan of comparable maturity.

Question 26

Reason why swap credit risk is not the same as loan credit risk:

Answer 26

“not the same” because:
 credit risk is only a problem when the swap has a positive value to you
(a loan will always have a positive value,
whereas the value of a swap could be positive or negative) 

 even if the swap has a positive value
the problem may be quite small because:
– the principal is not at stake
with an interest rate swap 

– the loss of future interest income will
largely be offset by the fact that you
will no longer need to make the interest outgo payments
if your counterparty defaults; ie
you lose the net present value of the swap,
not the gross value of your payments. 

If the swap is subject to margin payments through a clearing house or Central Clearing Party (CCP), credit risk will be minimal.