Options, Futures and Other Derivatives Ch3

Question 1

What are the primary differences between options and futures/forwards contracts?

Answer 1

Options provide the right but not the obligation to buy/sell an asset, whereas futures/forwards contracts require the buyer/seller to fulfill the contract.

Question 2

Define a call option.

Answer 2

A call option gives the holder the right, but not the obligation, to buy an asset at a specified price within a specific time frame.

Question 3

Define a put option.

Answer 3

A put option gives the holder the right, but not the obligation, to sell an asset at a specified price within a specific time frame.

Question 4

Explain the concept of intrinsic value in options.

Answer 4

Intrinsic value is the difference between the current price of the underlying asset and the option’s strike price if it’s favorable; otherwise, it’s zero.

Question 5

Define the term “time value” in options.

Answer 5

Time value represents the additional value of an option beyond its intrinsic value, attributed to the potential for future price movements.

Question 6

What factors influence the price of an option?

Answer 6

Underlying asset price, strike price, time to expiration, volatility, risk-free interest rate, and dividends influence an option’s price.

Question 7

Provide the formula for calculating the payoff of a call option at expiration.

Answer 7

Question 8

Provide the formula for calculating the payoff of a put option at expiration.

Answer 8

Question 9

Explain the concept of a covered call option strategy.

Answer 9

A covered call involves holding a long position in an asset while selling call options on that same asset to generate income.

Question 10

Define the concept of a protective put option strategy.

Answer 10

A protective put involves buying a put option to protect against potential losses in the underlying asset’s price.

Question 11

Explain the difference between European and American options.

Answer 11

European options can only be exercised at expiration, while American options can be exercised at any time before expiration.

Question 12

What is the significance of the strike price in options contracts?

Answer 12

The strike price is the price at which the underlying asset can be bought (for call options) or sold (for put options) upon exercise.

Question 13

Explain the impact of time to expiration on option prices.

Answer 13

As time to expiration decreases, the time value of options decreases, leading to potential decreases in option prices.

Question 14

Define implied volatility in options.

Answer 14

Implied volatility is the market’s expectation of the future volatility of the underlying asset, inferred from the option’s price.

Question 15

Explain the concept of the option writer and the option holder.

Answer 15

The option writer (seller) is obligated to fulfill the terms of the contract, while the option holder (buyer) has the right but not the obligation to exercise the option.

Question 16

What are the advantages of using options contracts?

Answer 16

Potential for leverage, risk management, speculation, and flexibility in investment strategies are advantages of using options contracts.

Question 17

What is a forward contract?

Answer 17

A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price on a future date.

Question 18

Differentiate between a forward contract and a futures contract.

Answer 18

Forward contracts are customized, traded over-the-counter, and have counterparty risk, whereas futures contracts are standardized, exchange-traded, and have minimal counterparty risk due to clearinghouses.

Question 19

What is the role of the clearinghouse in futures markets?

Answer 19

Clearinghouses act as intermediaries, ensuring the performance of futures contracts by guaranteeing trades and managing margin requirements.

Question 20

Explain the concept of marking-to-market in futures trading.

Answer 20

Marking-to-market involves adjusting the margin account daily to reflect changes in the market value of the futures contract.

Question 21

Define the term “marginaling” in futures trading.

Answer 21

Marginaling is the process of adjusting margin accounts daily based on price changes in the underlying asset.

Question 22

What is the significance of initial margin in futures trading?

Answer 22

Initial margin is the minimum amount of cash or collateral required to open a futures position, ensuring that traders can meet potential losses.

Question 23

Explain the concept of variation margin in futures trading.

Answer 23

Variation margin is the amount of money transferred between the buyer and seller’s margin accounts daily to cover gains or losses on the futures contract.

Question 24

Define the term “basis risk” in futures contracts.

Answer 24

Basis risk refers to the risk that the relationship between the spot price and the futures price may change, resulting in potential losses for hedgers.

Question 25

What are the primary reasons for using futures contracts?

Answer 25

Hedging against price fluctuations, speculation for potential profits, and arbitrage opportunities across markets.

Question 26

Explain how futures contracts aid in price discovery.

Answer 26

Futures markets provide information on future price expectations, aiding in determining the fair value of assets and commodities.

Question 27

Define the concept of backwardation in futures markets.

Answer 27

Backwardation occurs when the futures price is lower than the spot price, usually due to immediate demand or supply constraints.

Question 28

Explain the concept of contango in futures markets.

Answer 28

Contango occurs when the futures price is higher than the spot price, often observed in markets with ample supply and reduced demand.

Question 29

What are the advantages of using futures contracts over forward contracts?

Answer 29

Standardization, liquidity, reduced counterparty risk, and ease of trading due to exchange-trading are advantages of futures contracts over forwards.

Question 30

What role do speculators play in futures markets?

Answer 30

Speculators provide liquidity, take on risk, and aim to profit from price fluctuations, increasing market efficiency.

Question 31

Define the term “deliverable grade” in futures contracts.

Answer 31

Deliverable grade refers to the quality standards that the underlying asset must meet for physical delivery in a futures contract.

Question 32

Explain the process of convergence in futures markets.

Answer 32

Convergence refers to the gradual approach of futures prices towards the spot price as the contract approaches its expiration.

Question 33

Differentiate between the cost-of-carry model and the cost-of-carrying model in determining futures prices.

Answer 33

The cost-of-carry model assumes carrying costs like storage, dividends, and interest rates remain constant, while the cost-of-carrying model allows these costs to vary over time, offering a more dynamic approach to pricing futures contracts.

Question 34

Explain how arbitrage opportunities arise in futures markets due to the basis.

Answer 34

Basis discrepancies between the futures price and the spot price can lead to temporary arbitrage opportunities when the basis deviates from its historical relationship, allowing traders to exploit the price difference.

Question 35

Provide the formula for calculating the basis in futures contracts and its significance in trading.

Answer 35

The basis (

Basis=Futures Price−Spot Price
It indicates the relationship between futures and spot prices, helping traders assess market trends and potential arbitrage opportunities.

Question 36

Explain the concept of full carrying charge in futures markets and its impact on pricing.

Answer 36

Full carrying charge refers to the total cost incurred when holding a physical asset until the futures contract’s expiration, including storage, financing, and other expenses. It influences futures pricing by considering all costs involved in carrying the asset to delivery.

Question 37

Define the concept of roll return in futures trading and its implications for traders.

Answer 37

Roll return refers to the profit or loss generated when shifting from one futures contract to another as contracts approach expiration. It influences trading strategies and overall portfolio returns in futures markets.

Question 38

Explain how convenience yield impacts futures pricing and trading strategies.

Answer 38

Convenience yield represents the non-monetary benefits of holding a physical asset, influencing futures pricing by reducing futures prices below expected levels due to the benefits derived from immediate access or production flexibility.

Question 39

Describe the role of the term structure of interest rates in futures markets and its impact on trading decisions.

Answer 39

The term structure reflects expectations of future interest rates, influencing pricing and trading of interest rate futures contracts, enabling traders to make informed decisions based on interest rate expectations.

Question 40

Explain the concept of carry trade in futures markets and how traders use it for profit.

Answer 40

A carry trade involves borrowing at a low interest rate to invest in an asset with a higher yield, potentially realized in futures markets by exploiting interest rate differentials for profit.