OTC Derivatives Flashcards
What is a forward contract?
An agreement to buy or sell an asset at a certain price at a certain time in the future
Effectively an OTC Future
How do Forwards differ from futures?
No standardisation in contracts (more flexibility / bespoke)
No central exchange = more counterparty risk
What is a forward rate agreement?
An agreement to:
- Buy or sell an interest rate fixed today
- But starting in the future
Buyer pays fixed rate
Seller receives fixed rate
Who benefits if rates go up and who benefits if rates go down (with an FRA)
Buyer benefits when rates go up
Seller benefits when rates go down
How are FRAs settled?
Cash settled on settlement date
(don’t exchange a principal amount just pay the difference on settlement)
What is the formula to work out the net settlement amount for an FRA?
What day count convention do the UK use?
ACT / 365
What day count convention does the US and EU use?
Act / 360
What is the formula to calculate a forward FRA rate?
Why are FRAs useful?
As they trade OTC they can be tailor made to suit a hedger’s exposure
In regard to STIR - What is a cap?
(Short term interest rates)
A call on interest rates
Paysout if interest rates rise above the strike price
Cap = Head = High up = good if price goes up
For a CAP, what is the:
1) Need
2) Benefit
1) Protection against rising floating rates
2) Cost of protection is known and limited to fee / premium
In regard to STIR - What is a floor?
(Short term interest rates)
A put on interest rates
Paysout if interest rates fall below strike
If a cap rises above strike price what happens?
The cap seller, will pay the difference between the floating rate and the strike.
If it falls, nothing happens and the cap remains in place for the life of the deal.
When would someone use an interest rate floor?
A lender is offering a floating rate, they wish to protect themselves from the lost interest if rates are to fall
What is a collar?
Combines a cap and a floor
Protection against a rise and institute a floor.
For a floor, what is the:
1) Need
2) Benefit
1) Protection against LIBOR falling below floor level
2) Cost of protection known
What is a contract for difference?
Agreement between two counterparties
Exchange the difference between opening and closing price of an instrument
Cash settled
What are the uses/benefits of CFDs?
1) Allow long / short position without having to own the stock
2) No stamp duty or broker fee
3) Can leverage position (extend gains)
4) No set maturity expiry
5) Stop loss included
6) Cheap easy exposure to foreign markets
What are some of the drawbacks of a CFD?
1) Incurs a daily financing charge
2) Overnight interest incurred
3) Requires a margin of up to 30%
How do CFDs differ from spread bets?
1) No expiry / maturity on a CFD
2) Spread bets are considered gambling and as such no tax is due.
What is a swap?
An OTC derivative contract where one party exchanges a cash flow stream against another.
These payments are known as “legs of the swap”
What is exchanged in an interest rate swap?
A fixed leg against a floating leg
What is the reasoning for entering into an interest rate swap?
Hedge positions.
e.g. a bank receiving a fixed income stream (mortgages) but paying a variable rate on savings.
What is a swaption?
An option to enter into a swap
Allows a firm to manage risk / take advantage of cheaper funding
Wholesale market - not open to the public
What is a currency swap?
Counterparties exchange principal + interest in one currency for another
What are the reasons for entering into a currency swap?
1) Obtain funding in foreign FX cheaper than borrowing directly
2) Hedging transaction risk (on existing foreign loans)
In short: replace unpredictable cash flows (due to fx movements) with predictable flows
What is an equity swap?
Exchange returns on an index with a fixed / floating rate of interest
Creates a synthetic portfolio of shares (no need to buy all underlying)
What is a credit derivative?
Credit derivatives relate to credit events relating to another company.
What is a credit default swap?
Insurance against a credit event in exchange for regular premiums
What are the three main types of credit default swap?
what are they
1) Basic - on a single asset
2) Index - on movements on an index
3) Basket - on a basket of goods
Which CDS carries the highest initial premium?
Basket - as it gains protection against a wider spread of securities
hich
What are index CDSs comparable to?
Total return swaps
What is defined in a CDS contract?
1) Trigger Points
2) Time Limits
3) Payment schedules
OTC - can all be made bespoke
What is a credit spread?
The difference between the yield on an asset and the yield on a reference asset (e.g. a govt bond benchmark)
What are credit spread options used for?
Credit spreads help to hedge against changes in credit spreads,
The buyer would likely already have exposure and is looking to hedge against a wideing of the spread.
What is a CDO? How does it work?
Collateralized Loan Obligation
A bundle of a bundle (e.g. bundle of MBSs)
Split and priced into tranches based on risk (more risk = less price but higher returns)
Senior low risk -> junior higher risk
How is a CDO created?
SPV issue bonds in order to purchase underlying assets
Income pays back investor in tranches
What is a CBO? How does it work?
Collateralized bond obligation
Bundle of junk grade bonds -> combined to make investment grade
Divesification in issuers and rating creates an investment grade security.
What is a synthetic CDO?
A CDO which pays its tranches through the premiums on a CDS.
If CDS defaults - synthetic cdo on the hook for losses - starting from bottom up
